UPDATE (10/1/21): Since releasing this report, HOOD went on a bit of a rollercoaster ride. You can read more here.

Years ago, Robinhood users only had access to a handful of select U.S. stocks. The app’s early backers would showcase their commission-free trades and free stock rewards — a rarity at the time. Robinhood was small and unknown.

Those days are gone.

The COVID-19 pandemic ushered in a new wave of investors — and new, fun ways to invest. First-time investors flocked to Robinhood’s user-friendly platform, which boasts trendy imagery and vibrant color schemes.

Robinhood is still a small fish in a big pond, but it’s hardly an unknown company anymore.

Today, Robinhood will become a public company, trading under the ticker HOOD. If you’re considering investing in HOOD’s initial public offering (IPO), we’ve compiled diligent answers to several relevant questions, including:

What does Robinhood do?
Who uses Robinhood?
How does Robinhood make money?
What are payments from order flow?
Is Robinhood profitable?
Why is Robinhood’s IPO unique?
What’s the risk of buying Robinhood’s IPO?
What are Robinhood’s operational risks?
Is Robinhood’s growth sustainable?

What does Robinhood do?

Founded in 2013, Robinhood started as a niche retail brokerage. It’s credited with being the first platform to offer commission-free trades (circa 2015 when it launched its app). Now, users can use Robinhood’s platform to:

Trade U.S. listed stocks and ETFs, as well as related options and American Depositary Receipts (ADRs)
Invest in offering prices of select IPOs
Trade cryptocurrencies
Trade fractional shares
Make recurring investments
Make cash transactions via Robinhood-sponsored debit cards
Trade on margin (must have a Gold subscription)
Access professional research (must have a Gold subscription)

Who uses Robinhood?

Robinhood’s primary demographic is new and inexperienced investors — which, historically, has been an untapped market. Let’s look at some key customer stats:

As of March, Robinhood had 18 million funded accounts.
From January 2015 to March 2021, first-time investors represented more than 50% of Robinhood’s funded accounts.
As of March, the median age of Robinhood’s customers was 31; approximately 70% of the company’s Assets Under Custody (AUC) belonged to customers between the ages of 18 and 40.

Much like the fabled Robin Hood storybook character, Robinhood (the company) targets people who are more likely to be limited by systemic barriers; the company specifically cites expensive commissions, minimum balance requirements, and complicated paperwork.

In that regard, Robinhood disrupted the financial services industry with its commission-free trades (which is now the norm) and gamification of investing (which made investing “fun”). That disruption has been particularly evident over the last 18 months, as Robinhood’s total funded accounts skyrocketed from 5.1 million to 18.0 million — a 252% increase.

But there’s a reason first-time investors aren’t as sought after by the financial services industry: they aren’t nearly as profitable for brokerages.

As of March, Robinhood had $80.9 billion of AUC across 18 million funded accounts. By comparison, Charles Schwaab had $6.69 trillion of client brokerage assets spread across 29.6 million active brokerage accounts at the end of 2020.

So, Robinhood’s client accounts hold a rough average of $4,500, while Charles Schwaab’s client accounts typically hold more than $225,000 each.

It pays to target the wealthy.

How does Robinhood make money?

Robinhood’s commission-free trading model revolutionized the industry. But to be a viable business, the company has to make money from trades somehow.

That somehow is payment for order flow (PFOF). Instead of charging investors a fee for every trade they make, Robinhood gets a rebate from market makers like Citadel Securities, LLC — who accounted for 34% of Robinhood’s revenue in 2020.

During FY20, PFOF accounted for 75.1% of Robinhood’s total revenue. In the first quarter of 2021, that contribution increased to 80.5%. Note that the company refers to PFOF as “transaction-based revenues.”'

Although much smaller, Robinhood has two other sources of revenue.

Net interest revenue: the net earnings made from lending securities to users (e.g. for short-selling purposes).
Other revenues: monthly subscription revenue from Robinhood Gold, which puts professional research behind a paywall.

Here’s an overview of Robinhood’s sources of revenue:

What is payment for order flow?

First, it’s important to understand what a market maker is.

Market makers are firms that continuously quote both sides of a transaction: the price they’re willing to pay for a stock (i.e. the bid) and the price they’re willing to sell a stock for (i.e. the ask). The difference between the two prices is known as the bid-ask spread. These firms are integral to the investing process because they help keep markets liquid.

When retail investors make trades through a broker (such as Robinhood), the broker sends orders to a market maker to execute the trades. In exchange, the market maker pays the broker a rebate for the volume activity (and, indirectly, insight into buy/sell orders). The rebate is based on a percentage of the bid-ask spread. This is how the PFOF model works.

PFOF is not illegal, rare, or exclusive to Robinhood’s business. Since commission-free trades are the norm, other firms use this model too. However, there are inherent problems with the PFOF model — problems that could jeopardize its legality down the road. We’ll come back to this.

Here’s a more detailed overview of the PFOF model and its nuances.

Is Robinhood profitable?

