RobinDaHood
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Outline |
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Intro |
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Remember when your high school buddy, Nick, texted you saying he made 1,000% on Gamestop in a day? Or, your coworker, Matt, pinged you about aping into AMC and making 50x his investment in a week? |
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What about when you decided to dip a toe into Blackberry, since all the other meme stocks were blowing up, but somehow you lost 67% and got a call from compliance to explain your rationale for investing and if you had inside information leading you to make said purchase? |
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Ah. Good times. |
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The entire meme stock hype of 2021 was made 10x worse thanks to one broker: |
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Robinhood. |
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Robinhood ($HOOD) revolutionized the trading world, taking us from a clunky, slow, expensive process to an incredibly simple and, some might even say, fun process. |
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“Back in my day, we had to fax our trades into the broker and wait 24-48 hours for confirmation!” |
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“Ok Boomer.” – Robinhood. |
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Even though $HOOD has revolutionized the trading and investing landscape for retail investors, the underlying business has been struggling and with new legislation in the works, could this be the end of Robin and his band of merry men? Let’s dive in! |
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History |
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Robinhood hit the investing scene with impeccable timing. Just when large brokerage firms were starting to lower their trading fees, Robinhood came in hot and said “I’ll see your discount and lower it. To $0.” |
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Robinhood was the first to introduce commission-free trading. |
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Not only was trading free, but they created a phone app where you could buy and sell $TSLA or $NFLX or any stock, ETF, cryptocurrency, option contract all while you were away from your computer. Gone are the days where you need to call a broker to place a trade. Now you don’t even need a computer to place trades, you can do it right from your smartphone! |
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The Millennial generation fell in love with this concept. Not only could they trade daily from their phone with as little as $5 (not the normal $500 or $1,000 minimum account size for most investment shops) but it felt like they were playing a video game while doing it. |
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<How could you not love the endorphine rush from buying a security and getting a confetti explosion?> |
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The unlock for the generation who grew up receiving participation rewards and medals was congratulating them for every trade they made. And then rewarding them for bringing friends onboard to experience the same thing. |
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Robinhood turned investing into a game. And this only gained them more customers. |
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Simplifying and gamifying a normally complex and non-intuitive industry was the major onramp to $HOOD’s success. |
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Just look at their customer acquisition growth leading up to 2021: |
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Unfortunately, this growth did not last and the nature of gamifying investing ended up leading to their downfall. But more on that shortly. |
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Business Overview |
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Our mission is to democratize finance for all. We use mobile technology to provide access to the financial system in a way that is simple and convenient for our customers. We believe investing should be familiar and welcoming, with a simple design and an intuitive interface, so that customers are empowered to achieve their goals. We pioneered commission-free stock trading with no account minimums, which the rest of the industry emulated... Through these efforts, we believe we have made investing culturally relevant and understandable, and that our platform is enabling our customers to become long-term investors and take greater control of their finances. |
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That quote from $HOOD’s Annual Filing sums up their business quite well. It is not all that revolutionary, when you stop and think about it. It is a mobile application that makes investing easy and simple, with low minimums, so that just about anyone has the ability to start trading within the Robinhood app. |
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Robinhood’s revenue consists of 3 main components: |
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1. Payment for Order Flow |
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a. For equities, $HOOD receives a fixed percentage based on the bid-ask spread on the public quote |
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b. For options, $HOOD receives a fixed dollar amount for each contract, depending on the underlying security |
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c. For cryptocurrency, $HOOD receives a fixed percentage based on the notional value of the trade, called a “Transaction Rebate” |
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2. Net Interest Revenue |
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a. $HOOD holds securities as collateral for margin accounts and will lend those securities out to other investors and earn interest revenue |
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3. Other Revenue |
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a. This consists of $HOOD’s subscription fees, any proxy rebate revenues and ACAT fees from other broker-dealers when transferring accounts |
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The tables below show the revenue split between these three components and the second table dives further into the largest portion, transaction-based revenues to understand those components better. |
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In the first quarter of 2022, PFOF revenue has fallen by 48% even though total Assets Under Custody has grown by $13 billion and cumulative funded accounts have grown by 4.8m. |
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Payment For Order Flow |
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How does $HOOD make money if they let clients trade as many stocks as they want for free? |
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PFOF. |
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Payment for Order Flow. |
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Payment for order flow is the revenue that a brokerage firm receives for directing trades to certain market makers or exchanges. |
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For example, let’s say Sally, Jim and Nick are engaging in a trade deal. Sally wants to buy a soccer figurine from Jim, but Jim only owns basketball figurines. Nick owns the soccer figurine, but Nick lives in Canada and doesn’t know Sally. Sally pays Jim for the soccer figurine and Jim pays Nick a discounted fee for the figurine. Nick delivers the figurine to Jim who delivers it to Sally. Everybody wins in this scenario – Nick got paid, Jim got paid and Sally got her figurine. |
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But, would Sally have paid less by buying the figurine from another seller, maybe without Jim’s help? |
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This is the key to Robinhood’s business - without PFOF, they would not be able to offer free trading and would not have grown so quickly. But PFOF can be a controversial topic. |
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Do clients receive the best execution for their trades if all trades are going to the market makers that pay Robinhood the highest fee? |
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Sometimes, yes. Sometimes, not at all. |
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For more in depth reading on PFOF, check out GRIT’s analysis from last December. |
