Robin Hood May Not Approve Of Robinhood’s Business Practices (NASDAQ:HOOD)

Robinhood Markets, Inc. (NASDAQ:HOOD) is a financial services company that operates a digital investment platform. The company was founded in 2013 and has since become a popular choice for retail investors. One of the key features of the platform is that it allows users to buy and sell stocks, exchange-traded funds (ETFS), options, and cryptocurrencies without paying any commissions or fees. This business model, known as “commission-free trading,” has been a major selling point for Robinhood and has helped the company attract a large and loyal customer base. Back in 2020, Robinhood’s popularity exploded with millions of home-bound youth trying their hands at investing in stocks for the first time, and the company quickly became the go-to platform among retail investors looking to make some quick bucks amid a record market rally. Fast forward to 2022, many of these young investors are running for cover, and arguably, some of them will never look back at the stock market until it’s too late.

Stealing from the rich and giving to the poor is what Robin Hood of Sherwood did. Robinhood the company continues to reward executives although its shareholders are reeling from losses, and the new year is set to bring new challenges as well.

How Does Commission-Free Trading Work?

There are a few different ways that Robinhood can offer commission-free trading. One way is by generating revenue from the sale of its users’ order flow to market makers. When a user places an order on the Robinhood platform, the company sends that order to a market maker, who executes the trade on behalf of the user. In return, the market maker pays Robinhood a fee for the order flow. This fee is typically a small percentage of the trade, but it can add up to significant amounts of revenue for a company, especially if it has a large number of users and a high volume of trades. Robinhood ticks these boxes.

Exhibit 1: Illustration of the PFOF model

Source: Medium

Another way that Robinhood can offer commission-free trading is through its subscription-based premium service; Robinhood Gold. Users who sign up for Robinhood Gold pay a monthly fee in exchange for additional features, such as after-hours trading and margin trading. The company also generates revenue from its cash management and cryptocurrency products, as well as from the sale of other financial products and services.

It is important to note that while Robinhood’s commission-free model may be attractive to some investors, it is not without risks. The company has faced criticism and regulatory scrutiny over its relationships with market makers and its handling of customer information.

Not Been An Easy Ride

In January 2021, Robinhood faced significant criticism and scrutiny after it implemented temporary trading restrictions on several stocks during the GameStop (GME) short squeeze saga where the stock price of GameStop was driven higher by a coordinated effort by retail investors on social media platforms like Reddit. The restrictions, which were implemented in order to protect the stability of financial markets and prevent potential losses for the company, led to widespread outrage and accusations that Robinhood was acting in the interests of institutional investors rather than its own users. Robinhood’s CEO Vladimir Tenev was summoned to appear before Congress about how Robinhood may have aggravated the problem.

Since the GameStop saga, Robinhood has faced a number of legal challenges and regulatory investigations as well. In June 2021, the company agreed to pay a $65 million fine to the Securities and Exchange Commission for failing to properly disclose its relationships with market makers and for not having adequate safety measures in place to prevent the misuse of customer information. In November 2021, the company revealed that hackers had obtained the identities and email addresses of millions of Robinhood customers, throwing the company’s security protocols into question. The SEC and FINRA fined Robinhood more than $130 million in total for misleading and irresponsible customer behavior. The company has also faced several lawsuits related to the GameStop episode, including a class action suit brought by its own customers.

The ongoing fallout from FTX has a number of possible consequences for the company. According to a filing submitted on December 22, FTX requested the assistance of a U.S. bankruptcy court in a dispute over ownership of over $450 million in Robinhood stock, with approximately 56 million shares of the brokerage at stake. The possible liquidation of these shares could push HOOD stock down further.

Robinhood Products

The company offers a range of products and services for retail investors.

1. Brokerage services: Robinhood allows users to buy and sell stocks, exchange-traded funds, options, and cryptocurrencies without paying any commissions or fees.
2. Robinhood Financial: This is a brokerage account that allows users to trade a wide range of financial instruments, including stocks, ETFs, options, and cryptocurrencies.
3. Robinhood Gold: This is a subscription service that provides users with access to additional features, such as after-hours trading, larger instant deposits, and margin trading. Robinhood Gold charges a monthly fee of $5 to provide consumers with access to a lower interest margin account. Users with a Robinhood margin account will pay 9.75% interest without Robinhood Gold, but that rate is reduced to 5.75% with Robinhood Gold.
4. Robinhood Cash Management: This is a cash management account that offers a high-yield savings account with a competitive interest rate, as well as a debit card that can be used to make purchases and withdraw cash from ATMs.
5. Robinhood IRA: This is an individual retirement account (IRA) product that allows users to save for retirement with tax-advantaged accounts.
6. Robinhood Snacks: This is a daily newsletter that provides users with market news and analysis.
7. Robinhood Crypto: This is a platform that allows users to buy, sell, and hold a variety of cryptocurrencies, including Bitcoin, Ethereum, and Litecoin.

