Robinhood's Reliance on Crypto Markets Revealed

In this episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matt Frankel, CFP, dig into the first earnings report Robinhood (HOOD -2.63%) has issued as a public company. Also, we recently learned Wells Fargo (WFC 2.74%) reversed course on a not-so-popular adjustment to its business, and Matt thinks it's a welcome change. Finally, Bill Ackman's mega-special purpose acquisition company (SPAC) Pershing Square Tontine Holdings (PSTH) has made a major strategy change, and it could be time for investors to move on.

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This video was recorded on August 23, 2021.

Jason Moser: It's Monday, August 23rd, I'm your host Jason Moser, and on this week's financial show, we'll take a look at Robinhood's earnings season premiere. Wells Fargo has had a bit of a change of heart and Bill Spackman's plans take, well, another turn. Joining me, it's Certified Financial Planner, Mr. Matt Frankel. Matt, how's everything going?

Matt Frankel: Just great. It's finally not raining. It was raining all weekend here.

Moser: Yeah. It seemed like we got away with one tropical storm. Now I guess it was a hurricane at the time. Would you call it Henry or would you go "Henri?"

Frankel: It depends where you are, I guess.

Moser: I mean, I took a lot of French growing up and so my default when I see the spelling, it's to call it hurricane Henri. That makes me feel very good so I just want to call it Henry. At least we skated at the worst of Henry and then hopefully our neighbors up to the north are all getting by OK. It looks like it could've been worse, but yeah, beautiful day here in Northern Virginia as well. Speaking of beautiful days, Matt, Robinhood didn't have such a beautiful day. The day after its earnings were announced, the market didn't really receive, I think, that report all that well. Going through the release, I feel like all things considered between the market's reaction and the actual numbers, for me, this isn't a company I feel compelled to put on my radar, but I also feel like this earnings report could've gone far worse.

Frankel: The numbers were great. Revenue more than doubled year-over-year. But what investors really need to know is, it's not a stock trading app. Everyone thinks of Robinhood as a stock trading app. They make the bulk of their money through options and crypto.

Moser: Yeah, I was going to say it's a crypto trading app.

Frankel: There are other platforms that do the stock trading part better, in my opinion. SoFi has a platform that does it better, the Cash App brokerage platform does stock trading better. No one does options trading quite as free and democratized as Robinhood does, and no one offers as much variety in crypto as Robinhood does through a traditional brokerage platform. Robinhood has seven cryptocurrencies, including Dogecoin, which accounted for 34% of its crypto revenue this quarter, by the way.

Moser: That can't be good. Let's be real here, folks, that can't be good.

Frankel: My point is, those are things that are, the crypto, I don't want to call it a fad, because there are some long-term use cases for those coins of fad. I will be plain and simple.

Moser: It feels like it is.

Frankel: But is it going to be at its current interest level forever? I don't know. It may be, it may not. That was 51% of Robinhood's transaction-based revenue, crypto trading. That's a lot to rely on crypto trading.

Moser: It is. It really is.

Frankel: Options trading especially is a worry. It's not quite as big as crypto trading for Robinhood, but it's a lot bigger than equities trading. It made up $165 million out of $565 million of revenue. You could probably back me up on this. If you don't know what you're doing with options, you're probably going to lose money.

Moser: I would agree. I think that with options, it's far more nuanced. It requires more education. I think it's far more than an active style of investing. You need to stay on top of that strategy far more than you would if you just stay a buy and hold investor taking that longer view.

Frankel: That's the point. Robinhood are relying on these other options traders to keep trading at these elevated volumes. But what happens when inexperienced option traders buy too many call options and lose their money and then lose interest?

Moser: I feel like we've seen the worst case scenario there. We've seen some stories that exist, the worst of the worst case.

Frankel: I would worry as a shareholder, I'm not a shareholder of Robinhood but, If I were, I would worry that they are so dependent on those two forms of revenue that make up almost between the two of them. That's 90% of their transaction-based revenue. They make a little bit of revenue from selling subscriptions. They have a premium, the Robinhood gold platform that accounts for a little bit of revenue. But 90% or close to it of their transaction-based commission revenue, in other words, not commissions, but they make a payment for order flow, things like that, comes from crypto and options. That would worry me if it was, say 50% stock trading revenue, great, that's sustainable. The crypto and options thing scares me. I don't know about you.

