Party's Over! It's Time to Get Serious!

A look under the hood ahead of Robinhood's IPO

Three weeks ago my little sister (25) told me she wanted to buy Bitcoin. She’d never invested a nickel.

I told her I could give her a list of ETFs for her to consider, but she was hellbent on Bitcoin. Cool with me.

I’m just glad she’s starting to invest.

What struck me was when she brought it up she asked:

“Where should I open an account? I already know not to use Robinhood.”

Again, my sister = first-time investor.

She went with Coinbase.

Last week Robinhood announced it had confidentially submitted its S-1 with the SEC.

While we wait for that to become public, let’s take a look under the hood.

  1. Fundamentals

  2. Competitors

  3. Growth

  4. Risks

  5. Valuation

How I’m playing it.

Highlights

  • 2020 revenue = $682M (PFOF only)

  • 3 revenue streams = PFOF, subscriptions/margin loans, Cash Management (debit) accounts

  • Users = 13M

  • Average user age = 31

  • GameStopped

  • ~ $50B valuation

1. Fundamentals

Robinhood is a trading app that tailors to young, first-time investors.

They started back in 2013 and have gained huge popularity over the last several years. The pandemic definitely served as a catalyst, creating millions of these Twitter bios:

Not a financial advisor. Yeah, we know, bro.

Robinhood was among the first to offer commission-free trading, an advantage that has since been lost as all other online brokers followed suit.

What separates them is the simplistic user experience.

For the uninitiated, trading stocks can be a daunting prospect, Robinhood essentially removes all the scary stuff (fundamentals, analysis, projections) and gives you a clean screen that won’t have you rushing for your Zoloft.

They also incentivize new users by offering free stock when they make their first deposit, and for referring friends.

Revenues

So how does Robinhood make their money?

Payment for order flow, or PFOF. This means when you place your buy order on the app, Robinhood sends that order to a 3rd party that…you know what? Screw this:

The small fees they collect on high-frequency, and high volume trading aren’t so small when you add them up: last year they generated $682M in PFOF revenue.

This is a controversial practice, but they’re not alone, E-Trade and Chuck Schwabb do the same thing, just on a much smaller scale:

“Assume the average stock traded has a share price of $50. It takes 20,000 shares traded at $50 for $1,000,000 in volume, for which E-Trade makes $22 per $1,000,000 traded, which sounds like a small number until you realize they cleared $47,000,000 last quarter from this. But off an identical $1,000,000 in volume, Robinhood gets paid $260 from the same [high-frequency trading] firms. If Robinhood did as much trade volume as E-Trade, they would theoretically be making close to $500 million per quarter in payments from [high-frequency trading] firms.

Logan Kane, founder of North of Sunset Capital Management

How long they can keep this up is debatable. In December they agreed to pay $65M to settle charges brought on by the SEC:

for repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing customer orders to them, and with failing to satisfy its duty to seek the best reasonably available terms to execute customer orders.

SEC

This is to say: when you put in your order with Robinhood, you may not be getting the best price.

Not great for a company that relies so heavily on PFOF revenue!

This bar chart also tells me that the typical Robinhood user prefers a more ‘Wallstreetbets YOLO’ style of investing as opposed to a diversified portfolio of ETFs.

YOLO style investing segues nicely into Robinhood’s secondary source of revenue = subscriptions.

$5 a month gets you a Robinhood Gold membership which includes perks like instant deposits, Level II Market Data, and Morningstar research reports.

It also gives you access to margin.

Maybe you remember the “Infinite Money Cheat Code” from a couple of years ago?

No?

Well, a Reddit user discovered a glitch in the app that effectively allowed users to get up 500x leverage in some cases.

Whoops!

Robinhood’s introductory margin rate was 5%, but that was slashed in half in December of last year (presumably a way to retain customers amid ongoing legal/trust issues).

The third wheel of the revenue stream is their Cash Management accounts, which are essentially debit accounts that pay .30% APY - on par with the industry average.

Robinhood doesn’t actually make the interest payments, though.

Those are made by a “real” bank to whom Robinhood has fed the funds. The bank pays Robinhood a fee for bringing them the cash, and they also earn transaction fees on the debit cards.

Pre-COVID Revenues

The pandemic has been awful for a lot of industries, but Wall Street was not one of them. This chart shows how often “how do I buy stocks” was Googled from 2013-present:

It’s safe to say Robinhood has benefited immensely from this, but their revenues were doing just fine without the help of a global pandemic:

So don’t be so quick to write off Robinhood as a result of a bunch of apes funneling money into the stock market one stimmy at a time.