Yes, Robinhood is a profitable company as of its latest fiscal year. In FY20, Robinhood generated a $7.4 million profit, resulting in a profit margin of less than 1%. This was driven by the sizable increase in funded accounts and trading activity that coincided with the pandemic.

However, Robinhood’s General and Administrative expenses for the year were $294.7 million — a 244.7% increase relative to 2019. So, were they just paying their employees more or what?

Partially.

Share-based compensation (a non-cash expense) was $24.3 million in FY20, so if we add that back, their net profit doesn’t look as minimal. However, the predominant catalyst was $105.5 million of expenses related to legal settlements and reserves. We’ll come back to this.

The first quarter of 2021 is a longer story.

Robinhood would’ve made a $47.5 million profit in the first quarter of 2021 if you back out a hefty non-cash expense — a $1.5 billion change in fair value of its convertible notes and warrants liability. This expense relates to emergency funding that took place during the meme stock frenzy earlier this year.

Stocks like GameStop and AMC attracted extreme levels of demand from retail investors — to a point where Robinhood limited transactions involving these companies. Naturally, this sparked outrage among Robinhood’s tribe.

Robinhood faced a liquidity crunch, as it scurried to secure enough capital to back the flurry of trading activity. Within a week, it raised $3.55 billion of convertible notes, which convert into common stock as soon as the company completes its IPO. Robinhood also compensated the convertible noteholders with warrants to purchase additional equity in the company.

All said and done, the massive $1.5 billion change in fair value expense is more so an accounting anomaly; Robinhood raised quick capital to remedy a dire situation at the cost of diluting its future share value.

We’ll also address the bigger potential risk of this situation a bit later.

Why is Robinhood’s IPO unique?

Per the company’s prospectus, Robinhood expects to allocate anywhere from 20-35% of its common stock to retail investors. But not just any retail investors — specifically Robinhood customers.

Robinhood is allowing its customers (through the Robinhood app) to sign up for early access to HOOD’s IPO, which will be $38 per share.

Why is this significant?

Let’s walk through an example of a recent IPO. I’m a believer in Airbnb, so I bought shares on the day ABNB started trading. By the end of the day, ABNB was up 112%. So my investment was up 112% too, right?

Wrong. ABNB more than doubled from its listing price of $68 — an entry point that’s almost always reserved for institutional investors or individuals with ridiculous fortunes. Not normal people like you and me. Shares of ABNB opened on the market at $146 and closed under $145. Not exactly a 112% return.

So, Robinhood’s IPO tactic is significant because it enables its customers (some of them, anyway) to get their hands on the listing price of $38 instead of the price it eventually opens at on the market.

What an incredible marketing tactic.

Is Robinhood the only brokerage that offers early access to IPOs?

No, it’s not uncommon for brokerages to grant their customers access to IPOs before they hit the market. However, brokerages typically reserve this benefit for wealthy clients. For instance, Fidelity requires customers to have hundreds of thousands of dollars in assets to participate.

In that sense, what Robinhood is doing is mostly unique — it removed a barrier to entry. (We say mostly because SoFi offers its members access to traditional IPOs too, so long as they have $3,000 in brokerage accounts.)

What’s the risk of buying Robinhood’s IPO?

By offering so many shares to the general public, Robinhood’s price could be extremely volatile in the opening days/weeks/months of trading — more so than the usual IPO.

Why? Generally speaking, retail investors tend to have shorter outlooks relative to institutions and are more tempted to trade during volatile periods. Considering a lot of individuals will want to make a quick profit — especially since Robinhood’s IPO is being hyped as a major risk in the media — there could be some crazy price swings.

Although Robinhood does have a policy that discourages “flipping” (selling to make a quick profit), the penalty is minimal and not even guaranteed:

Like any investment you make, you can sell the shares you received through IPO Access at any point in time. However, if you sell IPO shares within 30 days of the IPO, it's considered "flipping" and you may be prevented from participating in IPOs for 60 days. This policy applies to all IPOs offered on IPO Access.

Offenders “may” be temporarily banned from participating in IPOs.

What are Robinhood’s operational risks?

Robinhood smells funny. You don’t have to do much digging to uncover some grave details, particularly regarding recent and looming regulatory risks. Before we dive into those though, I want to share an interesting tidbit that’ll make more sense once you read further.

Who do you think was the most compensated employee of Robinhood in 2020? We’ll give you three guesses.

The company’s CEO, Vlad Tenev?

No, but that’s an understandable guess.

Well, then it must be Robinhood’s Co-Founder and Chief Creative Officer, Baiju Bhatt?

Incorrect, guess again.

Well, Robinhood is in financial services, so the CFO...Jason Warnick?

Nope, not even him.

The title of “highest paid” goes to Daniel Gallagher, Robinhood’s Chief Legal Officer, and it’s not even close.

Of course, you would expect a long-time asset and legal expert to be well compensated, especially in a heavily regulated industry. Except Robinhood hired Gallagher in May 2020. He made $30 million for seven months of work.

