Robinhood IPO

Robinhood IPO: Don’t buy the hype

Robinhood Markets Inc. (HOOD) is expected to debut as a public company on July 29, 2021. At an expected IPO valuation of roughly $35 billion. The announced price range per share is between $38 and $42.

The company

Robinhood is an American broker-dealer known for offering commission-free trades of stocks and exchange-traded funds via a mobile app. Additionally, its platform also trades fractional shares, cryptocurrencies, and American Depositary Receipts (ADRs). The company also offers cash management solutions through debit cards.

The company’s revenue comes from three main sources (in parenthesis, as of percentage of total revenue in 2020): 

  1. Selling order information to market makers (75.1%)
  2. Margin lending and interest earned on customers’ cash balances (18.5%)
  3. Subscription for premium services such as research and data (6.4%)

As of March 31, 2021, Robinhood has 17.7 million monthly active users and $81 billion assets under custody. The company claims that more than 50% of its customers are first-time investors.

Is the stock a good investment opportunity?

Independent estimates value the company at no more than $9 billion. A $35 billion valuation implies Robinhood will maintain its unprecedented pandemic-era growth for the next 10 years. Such a scenario looks unlikely due to looming regulatory risk, increasing competition, and an undifferentiated service.

In my opinion, it is not worth investing in Robinhood’s stock at this time.

The good

There are a few reasons why Robinhood has grown rapidly since its founding and has become popular especially among young first-time investors. The following are some of those reasons:

  • Product design: its platform is designed with the premise of “mobile-first”, it is easy to use, and it is engaging.
  • Brand: Robinhood has built a brand with strong recognition in the USA.
  • Positioning: if it wasn’t the first, Robinhood certainly was among the first ones to offer commission-free trades without an account minimum balance. Its target audience liked this offering because it lowered the entry barriers to start investing. (I see the other side of this coin as a negative, as I will explain below.)
The Bad

Just as any other company, Robinhood faces factors that are weaknesses or represent risks to its existence. In my opinion, the following are some of the most relevant issues the company must deal with:

  • Revenue model at risk: As mentioned above, Robinhood generates most of its revenue from payment for order flow. The figure over total revenue was 75.1% in 2020 and 80.5% in Q1 2021. While this source of revenue is not currently illegal, the Security and Exchange Commission (SEC) is reviewing if this practice violates a broker’s duty to provide the best execution of trades. If payment for order flow is ever banned, it is unlikely that Robinhood could continue offering commission-free trading, which would put the company at a significant disadvantage to rivals Fidelity and Charles Schwab (who can afford to continue offering commission-free trading thanks to their other sources of revenue which Robinhood currently does not have.) 
  • Undifferentiated offering: During the last few years the brokerage business has been commoditized which makes it hard for any of them to differentiate from the pack. Not only do they all offer commission-free trades, but most also offer other services, such as education, an ample menu of asset classes to invest in, retirement accounts, personalized wealth management, and options trading. When Robinhood has found a way to differentiate itself from others, its competitors have been able to copy it relatively quickly. That will probably continue happening in the future. 
  • Small fish in a big pound: Most of the profitability of any given market is captured by the top 2 players. While Robinhood has grown rapidly the number of customers accounts (18 million at the end of Q1 2021), it is still behind other players like Charles Schwab (30 million) and Fidelity (36 million). More importantly, the assets it holds for its customers are still relatively small compared to the bigger players. For example, by the end of Q1 2021 Robinhood held $81 billion; while Charles Schwab held $6,692 billion; and Fidelity $6,500 billion. In the brokerage business, scale matters, and Robinhood currently doesn’t have it.
The Ugly

Beyond the good that has driven Robinhood’s growth so far, and the bad that threat is continuing success, there are other factors that are worth pointing out when considering investing in the company. The following are some of those factors: 

