Robinhood is making waves in the investing world by allowing customers to take part in its initial public offering. However, before you consider investing, it’s crucial to examine these five risks.
Financial platform Robinhood has taken a bold step with its own IPO, which began trading on the Nasdaq under the ticker symbol HOOD. Initially priced at $38, the shares faced an immediate drop.
This approach of involving customers marks a shift from the traditional IPO model, where only select investors usually benefit.
Nonetheless, this access might not be as impactful for the typical Robinhood user, as selection for participation in the IPO was random. Here's a look at how Robinhood's IPO was structured and the five key risks for potential investors.
Robinhood's Booming IPO: Key Information
Robinhood executed one of the most talked-about IPOs of 2021, during a record-breaking year for initial offerings. The company gained notoriety for its involvement in the GameStop trading frenzy, where it faced backlash for limiting trades at a critical moment.
Now, this app that claims to democratize trading is offering its own shares to users. Unlike conventional IPOs where shares are reserved for insiders, Robinhood allocated up to 35% of its stock for its customers through a new IPO Access initiative.
“This is a positive development, reinforcing their model,” states Sam Hendel, president at Easterly Investment Partners. “They are embodying their mission to democratize market access.”
However, the process for selecting who can buy shares was randomized. The numbers indicate that individual investors might receive minimal allocations, even though the outlook appears favorable for the customer base overall.
Specifically, the IPO reserved between 20% to 35% for Robinhood users. With around 60.5 million shares available, customers could be allocated approximately 21.2 million in the best-case scenario. While this sounds significant, the rapidly growing number of users diminishes its impact.
As of June 30, Robinhood reported 22.5 million funded accounts. If shares were evenly distributed, each account would receive less than one share. Even selecting just 1% of clients to participate would yield fewer than 100 shares per individual on average.
Thus, while the attempt to democratize access is commendable, the actual benefit for most users is nearly negligible.
Hendel recognizes this drawback but adds, “Robinhood accounts tend to be smaller than those at E-Trade or Charles Schwab, but even having a few shares is more impactful than at other brokerages.” He notes this move could enhance customer loyalty.
Five Risks Associated with Robinhood's IPO
Like any investment, Robinhood carries several risks. Below are five critical ones to consider.
1. Valuation Concerns
Robinhood's shares debuted at $38, giving it a market capitalization of approximately $32 billion, a hefty figure by most standards.
For context, Robinhood manages around $102 billion in assets as of June 30. In comparison, Charles Schwab reported a staggering $6.69 trillion in client assets by the end of 2020. What does this imply for investors regarding valuation per client asset?
| Brokerage | Client Assets | Market Capitalization | Market Cap/$1,000 in Assets |
|---|---|---|---|
| Robinhood | $102 billion | $32 billion* | $314 |
| Charles Schwab | $6.69 trillion | $128 billion | $19 |
* Based on IPO target price
This table illustrates the disparity in what investors pay for client assets between Robinhood and Schwab. At the IPO price, investors are paying $314 for every $1,000 in Robinhood's client assets, compared to only $19 for Schwab. Moreover, Schwab benefits from diverse revenue streams, including interest income and management fees, while Robinhood is also looking to broaden its revenue sources.
2. Profitability Issues
Potential investors will want to assess Robinhood's profitability, which may be challenging to gauge. The company recorded a profit of $7.5 million in 2020, rebounding from a loss exceeding $106 million in 2019. However, 2021 is expected to show complicated figures due to accounting nuances, with management projecting a loss between $487 and $537 million in the second quarter, according to the updated prospectus.
Rising costs tied to a 190% increase in headcount and expanding cloud services are anticipated. These growths are a result of increasing customer numbers, which could be beneficial if the firm can profit from these new users.
Revenue, however, has soared—estimated to rise by 129% in the second quarter (midpoint estimates). This remarkable revenue growth in 2020 enabled Robinhood to shift from a significant loss to a modest profit, suggesting a similar trajectory could emerge beyond 2021 if revenues continue to rise. Nevertheless, 2020 marked Robinhood’s first profitable year, leaving its earnings track record inconsistent.
3. Dual Share Class Structure
Robinhood employs a dual share class structure, often viewed unfavorably by investors. This system allows insiders to hold shares with amplified voting rights compared to regular investors, consolidating control among insiders. While many recent tech IPOs have adopted this model, it can be off-putting for those looking for equal voting power.
In Robinhood's case, insiders possess Class B shares, which offer 10 votes each, while standard investors receive Class A shares with only one vote. The CEO and chief creative officer will collectively hold about 15.8% of total stock, while wielding over 65% of voting power.
This arrangement can frustrate investors, who may feel their influence is limited despite their financial investment.
4. Investor Sentiment
Granting customers access to 35% of shares in the IPO is a daring strategy. Will a significant portion of these investors sell their shares right away? Do they seek a quick profit on the first day and plan to exit if they don’t see immediate gains? Or are they in it for the long term? The reactions of this investor group could have consequences for the stock’s performance and future IPOs.
Although it’s uncertain how this will unfold, if the IPO succeeds—marked by a rising stock price in the following days, weeks, and months—it could set a precedent for other companies aiming to attract individual investors.
“It’s too early to determine if this will become standard practice, but with the recent surge in retail investor activity, companies may want to tap into this market,” states Hendel. “Accessing these distribution channels could be crucial for fundraising.”
Additionally, a climbing share price would benefit Robinhood itself.
5. Business Model Vulnerabilities
Investors must scrutinize Robinhood's business model, primarily reliant on payment for order flow. This means that trading firms compensate Robinhood for directing customer orders to them. These firms profit by slightly increasing the purchase price of securities and lowering the sale price.
Although this presents a conflict of interest, it’s a common practice among many firms. The crux for Robinhood is that this revenue stream accounted for 81% of its overall sales in the first quarter, even as the SEC begins to scrutinize this model. If the SEC implements significant changes, it could adversely affect Robinhood's operations.
While Hendel believes major changes from the SEC are unlikely, any adjustments could still pose a significant threat to Robinhood's business model.
Moreover, even without regulatory changes, Robinhood's profitability hinges on maintaining high trading volumes. This places pressure on the company to encourage frequent trading among its clients, despite the fact that active trading is often less lucrative for investors than a passive strategy.
Final Thoughts
As with any IPO, investors should ask themselves, “What’s motivating the company to offer the public a stake if it’s truly a good opportunity?” and “Why pursue an IPO at this moment?” For Robinhood, the latter question may highlight the recent market boom, driven by low interest rates and substantial government spending.
Thus, it’s perhaps not surprising that a trading-focused financial app is capitalizing on the hottest IPO climate to strengthen its business. The move to include clients might be less about democratizing finance and more about securing favorable terms for the company itself.
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