The purveyor of meme stocks had its day in the sun yesterday and it got off to a bit of a rocky start. Shares of the broker fell 8.4% in its first day. It has been characterized as the worst debut for an IPO of its size.

The price movements of the stock are what grabs the headlines but in an environment of information overload, it can be difficult for investors to find useful and succinct insight into the markets and new issuances. In browsing the mainstream media, offbeat media, as well as social media however, some interesting caveats can be pulled from the noise which is what I wanted to highlight in this post. The result is probably a cautionary tale for anyone looking to get into an IPO given the risks and insider paydays that are typical of the IPO process in the recent past.

Twitter Highlights

In reading up on the IPO, I stumbled across a tweet thread from a person named Christopher Bloomstran, who had taken issue with the way the IPO was managed. Mr. Bloomstran did seem to have taken a good look at the offering memorandum but I found his series of tweets to be confusing for anyone who didn’t already run through the 300 page memorandum, so I decided to grab some of his highlights, summarize them and compact them as well as look into the filing myself. His points bring out some valid questions and his doubts raise even more troubling issues as to the validity of the business mode going forward, something all investors should be concerned about.

I will first start with an overview of the business, then the recent financing and finally with the lingering doubts as to the business model going forward.

Robinhood Overview

A few highlights of Robinhood at the IPO date and as of their last filing (March 31st):

• 18 million (million as MM from here on) accounts, 17.7MM active users, $81 billion assets under custody;
• Over 50% of investors are first time investors;
• Revenue of $959MM in 2020, up from 278MM in 2019;
• Net income of $7MM in 2020, compared to a loss of $107MM in 2019;
• 1Q 2021 saw revenue at $522MM, up from $128MM year over year, high end estimated revenue of $574MM for Q2;
• Net loss on the quarter of $1.5 billion, through a fair value adjustment to convertible notes and warrants compared to a net loss of $53MM in 1Q 2020;
• $81 billion under custody with 18MM accounts means an average value of $4500 per account;
• Total assets under custody break down as: $65 billion in equities, $2B options $11.6B crypto (up from $3.5B at 12/31 & $481m a year ago) $7.6 billion cash ($5.4 billion margin);
• Half of transaction revenues, which are 81% of firm revenues, come from option rebates, while options at market value account for only $2B of customer assets;
• 17% of firm revenues were earned in Q1 from crypto transaction “rebates,” up from 4% in the prior quarter. While $HOOD supports 7 cryptos for trading, no less than 34% of crypto revenues were from Dogecoin;
• Robinhood further discloses that 81% of Q1 revenue came from selling equity and option order flow to 4 market makers, up from 75% of revenue during 2020.

To give you some context for the above figures, Schwab’s market cap is $128 billion, with $58 billion of book value and $5 billion of profit, $7.5 trillion assets under custody and 31.5MM active accounts. What you are essentially getting at the moment with Robinhood is a firm that caters to small first time traders with little cash, trading in highly risky assets like meme stocks, options and crypto. Do you really think these investors will stick with Robinhood if there is a prolonged bear market in any of these assets?

The IPO and Financing

I don’t take too much of an issue with insiders and venture capital using scale, taking risks and getting in early. Like it or not, that is the service they offer to their clients. Unfortunately for smaller investors, big wealthy investors can take greater risks. A million dollars to someone with $200 million can afford to throw a million at risky venture deals in the hopes of a home run. Otherwise it’s just 0.5% of their net worth that they would lose, some days the stock market itself moves more than that.

Yet as Mr. Bloomstran aludes to in his tweet thread, the conduct of founders and executives does set a precedent for the culture and for the firm and is a good signal as to whether they keep investors in mind or are just looking after themselves. In this sense, I agree with Mr. Bloomstran in that they don’t seem to have the interests of the typical retail investor anywhere near the forefront of their thought process. To understand why, take a look at my simplified highlights of the recent capital situation:

• To get to the potential shares outstanding, there are 514MM shares outstanding as of March 31 2021, these are all allocated to insiders;
• Add to this 130MM shares of Class B stock which can be exchanged for class A stock and hold special voting rights of 10 to 1 over class A shares, these are the ones held by the founders which would then control 65% of the voting rights;
• Add to that $2.551 billion in convertible debt issued in February 2021, which could potentially convert to approximately 96MM shares. This is the big money put in by private equity and venture firms;
• Add to that $1.028bln which could convert to 39MM shares as well, this debt was issued in May of 2021, again likely to large rich investors who can come in before the little guy;
• Finally, 60.5MM shares for the IPO, assuming an option for 5.5 million extra shares is exercised;
• This brings the total potential shares outstanding to about 840MM with only 60.5MM allocated to investors or about 7% of the company.

What does the market end up paying for these 60.5MM shares? About $2.3 billion, which would value the entire company at around $32.9 billion. That compares with just $5.6 billion in capital raised before the IPO. Essentially the founders, the insiders and the wealthy were able to flip $5.6 billion into $30.6 billion within a matter of months thanks to you the public that is so eager to get in on this. That’s a return of 446%, something I doubt average retail investors will be able to look forward to in the near future and this is the issue Mr. Bloomstran has with the system: insiders become billionaires, then the already wealthy take their cut, then the retail investor is left holding the bag. Don’t forget that this IPO also included the unprecedented distribution of 25% to 35% of the offering to Robinhood’s retail customers themselves.

Congratulations, you now have helped enrich a small group of people and have little to no say in how they manage the company going forward, what a deal.

Business Model Doubts

Remember that Robinhood is a pass through service, their value is based on the revenue they can extract from their customers by selling them innovative services and products that keep them coming back. Crypto and meme stocks may be fine for the moment but there are issues with this strategy in the long run which the company itself points out in the offering memorandum:

• Growth Strategy: Add new customers, gain revenue from current customers, expand internationally and the buzzword of the moment: “innovation”;
• They have limited operating experience at scale;
• Reduced trading volumes and spreads may impact profitability;
• May require additional capital or regulators may require them to hold additional capital;
• Ongoing litigation.

Keep in mind that Robinhood was fined $65MM last December for lack of best execution by the regulator, something that is required of all broker dealers and brought their business model under heavy criticism.

I don’t find much that they do that other brokers cannot do. TD Ameritrade or Schwab each have enough scale to literally buy an app or build a programming team to produce one on their own. They already offer best execution, free research and free trades. Plus these names have the experience of executing at scale and dealing with regulatory headaches, something Robinhood is just getting their feet wet in.

That Robinhood brought about free trading and more free add ons for investors is their great contribution to the consumer but that is in the past. The question now is if they can add value for their owners as an individual company and I have my doubts about that. There may be value at some price for this name but I doubt it is at 32 times last year’s revenue.

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