Coinbase Stock: Beware The Massive Risks (NASDAQ:COIN)

Coinbase Global (NASDAQ:COIN) stock took a dip last week when Bitcoin (BTC-USD) prices crashed along with the FTX crypto exchange. An exchange itself, Coinbase shares similarities with FTX, making it a natural target for contagion worries.

Coinbase, like FTX, is subject to minimal regulations when compared to conventional financial services companies. Regulations like required capital ratios are required to prevent banks from failing, but they do not apply to crypto exchanges. Coinbase, as a listed stock, is subject to SEC requirements like reporting its financial position and disclosing corporate/manager holdings, but it is not subject to the Basel III capital adequacy rules which govern conventional banks. In other words, it isn’t required by law or treaty to hold certain amounts of cash, to weight its assets by risk, and all of the other things that are commonplace in non-crypto finance. Given this, you can’t fault investors for pulling out of COIN when FTX went under. The two exchanges are subject to the same risk factors.

The FTX situation has been summarized on Seeking Alpha many times before. In case you missed it, the basic rundown is: FTX was an exchange that let people buy and sell cryptocurrencies. It transferred $10 billion to its investment arm, Alameda Capital. Alameda held a lot of FTT (FTT-USD), FTX’s own token. Alameda’s balance sheet leaked, revealing that it would become insolvent if FTT declined sufficiently. Upon hearing news of the solvency issue, Changpeng “CZ” Zhao, the CEO of Binance, publicly announced he would sell all of his FTT. That resulted in more people trying to sell their FTT, and remove their cash balances from FTX. But because $10 billion had been transferred to Alameda, which lost the money, the withdrawals could not be processed. Shortly afterward, FTX filed for bankruptcy.

At this point, the FTX situation is in the past. The company is finding assets in its bankruptcy proceedings, so some users may be partially compensated, but it’s unlikely that all will be made whole.

Coinbase is another matter entirely. The company’s stock has been selling off on the perceived risk of FTX contagion, but the exact nature of Coinbase’s exposure to FTX is unclear. Brian Armstrong, the company’s CEO, has said that Coinbase has no exposure at all, but the exchange still has a ‘buy FTT’ button on its website.

At any rate, direct exposure isn’t required for a contagion effect to kick in. “Financial contagion” refers to the tendency of weakness in a small part of a system to affect the whole-you don’t need a direct connection to the source to be affected by it. If FTX’s collapse causes people to leave the cryptocurrency space altogether, then Coinbase will likely see an increase in withdrawals, and lower trading volume after the dust settles. That will take a bite out of its earnings; therefore, it is a risk factor for COIN shareholders.

Furthermore, Coinbase is exposed to two separate types of regulatory risk. It is at risk of increased regulations, which many think are coming, as they will increase compliance costs. It is also at risk of inadequate regulations, in that it’s not required to keep certain amounts of cash like banks are.

A March article in Australia’s Financial Review stated that a senate committee explored capital adequacy rules for crypto exchanges, which implies they weren’t governed by them at the time of publication (earlier this year). Furthermore, Financial Review posted no follow-up to the story, which it likely would have had the rules passed. Extensive searching by the author found no evidence of regulators in other countries even considering capital adequacy rules for crypto exchanges, but did find evidence of capital adequacy rules for broker-dealers and custodians. In other words, banks, brokers, and custodians are all operating under capital adequacy rules to one extent or another, only crypto exchanges are exempt!

COIN’s balance sheet reveals the kinds of things one might expect of a company un-bound by capital adequacy rules. As of November 2022 Coinbase lists USDC Coin as part of its ‘cash and equivalents‘ in its balance sheet, which suggests that its capital position may be shaky. Treating crypto as cash is exactly what got FTX into trouble; the $10 billion transfer to Alameda wouldn’t have been a problem had FTT held its value. Now, in Coinbase’s case, the real cash vastly outstrips the stablecoin “cash”; USDC is only 6.5% of COIN’s cash balance. But in principle, the risk is there. Earlier this year, the world witnessed the stablecoin LUNA (LUNC-USD) lose its peg to the dollar, demonstrating that stablecoins aren’t always as stable as they purport to be. Coinbase is similar to other crypto companies in that it counts crypto among its assets, which can lead to liquidity issues if various ‘coins’ lose their value.

My Thesis Defined

My investment thesis on Coinbase is quite simple:

The stock is too risky to own. For investors with typical risk tolerance and time horizons, it entails too great a probability of permanently losing capital. Coinbase’s recent 10-Q says it holds $95 billion in crypto assets for customers, yet it only has about $5.5 billion in cash and equivalents.

