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Weekend Thoughts: Coinbase $COIN
I mentioned a few weeks ago that, if you’ve talked to me recently, it’s near invariable that I’ve brought up banks in some way, shape or form to you.
There’s one other topic that has been top of mind recently, and that’s been Coinbase. To put it simply, I’m perplexed how COIN can trade with a ~$12B market cap when the business faces enough headwind I think it would be fair to call it a hurricane and they are in the opening stages of an SEC suit that could zero the company.
I’ve read the SEC complaint against Coinbase. I’m not a lawyer (nor am I a financial advisor; never forget to read the legal and disclaimer on the blog. I’ll disclose here I have a very small short in COIN, and shorting carries an extreme extra level of risk, so definitely consider all of that!), but the SEC’s case seems pretty serious to me. I’m still in the process of talking to people much more knowledgeable than me (read: securities lawyers), and I can find lawyers who would take both sides of the case…. but in general I think the majority (perhaps the strong majority) of lawyers I’ve talked to would prefer the SEC’s side of the case.
That’s bad for COIN. The SEC win is death for COIN. If the SEC wins, then COIN was operating as an unregistered broker and selling unregistered securities. On top of being a casual felony, an unregistered broker selling unregistered securities would be on the hook for any losses customers had sustained on their platform. That’s an instant death knell.
Even if you don’t believe all of the tokens the SEC lists in their complaint are securities, the staking piece of the complain seems pretty damning to me.
Anyway, the complaint seems quite damning / serious and a win is enough to put COIN out of business. I think COIN knows that as well; I’ve read / listened to most of their public appearances since they got notice of the suit early this year, and I’m really struck by two things:
I remember listening to someone discussing why they avoided shorting Tesla (I think it was Dan McMurtrie on the Business Brew). He talked about how the bear case for Tesla was “it’s an overvalued car company” and the bull case was “Elon’s taking us to Mars,” and it’s hard to bet one way or another when the bull/bear case are clearly so focused on such different things. I get a little bit of that vibe from Coinbase and the crypto community’s response to the SEC right now; I feel like Coinbase is coming from a position of “crypto trading should be allowed and the SEC should tell us how to facilitate trading legally” while the SEC is thinking “basically all crypto trading is illegal and we don’t need to give clarity to people on how to do it legally because you can’t.” There are a whole host of things the government doesn’t give advice on how to do within the purview of the law (sell nuclear secrets, blackmail government officials, rip the tags off of mattresses, etc.) because there is no way to do them legally.
To give a little bit more on Coinbase’s point of view here: listen to this interview. Coinbase’s CEO talks about how the case is about getting clarity for the industry and how unfair it is that the SEC didn’t give Coinbase enough guidance on what they can and can’t do.
Outside of the “the SEC was not fair to us” argument, the most common defense COIN seems to have is “Congress needs to change the laws to bail us out.” I am being a little hyperbolic there, but not much!
I’m sure COIN will fight this suit tooth and nail; again, it’s a death knell for them if they lose. And Congress very well might change the laws for COIN; I’m very skeptical of crypto and don’t think we’d lose much “financial innovation” if all crypto was banned (in fact, given how much fraud has happened in the space, there’s a good argument that the U.S. would gain financially if crypto was banned!), but I also believe people should be free to do what they want with their money and if Congress wants to change the rules to allow that than have at it!
But if the bull case for COIN is that Congress is going to change the laws for them…. I’m honestly not sure if that’s much of a bull case?
Below is COIN’s adjusted EBITDA statement from their Q1’23 earnings.
In Q1’23, they did $283m in adjusted EBITDA. Of course, that’s after adding back $12m of crypto impairments, $200m in stock comp, and $144m in restructuring charges (plus another ~$14m in “other”, but what’s $14m among friends?), so I think there’s an open debate on how much they are really “earning.”
Coin has ~230m shares out, so at today’s share price of ~$55/share, the market cap is ~$12.5B. They’ve got ~$2.5B in excess cash / crypto assets / USDC, so let’s call the enterprise value $10B. Put it all together, and at today’s prices you’re paying ~10x annualized EBITDA run rate from Q1’23 (and, as noted, that EBITDA is very heavily adjusted).
If you believe crypto is the future and COIN is going to grow like crazy and be the only exchange and trading platform for crypto in the new world, then sure, that’s probably cheap.
But in a scenario where Congress bails COIN out and makes crypto legal, what stops Fidelity / eTrade / every other broker from offering crypto trading services? Why is COIN the winner (or even a winner) in that scenario? They already seem to be losing share in the “wild west / regulatory uncertainty” market we have today.