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Bulls |
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$HOOD appears to have a strong balance sheet position that should allow them to weather the current storm and bear market. They currently sit on nearly $13bn of cash, which gives them plenty of runway to continue operating through this bear market and into the next bull cycle. |
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Robinhood has ingrained themselves in this world of gamified trading and investing. They have also never experienced a Bear Market like the one we are currently living through. |
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March 2020 was such a unique time because even though the market was tumbling, a global pandemic was rising, markets reacted faster than anyone expected. |
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The S&P 500 went from an all-time high in February 2020, to a market bottom in March 2020, back to a flat level by May 2020. This volatility provided an immense opportunity for Robinhood traders to put capital to work and make short-term profits. |
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Today, the S&P 500 has been trending downward for all of 2022 and the end does not appear to be in sight. The short-term volatility that traders rely on to turn a profit is also nowhere near what was seen in 2020. |
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This may seem bad, but Robinhood has positioned themselves to still profit from trading and ideally come out the other side, wounded maybe, but still alive. |
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Bears |
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Even though $HOOD has a significant cash position on their books, the market views them to be worth less than the cash they have on cash. |
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$HOOD currently has $12.9bn of cash on their balance sheet. Current market value stands at $7bn. Some might view this as an opportunity to buy an undervalued asset, but further analysis and understanding is required to figure out why this is the case. |
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HOOD is currently losing ~$400m per quarter. |
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Net Income for 2021 was -$3.7 billion, after only bringing in $1.8bn in revenue. This alone should be cause for concern. |
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50% of the company is owned by the two co-founders. Which means that all voting, control, direction, etc. is going to be determined by those two and almost no one else. |
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There are rumors floating that an acquisition may be in the cards for $HOOD. But a buyout would have to be approved by the two founders and most likely would be favorable only to them, not the broader investor base. |
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Management incentive compensation is based on two factors: net cumulative funded customer accounts and adjusted-EBITDA margins. This means bonuses are granted for bringing on more customers, generally a positive incentive, although easy to manipulate, and for hitting a specified and easily manipulated accounting target. |
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Generally, these incentives do not align management with shareholders and in fact, can cause nefarious actions to be taken and considered by management in order to ensure they hit their targets and receive their bonuses. |
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Robinhood has been highly reliant on bull markets to maintain their growth. Bear markets do not make investors excited about putting more money to work in their investment accounts. |
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In fact, financial advisors have to work their hardest during bear markets just to keep clients invested. For Robinhood, an investment platform focused on short-term performance, customers will be dropping like flies and their source of revenue will dry up very quickly. |
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Not only during equity bear markets, but during crypto-winter as well. Robinhood is highly reliant on the revenue they earn from crypto transactions. |
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In 2021, Crypto transactions made up 30% of total revenue, beating equity transactions by nearly double. In the first quarter of 2022, crypto revenues have fallen by 39% and only account for 18% of transactional revenue. |
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Catalyst |
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In 2021, Congress asked the SEC to provide a report and a recommendation on PFOF and whether or not it created a conflict of interest for brokers and investors. SEC Chairman recently made some comments leading the market to believe that PFOF may be going away in the near future. |
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Whether it goes away or not will be a huge catalyst for Robinhood, whose survival depends on PFOF. Without 77% of their revenue, there would be no rescue available to them other than a fire sale of assets and clientele to another exchange that is less reliant on PFOF revenue. |
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Sam Bankman-Fried (SBF), a crypto-billionaire and founder of FTX Exchange, has accumulated a ~7% stake in Robinhood recently. FTX has been on a spree with loaning funds to failing crypto exchanges and garnering the option to outright purchase them at a heavy discount. |
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While SBF has publicly denied the idea that he would purchase Robinhood, the crypto revenue stream is most likely very attractive to SBF, especially at current prices. It is not out of the question that he might offer a loan, in the event Robinhood needs funding, and take a chance at purchasing their assets or acquiring the whole firm. |
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In early 2021, Robinhood halted trading on Gamestop and AMC stock due to the deposit requirements imposed on Robinhood by the NSCC. Investors viewed this as an intensely negative event and even believed that Robinhood halted trading for their own benefit. |
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This event was a major negative catalyst for Robinhood’s growth and has negatively impacted them since then. Look closely at this slide from the Q1 2022 earnings call – growth has been nonexistent in new users since Q2 of 2021. |
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In fact, funded accounts have essentially been flat for a year but monthly active users have fallen precipitously. |
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Key Metrics as of 7.12.22 |
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Conclusion |
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Robinhood was a revolutionary technology offering when it hit the market: a trading mobile app that allowed users to buy fractional shares of their favorite stocks, play in complex markets and not pay a dollar for their transactions. We were all clambering to sign up and start trading. |
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But when the meme-mania heated up and everyone was making money hand-over-fist on companies like Gamestop & AMC, Robinhood halting trading was the absolute worst thing that could have happened. |
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Not because it kept investors from making money during that mania, but because it opened the door for users and investors to start questioning Robinhood’s motives. When Robinhood went public in July 2021, Wall Street and mom-and-pop investors scrutinized their public documents and realized the nature of Payment-for-Order-Flow and how misaligned the incentives were for management of Robinhood. |
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While we may still use the app for trading, the business itself appears to be on it’s last leg. Will it survive this bear market and come out a tougher and more shareholder-aligned business? Or, will PFOF legislation be the nail in the coffin for Robinhood? |
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Only time will tell. |
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Sources |
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https://seekingalpha.com/article/4522148-robinhood-4-reasons-you-should-avoid-this-stock |
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Factset; Edgar; $HOOD 10-K & Q |
