9 Red Flags Investors Should Know About the Robinhood IPO

Robinhood’s S-1 filing raises some potential red flags.

Trading app Robinhood Markets Inc. (ticker: HOOD) is going public today in one of the largest and most highly anticipated initial public offerings in recent memory. Yesterday, the company achieved a valuation of around $32 billion and raised close to $2 billion, pricing shares at $38 apiece. Robinhood says it has 22.5 million funded accounts and estimates that its second quarter revenue was between $546 million and $574 million. There’s no question Robinhood has been a tremendous success, but the company has also had its fair share of controversy. Here are nine potential Robinhood IPO red flags.

Robinhood’s Engagement Is Through the Roof.

At first glance, Robinhood’s customer engagement numbers may seem like a great reason to invest in the IPO. Roughly 47{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} of Robinhood users use the platform on a daily basis. That’s the type of engagement investors usually see from social media platforms, not investing platforms. One of the most common criticisms of Robinhood is that the app encourages market speculation rather than responsible, long-term investing. In 2020, the average number of visits was seven per day. Robinhood critics say that engagement is indicative of Robinhood’s “gamification” of investing.

Robinhood Is Struggling to Handle Its Growth.

Robinhood reported that its total funded accounts have grown from 5.1 million in 2019 to 22.5 million in the second quarter. But there is also evidence that the platform is struggling to handle that growth. Robinhood recently paid a $70 million fine to the Financial Industry Regulatory Authority related in part to platform outages in 2020. Robinhood also came under fire for temporarily restricting trading in so-called “meme” stocks earlier this year. Robinhood claims it simply didn’t have enough cash to meet deposit requirements when trading volume surged to unprecedented levels. The restrictions triggered dozens of lawsuits by angry users.

Robinhood Has an Image Problem.

The fiasco surrounding the trading restrictions on GameStop Corp. (GME) and other stocks created a storm of negative attention for Robinhood. Berkshire Hathaway Inc. (BRK.A, BRK.B) Vice Chairman Charlie Munger recently accused Robinhood of providing “gambling services” and making money in a “dirty way.” Influential Barstool Sports founder David Portnoy even called Robinhood one of the “the biggest frauds of them all.” Robinhood CEO Vlad Tenev was forced to testify in front of Congress as part of its investigation into the trading restrictions. This type of negative press is certainly not what a company would prefer heading into an IPO.

Robinhood Relies Heavily on Payment for Order Flow.

One of the most controversial topics that Tenev discussed with Congress is Robinhood’s primary source of revenue — a process called payment for order flow, or PFOF. PFOF is compensation Robinhood and other brokers receive for routing trades to a particular market maker for execution. PFOF is the reason Robinhood can offer $0 trading commissions, but critics argue that it also results in larger spreads and worse execution prices for customers. In the first quarter, PFOF accounted for 81{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} of Robinhood’s total revenue. If regulators restrict or ban PFOF at some point, it could create a huge loss for investors.

Robinhood’s IPO May Be a Social Media Target.

In addition to the negative press and lawsuits prompted by Robinhood’s meme stock trading restrictions, there is some evidence suggesting the groups of social media retail traders that sent AMC Entertainment Holdings Inc. (AMC) and GameStop shares skyrocketing this year may target the Robinhood IPO by short selling the stock. Subreddits such as WallStreetBets, Superstonk and Amcstock have several popular posts encouraging community members to avoid Robinhood stock or even short the Robinhood IPO. If all the retail stock traders buying AMC and GameStop collectively sell shares of HOOD stock out of spite, they could do a lot of damage.

Robinhood Is Highly Exposed to Option Trading.

Stock options make up about 3{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} of Robinhood’s total assets, yet they reportedly accounted for a surprising 38{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} of all transaction-based revenue in the first quarter. While option trading strategies such as selling covered calls are relatively conservative, extremely leveraged and high-risk strategies such as buying directional put or call option contracts have become popular “YOLO” trades on social media in the past year. More than half of Robinhood’s users said their Robinhood account is their first brokerage account. Having such a large number of inexperienced investors trading sophisticated, high-leveraged stock options could be a recipe for disaster in the long term.

Robinhood Has Major Cryptocurrency Risk.

Bitcoin and other leading cryptocurrencies are extremely volatile, high-risk assets, and Bitcoin is already down close to 40{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} from its April 2021 all-time highs. Some traders are concerned that the cryptocurrency market could repeat its 2018 swoon in which Bitcoin prices dropped more than 80{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} from 2017 peak levels. Robinhood reported $87.6 million in cryptocurrency trading revenue in the first quarter. In its S-1 filing, Robinhood expressed particular concern over its exposure to meme cryptocurrency Dogecoin, saying that the crypto that was created as a joke accounted for “a substantial portion” of its recent cryptocurrency revenue growth.

Robinhood Customers Could Get Burned.

Robinhood is taking a unique approach to its IPO by setting aside up to 35{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} of its IPO shares to sell directly to its customers. The goal is presumably to allow retail users to participate in a part of the market process that is typically reserved purely for institutional investors. However, Robinhood warned in its S-1 filing that this gamble could create problems if the IPO doesn’t go well. If HOOD shares initially drop, inexperienced Robinhood customers could feel they were somehow swindled or misled. If they all start to sell at once, the stock could experience extreme downside volatility.

Robinhood Is Steeply Valued.

Since Robinhood’s IPO values the company at more than $30 billion, HOOD stock will initially be trading at a price-sales ratio of more than 30, which is an extremely high valuation. In fact, there is not a single tech stock in the entire S&P 500 that currently has a price-sales ratio of more than 30. Even if Robinhood maintains its first-quarter growth rate of 130{8a924211cc822977802140fcd9ee67aa8e3c0868cac8d22acbf0be98ed6534bd} throughout 2021, the stock would still be extremely richly valued, and it seems highly unlikely Robinhood will be able to match the growth numbers of the retail trading boom of 2020 and 2021 in 2022 and beyond.

Red flags investors should know about the Robinhood IPO:

— Robinhood’s engagement is through the roof.

— Robinhood is struggling to handle its growth.

— Robinhood has an image problem.

— Robinhood relies heavily on payment for order flow.

— Robinhood’s IPO may be a social media target.

— Robinhood is highly exposed to option trading.

— Robinhood has major cryptocurrency risk.

— Robinhood customers could get burned.

— Robinhood is steeply valued.

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