Poor results hit Robinhood shares

To begin with, let’s take a look at the latest report. Total net revenue came in at $365m for Q3, which was up 35% year-on-year. Yet Q2 revenue was at $565m, so around a 36% drop was seen in the latest quarter. When looking for reasons, crypto trading was flagged up. 

In Q3, $51m of transaction revenue came from cryptocurrency, a large fall from the $231m seen in Q2. I specifically flagged up this risk back in August, when I reviewed the company here. I noted that the reliance on crypto revenues was unlikely to be sustainable. To be honest, I didn’t realise how quickly this could prove to be true.

Although there’s still an active market in crypto, the specialist exchanges such as Coinbase are taking clients and attracting more new ones. In recent results, Coinbase showed a large increase in customer acquisitions, with the outlook also positive. I struggle to see Robinhood (that’s more geared for stock trading) being able to compete in this space going forward.

Robinhood shares dropped following the results on Wednesday, and have continued to fall since then, even below the IPO level.

Better opportunities elsewhere

One bad quarter doesn’t mean the end of the world though. I do think that Robinhood has a great interface and is easy to use. This should see it retain stock investors, particularly younger ones. Being in this market should put the company in a good place in the long run, as the wealth of younger investors grows with age.

However, I don’t see value in buying Robinhood shares right now. The company posted another net loss in Q3. Personally, I don’t see why a firm in this sector shouldn’t be able to generate better levels of profitability and operate with higher profit margins.

Another issue I have is the fact that optimism was priced in to the IPO due to a surge in retail trading activity during the pandemic. Now that many are adjusting back into normal life, I think the benchmark for expectations from Robinhood is too high. Personally, I think the pandemic trading boom was a one-off and won’t continue at such elevated levels.

Clearly, I could be wrong. Robinhood could profit from another rally in crypto, fuelling activity into Q4. It could also bring out new products that allow more consistent revenue. Yet with the current business outlook, I won’t be buying Robinhood shares now.

Robinhood filed its first earnings report as a public company yesterday, and it looks as if the report has gone down like a lead balloon among investors. 

Mixed earnings 

The company’s earnings were a bit of a mixed bag. The trading app recorded a loss of $502m on revenue of $565m. Most of its revenue came from digital asset trading. Nearly 63% of users with funded accounts traded digital assets in the quarter, raking in $233m in fees for the firm.

A year ago, Robinhood earned just $5m in fees from digital assets. The group earns fees by routing customers’ cryptocurrency trades to high-speed trading operations. 

Meanwhile, fees earned from customers equity totalled just $52m, down 27% year-on-year. 

The bulk of Robinhood’s revenue is earned when the company sends customer orders to high-speed trading firms. But it also operates a booming margin lending business.

Interest the enterprise received on margin loans nearly tripled to $31m during the quarter, with around 700,000 users holding $5.4bn in margin-loan balances at the end of June.

It would appear investors have been dumping the Robinhood share price as management expects the company’s growth to slow in the current quarter.

“We expect seasonal headwinds and lower trading activity across the industry to result in lower revenues and considerably fewer new funded accounts than in the prior quarter,” the firm noted in its results release.

These comments appear to have spooked investors. With revenues from stock trading already sliding, it seems as if the organisation’s appeal as a growth stock is evaporating. 

Considering all of the above, I wouldn’t buy Robinhood stock even as it slides. 

Robinhood share price drawbacks 

While I think the free trading model does have potential, it is not unique. Other brokers already offer this service, and I think it will only be a matter of time before it’s the industry standard. The company is also only one of many platforms investors can use to buy and sell digital assets. 

As well as the lack of any clear competitive advantage, it’s also hard for me to value the Robinhood share price. The company’s revenues jumped in the last quarter, but it isn’t clear to me this growth is sustainable. Further, the enterprise is still losing money. It’s already been bailed out once this year after running out of cash. That could happen again. 

Still, it’s clear to me Robinhood does have a devoted customer base. It’s also one of the most recognisable brands in the trading app space. These qualities could help the firm outperform its peers as we advance. And if it can outperform, then the Robinhood share price may offer value after recent declines. 

However, I’m struggling to work out how much the firm is really worth, which is why I’m going to stay away. 

Personally, I don’t see much appeal in Robinhood stock at the moment. In my view, the stock’s risk/reward profile isn’t favourable. Having said that, there’s one meme stock I’d consider investing in right now.