  • Business model built on conflict of interest: With payment for order flow generating most of the company’s revenue (81% on Q1 2021), Robinhood has huge incentives to entice its customers to trade more to generate more flow to sell it to high-frequency traders and market makers. And so far, the company has successfully engaged its users to make them trade (where else have you seen a broker’s platform that throws confetti when you trade?). The issue is that often active trading leads to losses. So, while the company says it is trying to “democratize investing”, what is really doing is luring novice investors to gamble to make a profit. However, the many casinos and gambling platforms that do business around the world are a testament that millions of people like gambling.
  • Its reputation has been tarnished: During the last year, customer satisfaction has dropped markedly. According to the S-1, in 1Q 2021, 206,000 users transferred accounts out of Robinhood (~$4 billion of assets), nearly 10x the quarterly average of 22,000. Many customers have felt aggravated by the outages the platform has experienced, the sudden trading restrictions the company has imposed without notice, and its customer service. While the company has recently hired more customer service representatives and has added new customer service features to the app, its reputation has already been tarnished in the eyes of many users.
  • Share classes give investors little voice: Robinhood will go public with separate classes of common stock. All shares that will be allocated to investors at the IPO will be Class A shares while founders and executives will hold Class B shares. Class A shares only carry one vote per share while Class B shares carry 10 votes per share. Upon completion of this offering, co-founders Baiju Bhatt and Vladimir Tenev will hold around 65% of the voting power in Robinhood. In other words, investors will have little say over corporate governance once Robinhood is a publicly traded company since two individuals will hold the majority of the voting power.

Are Robinhood’s Best Years Behind It?

Contrary to what happened to many businesses, the pandemic of 2020 was an important driver of Robinhood’s growth. People staying at home, billions of dollars in stimulus money, and fewer entertainment options drove people to invest in the stock market. For many, for the first time. 

According to E*Trade, more brokerage accounts were opened on its platform in March 2020 alone than in any full year in its history. Robinhood added 3 million accounts in the first quarter of 2020 and has more than tripled accounts since 2019.

The influx of retail money flowing into the stock market drove stock prices higher and delivered quick gains to these new market participants. Especially, in a group of popular stocks that were hipped online in places like Reddit. The meme-stock phenomenon drove even more first-time investors to the market who were seeking to make a quick profit. Both of these dynamics led to a surge in Robinhood accounts. Robinhood added 5.5 million accounts in 1Q 2021, at which point the company had more than tripled funded accounts since 2019.

With more people getting vaccinated and taking precautions, the number of COVID-19 cases has gone down from its peak. If this progress probe to be sustained in time, Americans are going back to their normal lives, spending less time trading, and spending money on things other than stocks. If this occurs, it is unlikely that Robinhood will be able to reach the scale required to justify its valuation.

In order to justify the IPO valuation of up to $35 billion, Robinhood must:

  • improve its NOPAT (Net Operating Profit After Taxes) margin to 16%, compared to -37% in 2019 and 8% in 2020, and
  • grow revenue by 32% compounded annually through 2030, which is 8x the projected industry growth rate through 2026

In this scenario, Robinhood would generate more than $15 billion in revenue in 2030, which is more than 16x its 2020 revenue. Additionally, the company would generate $2.5 billion in NOPAT in 2030, which is more than 31x its 2020 NOPAT.

Let’s analyze an additional DCF (Discounted Cash Flow) scenario to highlight the downside risk should Robinhood’s revenue growth fall more in line with industry expectations.

If we assume Robinhood:

  • achieves NOPAT margin of 16% and
  • grows revenue by 16% compounded annually from 2021-2030 (4x projected industry growth rates through 2026) then

HOOD is worth just $9 billion today – a 75% downside to the expected $35 billion IPO valuation.

Each of the above scenarios also assumes Robinhood grows revenue, NOPAT, and FCF (Free Cash Flow) without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate the level of expectations embedded in the current valuation. For reference, Robinhood’s invested capital increased $1.4 billion (146% of revenue) YoY in 2020. If we assume Robinhood’s invested capital increases at a similar rate in the second scenario, the downside risk is even larger.

For these reasons, I don’t believe participating in Robinhood’s IPO is a good investment decision.

Disclaimer

This article was written for educational purposes and does not provide investment recommendations specific to individual investors. As such, the financial instrument(s) discussed may not be suitable for all investors and investors must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Past performance of the financial instrument(s) listed in this newsletter should not be taken as an indication or guarantee of future results.

The price, value of, and income from, any of the financial instruments showed in this article can rise as well as fall and may be affected by changes in economic, financial, and political factors. If a financial instrument is denominated in a currency other than the investor’s home currency, a change in exchange rates may adversely affect the price of, value of, or income derived from the financial instrument described in this report.

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