Summary Coinbase's stock has risen by over 300% since the beginning of the year, but there are concerns that it may be driven by speculation or a short squeeze. The recovery of Coinbase's business is tied to the performance of cryptocurrencies, particularly Bitcoin. The use case for cryptocurrencies as a hedge against inflation and government failures is growing, but Coinbase's profitability is still uncertain. Coinbase may be on the verge of consistent profitability, but its EPS outlook is shallow compared to its stock price. At the beginning of the year, most investors had a bearish outlook on Coinbase ( COIN ). The stock lost tremendous value as cryptocurrency volumes slowed, and more investors and traders avoided the sector. Further, at that time, following the collapse of FTX, many were cautious toward crypto exchanges and viewed them as having high regulatory and liquidity risks. The latter issue was one of my primary bullish points behind Coinbase, as detailed in " Coinbase May Soar In 2023 As Crypto Investors Flock To 'Safe Haven' Exchanges." In January, I was bullish on Coinbase due to its low relative valuation and an outlook that its business would recover due to its higher regulatory standards (giving it a "trust" edge over private peers) as well as a bullish view on cryptocurrency, due to declining stability of the US dollar. Since that article was published, COIN has risen by a staggering 306%. Accordingly, I must take another look at the stock to determine whether or not it is still a viable or reasonable investment opportunity. Indeed, given its parabolic bullish movement in recent weeks, we must consider the possibility that it is rising in a speculatively-driven or short-squeeze-driven rally that will not last. COIN had higher short interest before this rally and retains a relatively high short interest level of ~13%, indicating a bearish sentiment on the stock and a high probability for a short squeeze, which appears to be a significant bullish factor behind the stock today. In my view, it is generally unadvisable for investors to try to catch a short-squeeze rally as they usually end in significant losses. Of course, there has been a fundamental recovery in much of Coinbase's business. For one, COIN usually trades as a proxy for Bitcoin and other cryptocurrencies because its fee revenues will often directly correlate to the price of cryptocurrencies. Thus, to a great extent, we can only be bullish on COIN if we are also bullish on the primary cryptocurrencies traded on that exchange. Bitcoin and its peers have performed tremendously over the past two months, rising by around 70%. One fundamental cause is likely the decline in real interest rates and the related rally in gold, indicative of a decline in the US dollar's stability and potential renewed inflation, as was last experienced in 2020. Regarding Coinbase's primary operations, I believe the company still has ways to go and has not necessarily been as strong as earlier assumed. The company has slightly moderated its operating overhead; however, it has a ways to go before we can expect consistent profitability independent of a continued rise in cryptocurrencies. To me, it is given that Coinbase will fundamentally perform well if we see Bitcoin (and peers) reach a new all-time high, which is not unfeasible given the most recent shift in the monetary outlook. Even then, I would only buy COIN today if I could expect it would earn a profit without a rise in Bitcoin, which is not necessarily likely but still possible, given ongoing operational efforts. I believe COIN could continue to rise, but there is a high risk of reversal as short positions are pushed out. Cryptocurrencies and Monetary Policy Risk To a large extent, COIN will always be a proxy trade for Bitcoin and peers because transaction volumes and sizes usually change with crypto prices. As we've seen since their origin, cryptocurrencies are highly cyclical and are not clearly correlated to economic and monetary shifts; however, I believe they are becoming more economically driven as their market size grows. Fundamentally, cryptocurrencies are seen as a hedge against US and global inflation because they operate as currencies without central bank control. The possibility of widespread fiat currency failure in Western nations is the most significant speculative bullish argument for cryptocurrencies. However, the frequent and growing failures of many emerging market currencies, some of which are US dollar-hedged, have already caused many cryptocurrencies to become active operating currencies and wealth storage platforms in third-world countries, particularly in Africa and South America. As a result, some governments in those regions are now looking to ban or restrict their usage, which, to me, goes to show the use-case of cryptocurrencies as a potentially viable alternative against fiat currencies exposed to pro-inflationary government monetary policies. Further, cryptocurrencies are being used in countries with capital flight controls, such as China , where billions in cryptocurrencies are used to quietly move money out of that heavily controlled financial system. Of course, many billions in cryptocurrencies are also used in black-market transactions despite Western government efforts to halt such activity. I believe there is a growing argument that cryptocurrencies have a solid use case in the precarious global political and monetary environment. With many governments having extremely high debt, out-of-control deficit spending, and perceived corruption, there is potentially a tendency to dilute fiat currencies through money-supply growth policies, as last experienced in 2020-2021. The "inflation tax" is a quiet way for governments to lower debt levels in real terms while increasing revenues, making it the most viable way to reduce debt issues without austerity measures. Gold and silver are the oldest ways to protect against such actions, but cryptocurrencies have the benefit of being more suitable for online transactions. Unsurprisingly, this results in a relationship between gold, Bitcoin, and real interest rates. Real interest rates are interest rates on Treasury bonds after CPI inflation, as directly measured by inflation-indexed Treasury bonds. Real rates are tightly inverted and correlated to the price of gold, as lower returns after expected inflation make gold more valuable. Low real rates indicate pro-inflationary monetary policies, such as QE, and prolonged low rates. The last rally in gold and Bitcoin occurred in 2020 when real rates collapsed, causing many investors to look toward alternative assets to hedge against inflation risks. Inflation subsequently rose and is now slowly declining. Real rates