Robinhood files for IPO: Just PFOF

• Regulatory scrutiny may present risk to business model
• Mega growth in active clients
• Crypto a growing part of the business

US online trading company Robinhood has finally filed for its long-awaited public listing in what’s sure to be one of the most closely watched IPOs of recent years. The company, which enjoyed rapid growth last year but has been at the centre of a storm over trading outages and restricting access to trades earlier this year when capital limits were reached, is seeking a valuation of around $40bn. The stock is set to list on the Nasdaq under the ticker HOOD.

Regulatory scrutiny

The S1 prospectus dropped just a day after FINRA issued Robinhood with a $70m for “widespread and significant harm” to its customers. The investigation remains ongoing and Robinhood expects more penalties. There are numerous other cases, including class action suits relating to Robinhood restricting access to trading on a number of very volatile stocks at the height of the GameStop frenzy. As I commented on back in January when all this was taking place, I didn’t think Robinhood wanted to stop trading – it was just a question of regulatory capital requirements and Value at Risk models that left the clearing house demanding more cash up front.

Since having to secure $3.5bn from investors PDQ, Robinhood has strengthened the balance sheet considerably and now has about $4.8bn in cash or cash equivalents, plus it has a new $2.2bn revolving credit facility for financing margin trading in the event of another volatile episode.

Meme stocks

“Our vision is for Robinhood to become the most trusted, lowest-cost, and most culturally relevant money app worldwide,” the company said in the SEC filing document. Part of this has involved offering questionable products (like stock options) to relatively unsophisticated traders. (Although the GameStop frenzy proved the Reddit crowd could be very sophisticated indeed, ganging together to concentrate out of the money calls where dealers couldn’t hedge on stocks with lots of short interest, the concentrated buying of the physical to squeeze shorts and create a gamma squeeze on the dealers). The tragic suicide of one customer

Robinhood has ridden – and in many ways helped fuel – a boom in retail trading in recent years, particularly since the pandemic hit. Retail investing now comprises roughly 20% of US equity trading volume, doubling in the decade from 2010 to 2020. “Yet, we believe there is still significant room for growth,” the company asserts. Meme stocks are a big part of the business and I think this presents a risk, albeit Robinhood itself could benefit from becoming the next big meme stock itself – a lot depends on how much reputational damage it suffered this year and how much good faith it retains among the retail crowd. The fact that it is reserving as much as 35% of the shares at IPO for its retail clients could be a master stroke.

Financials

For the year ended December 31, 2020, total revenue grew 245% to $959 million, up from $278 million in 2019. But it’s still not exactly profitable, recording net income of $7 million, compared to a net loss of $107 million in the prior year. Adjusted EBITDA rose to $155 million, compared to negative $74 million.

Fuelled by the meme stock craze, the first three months of 2021 saw total revenue grow 309% to $522 million, up from $128 million in the same period of 2020. However it recorded a net loss of $1.4bn in the quarter due to a $1.5 billion fair value adjustment to its convertible notes and warrant liability.

Incredibly, Robinhood has doubled the number of users since the start of the year, with 31m accounts. Of these, 18m are funded, representing a 151% increase from last year. Fundraising in 2020 indicated a market valuation of around $11bn, but the rapid growth in active accounts and revenues this year has seemingly propelled the company to seek a much larger valuation.

Payment for order flow

Robinhood came under fire in the first quarter of 2021 as meme stock craze exploded. Among the many charges levelled against the platform was the practice of paying for order flow. Robinhood sells market makers like Citadel client trades, who will execute at or better than the current market price. This is what enables commission free trading but has come under scrutiny as could represent a conflict of interest. Nevertheless, Robinhood made 75% of its revenues last year – some $720m – from selling client trades. Of this, about half comes from Citadel Securities (34% of total revenues).

This is perhaps the biggest risk for investors: the SEC has already fined Robinhood $65m for misleading customers over PFOF, as it is called. And chief Gary Gensler has ordered a review of the practice, as well as the ‘gamification’ of investing through apps and incentives. This would tend to put Robinhood in the crosshairs of the SEC just as the former seeks to go public and the latter is likely to get stricter. Timing appears problematic for Robinhood.

If the US regulator were to act on PFOF it could hit the very business model that Robinhood has relied on to secure growth so far. “Because a majority of our revenue is transaction-based, including payment for order flow … reduced spreads in securities pricing, reduced levels of trading activity generally, changes in our business relationships with market makers and any new regulation of, or any bans on, PFOF and similar practices may result in reduced profitability, increased compliance costs and expanded potential for negative publicity,” the filing states (my emphasis).

Crypto trading: blame Elon

Robinhood specialises in stocks and stock options, but cryptocurrency trading is a growing part of the business. From just 4% last year, crypto accounted for 17% of revenues in Q1 2021.

Robinhood notes that 34% of its cryptocurrency transaction-based revenue was attributable to transactions in Dogecoin, as compared to 4% for the three months ended December 31, 2020. For a token set up as a joke, that’s a staggering amount – roughly 5% of all Robinhood revenues in the first quarter of the year.

“A substantial portion of the recent growth in our net revenues earned from cryptocurrency transactions is attributable to transactions in Dogecoin. If demand for transactions in Dogecoin declines and is not replaced by new demand for other cryptocurrencies available for trading on our platform, our business, financial condition and results of operations could be adversely affected,” the S1 states.

I tend to think there is always another Dogecoin round the corner. Robinhood currently supports 7 cryptocurrencies on its platform. That compares with 25 at Markets.com.

The view

Regulatory headwinds appear strong, particularly regarding PFOF, which should see the shares trade at a discount. Crypto is also clearly an area that presents a high level of regulatory uncertainty as well as unreliable flow and trading activity. Reputational risk is also a big factor post-GameStop and in a highly commoditized industry, it’s hard to see where it can really deliver much in the way of margin growth. The business is still not really profitable and the valuation of $40bn+ looks well above peers, even assuming growth continues apace this year.