Coinbase could rally in 2023 as cryptocurrency investors flock to “safe haven” exchanges.

Last year ended with fireworks in the cryptocurrency market. bitcoins (BTC-USD) and its peers underperformed throughout the year due to declining investor confidence. As the market slowed down, cracks started to emerge between cryptocurrency exchanges, leading to the implosion of FTX (FTT-USD) in the middle of allegations of significant misuse of client funds. This event led to a massive drop in the value of the most significant cryptocurrencies as fears of contagion increased and investor confidence plummeted.

Stocks in the cryptocurrency sector have also imploded. Coin base (NASDAQ: COIN) lost 86% of its value in 2022 and recently saw short interest skyrocket to 24%. COIN is essentially a proxy investment for Bitcoin and has a very high correlation with a “beta” to close to 1 (meaning that COIN usually increases or decreases by 1% with every 1% change in Bitcoin). Look down:

Many speculators are betting against the company, potentially assuming that some contagion will occur in the cryptocurrency market. Coinbase is a publicly traded company, so the company is less likely to bear the same risks as private peers like FTX. That said, this is a financial institution that operates outside the immensely strict regulations of traditional banks and stock exchanges, opening the door to abnormally high “banking” risks (poor liquidity, etc.).

At this point, COIN is a high risk stock. However, it is distant less expensive than a year ago. The stock is also prone to high short selling, which makes a significant “dead cat bounce” or “short squeeze gain” more likely, particularly if it beats weak expectations. I believe the company deserves a deeper look at its risk exposure and upside potential as a potential “high-risk, high-reward bet” for 2023.

Coinbase risk analysis

A key investment issue with Coinbase is the number of potential risk factors to which the company is exposed. While no particular risk is too likely or too great, there are so many that it seems likely that at least one will have a huge negative impact on the company in the future. In my opinion, these include (in order of severity): a widespread loss of confidence in cryptocurrencies, liquidity and solvency risks, business model risks, competitive pressure, and regulatory risks. The “collateral risk” is, of course, the potential for fraud or “FTX-like” issues, which is difficult to gauge; however, since Coinbase is an older e publicly listed company, I believe that this risk factor is generally low.

COIN’s value is strongly correlated with price fluctuations of Bitcoin and other major cryptocurrencies, making it the stock’s primary risk factor. Even that risk is almost entirely out of the company’s control. For example, the problems in FTX have led to a broader loss of trust in cryptocurrencies, creating losses for Coinbase. Amid the debacle, exchange giant Binance (BNB-USD) lost its auditor Mazars, no longer guaranteeing proof of the firm’s reserves. The auditor also withdrew from other major exchanges, raising potential contagion risks. While the cryptocurrency was “supposed” to operate under a “decentralized banking” platform, it has become highly centralized among a small number of exchanges. If more than one of these changes prove to have low liquidity or discrepancies in proof of reserve, then a complete loss of confidence is possible.

In my view, this risk factor is quite significant for Coinbase as it could lead to the end of the cryptocurrency industry, or at least its form of currency. That said, since Coinbase is the rare public cryptocurrency exchange, it is the only one audited by a “Big Four” accounting firm (Deloitte). While Coinbase isn’t as big as Binance and is considerably more expensive than its peers, it does have the highest “trust score,” mainly due to its additional regulations associated with being a public company. Therefore, as long as fundamental trust in cryptocurrency remains, Coinbase could become a huge net benefactor as cryptocurrency investors move towards more reputable companies.

That said, while Coinbase is more reliable than (in my opinion) all other exchanges, it is not as secure as traditional financial institutions. For one thing, it doesn’t carry the same regulatory burdens as conventional financial institutions. Secondly, its assets and liabilities are highly volatile due to the volatility of the value of cryptocurrencies. Coinbase has experienced a decline in cash and tangible book value and a sharp increase in leverage this year. Look down:

Comparing the creditworthiness and liquidity profile of Coinbase to traditional financial exchanges, Coinbase appears much riskier with high leverage and low cash liquidity versus assets (~$110B). Such risks are compounded by the volatility in the value of cryptocurrencies as they cause immense fluctuations in Coinbase’s balance sheet. While not as popular as some other exchanges, Coinbase does have a margin trading (and asset lending) program. A significant decline in major cryptocurrencies could drastically damage Coinbase’s remaining liquidity if counterparty risks grow (or Bitcoin becomes less liquid due to volatility). If 2023 is like 2022 for the cryptocurrency market, then I believe Coinbase is at high risk of bankruptcy due to its low creditworthiness. However, this risk generally appears to be priced into the value of COIN (as seen in its massive drop last year).