Moser: Well, it does. For me, I don't know if it scares me as much as it just makes me really doubt the sustainability. I think that's the key. It's one thing to do it well for long stretches of time, and I think that's where I grow a little bit concerned, and I think one of the signs with Robinhood that makes me view it a little bit more glass half empty, you look at assets under custody, and it was very encouraging when you look at the actual number. Assets under custody reached $102 billion. I think it was up something like 205% from a year ago. On the surface it sounds great, but now, when you couple that with the actual number of cumulative funded accounts at 22.5 million accounts, all of a sudden now you see that there's this account average of around $4,500. That's telling us a couple of things. It's telling us number one, that, on the average, they're not high-value clients. I mean, $4,500, it's not a high-value client, particularly when you look at something like Schwab that holds $7.5 trillion under custody. I would also imagine that of that $4,500 average, I bet you the median is far lower. You've got this one, two punch of not the most valuable clients in the world, and they're not investing as much as they are speculating. That to me is scary.

Frankel: Yeah. Two points to back that up. I don't know Schwab's average, but I know their average retirement accounts in a $100,000 ballpark as Schwab. Schwab has an average account size that's about 20-30 times greater than Robinhood. But it's not churning. They're not relying on high-frequency trading. You're relying on these relatively small balance accounts. In a way right now, those accounts are very valuable. Those are high-value customers to Robinhood just because of how frequently they trade.

Moser: Sure.

Frankel: The Schwab account is not that valuable to Schwab if nothing ever moves in the account. In that sense, they're valuable to Robinhood. But how sustainable is that from a smaller account like that? I know for a fact, my first trading account that I started with about $2,000 didn't end well for me the year back in college. I could see the same thing happening with a fair percentage, not all, but a fair percentage of Robinhood's clients, and specifically the ones that are frequently trading cryptocurrencies and frequently trading options. People are buying stocks in the Robinhood account to hold, or buying Bitcoin in their account to hold I'm not worried about. It's those frequent traders who a lot of whom, not all, but a lot of whom don't know what they're doing, and they're starting with relatively small balances. What happens when that goes the wrong way and they get bored of it or decide to get their speculation out through sports betting instead? The lack of gambling options in 2020 remember was a big reason why the ratification of trading really picked up.

Moser: Well, I'm glad you brought up sports betting because it's what this really makes me think of, it's something tantamount to bad. I enjoy throwing a few bucks on a game here and there. That's something. But I really enjoy doing that during football season. I'll fiddle around with golf during the majors and stuff like that. I couldn't care less about baseball and the NBA and whatnot because I'm not going to ever gamble on that stuff because I don't care about it. There's a good seven to eight months out of the year where I just I'm not really interested in placing too many wagers, therefore there's no activity, and I would imagine that in regard to something like Robinhood, you've got people who for the most part are speculating somewhat you could say gambling to some extent. If you're losing money, you start losing interest. Then you start figuring, OK there's no way to win. This thing is rigged against me, I'm going to go after other greener pastures and try something else. Yeah, to your point, I mean, it does make you wonder. 

Again, we go back to that one word, sustainable. I mean, how long can they keep this up? The clock is running on the defined new avenues of revenue. Whatever that may be, subscription services, media, financial media services, whatever it may be, they really do need to double down on figuring out alternative revenue streams because I don't know that being just a crypto slash options trading platform is going to cut it. I mean, at least from the investors' perspective. I mean, I have no interest in investing in this business simply because of the way they make their money.

Frankel: Yeah, if I were an investor in Robinhood I would want to see them double down on their subscription options. I said they offer seven different crypto currencies, they offer more but only for people who are paying for access deals.

Moser: Yeah.

Frankel: They come up with different subscription products that appeal to the options traders and appeal to the crypto traders. Because that commission, not the commission, I keep saying commission. That payment for order flow, the transaction-based revenue that they make, it's not going to sustain at that level, they even called that out. They said that they're seeing a slowdown in the third quarter already in terms of trading activity.

Moser: That seems very believable.

Frankel: Even if it lasts best-case scenario, if it lasts, it's not going to be consistent.

Moser: Yeah.

Frankel: I mean, recurring revenue. We always talked about software as a service business just because they produce recurring revenue and I'd love to see Robinhood double down on that. If they get to the point where subscription revenue is more than half of their total, I mean, that would get me interested.