appear very high but could theoretically be overstated if CPI inflation is understated . Regardless, we're now seeing a decline in real rates as investors expect a reversal in "tight" monetary policy, prompting a rally in gold and Bitcoin. See below: Data by YCharts In my view, it is too early to determine whether or not real interest rates will fall back below zero for a prolonged period. In the event of more bank failures and economic woes, I expect the Federal Reserve will shift back toward a pro-inflationary monetary policy as it consistently had from 2008 to 2021 during all periods of economic slowing. Specifically, I do not expect near-zero rates or QE but a reluctance to raise rates in light of a potential inflation rebound, potentially caused by ongoing geopolitical issues in oil-producing areas. While Bitcoin is not closely correlated to the price of oil, I believe a sharp rise in oil would be a vast bullish factor for cryptocurrencies as that could trigger a "crisis" for Western central banks forced to choose between economic stability and inflation, likely without the potential to maintain both. Can Coinbase Become Consistently Profitable? I have a bullish outlook on cryptocurrencies due to the perceived high risk of government failures to maintain stability in fiat currencies. It may still be some years before the US faces this issue, but widespread currency failures in developing markets are a more immediate catalyst. In comparison, Bitcoin is a significant target and Coinbase benefits from not being exposed to all cryptocurrencies. One can bet on COIN and benefit from the rise and fall of the entire cryptocurrency space. Fundamentally, in the long term, I believe other cryptocurrencies are more viable as currencies than Bitcoin . Still, COIN's value is more correlated to Bitcoin. See below: Data by YCharts Since January of 2023, we've seen Bitcoin and COIN rise in value together. COIN has had a "beta" to Bitcoin of around 1.2X this year, meaning a 1% change in Bitcoin may alter COIN's value by about 1.2%. That measure will change over time, but I generally expect COIN to be slightly leveraged to Bitcoin, particularly as long as it is on the cusp of profitability. Coinbase's fundamentals are also correlated to Bitcoin. Its sales, gross profit, and EPS per share have all generally tracked the price of Bitcoin since it went public. That said, its operating expenses continue to absorb all its potential profits. See below: Data by YCharts Last quarter, Coinbase had a gross income of $2.82 per share and an OpEx of $2.45 per share, meaning it lost around $0.37 per share in operating income, gaining some of that back through non-operating income. With relatively high short-term rates today, Coinbase should earn a decent non-operating income from cash positions. Still, in the long run, it will need to dramatically increase its sales or lower its operating expenses to become viable. In the past, when Bitcoin was around $45K, Coinbase had gross profits per share of around $4. If its operating overhead and non-operating income remain constant, I expect it should earn a quarterly EPS of about $1.5 (using a 30% tax estimate). EPS would differ from that figure because it may benefit from past negative income on taxes. The current analyst consensus EPS outlook for Coinbase in 2024 and 2025 is around $1.4, and the company is not expected to break even consistently until 2027. By 2032, analysts expect the company to earn an EPS of around $10 per share annually. Of course, the company's true performance will likely differ significantly as it depends on the volatile cryptocurrency market. In my view, the company's high operating expense is not necessarily an issue, but its stock-based compensation could be, as it accounts for ~40% of its annual income. Still, that is not a prominent figure compared to its market capitalization, so it is not diluting shareholders too much with this practice. That said, it is challenging to justify COIN at its current valuation, even with a solid long-term EPS outlook. Based on the current consensus, COIN's forward "P/E" in 2032 is 13.4X, and we should expect it to have reached maturity by a decade from now. At maturity, most stocks (depending on their risk) trade at "P/E" valuations of around 15X and often upwards of 20X during low-rate periods (see 2010-2021 ). There are many factors to consider, but the company trades at a very high valuation with that long-term EPS target. Even if its 2024 EPS is around $6, as I expect, its "P/E" would still be around 23X, which is high given it may not maintain that EPS level without a continued rally in cryptocurrencies. The Bottom Line Overall, I am neutral on COIN today. On the one hand, I expect the company will benefit from another wave of bullish activity in the cryptocurrency space. This wave appears to be fueled by a potential return to pro-inflationary monetary policies due to negative headwinds in global economic activity. Based on the relatively small decline in real interest rates, it may be that both Bitcoin and gold are getting ahead of themselves, as most Western central banks remain in a hawkish position. However, understandably, after the tremendous and rapid dovish pivot in 2020, investors and speculators may be quicker to buy monetary hedges in the event of a dovish pivot. My bullish view on cryptocurrencies is mitigated by potentially significant overvaluation in Coinbase. Based on reasonable conservative estimates, Coinbase may still be some years from consistent profitability and, even then, may not earn a huge profit compared to its current stock price. If we see Bitcoin rise over $100K, I expect Coinbase to make profits well above the consensus estimate, but that is certainly not a given. It is not necessarily likely Bitcoin can maintain such a high valuation in the long run without the collapse of more fiat currencies. Accordingly, I believe COIN is undervalued today only under the assumption of immense monetary instability over the next five to ten years. Is that possible? Yes, but we must keep in mind that a tremendous inflation shock (or hyperinflation) would also create business issues for Coinbase and the financial system it is tied to. To me, that is one of the most exciting points behind Coinbase, as it operates within a highly regulated financial system but generally benefits from issues within that system, making it unclear how it will perform given greater instability in the global financial system. That said, being a publicly regulated firm, I continue to believe it has an edge over private crypto brokers without such regulations, particularly for traditional market investors looking to "dip their toes" into the cryptocurrency market.