Aside from the “macro” risks that Coinbase faces, a number of company-specific risk factors are needed. Coinbase is a relatively more expensive trading platform with fewer tradable options and cryptocurrencies than most of its peers. For this reason, Coinbase has not grown much in recent years, while peers such as Binance, (formerly) FTX, Kraken and others have grown considerably. Coinbase has lost significant market share due to its higher fee structures, opening up the possibility of corporate failure if the trend continues. That said, if higher fees equate to higher trust and investors move to higher trust platforms, Coinbase could indirectly benefit from its higher fee structures.

However, Coinbase has struggled to make a consistent profit despite its higher fees. The company hasn’t been publicly traded for a long time and was profitable in 2021. Of course, 2021 was a banner year for the cryptocurrency market, so it’s unclear whether Coinbase is operating under a viable business model over the long term. However, this risk is largely priced into the stock following its significant decline and could be significantly discounted if its outlook recovers.

Reward Potential at Coinbase

As an analyst, I’m generally skeptical of unprofitable tech companies, and have had a bearish bias in most of my research over the past couple of years. In my view, Coinbase is one of the few examples today where I see a solid contrarian bullish argument. It goes without saying that COIN is a very high risk stock subject to immense volatility and numerous fundamental risks that could jeopardize the company. However, the book value of COIN decreased by a astounding 95% from the beginning to 1.4 times today. Two years ago, COIN’s valuation was tremendously high compared to traditional brokers; today it is well below that of Schwab (SCHW), Interactive Brokers (IBKR) and others (price-to-book ratio). Therefore, I believe that COIN’s risk profile is generally considered in its valuation.

If we assume that the “bottom will not fall out” from the cryptocurrency market, Coinbase could return as the market share leader among exchanges. Due to its age, business focus, and public status, Coinbase objectively has the highest trustworthiness and security in the industry. Cryptocurrency investors pay a premium for using Coinbase’s services.However, in my view, that premium is relatively small compared to the huge losses experienced by FTX users who have lost “safe” funds to safer public companies like Coinbase.

Also, with Bitcoin (and peers) at extreme lows, there will likely be more long-term investors in the market than short-term traders and speculators. Coinbase is a poor platform for trading cryptocurrencies due to its higher fees, but it’s a superior option for long-term investors due to its security. Therefore, I believe Coinbase can have competitive dominance with Bitcoin at low prices and cryptocurrency investor confidence as weak as it is.

COIN’s upside potential is difficult to calculate as there are many paths the future could hold. If the company can regain its late 2021 TTM EPS level of $9-$12, its “P/E” today would be ~3-4x, which is extremely low. This could happen if trading activity and bull flows return to the cryptocurrency market, potentially causing COIN to surge above $100. Of course, if there is a widespread shift of assets to Coinbase as investors move to more reputable exchanges , COIN could soar much higher as it regains the dominance of the market share it held many years ago.

The bottom line

While COIN is exposed to significant downside risks, its upside potential is also huge. In my view, the company is priced as if the cryptocurrency sector is likely to collapse. In fact, I don’t think this is impossible as there is no physical value in cryptocurrencies, with their value in my view largely stemming from the beliefs surrounding fiat currencies and a belief in alternatives. The value of emotional beliefs shouldn’t be discounted, but they are fickle. However, with confidence in traditional fiat currencies declining and objective risks rapidly increasing, I tend to believe that some cryptocurrencies will hold value over the long term as more people globally look to reduce exposure to government-controlled assets.

Public trust in institutions is at (or close to) historic lows in virtually all categories, creating immense potential value for alternative structures. While there are considerable risks within the cryptocurrency industry, this is a potentially viable alternative structure. In this sense, COIN is a potential hedge against generalized social, political and economic risks.

Looking at the market today, I’m not bullish enough on COIN to buy the stock; but on balance I have a positive long-term view of the stock. COIN also has significant short-term upside potential if there is a short squeeze due to its immense short exposure. I personally wouldn’t make that particular speculative bet today, but it is one factor that could lead to quick gains for the stock. Once the volatility of the cryptocurrency stabilizes and Bitcoin reaches a more stable support level, I could become very bullish on COIN.