Robinhood (HOOD) – Get Robinhood Markets, Inc. Class A Report investors have reason to be worried. Shares of the commission-free broker have been tumbling basically since the stock’s IPO. The company has struggled to reach profitability and is reporting slow growth.
HOOD has already fallen more than 80% since its peak in July 2021, when it hit $55 per share. Also, in its recently released Q1 earnings, Robinhood reported a drop of more than 43% in revenues, which caused the stock to plunge more than 10% after hours.
However, although the stock suffers a lot of resistance — mainly from retail investors who have an aversion to its business model — is Robinhood really destined to become a penny stock?
Figure 1: Is Robinhood Doomed to Become a Penny Stock?
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Robinhood’s Profitability Problem
Investors want to buy a healthy business. After all, the more profits a company makes for its shareholders, the better.
There is a key metric for this. ROE (return on equity) measures the profits shareholders get for their initial investments. For example, if you invest $5,000 in a company and profit $1,000, the ROE will be 20%. An ideal benchmark in today’s market is 10% and above.
Robinhood’s ROE was once much worse than it is today. In 2019, the company recorded a return of -109%. In 2020, with the company under strong valuation, it managed to achieve a record ROE of -5%. Currently, Robinhood’s ROE stands at -50%. This implies the size of the loss that shareholders have been taking for their contributions to finance Robinhood’s business.
The Bank of America is bearish on Robinhood due to a pandemic-related tailwind reversal and its potential lack of profitability till 2025. Morgan Stanely is more positive. It forecasts the company will achieve profitability on an adjusted EBITDA basis by 2023.
HOOD’s Growth Potential and Valuation
Robinhood is considered a growth stock. That means it trades according to its growth potential, rather than based on its current financials.
It turns out that Robinhood grew too fast. Boosted by the frenzy of meme-stock and crypto trading, Robinhood saw its business soar from 2020 to mid-2021 — when the company went public.
In the first and second quarters of 2021, HOOD shares peaked after the company reported better-than-expected revenue results and extraordinary growth in the number of new accounts.
However, the following quarters have told a different story. After stay-at-home trends, meme-stock momentum, and cryptocurrency mania peaked, Robinhood’s financials took a turn for the worse.
However, while the company is still far from enjoying significant growth in the near term, Wall Street believes that, in the long term, Robinhood may still pay off. For example, one Mizuho Financial analyst recently wrote that Robinhood should trade at an adjusted EBITDA multiple of 25 times by 2024, which would be even lower than other fintech companies.
Robinhood’s Business Risks
There are a number of considerable risks with regard to Robinhood’s business. According to the company’s 10-K form, its short history of operations, difficulty in managing accelerated growth, and fluctuations in financial results from quarter to quarter are the main risks to its Robinhood stock.
But among these risks, there is one that draws a lot of attention: the dependence of Robinhood’s revenues on payment for order flow (PFOF) — a practice that allows the company to “opt out” of charging commissions to its customers.
Payment for order flow is compensation received by the brokerage firm from different parties for its execution. It usually consists of a few pennies per transaction received for routing the order to a market maker.
The practice has been criticized because of possible conflicts of interest among market makers. There are theories that the practice of PFOF can turn executable orders into non-executable ones, due to being routed to market makers who are willing to pay a higher amount. This can possibly have an impact on the share price of an asset.
PFOF is illegal in Canada, the U.K. and a few other countries. Initially, the practice was endorsed by the controversial market maker Bernie Madoff, who pioneered its adoption. Today, besides Robinhood, many other brokers also use PFOF, including TD Ameritrade (AMTD) – Get TD Ameritrade Holding Corporation Report, Charles Schwab (SCHW) – Get Charles Schwab Corporation Report, and E-Trade (ETFC) – Get E*TRADE Financial Corporation Report. There is also a benefit of increased liquidity of the markets with the use of PFOF by the brokers.
However, an eventual ban of the practice — which is neither unthinkable nor unfeasible — would be strongly detrimental to Robinhood’s revenue model. Retail investors who bet massively on meme stocks like GameStop (GME) – Get GameStop Corp. Class A Report and AMC (AMC) – Get AMC Entertainment Holdings, Inc. Class A Report have a strong aversion to the practice of PFOF. They consider it an attack on the transparency of the markets due to market makers supposedly being the biggest beneficiaries.
In Summary
Robinhood is still a long way from reaching the level of a penny stock. But it is undeniable that its performance since its IPO in mid-2021 has been tragic.
However, the company still has about $6.4 billion in cash, excluding debt. This is crucial for financing new projects and to take steps toward restoring growth to its business and achieving profitability as soon as possible.
There are several risks that could bring Robinhood’s business down in a short period of time, such as its dependence on PFOF. But on the other hand, there are also good opportunities and methods to monetize its large user base. So, even though I view Robinhood’s business with a lot of skepticism, I believe it is unlikely that the company will ever reach a penny stock valuation.
(Disclaimers: this is not investment advice. The author may be long one or more stocks mentioned in this report. Also, the article may contain affiliate links. These partnerships do not influence editorial content. Thanks for supporting Wall Street Memes)
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