So changing the laws to make crypto trading legal might save COIN, but I think it would be a disaster for its business. Consider their Q1 revenue breakout:
Roughly a third of their revenue ($240m) comes from interest income. That’s income COIN receives from taking their customers’ fiat cash and parking it at the bank (or from a revenue share agreement with USDC, which basically does the same thing). Here’s the “interest income” definition from their 10-Q if you’re looking to get wonky.
The interest income is effectively free money for COIN (COIN’s interest expense is ~$21m/year and is coming from their bonds, not paying customers interest on their deposits). It is a truly incredible deposit base, and the spread on that deposit base is basically responsible for all of COIN’s adjusted EBITDA ($240m of interest income revenue is >80% of their ~$284m in adjusted EBITDA in Q1’23).
But consider what happens if and when Congress changes the laws to make crypto legal. How long until you get emails from eTrade offering free crypto trades plus interest on your deposits? How long until competitive dynamics force Coinbase to start paying their customers interest on that deposit base?
My guess? Not long. Heck, we’ve already seen a similar movie play out this year with Charles Schwab and cash sweeps. What customer is going to keep their cash / assets in a zero-interest account that doesn’t have federal protection when they could move it over to a money market fund and get ~5% interest (in today’s environment) and federal backing? By sticking at Coinbase and not moving, they’re effectively giving Coinbase a free loan and taking extra risk for no reason. Maybe that’s worth it today when Coinbase is one of the few games in town for trading crypto in the U.S. (and, even better, one of the few U.S. exchanges you can trade on and feel reasonably comfortable isn’t going to run off with all of your assets). Crypto gets legalized and Interactive Brokers, Fidelity, etc. offer crypto trading accounts, and that math changes real quickly.
So, on the bear side for Coinbase, you’ve got an SEC case that seems credible and likely to kill them.
On the bull side for Coinbase, Congress could bail Coinbase out by changing the laws to make crypto legal (and not just make crypto legal, but specifically endorse how Coinbase has handled crypto and absolve them of what I think are pretty clear securities violations!)…. but, in that world, competition is likely to come at Coinbase fast, and you’d be left with an overvalued and subscale broker.
Obviously, those aren’t the only outcomes. The best bull case for Coinbase would probably be: the SEC lawsuit drags on for years, during which time we have another crypto bull market. Coinbase makes a fortune during it because U.S. based competitors won’t enter the market due to regulatory uncertainty…. and then Coinbase wins the lawsuit and emerges into a new fully legalized market with their coffers flush from the crypto boom.
If there’s a universe with a Spider-Ham in it, then surely there’s a universe where that exact scenario plays out.
But it seems really unlikely. Again, I think the SEC’s case is pretty serious. The most likely outcome to me is that the SEC is going to win this case, and the only way COIN survives is for Congress to change the laws before the SEC wins. COIN’s actions and lobbying seem to suggest they believe a change of laws are their best shot…. but if Congress needs to change the laws for COIN to survive, then COIN is going to face a host of competition on the other side.
So why am I writing this article? Well, I’ve talked to lots of investors about COIN over the past few days…. but the reach of this blog is much larger than the handful of investors I talk to every day. If you’re an investor who reads this blog who’s done real work on COIN and sees something I’m missing (either on the bull or bear side), I’d love to chat! In particular, the areas I’m thinking through are timing of the litigation, if legislative changes would completely “cure” COIN or if they could still face issues (likely from the staking side), how the business would evolve as competition cameo n, and plenty more.
And, as a reminder, shorting is extremely risky. In fact, that’s a large part of why I’m putting this piece up; I’d love to hear why or how I’m wrong on this before I get a rude awakening from the market.
Odds and ends
Matt Levine is the GOAT of financial writing; very much worth reading his piece on the day of the SEC complaint as well as his follow up on when tokens are not securities.
On COIN’s deposit base. COIN has ~$125B in customer crypto assets plus another ~$5B in customer custodial funds. That’s an enormous balance sheet, and it’s kind of surprising how little regulation they’re operating under given that huge size.
Another common defense you’ll hear from Coinbase against the SEC is “The SEC approved us to go public and now they’re coming after us? How can they change their mind like this?” In fact, it’s not just a common defense, it’s one of their first line defenses; it’s literally the first thing the CEO brings up in his WSJ interview. That’s not only an insane claim; it’s a claim made in potentially criminally bad faith. I’m not being hyperbolic; literally the first page of COIN’s prospectus has a bold line on it that says “Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.” I’ve included a screenshot with that part highlighted below: