Fintech wars are heating up as they encroach on each other’s turf — how investors should play it

Published Thu, Sep 2 20212:50 PM EDTUpdated Thu, Sep 2 20214:08 PM EDT

Earlier this week, CNBC reported that PayPal is exploring ways to let users trade individual stocks. Since all of the major fintechs now have the goal of becoming customers' digital financial supermarket, CNBC Pro broke down which stocks investors might want to own as the group battles it out. Investors and analysts told CNBC Pro that since everyone is playing the same game, it's going to be a very competitive. However, this won't be a winner-take-all situation. Most fintechs start with a niche to grab users and later diversify their products. For PayPal , it was merchant-to-consumer payments; for Square , it was devices that facilitate credit card payments when inserted into tablets. Robinhood pioneered free stock trading and SoFi made its name in the student loan industry. Once fintechs reach diminishing returns on new users in their core business, they try to crack the same code in a new area. It remains to be seen if many of these fintechs are versatile enough to transfer into other services beyond what they became famous for in the first place. "To satisfy the rapacious desire of shareholders for new revenue streams and future growth, you have to expand laterally," said Hugh Tallents, senior partner at consulting firm cg42. "They can't all win. So most of it will be determined by what your entry point is and what permission you get from the customers to play a more active role in their lives and how you take risks and innovate ahead of the curve." On the surface, Wall Street unanimously loves SoFi, which has buy ratings from just the three analysts that cover the stock. They collectively see the stock rallying 86% in the next 12 months. Wall Street also likes PayPal, with 87% of analysts covering the company giving the payments giant a buy rating. PayPal is expected to rally 16% in the next 12 months, based on consensus price targets. Newly public brokerage Robinhood is forecast to rally nearly 25% in the next year, but only half of the analysts that cover the stock trading app give it a buy rating. Square has 64% buy ratings, and analysts see an average upside of 13.3% over the next 12 months. PayPal stepping on Robinhood's toes? The pandemic pulled more people online with a record number of consumers engaging with financial technology companies. During lockdown periods, consumers became more comfortable using online applications, which drove new clients into an already busy space. "There's been tremendous scale that's been achieved by the industry-leading fintech platforms, so adding other products and services for engaged customers is a natural extension and I think the end goal is to help those customers better optimize their financial life," JMP Securities analyst Devin Ryan told CNBC. Recently in the diversification of fintech, PayPal hired brokerage industry veteran Rich Hagen to explore a stock-trading platform. After leaving Ally Invest, Hagen is now the head of a previously unreported division of PayPal called Invest at PayPal, according to his LinkedIn page. Hagen was the co-founder of online brokerage TradeKing, which was bought by Ally Invest. Analysts are not surprised by PayPal's move, which put pressure on Robinhood's stock. "With ~371 [million] global active customer accounts (ex-merchants) as of 2Q21, we see stock trading as a material engagement driver for PYPL as the company looks to gain more share of the customer's wallet and drive more funds in its ecosystem," Wolfe Research analyst Darrin Peller told clients. Because of the velocity at which the brokerage industry is changing, Tallents said PayPal should acquire a stock trading company for its eventual service. Hagen "has previously built and sold things and I wonder whether he will look at the need to buy or potentially partner and then leave it separate," Tallents noted. Analysts also spoke to the psychological hurdle that PayPal — which also owns Venmo — will have to clear when establishing its as a vehicle where customers can trade stocks. "I honestly think the stretch from peer-to-peer and merchant payments to investing is a big one," Tallents added. For Robinhood — which has plans to diversify its services — the hurdle will be getting customers to see it as more than a millennial-favored stock trading app that partially facilitates so-called meme stock volatility. The firms that are succeeding in this area are building products purely based on what their customers are telling them they want, Ryan said. Robinhood's Cash Management service is now used by more than 20% of the company's customers. The service went live just two years ago. "You have to establish trust with customers around whatever your initial area of service or product is with them. Then as you extend into other areas, you have to build those products in conjunction with the customers' feedback," JMP's Ryan said. Bloomberg News reported Wednesday that Robinhood is developing a new feature that lets users access their paychecks via direct deposit up to two days early. PayPal and private fintech Chime also offer this feature. Risks to Robinhood? From a finance perspective, analysts told CNBC that it is going to become increasingly more important to own more pieces of the economic chain. "As