Robinhood's Slow Demise
- Robinhood revolutionized a market, but since going public, its share price has consistently suffered.
- The company earns money from "payment for order flow" a risky business model that angers customers and remains volatile.
- The company earns most of its revenue from options and crypto trading, which is a more volatile business.
- The company is losing money and no longer growing, which in our view, means it's slowly dying.
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Robinhood (NASDAQ:HOOD) has dropped almost 90%, wiping out $10s of billions in shareholder value. The company was recently called out by Charlie Munger at Berkshire Hathaway's (NYSE: BRK.A) (NYSE: BRK.B) annual meeting, as he pointed out that the company's demise was expected. As we'll see throughout this article, this is just the start.
Pay for Order Flow
So what's pay for order flow?
Companies that offer commission free trading look for other sources of income. Among that is the execution of the trades. When you execute a trade, your broker isn't directly trading the stock. Rather they're sending the trade to a wholesaler / market maker which executes the trades themselves. In exchange the wholesaler pays them a fee.
Robinhood collects hundreds of millions from these fees. Legally, the wholesaler is required to find the "best execution", however, that has a variable definition, and as SEC action against Robinhood shows, regulatory bodies don't believe the company meets that. In fact, the SEC has argued that Robinhood's pay for order flow costs customers more than free trades.
There were also allegations that Robinhood restricted trading on stocks as investors caused a short-squeeze, in order to protect Citadel.
Robinhood and The Move Away from Equities
In our view, the much larger problem for Robinhood is the source of revenue.
Robinhood Equity Moves - Robinhood Investor Presentation
Robinhood has seen its revenue go from equity investments to being primarily options and crypto investing. These two categories now make up almost 90% of the company's revenue. Without these categories the company's annualized revenue is roughly $100 million for a company with a market capitalization of almost $10 billion.
In our view, that's incredibly risky. Both represent "gamified trading" that are likely to underperform in a market downturn. Investors who might have "play money" now might not still have that money during a downturn. The company's average account size of less than $5000 indicates the small company size and "retail investor" trading.
The move away from equities for the company represents significant risk to the company's earnings.
Putting this all together, Robinhood seems to have peaked. Unfortunately for the company, at that peak, it's losing money.
Robinhood Losses - Robinhood Investor Presentation
Robinhood is still losing hundreds of millions per quarter with no sign of reaching profitability. With decreasing annualized revenue of less than $1 billion and annualized losses of roughly $1.5 billion, the company shows no signs of fixing its massive losses even if the trend has been slightly downward over the past quarters.
More so, those losses don't count the company's increasing shares outstanding, a cost of retaining talent that's likely to go up as the company's share price has decreased. That cost alone would cost hundreds of millions in annual buybacks to neutralize out. This peak shows that the company has no path towards generating shareholder rewards justifying its valuation.
In our view, Robinhood might eventually get acquired by a larger brokerage, but in its current form is significantly overvalued.
Other Brokerage Risks
We do want to take a moment to highlight that the risks we've discussed above are not unique to Robinhood.
Charles Schwab (NYSE: SCHW) is a much larger brokerage but it's worth noting that it makes more revenue from payment from order flow versus any other broker. The broker has also moved to free trading "no cost trades" along with many other brokerages, after pressure from Robinhood put pressure on the entire industry.
That means that the same bad press and risks that have faced Robinhood could eventually affect these other "PFOF" (pay-for-order-flow) brokerages as well.
Robinhood took what could have been an enormous boon (the flock of customers and retail traders) and pay-for-order-flow and the Citadel fiasco has hurt its reputation, in my view. It takes a lot to have Charlie Munger critique your brokerage on the internet, especially when you're using the same business model as numerous other companies.
The company's assets under custody and revenue are both declining YoY. The company's continuing to generate substantial operating losses, and given the size of the costs at 2.5x revenue, there's no indication that it'll be able to return to profitably. Given the majority of the company's revenue from option and crypto trading, we expect this decline to continue.
We expect the company's terminal decline will harm its ability to continue generating shareholder returns.
The risk to our thesis is Robinhood's market defining position. The company continues to have one of the best mobile interfaces for trading and remains a dominant platform in the space. Its technology makes it a potential acquisition opportunity. This combination of factors could put an end to the decline of Robinhood's stock.
Robinhood was called out by Charlie Munger, which should show a sign of the company's difficult market position. The company takes payment for order flow, like many of its competitors; however, its halting of trading on popular meme stocks at the same time that those trades were hurting its largest customer shows the risk of the company's business.
The company has seen its assets on the platform slow down along with active accounts plateau. The company's revenue has been slowing down and the majority of that revenue now comes from crypto and options. Given the company's current losses, in our view, the company is in perpetual decline - highlighting how it's a poor investment.
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