Robinhood stock: the risks

Looking at the investment case for Robinhood, I see several big risks. The first is the company’s business model. Robinhood generates the bulk of its revenues (81% in Q1) from selling customer orders to institutions. This is called ‘payment for order flow’.

The issue here is that regulators don’t like this model. Currently, the US Securities and Exchange Commission (SEC) is in the process of reviewing it. If the SEC was to ban payment for order flow, it would impact Robinhood significantly.

A second issue is that growth could slow significantly. Last year, conditions were very favourable for the online broker. People were stuck at home in lockdown, casinos were closed, and sports events were cancelled (no sports betting). This led to huge growth. As the world reopens and people go back to their jobs, they’re likely to spend less time on the trading app.

Finally, there’s the valuation. When Robinhood came to the market in late July, many people thought the valuation was expensive (the trailing price-to-sales ratio was about 30). Today, the valuation is over 40% higher. If growth does stall, the stock could fall significantly.

Of course, there are some reasons to like Robinhood. The company does have a strong brand. It also has over 20m accounts, an impressive achievement.

Overall, however, I don’t see the risk/reward proposition as attractive.

The meme stock I’d buy

But one meme stock that does look interesting to me right now is semiconductor group Advanced Micro Devices (NASDAQ: AMD). It’s received a lot of attention on Reddit’s WallStreetBets forum recently.

I can see several reasons to like AMD. Firstly, the company – which develops high-performance computing products – has a huge amount of momentum at present. Just look at the company’s second-quarter 2021 results. For the period, revenue was up 99% to $3.9bn while earnings per share leapt 346% to $0.58.

“We are growing significantly faster than the market with strong demand across all of our businesses,” said CEO Lisa Su.

Secondly, the company looks set to benefit from the growth of a number of industries. Not only is it likely to gain from the growth of video gaming but is also likely to benefit from the growth of the data centre/cloud computing.

Third, the valuation doesn’t seem unreasonable. Analysts expect the group to generate earnings of $2.83 per share next year. That puts the stock on a forward-looking P/E ratio of about 37.

Of course, there are risks associated with this meme stock too. AMD operates in a very competitive industry and is up against the likes of Intel and Nvidia. These companies could steal market share. The company also operates in a cyclical industry.

However, I’m comfortable with the risks. I like the long-term growth story here.

The stock has since contracted down to around $55 per share. But that’s still around a 50% gain in a week. So what’s behind this sudden growth? Should I change my opinion on this company? If so, is it too late to buy? Let’s take a closer look.

The surging Robinhood share price

I previously explored Robinhood shortly after going public. But as a quick reminder, the business provides a mobile trading platform for retail investors to buy and sell shares, options and cryptocurrencies. Being the first major broker to remove its trading commission fees, the platform has become immensely popular with nearly 18 million users across America.

During its public debut, there seemed to be much uncertainty surrounding its Payment for Order Flow transaction model. This may explain why the Robinhood share price didn’t perform as the management team had expected. As far as I can tell, that uncertainty remains. But that didn’t stop ARK Invest’s Cathie Wood from buying roughly $45.2m worth of Robinhood shares.

The fund manager has gained a substantial following among retail investors in recent months. With tech stocks exploding in 2020, her funds under management achieved staggering triple-digit returns. From what I can tell, her conviction sparked a new wave of confidence that led to Robinhood’s 50% share price rise the following day.

I’m still not convinced

The firm undoubtedly has the potential to keep surging over the long term, especially since 2020 saw an enormous boost to interest in the stock market and cryptocurrencies. However, even with last week’s explosive surge in the Robinhood share price, my fundamental concern remains.

The Payment for Order Flow transaction model enables commission-free trading. But it also creates a conflict of interest between investors and the market makers (the firms that actually fill the buy and sell orders). This has led to a controversy that has even sparked an investigation by the Securities and Exchange Commission. Since Robinhood’s revenue is almost entirely dependent on this transaction model, any regulatory changes could have an enormous impact on the business, and consequently, the share price.

Final thoughts

I can’t deny the firm’s long-term growth potential. But Robinhood’s share price seems to be driven by speculation rather than fundamentals, I feel. With a market capitalisation of approximately $46bn, its price-to-sales ratio sits at 48.

Needless to say, that’s a high premium to pay for a business that could be navigating treacherous regulatory waters in the not-too-distance future. Therefore, I’m still not adding any shares to my portfolio today.

The online share-dealing broker listed on the Nasdaq stock exchange just last week, but initial investor appetite was lacklustre. It also listed at the lower end of the anticipated price range.

