Robinhood: Still Nothing But A Bet (NASDAQ:HOOD)

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Robinhood’s (HOOD) 4Q21 earnings report underscores our thesis that the stock is grossly overvalued and could drop as low as $6/share.

Robinhood went public at a valuation that implied its earnings would outpace industry stalwart Charles Schwab (SCHW), but that growth hasn’t materialized, not even close. No matter how management tries to present the latest results or the wrong directions for the future, one thing is clear. Robinhood’s growth story is over.

Without the tailwinds of COVID-19, the main issues for this stock become more apparent:

  • growth has fallen to near zero and forecast implies negative year-over-year growth in 1Q22
  • Robinhood’s main source of income remains highly volatile cryptocurrency and riskier options trading (compared to standard stock trading).
  • competitors continue to hold large-scale advantages and profitable businesses outside of a brokerage
  • the lack of scale in an undifferentiated market begs the question – will Robinhood ever be profitable?

The stock is down 63% from its IPO price and 83% from its 52-week high, but still has many more downsides.

The dodgy revenue model comes to a screeching halt

Robinhood’s use of order flow payment (PFOF) has been widely criticized, and we discussed potential regulatory issues in our initial report.

More importantly, what was once a growing revenue model is no longer. According to Figure 1, Robinhood’s revenue grew only 14% year-over-year (YoY) in 4Q21, compared to growth of over 300% in 1Q21. Management’s forecast for 1Q22 implies a -35% year-on-year decline in revenue as retail investors/traders look elsewhere (competitors or non-investment businesses).

Figure 1: Robinhood Annual Revenue Change: 1Q21 to 1Q22 Forecast

Robinhood revenue growth since 1Q21

Robinhood revenue growth since 1Q21 (New Constructions, LLC)

Sources: New Constructs, LLC and company filings.

Investors no longer flock to Robinhood

In our initial report, we noted the impressive customer account growth Robinhood achieved before its IPO, but argued that its best days were probably behind it. Figure 2 shows how accounts receivable growth stagnated in the last three quarters of 2021.

Since growing to 22.5 million accounts in 2Q21, Robinhood’s account growth has stalled, and by the end of 4Q21, total cumulative funded accounts were just 22.7 million.

Figure 2: Robinhood Cumulative Funded Accounts – 2017 to 4Q21

Robinhood account growth since 2017

Robinhood account growth since 2017 (New Constructions, LLC)

Sources: New Constructs, LLC and company filings.

Brokerage assets are locked in line with user growth

We believe that in order for Robinhood to compete with its much larger competitors, the company needs to significantly increase its brokerage assets, which Robinhood calls assets under custody. Asset growth would provide a basic source of net interest income if the PFOF is banned, business activity diminished, or both. However, according to Figure 3, Robinhood’s assets in custody, at $98 billion at the end of 4Q21, fell from a peak of $102 billion in 2Q21.

Figure 3: Robinhood Assets in Custody – 2019 to 4Q21

Robinhood Assets in Custody Growth

Robinhood Assets in Custody Growth (New Constructions, LLC)

Sources: New Constructs, LLC and company filings.

Lack of scale is still a critical flaw in the business model

Robinhood’s lack of scale continues to be a big competitive disadvantage. The company’s focus on new low-profit investors initially helped the company open a large number of customer accounts, but the average size of these accounts is much smaller than that of its competitors. According to Figure 4, Robinhood owns less than 1% of the combined assets of its larger peers and lacks the scale to generate enough revenue to compete with incumbents without PFOF.

Figure 4: Robinhood customer assets are tiny compared to their peers – 2021

Robinhood Scale vs. Peers

Robinhood Scale vs. Peers (New Constructions, LLC)

Sources: New Constructs, LLC and company filings. Loyalty data available here.*Estimate based on $11.1 trillion in client assets at Fidelity minus $4.2 trillion in “discretionary assets” or assets in managed accounts where Fidelity has discretion over how they are invested.