Moser: Yeah, one other little nugget that stood out to me on the call and I'd be interested to get your input here, your insight. I noticed that they said they noted they are incurring losses from debit card charge backs and reverse deposit transactions. In other words, people trying to fund accounts that they can't ultimately fund and then that money gets charged back. I mean, it wasn't something that is so impactful to the business today, but it's not insignificant. It was $40 million during the quarter. Given the nature of their demographic, I mean, that's something that we have to keep in mind. Maybe we keep an eye on that number because if that number doesn't go down, and worse if that number continues to go up and I think they've got another problem they need to address all together.

Frankel: Yeah, it just circles back to the controversial nature of a lot of what Robinhood is doing. Like I mentioned, the gamification of trading, having a lot of debit card charge-backs, which I have to imagine it's not really a significant part of Schwab's revenue.

Moser: Yeah.

Frankel: It could really start up even more controversy, I would think.

Moser: Well, speaking of controversy, Matt, several weeks back we talked about Wells Fargo's decision to shutter its personal lending products. It looked like it was something where they more or less just decided one night they were going to stop offering these personal lines of credit I believe they were and then they said, well, they are doing it because they just felt like they needed to and by the way, it may impact our credit score. We're not really sure, but this is just what we're going to do. We said on the show when we were talking about this initially that probably the biggest risk to Wells Fargo was just in their messaging of this because it didn't seem to be very well-planned out. I can certainly understand consumers doing a double-take and saying, what do you mean it might impact my credit score and this is going to be something that I have zero control over. I wasn't terribly surprised, Matt, to see that it seems like Wells Fargo has had a little bit of a change of heart.

Frankel: Well, and it also seems like their PR people are getting better for the first time around. Remember, we said they expanded really poorly.

Moser: They did.

Frankel: They should have blamed the credit scoring thing on FICO because that's whose fault it was.

Moser: Yeah.

Frankel: They expanded better this time. They said they're leaving existing credit lines alone provided that they are active, customers are actively using them. They're not opening any new personal lines of credit and they made that decision over a year ago, by the way, so that's nothing new. Inactive accounts will be closed in December, so if you have a Wells Fargo line of credit that you're not using, they're going to go ahead and close it in December and that's actually really common with a credit card too. I don't know about you if you've ever gotten one, but If I don't use a credit card for a year or so, they'd send me something saying your account is inactive and we might close it. It's a common practice with inactive accounts because banks want to lend money to people who want to borrow. I'd say they actually expanded a lot better this time. They said this decision was based on feedback from their customers, I think it was based on pressure from people like Elizabeth Warren and the media and whoever else. I don't really think that it was the customers, but better messaging this time. Smart management decision, and this is a pat on the back to Wells Fargo's management. I think they did it well.

Moser: Yeah, I tend to agree. I mean, it didn't make a whole heck of a lot of sense. I mean, the decision is one thing, the way they message it is an entirely separate thing and it really did feel like the messaging they just missed the mark and so hopefully, I'd like to think that they did make this decision based on consumer feedback. If the reality of the situation is that it was from other external pressures, at the end of the day, I think it's still the right decision, and so it's good to see that end result no matter how they got there and probably boards well for their brand in the longer-term as being a more customer-centric, customer-friendly, therefore, your customer type brand, which ultimately, I mean, let's face it, with a bank like Wells Fargo, I mean, that's a very familiar brand you want and you need really that consumer trust, that faith, that your bank, you are going to be there for your consumers, for your customers when they need you most and this hopefully makes customers feel a little bit better. What probably doesn't make people feel a lot better, at least people in the SPAC world and folks who follow Bill Ackman and Matt, I'm going to put you in both categories there. We've been talking about this story a lot too. I'll admit, I'm growing a little bit confused as to exactly what's going on here, and I like to say that investing is as easy or as difficult as you want to make it. Bill Ackman in his SPAC aspirations seemed to have been put on hold yet again and is now facing, I think at least some litigation. Is Ackman making this more difficult than it really has to be?

Frankel: Well, I'm looking at some of my previous headlines about this. There's one that says, here's why Bill Ackman's SPAC is a liquid long-term value, one says breaking down Bill Ackman's Universal Music deal, here is why I'm excited about the deal, here's why investors should stick with Pershing Square Tontine after the deal went away.

Moser: What's today's headline, Matt?

Frankel: Yeah, those four didn't age very well, did they?

Moser: Well, what's today's headline, Matt?

Frankel: Well, today's headline is why I'm cutting my losses and moving on.

