Coinbase: Fortune Favors The Brave (COIN)

Fortune favors the brave.

That quote is actually from Matt Damon from his widely-despised Crypto.com (CRO) commercial from late 2021. Crypto.com is not Coinbase (NASDAQ:COIN) but the sentiment still applies. Though at that time it was consumers who were “brave” when plowing fiat into Shiba Inu (SHIB-USD) and other dog-themed joke coins. Now it’s all about Bonk (BONK-USD), the new dog money that everyone seems excited about. We know how the Bonk story will likely end. This time though it’s seemingly investors in the very business of crypto who need to be brave as buying COIN today would be buying shares of a company that looks like a sinking ship. With so many obvious scam crypto coins and currencies, the rational question is what kind of regulatory wrath awaits this industry?

Regulatory Game Theory

Let’s start with a simple question; can the U.S. government ban the use of crypto? The answer I have come to for years is probably not in a way that is actually enforceable. Crypto can very easily be criminalized but laws don’t ultimately stop people from becoming criminals when they want to break the rules. Look no further than the recent FTX disaster (FTT-USD) or any financial fraud throughout history. Companies like Coinbase may ultimately survive crypto winter if it is in the interest of the US federal government that they do.

The alternative is all crypto trading activity moves on-chain where, despite the transparent nature of a public ledger, it will likely be harder for the IRS to associate gains directly with Social Security numbers. Ultimately tax revenue is what matters and that is what is likely the real motivation behind the recently proposed Digital Asset Anti-Money Laundering Act. It is interesting that after the failure of a centralized crypto custodian marketed as the “trusted” exchange, rather than guidelines for greater proof of reserves transparency from custodians, the push from some in the government has instead been to make it more onerous for self-custody wallets to do business. From CoinDesk:

If it becomes law, the Digital Asset Anti-Money Laundering Act will bring know-your-customer (KYC) rules to crypto participants such as wallet providers and miners

KYC rules for wallet providers would essentially make any self-custodial wallet application that doesn’t collect personal identification information like physical addresses and driver’s license data not compliant with the law. From where I sit, this would mean that self-custody applications like Trust Wallet (TWT-USD) would have to start collecting and reporting user data with the federal government. It is highly unlikely that any or most of these applications would be able to do such a thing. Many of them are built with open-source software and are maintained by volunteers.

To be clear, I’m not saying the Digital Asset Anti-Money Laundering Act is likely to pass or that it should pass. But if it does pass, it’s probably good news for centralized exchanges. Since there are numerous regulatory concerns about Binance (BNB-USD), I think the biggest beneficiary of more crypto-centric regulation would ultimately be Coinbase. However, predicting what Washington will do is difficult and not the main reason why COIN looks interesting today.

Short Squeeze Setup

The level of shorting that has taken place in Coinbase has been substantial. According to the last short interest report, COIN has 38.5 million shares short – essentially 17% of the shares outstanding and 21% of the float.

Short sellers have done incredibly well with Coinbase since $400 – it’s truly been a remarkable trade. But I have to wonder if the trade has become too one-sided at this point. Looking at the iBorrowDesk data shows a stock that is very expensive to borrow currently with not many shares available left to sell:

And this has actually been the case for a long time. COIN’s shares available to short haven’t touched pre-LUNA (LUNC-USD) collapse highs. Not only that, but the borrow rate has been extremely elevated as well. There is serious squeeze potential in this name right now in my view. In my experience, short interest ratios this high are generally for dying retail chains and companies that are clearly going bankrupt. I can’t get there on Coinbase because the balance sheet doesn’t yet reflect a company knocking on death’s door.

Balance Sheet and Valuation

We have to caveat these metrics because they are the latest numbers we have and they pre-date the FTX collapse. The assets held for customers are likely much lower than they were at the end of Q3 but according to the last filing those were liabilities that were over-collateralized.

Click to enlarge

Source: Seeking Alpha, figures in millions of U.S. dollars

The company’s liquid assets exceed the long-term liabilities with over $5 billion in cash and just $3.4 billion in long-term liabilities. With a current share price now well below $40, Coinbase actually isn’t that expensive from a valuation standpoint based on a traditional P/S ratio. At 1.46, COIN is still near its all time low price to sales ratio of 1.41.

This prices COIN well below the sector median price to sales ratio of 2.84 trailing twelve months. On a forward looking basis, the discount isn’t quite as steep with COIN trading at a P/S ratio of 2.4 vs a sector median of 2.73. Where COIN is still overvalued is with trailing price to book (1.35) and trailing EV to EBITDA (62.53) – each of which are premiums over sector median with EV/EBITDA being the most egregious multiple premium at 411%. This gets us to risks.

Risks

There are many. The most obvious one is that cryptocurrency as an idea could simply be out of gas. I don’t personally take that view as we’ve seen these kinds of deep drawdown cycles in Bitcoin (BTC-USD) and in the broader crypto market before. But if crypto is indeed dead in the eyes of the masses and adoption has peaked, then Coinbase is almost certainly in serious trouble as a business and will likely fail to ever deliver positive earnings again. That seems to be the most likely outcome according to the Street:

The market clearly has doubts about Coinbase’s ability to pay its debt obligations. The company’s corporate bonds are trading at a very large discount to par and currently offer a yield near 17%. This is with common shares that are down 92% from their peak. Like the crypto market broadly speaking, sentiment in Coinbase is awful. Coinbase may have a nice hoard of cash but if the crypto market doesn’t turn around in the next 12-24 months, the company could theoretically burn through that cash well before Coinbase has finished paying its debt based on the negative net income figures we’ve seen in recent quarters.

Summary

This is a very contrarian trade for me. I’m a proponent of cryptocurrency but my area of focus is more in the native assets and the miners. I am very much in the camp that people should self-custody their assets. As a centralized exchange, Coinbase is not a company that I have a history of going long and it’s not something I’ve advocated purchasing frequently in BlockChain Reaction. However, it is a platform that I use as a consumer and one that I will continue to use when I buy digital assets before taking custody.

I believe COIN is priced as if crypto won’t recover and I simply don’t think that’s going to happen. Short of the opinion that crypto is all going to zero, I don’t see a great reason to sell Coinbase at these levels. I can’t say I love it as a long-term investment, but as a shorter-term trade I believe fortune favors the bulls here with Coinbase. The fundamental thesis could ultimately favor Coinbase bulls as well if the U.S. government succeeds in making self-custody as difficult as possible – which is something that it seems to be attempting based on what is in the Digital Asset Anti-Money Laundering Act. AML/KYC regulations of the DeFi space is theoretically a tailwind for Coinbase. How that plays out remains to be seen.