Young Investors Are Running For Cover: Bad News For Robinhood

Although Robinhood’s equities business appears to be stable, there is limited growth given the uncertain market outlook and diminishing confidence in markets among young investors. The number of DIY investors – individuals who manage their own investments rather than depending on professional financial consultants – has risen in recent years with many investors relying on online investment research platforms and social media to identify new investment opportunities. This trend has increased in recent years fueled in part by the availability of online brokerage platforms, which have made it easier for individuals to access financial markets and manage their own investments. The rise of social media and online communities has also contributed to this trend, as young people have been able to connect with other investors and share ideas and strategies. Young investors choose to invest on their own because they feel confident in their ability to make informed investment decisions or may prefer to have more control over their investments and the convenience and flexibility of managing their own portfolios.

The COVID-19 pandemic played a massive role in bringing new investors to the market as many people were forced to stay at home and had more time to research and learn about investing. Arguably, many young individuals got interested in investing and trading in order to make quick money during the favorable market conditions in 2020. A Charles Schwab survey (2021) found that 15% of total stock market investors in the U.S. got their start in 2020. Let that sink in! According to JMP Securities, 10 million new clients were added in 2020, with six million of them choosing Robinhood.

Exhibit 2: Robinhood app downloads

Source: Statista

Although it is important to approach investing with a long-term perspective and to build a well-diversified portfolio in order to manage risks effectively, many of these young traders seemingly got carried with the gains in 2020 and thought such gains were the norm, not the exception. I have come across many social media posts of young investors who claim we should not be investing in markets if we cannot reliably earn annualized returns in excess of 100%. This goes on to show the absurd, unrealistic investment return expectations of some of the youth that started investing in stocks only in 2020. It is not uncommon for investors, regardless of their age, to take breaks from trading or investing if they feel overwhelmed or uncertain about the markets.

New investors that entered the market for the first time in 2020 or 2021 are considering taking a break from trading or investing, as they begin to realize the risks associated with DIY investing. According to a survey by Morning Consult, wealthier, mature investors are investing in stocks today while younger investors with an income of less than $50K/year are distancing themselves from stocks.

This year, Robinhood’s reliance on young investors is coming back to haunt the company. Last year, Reddit-driven trading and stimulus checks encouraged those investors to invest in meme stocks, riskier option trades, and new cryptocurrencies to make quick profits, resulting in Robinhood’s revenue skyrocketing to $1.82 billion in 2021. But the financial markets can be volatile and investing carries inherent risks. As interest rates rose, the market shifted toward more conservative investments, resulting in a bear market that stalled Robinhood’s monthly active users (MAUs) and profits. The company had 12.2 million MAUs at the end of the third quarter of 2022, down from 18.9 million MAUs the previous year. Although ARPUs are trending in the right direction finally, investors should not mistake Robinhood for a software company with infinite ARPU growth potential. The competitive nature of the industry caps Robinhood’s ARPU growth potential, which is why investors need to curb their enthusiasm about this positive trend.

To attract more users, Robinhood launched IRA Match in December. The platform already offers an individual retirement account (IRA) product that allows users to save for retirement with tax-advantaged accounts. There are two types of IRAs offered by Robinhood: a traditional IRA and a Roth IRA.

Both traditional and Roth IRAs have annual contribution limits, which are set by the IRS and may vary from year to year. It is important to note that there are rules and restrictions regarding contributions, withdrawals, and other aspects of IRAs. According to federal regulations, investors cannot contribute more than $6,500 to an IRA in 2023. Investors over the age of 50 can invest an extra $1,000. Since December 6, customers have been welcomed join the Robinhood Retirement waitlist to invest for their retirement, without the need for employment, and get a 1% match from Robinhood on every qualified contribution dollar made through the Robinhood Retirement program. The program is geared toward gig workers who may not have access to an employer retirement plan or the perks of 401(K). In January, the company will expand the availability of its Robinhood Retirement program.

Managers Vs. Shareholders?

The primary objective of a company’s existence should be to reward its shareholders in the long run. To this extent, corporate governance best practices dictate that the interests of shareholders and managers should be aligned. Robinhood’s stock-based compensation policy, however, seems to miss the trick. The below chart illustrates the annual stock based compensation expenditure relative to revenue for the last three years.

Exhibit 3: Robinhood stock-based compensation vs revenue

Source: Company filings

The massive increase in revenue since 2020 has not led to any gains for shareholders as the market value of the company has plummeted after peaking in July 2021, but the company has continued to issue new shares to executives, rewarding executives at the expense of shareholders because of the massive dilution that is taking place.

In the investment world, managers vs shareholders is the last thing you would want to hear, but the numbers only add up to that conclusion today. I have a feeling that Robin Hood – the Sherwood guy – would not have loved these numbers either.

Takeaway

Robinhood has a lot on its plate with the company struggling to land softly following the explosion of active users at the height of pandemic fears. The improvement in ARPUs does not make up for the substantial ownership dilution resulting from stock-based compensation and the competitive threats. As we head toward 2023, I believe HOOD might recover temporarily along with a comeback from tech stocks, but such gains, in my opinion, will not last long as the market focus shifts back to Robinhood’s dismal earnings.