During its brief history as a publicly-traded company, cryptocurrency exchange Coinbase Global (COIN -3.24%) has surpassed expectations by an incredible margin. For example, analysts believed the company would report earnings of $2.33 per share in the second quarter of 2021. Coinbase actually delivered earnings of $6.42, outperforming estimates by 176%.
But according to TipRanks, analysts are extremely divided on Coinbase stock, which trades at about $260 per share as of this writing. Price targets are as high as $500 and as low as $220. Clearly, Wall Street doesn't know what to make of this company.
Sometimes, confusion like this presents an opportunity for those who can see through it. It's unclear whether this applies to Coinbase stock, but there does appear to be underappreciated upside here.
Image source: Coinbase Global.
Growing the core business
Coinbase has two primary sets of customers: institutional investors like hedge funds and retail investors like you and me. The company generated 88% of its total revenue in the second quarter by charging fees for trades. But even though institutional investors have far more assets on the platform and trade more often, 95% of this transactional revenue came from retail investors.
Coinbase needs to better monetize institutional investors, but for now, let's accept the business model for what it is. Based on the numbers we've seen, it must grow its retail investor user base to grow its core business, and it has a couple of ways to do this.
First, Coinbase can grow the list of cryptocurrencies that it supports. For those unaware, there are thousands of cryptocurrencies, and each one requires particular support infrastructure. You can't just throw them up on the platform.
To the company's credit, it added 22 new crypto-assets in the second quarter alone, a quarterly record. And perhaps this is part of the reason it has seen strong user growth. It had 8.8 million monthly transacting users in the second quarter, versus just 1.5 million in the same quarter last year.
Second, Coinbase can launch internationally. Right now the company is working on entering Germany and Japan. It's a challenge, because every country has its own regulations regarding cryptocurrencies. However, with such a small user base, Coinbase has a shot at outsized growth by widening its net overseas.
Image source: Getty Images.
Exercising optionality
Many investors rightly approach Coinbase stock with great caution. Cryptocurrency has historically been volatile, motivating people to trade often. Remember: The company disproportionately profits with frequent transactions. Therefore, if trading decreases with increased cryptocurrency stability, its business model could fall apart.
However, consider two things. First, potential Coinbase investors are being compensated for this risk with a cheaply valued stock. The company is very profitable and trades at just 22 times trailing earnings, according to data from YCharts, an almost unheard-of valuation for a fintech stock.
Second, Coinbase is plowing its cash back into the business. According to management, its capital allocation strategy has 70% of capital invested to improve the core business, 20% used for strategic investments, and 10% spent innovating with new products. Experienced investors will recognize this last item as the desirable trait called optionality.
Here are two examples of Coinbase's optionality. First, the company supports popular cryptocurrency Bitcoin. But it now has a feature called Bitcoin Borrow, allowing users to borrow money using Bitcoin as collateral. It also recently launched Coinbase Card from Visa so users can spend their cryptocurrency on everyday purchases.
A more compelling example of this optionality is Coinbase Cloud. Cryptocurrencies live on blockchains, but they're not the only thing that can be built on the underlying blockchain technology. Various decentralized applications can also be built on blockchains, and Coinbase wants its cloud product to become the de facto way these are built. Management envisions Coinbase Cloud becoming like Amazon Web Services but for cryptoccurency. This could be an enormous opportunity if cryptocurrency becomes a bigger and enduring movement.
A portfolio turbocharger?
In summary, Coinbase stock is a risky investment, because its primary source of revenue has questionable longevity. However, one can't dismiss the company completely, because its current growth gives it the optionality afforded by its significant financial resources. Its non-transaction-based revenue has increased more than 15 times over just the past 12 months, so it's clear Coinbase is mitigating risks to its core business by developing other revenue streams.
The cryptocurrency space is still young so it's hard to predict what it will look like in five to 10 years. However, if you believe cryptocurrency is still in the early innings, then Coinbase stock looks like it might be worth adding to a diversified portfolio.
However, I wouldn't make a large bet on Coinbase stock today. The risk that cryptocurrency trading volumes could decrease still stands. But if this company executes on its vision, then even a small portfolio allocation could boost your overall returns in the years to come.
