Perhaps no other topic in finance received more attention in 2021 than cryptocurrencies. These digital assets have the potential to disrupt not only the concept of money itself, the hope of Bitcoin (BTC 0.20%), but also a whole range of industries and profit pools. This budding revolution is also attracting top talent all over the world, a positive indicator for its prospects.
In order to gain broad exposure to the entire industry, crypto exchange Coinbase (COIN 4.14%) immediately comes to mind as a pick-and-shovel investment idea. However, cryptocurrencies are a nascent asset class, with the development of real-world uses still in the early stages and speculation driving a lot of the activity today.
So, is Coinbase a safe stock to invest in? Let's find out.
Image source: Coinbase.
Building the crypto economy
Coinbase generates the bulk of its revenue (88% in the last quarter) from transaction fees. As you might expect, the performance of this business is highly dependent on the volatility in crypto markets. Furthermore, as crypto values rise, customers are more inclined to trade, and vice versa. This dilemma makes it extremely difficult to predict the next quarter's (or next year's) financial results.
The bright spot for Coinbase, however, is that assets on its platform now total $255 billion. And while monthly transacting users in Q3 were down from the previous quarter to 7.4 million, they are up 252% year over year. These users tend to increase their engagement over time as well. Coinbase now has 73 million verified users. And although the path to widespread crypto adoption has proven to be a bumpy ride, the business carries a stellar adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margin of 50%.
Coinbase is already an important partner for institutional clients looking to gain access to the crypto market. With the introduction of Coinbase Cloud, a tool for developers to build applications and services on top of Coinbase's infrastructure, this company has the potential to be the Amazon Web Services of crypto.
Owning shares in Coinbase is essentially a bet on the growth of the entire crypto ecosystem. Investors don't need to speculate which specific tokens will rise in value; Coinbase stands to benefit as the whole industry expands and becomes more mainstream, a shift that could take years or decades.
A volatile stock
Because of the up-and-down nature of Coinbase's primary revenue base (transaction fees), the stock has been quite volatile since its public debut in April. For example, the shares declined 30% from April 14 to Oct. 1, only to soar 56% during the following few weeks until Nov. 9. Since that date, when the business reported third-quarter financial results, the stock has dropped about 30%. In fact, Coinbase's shares have tracked closely with Bitcoin's price movement, which lately has been falling.
I don't know why this is. I suppose the market assumes that Coinbase's success is directly tied to that of Bitcoin, but this is a wrong assumption. Of the $327 billion of trading volume on Coinbase's platform during the third quarter, 19% was from Bitcoin, a figure that has fallen during the past three quarters. Ethereum represented 22%, with other crypto assets making up the remaining balance.
This is clear evidence that Coinbase's prospects aren't tied to any one particularly cryptocurrency, a fact the market should pick up on soon. Additionally, the expectation is that over time, the business will expand its subscription and services segment to provide a steady and more reliable source of revenue.
Proceed with caution
Investing in the stock market is always a risky endeavor. As investors, we do our best to make accurate forecasts about the future with all the available information we have. Stocks of companies that operate in more predictable, proven, and slower-changing industries, are naturally safer than others.
With that said, I do believe Coinbase is a sound long-term investment for investors on two conditions. You not only have to firmly believe that cryptocurrency adoption is set to increase in the years ahead, but you must have a well-diversified portfolio to help you ride out the inevitable volatility Coinbase will bring.
I check both of those boxes, and that's why I'm a shareholder today.
