In 2021, Microsoft (MSFT) – Yahoo Finance’s company of the year – saw its market capitalization top $2 trillion. During the year, the ascendant cryptocurrency asset class set two major milestones: its market cap also topped $2 trillion, and Coinbase (COIN), the most popular U.S. based crypto exchange, went public on the Nasdaq through the largest ever direct listing.
With a market cap of just over $70 billion, Coinbase’s value is just a fraction compared to tech heavyweights like Nasdaq, but is multiples higher than the $8 billion valuation it fetched only a few years before. That’s no small feat considering Coinbase Global CEO Brian Armstrong co-founded the company with Fred Ehrsam at a time when Bitcoin cost less than $10 (it traded above $50,000 on Friday).
“The industry had reached a critical inflection point,” Emilie Choi, Coinbase’s president and COO, told Yahoo Finance in an interview.
She added that in many ways, Coinbase’s entry into the public markets was reflective of the mainstream financial world’s acceptance and adoption of cryptocurrencies, and how the sector has matured since its birth over a decade ago.
The company’s stock rode a euphoric wave that reflected the frothiness of digital coins, where Bitcoin’s (BTC-USD) price was setting record after record. Coinbase’s stock briefly touched $429 in its debut, briefly pushing its market value over $100 billion before it came back to earth.
Currently, the stock is down 45% or $90, trading at $238 per share from its debut high, weighed by a combination of factors: a deep crypto rout; China’s sudden decision to ban cryptocurrency mining; COVID-19 risk aversion; and head-spinning volatility stemming from the Federal Reserve’s looming rate hike campaign.
The momentous rise and precipitous drop from Coinbase’s debut price says a lot about the volatility in crypto, where fortunes are being made and lost at lightning speed. But it also explains why the firm performed so well over the past year, and why equity analysts see longer term issues with its current business model.
Short-term speculation in crypto comes with big risks and rewards. The digital coin boom has been both lucrative and devastating for small investors, and those outcomes shape Coinbase’s profit margins.
The company’s core exchange business generates revenue from a percentage fee, or the “spread” charged on top of every user’s trade. Based on its financials, Coinbase draws its best spreads from newer participants making smaller-retail sized trades on Coinbase’s platform.
Its Pro offering for institutions charges much cheaper transaction fees and also offers leverage.
On the day of Coinbase’s direct listing, revenue from trading fees accounted for 97% of the firm’s total revenue. As of the company’s latest earnings release in November, that percentage dipped to 89%. Of that figure, revenue from retail-sized orders accounted for 93.8% while much larger institutional customers made up only 6.2%.
In short, Coinbase generates most of its revenue during volatile but upward-trending market conditions, when crypto investor sentiment is at its highest.
That recipe has worked out for the company in 2021, but doesn’t bode well during sluggish periods of the market. During most of 2018 for example, newer retail-sized users tended to trade less often and institutional customers made a higher percentage of total trading volume.
It’s during slow times that exchanges need to retain customer funds. All exchanges compete for customer assets under management. To incentivize customers to hold crypto, platforms been increasingly turning to creative methods to mimic the features of traditional asset classes — namely, the ability to pay customers interest on their holdings.
This is the heart of the current movement toward decentralized finance (DeFi), where investors earn way more from yields on crypto-based accounts than the average, low-yielding savings account.
But regulators are skeptical of these efforts, even when offered by centralized crypto firms. In September, Coinbase announced plans to offer customers a “high-yield alternative to traditional savings accounts” paying 4% on USD Coin, a stablecoin redeemable one-to-one for each U.S. dollar.
But the Securities and Exchange Commission abruptly intervened, claiming the offering amounted to a security, which would require registration and open a regulatory can of worms.
In a lengthy Twitter post at the time, Armstrong lashed out at what he called “really sketchy behavior” by regulators, but nevertheless, Coinbase bowed to the SEC’s concerns.
Instead, at the beginning of December, it launched a DeFi yield product for customers outside the U.S. –and its own financial returns from DeFi lending underscored why. During the quarter, Coinbase had grown its revenue from staking from $3.3 to $81 million over a single year.
Robinhood (HOOD) deals with a similar issue, but because it uses a payment for order flow (PFOF) model particular to stocks, its zero commission trading fees prevent competitors from offering better prices. And like Robinhood, the Coinbase model has its share of critics.
“I want them to diversify their revenue stream and be a broader crypto platform, not just trading,” Chris Bendler, managing director and senior equity analyst with D.A. Davidson Companies told Yahoo Finance. His critique echoed the opinion of other analysts covering the stock.
Coinbase’s current business model means that its share price acts almost like a “bellwether” for the crypto market, Bender explained. And since COIN’s debut, its value correlates very closely, on average by about 60%, to Bitcoin, D.A. Davidson’s research sows.
Devin Ryan, senior analyst and director of financial technology research with J.M.P. Securities, said that for Coinbase to be a long term success story, it needs “to see terminal growth in other aspects of its business model.”
Since going public, Armstrong and Choi have publicly signaled how the company is working to address these concerns, using their successful exchange business as the beginning of a larger play to build out the infrastructure of a rapidly expanding crypto market.
Ryan argued that the company’s exchange business positions Coinbase to be one of the best companies in the crypto space. It can build itself into an “Amazon of assets” as Armstrong stated during its Q2 earnings call, as well as a foundational company for the blockchain-built internet that crypto optimists envision.
Addressing the strategy, Coinbase has announced a bevy of new products and features for 2022, such as a platform devoted to the booming non-fungible token (NFT) movement, and Coinbase One, a monthly subscription trading service that waives commission fees in addition to enhanced features.
While not quite as convinced, D.A. Davidson’s Bendler argues that the correlation between COIN and the larger crypto market serves as a massive advantage when it comes to branding.
“It’s almost like Xerox or Kleenex, when people think about trading crypto, they think Coinbase. It’s a huge advantage for their cost of customer acquisition,” Bendler told Yahoo Finance.
‘A great play’
Meanwhile, investors and analysts see Coinbase’s current leadership team as integral to its future. Ryan Selkis, Founder and CEO of Messari, recently argued in his firm’s end-of-year report that outside of Brian Armstrong, Choi is also “most responsible for the company’s ongoing success.”
It’s not hard to understand why. Choi, who joined Coinbase in 2018, is essential to helping the firm establish their infrastructure strategy.
She has spearheaded the company’s aggressive approach to mergers and acquisitions, which according to The Block Research, has included 5 companies this year, and 27 altogether – making Coinbase the most active crypto company in the M&A space. Notable acquisitions led by Choi include major custody provider Xapo (2019) and institutional trading firm Tagomi (2020), – both of which will increase service offerings to large institutional investors.
And the firm is positioning its earlier pickup of the infrastructure company, Bison Trails (now rebranded to Coinbase Cloud), as a blockchain hosting service provider for developers similar to Amazon (AMZN) Web Services (AWS), the tech giant’s greatest money maker.
Though crypto purists might shy away from COIN simply because it’s underperformed BTC and ETH since its launch, D.A. Davidson’s Bendler said that many of the stock’s investors are “traditional fintech investors” who seek exposure to crypto with a growth story, at a reasonable price.
“It’s not ridiculously expensive for what it is. If you’re bullish on bitcoin and the future of this blockchain-powered economy, then Coinbase is a great play,” Bendler added.
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