parts of the industry become increasingly commoditized ... having the ability to monetize a wide spectrum of the revenues that exists in the business model, I think is very important," Ryan said. For example, Robinhood's decision to create an in-house clearing house in 2018 means the brokerage earns more money from trades compared to brokerages that use a third-party clearing house and share revenue. Essentially, Robinhood has better unit economics for trading and can ultimately invest that extra money into a better, or different, user experience. To be sure, Robinnhood has many risks to its business model, including the regulatory overhang regarding payment for order flow. Securities and Exchange Commission Chairman Gary Gensler told Barron's on Monday that banning the controversial practice of payment for order flow is "on the table." Gensler told the outlet that payment for order flow — the back-end payment brokerages receive for directing clients' trades to market makers — has "an inherent conflict of interest." Gensler has said for months that an outright ban of payment for order flow is among several options the regulator could introduce. Robinhood's trading revenue are also heavily dependent on crypto trading, as told by its first earnings report as a public company . A regulatory roadblock for crypto or a downturn in the digital asset's price could be a risk to the brokerage's competitive edge. And of course, there is always the threat of legacy brokers catching up. "The narrative was 'what has Robinhood done to the legacy brokers?' I think that was true up until seven or eight months ago. Now the story needs to be "what are the legacy brokers doing to Robinhood?" And what they've done is taken all of the innovations that Robinhood did and copied them. They are becoming the graduation point for Robinhood customers who do well," Tallents said. SoFi love Several analysts told CNBC that SoFi has one of the most compelling stories of the fintech bunch. SoFi — short for Social Finance — went public in June by merging with Social Capital Hedosophia Corp V, a blank-check company run by venture capital investor Chamath Palihapitiya. SoFi was founded in 2011 with a focus on student loan refinancing for millennials. It now offers stock and cryptocurrency trading, personal and mortgage loans and wealth management services. The company is run by Anthony Noto, Twitter's former chief operating officer and a former managing director at Goldman Sachs. "Challenger banks like SoFi command a powerful cost advantage over incumbents which will lead to dramatic disintermediation over the next 5-10 years, leaving substantial primary bank accounts, revenues, and market value up for grabs," Rosenblatt Securities analyst Sean Horgan said. "Challenger banks face a 'jump ball' opportunity to seize market share from the old guard ... and SoFi is well-positioned to capture a significant amount of the value hanging in the balance." Tallents told CNBC he likes SoFi because student-loan debt is inherently a long-term relationship with a customer. Therefore, SoFi can warrant investing more money into its clients, knowing they will be there for decades. SoFi is already embedded into their monthly expenses and experiences, making it a logical place to integrate more of a consumer's wallet. Square's latest move Square is the second largest fintech on CNBC Pro's list by market capitalization. The Jack Dorsey-led company has a market value of $123 billion behind PayPal, which has a market value of $338 billion. (Robinhood and SoFi have a market capitalization of $38 billion and $11.5 billion, respectively). The company's Venmo competitor, Cash App, has 40 million monthly transacting active customers as of the second quarter . Square's stock-brokerage product is also delivering strong engagement, as more than 4.5 million customers held a stock or ETF in the second quarter. In its most recent steps to diversify, Square purchased "buy now, pay later" company Afterpay for $29 billion. This is Squares first move into installment loans. Square pointed to consumers eschewing traditional credit, especially younger buyers. Square already offers installment loans, which the company said have a "powerful growth tool" for Square's core seller business. It plans to integrate Afterpay into both its seller and Cash App ecosystems. "While so much of the focus is on integrating the two ecosystems at SQ, we believe the addition of Afterpay may be most notable for its potential to broaden SQ's presence on the merchant side of the equation," Ryan said. Ryan told CNBC having scale, like Square does, puts firms in a better position to more easily vertically integrate. "You maybe not have the scale but you have a better consumer offering. Or you have the scale which creates a more compelling economic model," he said. "The holy grail is having a combination of both the scale where you can leverage the economic chain but also you have the differentiation non commoditization of your platform that creates a user experience that customers want to engage with and pay for." To be sure, once any of these fintech companies gain market share, they become increasingly more competitive with the legacy banks. — with reporting from CNBC's Michael Bloom.

The PayPal application can be seen on a mobile phone.

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