Gallagher has been busy.

Robinhood has a concerning history of regulatory issues

On page 27 of the company’s prospectus, there’s a table that breaks down Robinhood’s Adjusted EBITDA — a non-GAAP metric calculated by the company. In essence, a company tries to make its earnings look better under “normalized” conditions by adding back extraordinary expenses and non-cash items. This is normal.

The last line item of this particular chart isn’t normal — it’s for $101.6 million and it’s titled: “Certain legal and tax settlements, reserves and expenses.” It has a staggering footnote.

Here’s a summary of the footnote for 2020 activity:

$65 million settlement paid to the SEC (on a neither admit nor deny basis) following the SEC’s investigation into Robinhood’s best execution and PFOF practices, as well as statements concerning its sources of revenue.
$26 million charge for potential resolution of March 2020 outages (when investors were locked out of their accounts), approving ineligible traders for options trading, and misleading customers regarding margin trading. Collectively, these are “the FINRA Matters.”
$10 million charge for potential resolution of a New York State Department of Financial Services (NYDFS) related to anti-money laundering and cybersecurity-related issues.

The FINRA Matters were settled for roughly $70 million in June on a “neither admit nor deny” basis. Stroking a $70 million check hardly sounds like they’re denying it. You can read the details behind the settlement here, but the company was pretty much recklessly neglecting its fiduciary responsibilities as a brokerage.

Per the company’s amended prospectus, Robinhood expects to settle with the NYDFS for $30 million. In short, the company wasn’t compliant with anti-money laundering regulations and other cybersecurity requirements. You can read more about it here.

You want to know what got a good laugh out of me? The immediate next page after these concerning statements is a colorful, nonsensical drawing of astronauts floating into a bizarre, fictional galaxy. As if to say, “Nevermind the settlements, look at these pretty colors!”

Now, let’s unpack the $65 million settlement with the SEC, as it ties back to our earlier discussion about PFOF.

Brokerages have a fiduciary responsibility to their customers — they’re supposed to follow “best execution” practices for trading activity. In other words, if investors buy shares of ABC company, the brokerage is expected to pick the market mover with the tightest bid-ask spread because this is the most inexpensive route for the customer. However, the higher the spread, the higher the broker’s fee. They’re systemically incentivized to go against their fiduciary responsibility.

In May 2019, the SEC investigated Robinhood’s best execution and PFOF practices, concluding that customers experienced lower execution quality and that Robinhood made misleading statements about the extent of its PFOF practices. This led to the $65 million settlement.

Robinhood has had a hard time fulfilling its fiduciary obligation.

PFOF is under heavy scrutiny from industry regulators and public officials due to its inherent conflict of interest. It’s already banned in the U.K. and Canada, which gives governing bodies a precedent to outlaw the practice.

Robinhood could face a major existential crisis if SEC restricts this method.

If PFOF is eventually limited or banned as a practice, Robinhood management said, “Robinhood and the industry would adapt.” However, Robinhood is in a much worse position to do so relative to its peers since the company isn’t anywhere near the scale of its competitors.

If PFOF is banned, it seems more likely that competitors will poach Robinhood’s customers rather than the other way around.

Brand image and customer retention concerns

As we mentioned above, first-time investors account for more than 50% of Robinhood’s customers. Customers aren’t locked into long-term contractual agreements, so they’re free to close their accounts at any time.

While Robinhood’s total funded accounts increased in the first quarter of 2021, so did its account transfers to other brokerages — 206,000 accounts collectively holding $4.1 billion elected to move to another firm.

In all likelihood, this was a result of the meme stock craze and Robinhood’s decision to limit trading of certain stocks. Robinhood can ill-afford to lose customers if it expects to expand, let alone maintain, operational growth and profitability.

Is Robinhood’s growth sustainable?

That’s the billion-dollar question.

Robinhood made a fortune from what many have referred to as a casino-like stock market over the last year and a half. The pandemic issued a new wave of risk-thirsty investors and even armed them with free government-sponsored cash to play around with. However, this environment is temporary.

There are plenty of routes Robinhood can take to continue growing its platform while simultaneously increasing the lifetime value of its customers. For instance, the Robinhood Gold membership grew significantly since the end of FY19, from 0.2 million to 1.4 million as of March 31; Robinhood Gold offers far more transparency and stability compared to transaction-based revenue.

Further, during the company’s virtual roadshow, Tenev expressed an interest in expanding into retirement accounts, "We are interested in building more account types, including IRAs and Roth IRAs, we've been hearing that a lot from our customers. We want to make first-time investors into long-term investors." Tenev also mentioned a desire to expand into international markets.

There are opportunities for growth, but the operational and regulatory risks sitting in Robinhood’s way are quite formidable.

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Sources

Robinhood Prospectus
Robinhood IPO: Looking Under The HOOD (Seeking Alpha)
Robinhood IPO: Still A Bad Bet For Investors With Alarming Risk (Forbes)

Due Diligence

Spotlight: the Robinhood IPO