Would this company be able to process all of its customers’ withdrawals were they to suddenly head for the exits and demand conversion of Bitcoin to cash? It’s hard to say. What we know is that Coinbase is now liable for any losses customers incur as per SEC guidelines. According to Seeking Alpha Contributor Frances Coppola, the SEC recently decided to force crypto exchanges to count customer assets as their own. As a result, exchanges like COIN are liable should customer assets go missing, so if Coinbase has an FTX moment, shareholders stand to lose it all. The risk of Coinbase declining further is substantial; therefore, a person identical to me in risk tolerance and time horizon, who invests based on the ‘margin of safety’ principle, should sell it.

By this, I do not mean to say that anybody should short COIN, or speculate on its short-term price swings. By ‘sell,’ I mean: if you have exposure, you’d be better off reducing it-assuming that you are identical to me in every way. For me, if an asset is subject to immense risks, it’s not a buy. I’ll admit there’s a non-zero chance of cryptocurrencies rallying and causing COIN to rally alongside them, but for me, the risks (including the regulatory factors discussed above along with quantitative factors I’ll explore below) make the risk/reward tradeoff not worth it. A highly risk-seeking individual might have legitimate reasons for disagreeing. If you don’t factor risk into your decision process at all, viewing each investment in terms of the ‘best case scenario,’ COIN could be worth it.

Next Quarter Likely to be Weak

I’m pretty skeptical of COIN as a long-term bet, but I’m even more skeptical of its upcoming quarterly release. Cointelegraph recently reported that crypto trading volumes fell 24% in the Month of October. The article framed the low volume as a positive (“not that many people are selling OR buying,”) and perhaps it is bullish for crypto as a whole.

Nevertheless, the low volume is bearish for Coinbase. If Cointelegraph is right that crypto volumes declined 24% in October, then COIN’s revenue is likely to be soft for the whole fourth quarter. The FTX collapse might have triggered a sudden spike in trading, but COIN’s fees are a function of transaction size as well as volume. So, a panic-induced trading spike might not even increase COIN’s revenue.

Indeed, Coinbase’s revenue growth has been negative for some time now. According to Seeking Alpha Quant, the company’s trailing 12-month (“TTM”) growth rates were:

• -14.9% in revenue.

• -97% in EBITDA.

• -5.6% in book value.

Not a pretty picture. And if you look at COIN’s most recent 10-Q, you’ll see that it covered the period ending September 30. The company shrank, and the FTX fiasco plus the October volume decline hadn’t even occurred yet! The upcoming release will include the impacts of these events, so it could miss by a wide margin.

Valuation

All of the above has bearing on COIN’s valuation. One of the points Coinbase bulls tout about the company is the fact that it’s “cheap.” Indeed, by the standards of recently listed tech stocks, it appears to be that way. At today’s prices, it trades at:

• 1.98 times sales.

• 1.8 times book value.

• A 1.79 EV/sales ratio.

These metrics aren’t too bad. The problem is that Coinbase’s revenues and earnings are shrinking. When revenue and earnings are trending downward, trailing multiples mean nothing, because they don’t reflect the likely future outcome. Seeking Alpha quant already has a 3.25 forward price/book estimate on Coinbase, and that could go higher if cryptocurrencies fall further on lower volume (assuming the stock price doesn’t fall more).

Shorting is Risky

As I explained earlier, Coinbase is-for me personally-a stock to avoid. If I had any I’d sell it. It’s for this reason that you see a ‘sell’ rating next to this article. I do not have that rating there to encourage anybody to short Coinbase, for reasons I’ll explain below.

One problem with betting on a stock like COIN is the fact that so many variables that go into its valuation are unknowable. Its financial performance is basically a function of crypto prices and trading volume. But as I wrote in my recent article “Bitcoin is Basically a Coin Flip,” you can’t value cryptocurrencies using any conventional valuation techniques. Crypto doesn’t produce cash flows that you can discount back to the present. The closest thing to fundamentals it has-real world transactional use-is impossible to know. A blockchain doesn’t record whether a crypto is being exchanged for cash or a product, it just tells you when a token exchanges hands. So, we can’t accurately measure the “Bitcoin economy” that would have to exist for BTC to be other than a bubble. We know it exists, based on stores accepting Bitcoin, but its size is impossible to gauge. Therefore, cryptocurrencies-COIN’s bread and butter-can’t be valued

The Bottom Line

The bottom line on Coinbase is that it’s one of the riskiest stocks out there right now. Interest rates are rising, crypto exchanges are going bust, stablecoins are losing their dollar pegs, and nobody knows when it will end. Given its utility to people who have drawn the ire of the government, crypto will likely retain some positive value for the foreseeable future. But the exchanges it trades on rarely prove to be good investments. Whether you’re a bull, a bear, or something in between, you can find better opportunities than Coinbase.