Robinhood — which makes 81% of its revenue by routing its users’ orders to market makers — is slated for an IPO on July 29, according to Bloomberg.
Here are three reason I would not buy HOOD’s shares when they begin trading:
- Risk of regulatory crackdown on its revenue sources
- Big fines imposed after its dodgy treatment of users
- Uncertain sources of revenue growth
Robinhood’s Pending IPO
Online trading platform Robinhood’s IPO could value the company at $35 billion, according to Barron’s. The logic for that valuation is to apply its last 12 months’ revenue of $1.35 billion by a price/sales ratio of 26 based on the comparable fast growth of TD Ameritrade in 1999, noted Barron’s.
Robinhood — which estimates it opened about half of new U.S. brokerage accounts in the last five years — is certainly an impressive growth story. Its cofounders Vlad Tenev and Baiju Bhatt used its zero commissions pricing model to attract millions of new investors which caused major brokers to eliminate commissions as well.
Given its business model, I think Robinhood is not really living up to the idea implied by naming itself after someone who steals from the rich and gives to the poor. After all, its business depends on revenue from allowing market makers to profit from its users’ trades.
How so? 81% of its revenues come from payment for order flow — “routing customers’ trades to trading firms [— including Citadel Securities that accounted for 34% of its 2020 revenue, according to its S-1] — that execute the trades and profit off the spread between the bid and the ask,” wrote Barron’s.
Robinhood enjoyed rapid growth in the number of accounts and in revenue. In the first quarter, accounts grew 150% to 7.2 million and revenue for 2020 was up a whopping 796% to $959 million, according to its S-1.
In the first quarter, Robinhood’s revenue rose a still impressive, but much slower 311% to $522 million. For the second quarter, Robinhood estimates revenue in a range — the midpoint of which is $560 million — an even bigger growth slowdown: 130% more than the year before.
One other thing about its IPO — Robinhood is making a large chunk of those shares available to traders on its own app. This means that as many as 35% of its shares will be offered to its users before the IPO. As Tenev said, ”We anticipate this will be one of the largest retail allocations ever.”
Big fines paid after its dodgy treatment of users
One of the biggest concerns I would have about investing in Robinhood is the huge gap between its values and its actions. More specifically, the first of its corporate values is “safety first.”
To be sure, Robinhood acknowledges slipups in its S-1. What’s more, it paid a $57 million find plus $12.6 million interest to the Financial Industry Regulatory Authority (FINRA).
Why? On its website Robinhood posted:
Why? On its website Robinhood posted:
"... FINRA found in its investigation that, despite Robinhood's self-described mission to 'de-mystify finance for all,' during certain periods since September 2016, the firm has negligently communicated false and misleading information to its customers. The false and misleading information concerned a variety of critical issues, including whether customers could place trades on margin, how much cash was in customers' accounts, how much buying power or 'negative buying power' customers had, the risk of loss customers faced in certain options transactions, and whether customers faced margin calls."
Is this mistreatment of users something that has been permanently eliminated after Robinhood paid its FINRA fine? Or will it continue? If it does continue, could it cause Robinhood users to switch their accounts to brokerage firms that treat them better?
Risk of regulatory crackdown on its revenue sources
With its rapid growth slowing down, investors should be concerned about talk of a regulatory crackdown on major components of its revenue. Indeed, SEC Chair Gary Gensler has raised concerns about payment for order flow in the last several weeks, according to TheStreet.com.
The SEC is also closely reviewing trade in cryptocurrency. Dogecoin, a joke cryptocurrency popular with Elon Musk — accounts for about 6% of Robinhood’s revenue, according to CNBC.
Could an SEC regulatory crackdown on these significant revenue sources put the brakes on Robinhood’s growth?
Uncertain sources of future revenue growth
If Robinhood can find new sources of growth that don’t raise regulatory hackles, perhaps it can keep growing faster than investors expect.
Indeed, Robinhood — which wrote in its S-1 that its customers “already trust us with their hard-earned cash and assets” — has tried to add lending and payments services.
However, it has suffered some setbacks. According to Barron’s it withdrew a plan to offer checking and savings accounts in 2018 after “misleading marketing and a lack of insurance.” Robinhood also failed to obtain a UK bank charter.
An industry consultant does not expect consumers to trust Robinhood with other financial services. Hugh Tallents is senior partner at management consultancy cg42 which “surveyed more than 1,000 account-holders at various brokers.”
Tallents notes that the average Robinhood account has “play money” of $240, based on a FINRA enforcement letter. He doubts that “customers will change their financial behavior to integrate a lot of their financial life with a company that has been mired in scandal for a long time,” noted Barron’s.
He also points out that rivals — including SoFi Technologies — are trying to cross-sell customers. Tallents said that SoFi — which is known for refinancing student loans — was having an easier time selling mortgages to its existing customers.
He thinks Robinhood will struggle with cross-selling. “It’s far harder to envisage a world where people take a quite basic tool, which Robinhood is by design, and put a lot of their debt-based products or their savings accounts and integrate those things together,” he told Barron’s.
Will Redditors bail out investors who hold Robinhood stock? TheStreet.com notes that Citadel Securities is not popular among them — writing “many Redditors or newer retail investors have unconfirmed theories around Citadel Securities and therefore want to avoid the market maker, among other firms on Wall Street.”
Buying in to Robinhood’s IPO is too risky — I would avoid it altogether.