Perhaps no other public company benefited from the explosion in cryptocurrency more than Coinbase (COIN -0.34%). Its financials soared, and it generated significant attention. Now many investors are looking at Coinbase as a diversified way to get exposure to the crypto market.
While Coinbase looks extremely appealing today, an intelligent investor needs to thoroughly examine both the bull and bear cases. Without doing this, they might be unprepared for surprises in the coming years. Here are three things that could hurt Coinbase in the not-too-distant future.
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1. Transaction fees aren't the future
Coinbase is one of the leading crypto trading platforms globally, with over 89 million users that traded $547 billion in Q4. The company takes a cut of every single transaction, so more activity on its platform means more revenue. Coinbase has been able to capitalize on the popularity of cryptocurrency over the past few years: Its revenue in 2021 grew 545% year-over-year, and its 2021 free cash flow grew to over $10.7 billion -- primarily due to a major increase in customers' custodial funds.
Most of this revenue, however, came from the company's transaction fees, and some worry that the crypto industry will follow a similar path to the stock trading industry. In stock trading, there was a time when investors paid a fee on every transaction, but that quickly became commoditized. Now almost all platforms have free trading. To take market share from Coinbase, its competitors could follow a similar path and decrease or even eliminate transaction fees. This would force Coinbase to either follow suit or lose market share, which would hurt the business.
However, the company isn't sitting back and waiting for this to happen. Coinbase is testing a subscription service that gives investors free trading, 24/7 customer support, and more for a flat monthly fee. The company is also looking to create a non-fungible token (NFT) platform, and it is even experimenting with allowing users to create their own decentralized applications. The bottom line is that management sees this risk is on the horizon, and it is investing heavily in diversifying its revenue away from transaction revenue. That said, if this shift comes earlier than expected, it could catch Coinbase on the wrong foot.
2. Crypto is still in the early innings
Over the past five years, the crypto industry has blown up. Bitcoin (BTC -0.12%) has soared over 4,200%, and Ethereum (ETH -0.69%) has gone up even more -- it jumped over 8,500% over the past five years. That being said, the cryptocurrency space is far from being mature.
This could be great news for Coinbase, but it also means there is more risk. The first-mover or initial leader is not always the industry leader as the space matures; just look at smartphones. Do you remember the Palm Treo 600? Probably not. It was one of the first smartphones made in 2003 -- five years before Apple's first iPhone came out. It was a first mover in the space, but the iPhone -- which was much better -- came out on top.
This might not be the case with Coinbase, but it is certainly one possible outcome that investors need to be aware of. The company might have 89 million verified users today, but the switching costs for consumers are relatively low. If a new platform has equally strong security, an easier-to-use platform, and more capabilities in the future, it could take over. Coinbase's growing product lineup would make this harder, but it is something to watch closely.
3. Growth could slow
Management is not expecting the coming years to keep up with the jaw-dropping growth the company put up in 2021. The company's average revenue per transacting user (ARPTU) is expected to fall to pre-2021 levels in 2022, which had ranged between $34 and $55. Even at the high end, this is substantially lower than its 2021 ARPTU of $64. This mostly means that users will be less active on the platform, and if the crypto industry enters a "crypto winter" where trading activity comes to a screeching halt, this could be even lower.
That being said, the market seems to be pricing in this slowdown. Coinbase shares trade at 12.2 times earnings. For reference, the S&P 500 index trades at an average of 24.5 times earnings, so Coinbase could be wildly undervalued today. There are a lot of questions around Coinbase's future, but there is an equal amount of potential as well. If the company's investments are successful and Coinbase continues to lead the cryptocurrency space, this investment could reap major rewards over the next decade.
