Last Week Another week, another new all-time high for stocks. Equities plunged at the beginning of the week. The S&P 500 dropped 1.6% on Monday as risk assets reacted to the very real risk of the COVI...
Last Wednesday, cryptocurrency exchange creator Coinbase launched its highly anticipated direct stock offering (as opposed to a traditional initial public offering) to great success and excitement. As cryptocurrencies like Bitcoin and Ethereum become increasingly accepted by major institutional investors and custodians (like the Bank of New York), the public offering of the main gateway for fiat currency (USD, EUR, JPY, as examples) was a big deal and a smashing success. However, when one looks at the valuation, over $90 billion on a fully diluted basis, we think that the stock, COIN, is following a troubling trend.
Using the valuation of relatively new electric vehicle makers like Tesla and cannabis companies, such as Grow Generation and Tilray, investors seem to be making two assumptions:
- The underlying new markets will mature and be fully up and running in the very near future.
- The companies in question will dominate their market with no consideration given to major existing players, or new players grabbing significant market share.
For instance, in the excitement over electric vehicles eventually taking over traditional combustion engine, driven vehicles, investors seem to be greatly discounting the fact that the infrastructure needed to support a vast electric vehicle market does not yet exist. Moreover, the valuations seem to be discounting the fact that gigantic traditional vehicle makers such as Ford, GM, BMW, VW, and Toyota are pivoting to electric vehicles and will garner significant market share.
With regard to the hot cannabis market, there is the question of how long will it take for the United States to legalize cannabis consumption on the federal level, and then how long will it take to implement the strong regulatory framework that will undoubtedly need to be created? Without federal legalization, there is the problem that the banking system is currently not allowed to handle cannabis company money. It is very hard for an industry to flourish when it is not supported by the banking system and instead remains a total cash business. Moreover, without federal approval, interstate commerce is restricted.
Currently, neither the White House nor many in Congress have legalizing cannabis at the top of their priority list, and even if they did, there is strong opposition from many in Congress. Therefore, federal legalization could be years away, and a working regulatory and banking framework could be many years away. Finally, when the day of federal legalization comes, there seems to be little attention paid to the interests of the very large tobacco and spirits companies. Surely, these mature companies will get involved (some already have) and provide stiff competition to the current cannabis bell-weather stocks.
This all brings us to the big Coinbase public offering, which is indeed a huge and exciting development in the rapidly growing crypto world. As large institutional money comes to accept the digital currencies as a store of value and a tradeable asset, Coinbase—the main gateway for fiat currencies to gain access to cryptocurrencies—ha over 56 million account holders in over 100 countries as of March 31, 2021. However, like our examples above in electric vehicles and cannabis, the valuation of Coinbase seems not to be factoring in a few very big items.
The first thing that sticks out is Coinbase’s fully diluted market capitalization of over $90 billion. When we compare this valuation to an exchange industry leader such as Intercontinental Exchange (ICE), Coinbase is currently about 30% higher. Considering that ICE owns 12 exchanges, including the New York Stock Exchange (NYSE), multiple security clearing operations, a very lucrative financial benchmark and data franchise, and pays a dividend, a 30% premium for Coinbase seems a little much.
Coinbase became profitable in 2020 for the first time, led by the last quarter of 2020 when cryptocurrencies began their latest moon-shot. In the first quarter of 2021, with crypto still on fire, Coinbase generated $1.8 billion in revenue and $700 billion in net income. ICE currently has a Price to Earnings ratio (P/E) of 30. If we annualize Coinbase’s first-quarter net income, that would put them at a P/E ratio of 30 as well.
However, that assumes that the move in crypto continues, account holders on Coinbase’s exchange continue to grow sharply, and they can charge the same price in trading fees of 1.5%, which are by far the highest in the industry. Competition in the crypto exchange will certainly compress the Coinbase margins and competition will most definitely coming from companies like ICE.
Additionally, Coinbase has gotten away with their 1.5% charge for trading on the exchange not only because they developed such a firm foothold as the gateway to crypto from fiat currencies, but also because Bitcoin and Ethereum have appreciated so sharply that relatively high fees of 1.5% have been overlooked. If the cryptocurrencies on the exchange flatten out or depreciate for a quarter or two, that 1.5% will stick out quite a bit. Just for reference, the NYSE charges a trading fee of 0.2%.
Coinbase also has a regulatory dilemma. Currently, Coinbase is not only an exchange but is also a broker and custodian. Coinbase very intelligently focused on the regulatory framework as they grew. This focus on a regulated, centralized exchange is a big reason why Coinbase is in such an advantageous position compared to their current crypto exchange competitors.
However, as Coinbase becomes a fully-regulated exchange, it's possible they would have to break up and sell off their brokerage and custodial businesses as having the operator of an exchange buy, sell, and custody the tradeable product is a compliance disaster waiting to happen. Current equity exchanges strictly forbid this type of combination. While exchange trading fees make up a significant majority of Coinbase earnings, the potential loss of revenue from brokerage and custodial services is a negative. Additionally, it is unlikely that retail customers will be allowed to stay on the exchange as they do now. That will also be a hit to revenue.
There is also the almost-guaranteed threat of serious competition. As stated earlier, a company like ICE, which is extremely well capitalized and possesses a great degree of political clout, can get involved. One of the current competing exchanges, Gemini—started by the Winklevoss twins of Facebook infamy—has very strong ties to Wall Street and will compete either on their own or (most likely) with significant additional financial backing.
Finally, there are decentralized exchanges, which are actually more in line with the whole crypto philosophy. Eventually, just like in equities where things like “dark pools” and negotiated block trades have taken significant revenues from centralized exchanges like the NYSE, these decentralized exchanges will pose a challenge to Coinbase’s centralized exchange. Pathfinding stocks like Coinbase, carrying a huge piece of a major financial market disrupter, cryptocurrency has a bright future. However, just like the new leaders in electric vehicles and cannabis, that future might be somewhat less rosy and further away than the market currently thinks.
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