2. Competitors

Small

  • WeBull +2M users = commission free stock/crypto trading

  • SoFi +8M users = decentralized personal finances

  • Acorn +8M users = micro/robo investing

  • eToro +30M users = crypto focused

  • Stashaway ~7M users = traditional investments, online trading

Large

  • E-Trade, TD Ameritrade, TradeStation, Interactive Brokers, Merryl, Fidelity, Chuck Schwabb…basically any big online broker.

That’s a lot of names, but the competition is actually relatively low for Robinhood.

Their advantage is that the smaller competitors are focused on more niche markets and traditional/mainstream investment products. Meanwhile, the large brokerages don’t seem to be too interested in the first-time investor that Robinhood is going for.

3. Growth

Launch

Robinhood’s app launch was a MASSIVE success thanks to their referral priority program.

Once you got on the waitlist, you could jump up the line by getting your friends to get on the list too.

By the time they launched the app in 2015, they had nearly 1M aspiring Jordan Belforts waiting to start their path to early retirement.

If it ain’t broke, don’t fix it

In 2018 Robinhood decided it wanted a piece of the crypto pie, so what do they do? They launched another waiting list, this time for access to crypto trading.

Because why the hell not? Worked last time.

The results were predictable: a waitlist 1M long, bumping up their userbase base by 33% up to 4M.

New Customer Acquisition

Low-low-CAC

Today Robinhood has 13M users, including 3M new users already this year:

They’ve been able to achieve these strong growth numbers all while keeping their CAC (customer acquisition costs) numbers on the low.

Figuratively and literally - they haven’t disclosed the numbers, but some analysts ballpark it ~$25.

This is presumably attributable to their strong referral program.

For reference - bigger brokers are estimated to pay around $150-200 per account.

Riding the podcast & newsletters wave

Everybody and their mother has a podcast and/or a newsletter these days, and Robinhood is no exception.

They acquired MarketSnacks in 2018 and rebranded it as ‘Robinhood Snacks’ which features a newsletter (+20M monthly) and a daily podcast (+2M monthly).

Alternative Investment Products

Aside from their Cash Management account, Robinhood doesn’t have much to offer investors in the way of alternative investments. I see this as a potential area of growth.

If a first-time investor already chose you over your competitors, why not put together a package of non-traditional products for them?

A product like robo-investing could appeal to existing Robinhood users who want separate, less YOLO portfolios.

Your competitors have shown you that it works, and you’ve already got the user. Why not?

4. Risks

Robinhood has been a growth machine, but that growth comes with some undesirables attached.

Low-low-LTV (lifetime value)

Robinhood’s strategy of catering to the smaller, younger investor overlooked by the big brokers means their average user account is much smaller, averaging between $1-5K. Your typical Morgan Stanley account, on the other hand, holds $69K.

So they’re able to acquire users cheap, but those users aren’t exactly backing up the Brink truck.

Adding those new alternative investment products could help mitigate this risk. Products like micro-investing or robo-investing could get hesitant newbies through the doors, opening up the possibility of stocks, options, and crypto trading.

Conversely, Robinhood could market these new products to existing users, creating an additional source of revenue.

GameStopped/Regulations

Robinhood’s revenue model could easily disappear. They’ve made it clear that they are comfortable living on this regulatory edge.”

Tyler Gellasch, executive director, Healthy Markets

That quote is from 2018.

Unless you’ve been living under a rock, you know about Gamestop mania, so you know what happened.

This drew the big public (therefore political) spotlight to a controversial COG in a machine that doesn’t like light.

COG = PFOF

Machine = Robinhood

Trust

Setting aside the complex regulatory issues that arose from the $GME saga, the damage done to the company’s brand image alone should be very concerning to potential investors.

When it comes to first-time investors, trust is BIG deal. They’re venturing into something risky and dangerous.

And it’s going to be a looooong time before Gamestop and Robinhood aren’t synonymous, if ever.

Robinhood (Audio)

5. Valuation

Robinhood’s last round of funding in September raised $600M at a valuation of $12B.

Today some experts estimate the company could be valued at over $50B when it IPOs. That’s 4x in 7 months.

Reference: $RBLX IPO last month = $45B

What am I doing?

Nada.

I find this valuation too high for a company that is right in the thick of regulatory issues.

And under a lot of pressure from politicians who don’t understand it.

We’re also less than 3 months removed (feels like a year) from the Gamestop fiasco, so I’m curious to see what the growth and revenue numbers look like once the residual effects get factored in.

But that's all I am right now: curious.

It might be a stock I revisit in the future once the dust settles and it shows its true colors.

For now….