Robinhood - Balancing Act

Summary

• Robinhood has gone public in an offering which was not well received by the market.
• The company has been a controversial name with many investors investing in booming stocks through the application, but demand for its shares has been lackluster at the offering.
• I see potential here, but the risks are plentiful and too diverse to see a compelling risk-reward here.
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Robinhood Markets (NASDAQ:HOOD) has not seen a nice welcome to the public market. While its clients typically invest in hot stocks, the public offering was not as the debate on the bull-bear case on Robinhood is very active. Robinhood certainly has some attracting features, yet the (idiosyncratic) risks is what makes me cautious here.

Democratize Finance For All

The paragraph header is the mission of Robinhood, as the idea that investing is only within reach for wealthier and older people is rapidly becoming outdated with everyone being able to invest, either large or small.

Notably the latter seems to be the case with the Robinhood application which has grown to host 18 million accounts of which more than half are first-time investors. The $81 billion asset base (held by clients) looks substantial, but reveals average account balances of just around $4,500 per client as of the end of the first quarter. These clients talk a lot with other (potential) clients, with more than 80% of clients referred to by clients, or attracted on an organic basis.

The company was only founded six years ago as the move to a mobile app and commission ¨free¨ trading resulted in a huge bump in popularity of investing. The way to invest in stocks you know and love stands in direct contrast to the passive ETF investing movement which overhauled investing over the past decade. Furthermore, Robinhood has been focused heavily on the trading in cryptocurrencies, resulting in a huge trading volumes in this area.

The lack of direct commissions makes that Robinhood has been so popular, but instead of charging fixed fees, the company makes its money from selling the order flow to market makers, as both parties share the spread.

While this is an expensive form of trading in huge volumes, perhaps it is not as expensive if you really trade in lower volumes, as is the case for many Robinhood users. Despite issues and involvement in the meme stock bubble earlier this year, the company has a goodwill factor, at least in the light of some clients (in line with the name of the business), as the business is up against big names like Etrade, Fidelity, IBKR, Schwab, TD Ameritrade, and some more. Of course, the meme momentum run makes that it has some very disgruntled clients as well.

Valuation Discussions

Management and underwriters aimed to sell 55 million shares in a preliminary price range between $38 and $42, with pricing set at the lower end of the range. 52.4 million shares were sold by the company, and a smaller portion by selling shareholders, as the company raised $1.99 billion in gross proceeds with the offering.

With some 835 million shares outstanding, equity of the business is valued at $31.7 billion. This however includes a large net cash position of $6.4 billion, implying that operating assets are valued at around $25 billion. There are huge other (trading) liabilities, offset by other assets as well (not including cash).

This is a steep valuation in relation to recent financial numbers, yet growth has been very strong indeed. 2019 sales came in at just $277 million on which a relatively large $17 million loss was reported. Sales more than tripled to $959 million in 2020 as the big loss actually turned into a small profit of $14 million. Of that revenue base, some $720 million in revenues were generated from transactions. With $63 billion in assets under custody the company generated well over a percent in average gross balances in terms of revenues (in fact some more given the rapid growth), or more than $100 per customer.

First quarter numbers were even more spectacular with revenue growth quadrupling to $522 million and without special charges a $60 million operating profit was reported. That revenue number is very substantial, running at more than $2 billion a year. In relation to the custody balances of $80 billion, this results in a revenue/custody cut of more than 250 basis points.

Preliminary second quarter results reveal that revenues come in at a midpoint of $560 million, still up significantly on a sequential basis as normalized operating profits are seen around $50 million. To date more than 22 million people use the application, assets under custody top the $100 billion mark, as revenues are a bit lower in relation to the asset base, as activity is down a bit after a hyperactive first quarter.

Based on the run rate, the operating asset valuation indicates that the business is valued at 12-13 times sales, while the broker is posting >100% year-over-year growth rates. It should furthermore be said that after a poorly received public offering, valuations have come down a bit. At $35 per share, the valuation has dropped by around $2.5 billion, implying that operating assets are valued at roughly $22.5 billion, or around 10 times annualised sales.

What Now?

Other than the valuation, there are plenty of risks to the investment case. Key risks include competition, regulatory scrutiny, scrutiny on the business model, a market downturn (and thus large losses for investors), unstable infrastructure behind the trading operations, abnormal stock price movements triggered huge losses with clients trading on margin, lower level of trading activity (in case investors flock to ETFs) and perhaps a transaction tax (indirectly putting pressure on trading volumes).

Other direct risks include potential lawsuits on its involvement in the meme stocks and losses taken by its customers. With users being the product as the ¨free¨ business model is not entirely free, such practices draw quite some attention from regulators as well, of course.

If we talk valuation we can of course compare the valuation to big names like Interactive Brokers (IBKR) which is valued around $25 billion. Interactive Brokers posts sales at a run rate of $3 billion, at 8 times sales, with these revenues up 40% year-over -year as well. While growth is a bit slower than Robinhood, Interactive Brokers with operating margins as high as 70%. Schwab (SCHW) is much bigger, but less of a pure play competitor as it has large interest rate and asset management activities as well.

Quite honestly there are many positive and negatives to the story. A 10 times sales multiple given the growth and margin potential in this industry is quite reasonable, as growth is still superior. With interesting demographic as and continued traction, there is certainly a bull case to be made, with the company already profitable. The drawback is that the company is heavily reliant on market momentum and besides the exhaustive list of risks, it faces some idiosyncratic risks as well, to the business model and past actions.

Weighing it all together, I am leaning neutral here and the situation it is too uncertain to initiate a position with conviction. I must say that valuations start to look compelling if growth can be maintained, but this is a very risky play.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.