Robinhood | Buy the IPO?

TL;DR

• Watch the YouTube video
• Robinhood IPO started slow, but has picked up 20% since
• It's really hard to predict future growth because of the cyclical nature of retail trading and cryptocurrencies
• The company has long-term potential, but trading at 100x earnings without a clear path reads "meme stock" at this point

One of the hottest IPOs of the year – Robinhood – started off "not so hot". On IPO day, the stock was priced at $38 per share (a valuation of $32bn). It fell 8% on the first day of trading, and has traded below that price until it shot up a today (currently as high as $50/share in afterhours). It's worth analyzing this stock, and understanding its long-term potential.

It's worth noting, Robinhood appears to have gotten Ark Invest's Cathie Wood's vote of confidence, as she has bought 3.15M shares since IPO. That's over $150m in today's prices.

But, the real question is... should YOU be buying?

Robinhood's Controversy

I know there is a lot of "hate" on Robinhood and negative publicity – which I'll explain below. But, it's always important to keep an open mind make investment decisions based on logic (rather than emotion). However, beliefs and ethics can always create boundaries – which is also fine.

Robinhood users have experienced several outages which have impacted trading, including a 2-day outage in March 2020. They finally settled that lawsuit for $70m for these outages. This doesn't include the temporary suspension they placed on trading specific "meme" stocks during the GameStop frenzy.

The GameStop Short Squeeze took place in early 2021, when retail investors (particularly from Reddit's r/wallstreetbets) drove up the price of GameStop (GME) to $500 in the pre-market, or 30x its valuation earlier in the month.  Because of the surge in retail demand, clearing houses required brokerages like Robinhood to put up more capital – more than 10x normal levels – to factor in the risk. Robinhood responded by temporarily halting trading of the meme stocks. GameStop lost 85% of its value thereafter; which many investors blamed on Robinhood’s restrictions. There's been a lot of theories behind the reasoning for this move, including Robinhood helping out the hedge funds who were shorting the stock. Thus, the emotional response from many.

What's the Robinhood Business Model?

Robinhood's mission is to "democratize finance for all". They are doing this by creating user-friendly, mobile-first apps that enable "commission-free" trading. This is how they've achieved rapid growth and benefited greatly from the rise in retail participation in the markets.

Robinhood did hit an inflection point of growth, which you can see above, during the 2020 pandemic lockdown. The markets were primed with potential, and people were at looking for ways to make money from home... the perfect recipe for their growth.

Most of Robinhood's users are pretty active. Most funded accounts are active each month – which makes sense. Assets Under Custody (AUC) is total user funds that are invested through the platform. Right now, that number is $80bn – which is up 320% from last year. ARPU also grew to $137 or 65% YoY.

Before we even attempt to breakdown or project these revenues for our valuation, it's important to understand how Robinhood generates its revenues. Although they market "commission-free" trading, Robinhood is actually making money on the backend of transactions via Payment for Oder Flow (PFOF)... another grey area of controversy.

Payment for Order Flow (PFOF)

PFOF is the kickback a brokerage firm (like Robinhood) receives for directing trades to third-parties (i.e. "market makers") for execution. Instead of the orders going to the markets, the clearinghouses provide liquidity and for routing orders and taking on the risk of the bid-ask spread.

A lot of controversy has been around this method of revenue-generation for brokerages because they may not have the client's best interest of executing at the best price. Instead, they are more incentivized to send orders where they receive the biggest kickback.

However, recent regulations have forced brokerages to reveal the quality of their execution; and in most cases market makers provide better prices than the National Best Bid/Offer. Robinhood, like any brokerage, is required to publicly release their Execution Quality.

I, personally, don't see an issue here. I do think Robinhood has created a unique opportunity for retail traders to get better pricing and has done an incredible job and making the stock market less "intimidating" to beginners. Although the platform may not make sense for more experienced traders, I don't think anyone can discredit Robinhood for its accomplishment.

Fair Valuation

Valuing Robinhood is an incredibly difficult task for me, because of the questions I have regarding its future. There is no doubt that we have experienced a surge in retail investing, which might have peaked. Historically retail participation in markets have always been cyclical. It's also clear that Robinhood is capitalizing on this opportune time to go public at a high valuation – which is why their insiders are selling shares. I don't blame them for this.

If we assume the breakdown of AUC is an equal representation of their transaction revenue, we see that equities make up 80% and cryptocurrencies make up 15%. We know that cryptocurrency investing has historically been very cyclical and we can't just assume consistent high growth from here. In fact, 34% of their cryptocurrency transaction revenue in Q1 came from Dogecoin. I'll let you interpret that on your own.

Because it's so hard to forecast their revenues and earnings, I'll focus on looking at historical results. Robinhood had a profitable Q1 2021 if we ignore one-time items, such as the "Change in fair value of convertible notes and warrant liability" (which relates to the debt they raised following the Gamestop saga), legal settlements, etc. Their adjusted EBITDA is over $100m.

The biggest question I have: How much can Robinhood grow from here? What are there plans to do so? They have captured a lot of the US retail traders... are the plans to go abroad? Are they planning to appeal to more sophisticated investors? There are opportunities, but I don't the answer to those questions. But, those unclear opportunities appear to be priced in.

For simplicity I'm going to assume EBITDA = Earnings; and a normalized earning of $400m/year. This means the growth in retail trading, cryptocurrencies, etc. have peaked but they'll be able to maintain these revenues going forward. We'll ignore the risk they drop. In that case, at a $32bn valation ($38/share) we're paying 80x earnings. So, there's clearly a lot of growth priced in. In fact, as I write this, the stock price is implying a $40bn valuation (or 100x earnings). That makes zero sense to me.

Final Thoughts

Robinhood (HOOD) stock appears to be trading like a meme stock right now – but it's too early to tell. I do think the company has a lot of potential for growth, and it has a solid foundation. They've done really well at opening up trading for retail investors. But, there's no clear path to how the growth will be achieved. In fact, I see clear risk of comping previous numbers from the pandemic surge.

A small allocation would've made sense to me at IPO price, just to get some exposure. The small position would've been up 20% right now. But the risk/reward, from a valuation perspective, doesn't make sense to me at this point. The stock may drop in the short-term, but there is long-term potential. I do recognize that if you wait until everything is clear, the opportunity no longer exists. So, I do understand the opposing viewpoint here.