However, interest in Robinhood shares picked up this week. At the time of writing, its share price had almost doubled since Monday.

Why are Robinhood shares soaring?

It’s unclear why there’s been a sudden surge in interest in the shares. There’s no apparent news from the company or industry. That said, there are several potential reasons why the shares could soar.

Speculative targeted activity from online chat rooms could be a possible cause. Earlier this year, heavily-shorted stocks like AMC and GameStop experienced similar volatility when their shares were targeted online.

Ironically, Robinhood was caught up in the drama at the time when it was forced to halt trading in the two stocks.

Some traders may also have gained confidence after seeing popular investor Cathie Wood buying Robinhood shares on Tuesday.

The popular trading app

Robinhood was launched in 2013 and has become popular with a younger demographic. It appealed to new traders and investors with fee-free trading and fractional shares. According to Robinhood, more than half of its customers are first-time investors.

Robinhood’s mission is to “democratize finance for all”. The ethos that everyone should have access to financial markets became particularly popular with its target market.

But how does it make money? As it doesn’t charge users for transactions, it needs another source of income. Much of its revenue comes by selling order flow and data to third parties. It also earns by charging interest on users’ cash and by offering premium services.

Should I buy Robinhood shares?

For me, Robinhood shares are currently far too volatile. I prefer to buy shares that don’t fluctuate so much every day. That said, the popular trading app is growing fast. Total revenues grew 309% to $522m in the second quarter of 2021 vs the same period in 2020.

Also, its easy-to-use app is designed for mobile users first and provides an intuitive experience. It’s not hard to see why the technology-focused broker is popular with young, tech-savvy investors.

And it looks like there are many avenues for future growth. For instance, by adding users in the US and expanding internationally.

However, I think its recent growth has come in a short period of time. It has limited operating experience and there is much room for error when growing a fast-moving business. Also, keeping up with and not falling foul of regulators is a critical factor in this industry. Any major regulatory mistakes could negatively affect Robinhood shares.

Overall, I can see far better growth shares that I’d rather invest in so I won’t be buying Robinhood shares anytime soon.

Risky business model

Robinhood generates 80% of its revenue from Payment For Order Flow (PFOF). As a brokerage, Robinhood is paid for client orders by a specific market maker. This makes its commission-free trading model possible. Market makers are companies that buy and sell stocks at a publicly quoted price. A conflict of interest arises because investors want to buy and sell stocks from their brokerage at the best price, while market makers make their profits by buying and selling stocks to brokerages at a premium.

In December 2019, Robinhood was fined $1.25m by FINRA for failing to provide the best price for clients. The US regulator is currently scrutinising the fairness of PFOF. The UK has already banned the practice and it is limited across Europe. If PFOF is banned or limited in the US, Robinhood’s business model could unravel.

It is worth noting the upsides too, of course. In March 2021 it recorded 18m users, up more than 150% compared to its 7.3m users in March 2020. It projects an additional 4.5m users in the second quarter of 2021. And unlike many IPOs, Robinhood was profitable last year, making $7.45m profit from $959m in revenue.

Robinhood IPO’s rocky road

Robinhood suffered from negative press in 2021. Two system-wide outages in March stopped investors from trading. Many lost money and some filed lawsuits against the company. In June, 20-year-old Alexander Kearns committed suicide after seeing a misleading negative balance of $730,000 in his trading account. 

Then there was the Q1 GameStop debacle that cost the company $1.4bn. Major hedge funds made bets that GameStop’s share price would fall — a practice known as shorting. Millions of young retail investors, many of them Robinhood clients, bought shares in GameStop, driving up the price. As the price rocketed, hedge funds were forced to close their short positions for horrendous losses. As this was happening, Robinhood was compelled to restrict trading of GameStop in order to meet collateral requirements. This led to a steep drop in GameStop’s share price, leading to a class action lawsuit against Robinhood.

The publicity was so bad that Google had to delete over 100,000 one star reviews from its Play store. Google chose to delete the reviews because they believed it was a coordinated attack against Robinhood. To me, it seems just as likely that Robinhood’s investors felt that leaving poor reviews was the best way to express their dissatisfaction.

Then the Robinhood IPO was delayed by an SEC investigation into its cryptocurrency arm. It expects to pay a $30m fine because of a New York State probe into poor cryptocurrency Anti Money Laundering practices. In addition, it will soon face stiffer competition from larger competitors including Fidelity and Charles Schwab. 

With competitor eToro’s IPO coming up later this year, it’s all too much for me. I’m staying away.