Business model based on conflicts of interest

With transaction-based revenue, including PFOF, driving 77% of company revenue in 2021, Robinhood has a clear incentive to generate and sell as much order flow as possible. The company has proven itself to be good – maybe too good – at enticing users to trade. Over trading is not always safe for clients and brokers generating account “rollover” is not a new phenomenon for regulators. Notable regulatory issues:

  • Robinhood previously agreed to pay a record $70 million settlement after a FINRA investigation into the alleged granting of options to unqualified investors.
  • This settlement comes after a trial filed by the family of 20-year-old Alex Kearns, who allegedly committed suicide in June 2020 after Robinhood misinformed him of the amount of money he had lost on options trading.
  • The State of Massachusetts filed a trial against Robinhood to revoke its license to operate in the state based on alleged allegations of “gamifying” investing and predatory business practices.

The growing regulatory risk facing Robinhood makes us fear that the public may see Robinhood’s stated goal of “democratizing investing” as a ruse to entice them into gambling. That said, there are plenty of gorgeous casinos in Las Vegas that pays homage to millions of people’s desire to lose money gambling.

Otherwise undifferentiated offer

In previous years, Robinhood stood out among its peers as the only brokerage offering commission-free trading. The biggest brokerages quickly eliminated this competitive advantage by reducing stock commissions at the end of 2019.

Generally, there is a lack of differentiation between most brokerage firms. Not only do they all offer 0% commission on stock trades, but most offer ancillary services, such as education, a variety of asset classes to invest in, retirement accounts, personalized wealth management and options trading. Robinhood is catching up in some cases. For example, the company plans to start offering retirement accounts later this year.

Robinhood’s most differentiating feature, options trading for new investors, has also been a source of significant legal and regulatory costs and challenges, and led famed investor Charlie Munger to call Robinhood “a gaming parlor posing as a respectable business.”

A niche player in crypto

Robinhood continues its push into cryptocurrency and plans to add more coins to its trading capabilities in 2022. However, just like in traditional securities, Robinhood is also catching up in this market. PEers such as Coinbase (COIN) eclipse its brokerage assets and others such as PayPal (PYPL) and Block (SQ) are also looking to take market share in the industry.

Valuation implies 2x the revenue of Interactive Brokers

Below we use our reverse discounted cash flow model to show that expectations for future cash flow in HOOD appear overly optimistic, given that Robinhood’s growth story was in the second half of 2021 and expectations for 1Q22 are low.

To justify Robinhood’s current price of $14/share, the company must:

  • improve its NOPAT margin to 16% (compared to 8% in 2020 and -355% in 3Q21) and
  • increase revenues by 26% per year until 2027, more than 6 times the projected industry growth rate to 2026

In this scenario, Robinhood would generate $4.9 billion in revenue in 2027, nearly 3x its 2021 revenue, 2x the TTM revenue of Interactive Brokers (IBKR), and 4x the TTM revenue of Coinbase. Additionally, Robinhood would generate $784 million in NOPAT in 2030, more than 9 times its 2020 NOPAT and just under half Interactive Brokers’ NOPAT TTM.

Keep in mind that the number of companies that grow revenue by more than 20% per year for such a long period of time is incredibly raremaking expectations for Robinhood’s share price unrealistic.

57% decline even though growth is 4x industry expectations

Robinhood’s economic book value, or no growth value, is negative $1/share, illustrating overly optimistic expectations for its stock price.

Even if we assume Robinhood:

  • achieves a NOPAT margin of 16% and
  • grows revenue by 15% per year through 2027 (nearly 4 times projected industry growth rates through 2026), then

the stock is worth $6/share today – a drop of 57%.

Figure 5 compares the company’s implied future revenue in these two scenarios to its historical revenue, as well as revenue from competitors, such as Interactive Brokers and Coinbase.

Figure 5: Robinhood Historical and Implicit Revenues: DCF Valuation Scenarios

Robinhood DCF Implicit Earnings

Robinhood DCF Implicit Earnings (New Constructions, LLC)

Sources: New Constructs, LLC and company filings

Each of the above scenarios also assumes that Robinhood increases revenue, NOPAT, and FCF 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 by $1.4 billion (146% of revenue) year-on-year in 2020. If we assume that Robinhood’s invested capital grows at a similar rate in the DCF 2 scenario, the downside risk is even greater.

This article originally published on February 2, 2022

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

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