Moser: Well, you know it happens to the best of us.

Frankel: Here is why, let's not sugarcoat it, this has been a disaster.

Moser: Yeah.

Frankel: Ackman raised $4 billion in the SPAC. A SPAC, the purpose of it is to find a business, one, singular to take public through this vehicle. They announced a relatively complex deal. I'd say relatively, it was the most complex SPAC deal I've ever heard of where they were going to acquire 10% of Universal Music, leave some money in the SPAC to find yet another target, and then create a whole new investment vehicle that doesn't even exist called a SPAC, and distribute SPAC rights to the existing shareholders. The deal sounded great, it's not what SPACs are for.

Moser: Right.

Frankel: The SEC quickly had an issue with it and the deal was canceled pretty shortly after it was announced if you remember?

Moser: Yeah.

Frankel: That would've disappointed me specifically. It seems like someone like Bill Ackman would've done the due diligence to see if they could do that deal. If you were going to run into regulatory roadblocks that quickly, you couldn't have found that out before you announced it. [laughs] That was red flag No. 1. But I held on because he said, "Okay, well, now we're $4 billion. We were already in talks with a few other businesses. We're still going to try to find someone to take public, we'll do a traditional SPAC merger instead. We have 11 months, whatever. We'll be fine." So I held on, the stock would come down a little bit. It didn't seem worth selling at that point. But then over the weekend he put up the shareholder letter that essentially said two things; one, he's not looking for an acquisition target anymore and plans to return investors' money, $20 a share. No. 2, that they're going to try to accelerate the creation of the SPAC vehicle and distribute a warrant to each shareholder so they can participate in that deal at costs. There's really no investment thesis here. You get your $20 back. That creates a price floor. That's a limit to how much the shares will go down at this point. But the only reason to hold, is to try to get one of these SPAC warrants, which is an investment vehicle that doesn't even exist yet and would require the New York Stock Exchange to change a rule in order for it to exist. That doesn't seem worth keeping my money tied up in anymore.

Moser: I tend to agree.

Frankel: It's not a stack if the stack is not looking for a target. Remember in Iron Man when he said this is a weapons company that's not making weapons. I can't feel like it's that situation here right now. What's the reason to hold? I can't really come up with a good answer to that question.

Moser: Well, I think that's a very pragmatic way to look at it. It feels like this is becoming the ultimate forward-looking investment and not really in a good way. But I think there's a good lesson for folks out there and it's one that you've learned. I know all along your investing journey is one that I've learned as well. It's one that I know a lot of our listeners have either learned or are in the process of learning. That is just that when the thesis changes, it's OK to change your mind when the situation changes you have to reassess. Now, there are levels of change. Some changes are more material than others, and there are some changes that may not be that big of a deal. I would qualify this, I'd classify this as a big deal. This is a significant change and it's one where it feels like OK, the investing case just isn't what it was before. I've to reassess, is it still worth keeping my money tied up here? What does the future look like? Clearly it's changed enough to the point where you don't feel like it's worth tying that money. There's no opportunity cost involved.

Frankel: Yeah, and I know you've said a lot of times on the show that humility is a great characteristic of any investor.

Moser: Sure.

Frankel: So it's important for investors to be able to admit when they were wrong. I was wrong about this. I would like Ackman to admit the same. I think he said he wants to return investors' money, but if and only if the SPAC thing is approved. He should just admit that the SPAC is not working out, they're not going to be able to find a target which he said in his letter and just return investors' money and move on. Create the SPAC if you want to and let people buy it if you want to, but just admit you're wrong and move on. Ackman is great at spinning things, speaking of Wells Fargo. It was well spun. But at the end of the day, this really hasn't worked out the way he wanted it to and it's time to move on.

Moser: Well, from your mouth to Ackman's ears, we can only hope that he thinks it's out in front of it, but we shall see.

Frankel: I'm still an Ackman fan though. I'd say that with peace and love.

Moser: Well, there you go. We'll leave it on that note, Matt. It's always a pleasure to talk with you on Monday as I appreciate you, certain times I could jump in and talk with us again today.

Frankel: Of course, it's always fun to be here.

Moser: That will do it for us this week, folks. Remember, you can always reach out to us on Twitter @MFIndustryFocus, or you can drop us an email at [email protected]. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks to Austin Morgan for making this show together for us. For Matt Frankel, I'm Jason Moser. Thanks for listening and we'll see you next week.