So, is this performance a sign of trouble ahead? Or is it a buying opportunity for my portfolio? Let’s take a look.

Looking at the business

Robinhood is a trading app. Like any ordinary broker, it allows users to buy and sell shares in businesses, in addition to other financial assets like options and cryptocurrencies. So, what makes it special? It was the first broker in the US to offer commission-free trading, significantly lowering the barriers to entry for investors with only a small amount of capital.

There are plenty of other services today that offer commission-free trading. But the advantage of being first has allowed Robinhood to grow its platform to over 17.7 million monthly active users. In total, there’s currently $81bn under the custody of the business. That’s quite extraordinary, in my opinion. And if it can continue to expand this user base, I think the Robinhood share price can start surging. But if it isn’t charging commissions, how does Robinhood make money?

It uses something called Payment for Order Flow. This is where things get a bit technical. But in simple terms, Robinhood receives transaction-based revenue from market makers in exchange for sending them customers (its users). But what’s a market maker? These are either firms or individuals that fulfil the buy and sell orders for investors using their own assets or capital, profiting from the difference between the current buy and sell prices of an asset to turn a profit.

The idle Robinhood share price

There are undoubtedly many reasons why the share price didn’t explode as many investors had hoped. But the primary reason seems to be the uncertainty surrounding its Payment for Order Flow transaction model. In fact, the company is already facing regulatory pressure due to its controversial nature.

While it does enable users to execute those commission-free trades, it also creates a conflict of interest between investors and market makers. Investors want the lowest buying and highest selling price. Whereas the market makers want the opposite to maximise their profits.

Given that Robinhood currently makes 80% of its revenue from this system, the introduction of new regulations could jeopardise its future growth and, in turn, its share price. 

The bottom line

The current volatile nature of the stock market and cryptocurrencies has created a favourable environment for trading and, in turn, for Robinhood’s platform. But as the vaccine rollout continues, this volatility has already started to stabilise. Consequently, the firm is already expecting revenue to begin falling next quarter. 

Having said that, it seems more people are realising the wealth-building power investing can provide. And with many brokers still charging expensive commissions, Robinhood may become the leading trading platform for many retail investors. For now, I believe there are better growth opportunities elsewhere. But I am adding Robinhood to my watchlist.

The backstory of Robinhood

Robinhood is an investing platform, geared towards new retail investors. The name comes from the famous English character, with a desire the make investing more accessible for all. To this end, it offers commission-free trading on stocks and other assets.

So how does the business make money? One way is on the balances held by clients on account. It doesn’t pay interest, but it gets paid interest from banking counterparts. It also makes money on lending, as it allows clients to trade on leverage. Finally, it sells on the trade information and order flow to institutional investors.

The company only launched less than a decade ago, but has developed a high profile among retail investors in the US. It has 18m customers, and claims that since 2016, around half of all new US investors have been signing up to Robinhood. With an average revenue per client of $137 in Q1, the business is now profitable. This is largely thanks to the boom in retail investing over 2020, fuelled by crypto and Reddit stocks.

In fact, the reliance on retail trading was seen with the IPO, with 25% of Robinhood shares being allocated to retail investors.

Why I’m staying away from the Robinhood share price

All of the above sounds positive. A young, high-growth business that’s getting high sign-ups and is making a profit. Yet underneath the surface, there are several red flags that make me want to stay away from the Robinhood share price.

It sells order flow to larger companies, to do with it what they want. This is a fairly controversial practice and it has been fined in the past with issues relating to this. In fact, it’s against the law in the UK to accept payment for order flow. I’d imagine this is a major reason why Robinhood isn’t available in the UK.

This is a negative to me for several reasons. It’s a large source of revenue for the company, and so if this practice gets banned then it could see a negative impact on the share price. And it could hold back further growth into new markets (such as the UK) as it doesn’t comply with local regulations.

Another point I’m concerned about is the reliance on crypto and Reddit stocks. Some 34% of crypto revenues from Q1 this year came from Dogecoin! Such assets are popular at the moment, but is it really sustainable to rely on unconventional stocks and coins to build a market-leading business? I don’t think so.

These are just my personal concerns. The Robinhood share price could rally in the future, avoiding regulatory issues and diversifying the product offering to create a more sustainable brand. It has a good presence in the market already, so has a position of strength to build on. However, I’m personally going to be staying well away from investing in it.

The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of investment advice. Bitcoin and other cryptocurrencies are highly speculative and volatile assets, which carry several risks, including the total loss of any monies invested. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.