Robinhood IPO

Background

Robinhood is a US stock trading app thought to be used by around 20 million investors. Launched in 2013, Robinhood have managed to entice the next generation of US share traders by offering zero commissions, an easy-to-use app and fractional share dealing.

While Robinhood’s growth has impressed, they have also singlehandedly forced other US brokers to slash commissions to zero in order to remain competitive. This has led to a number of monster mergers between some of the largest brokers and banks in the US market.

In October 2020, Charles Schwab purchased TD Ameritrade to create a company with over $6 trillion in client assets and 28 million accounts. At the same time, Morgan Stanley acquired E*TRADE to create a wealth platform with $3.3 trillion in client assets.

Revenues

Instead of generating revenue from trading commissions, Robinhood makes money through some “behind the scenes” activities.

A major source of revenue is known as payment for order flow (PFOF), where a broker directs client trades to an off-exchange trading venue in return for a fee. This practice is banned in the UK and Europe as it creates a conflict of interest as firms are thought to be incentivised to direct client trades to the venue providing the biggest kick-back instead of ensuring the client receives the best price available.

Another way Robinhood earns money is by investing client cash in money markets to earn a small yield. However, with the Federal Reserve slashing its policy rate to zero in the wake of the coronavirus pandemic, the revenue opportunity here has diminished.

The combination of zero interest rates and the inability to receive a kick-back on order flow saw Robinhood pull plans to launch in the UK last year.

Other sources of revenue include margin lending, its premium “Gold” service (which gives users additional benefits for $5 a month) and securities lending, where it loans a client’ stock to a third party who wishes to short the short in exchange for a fee.

Valuations

Since 2013, Robinhood has raised over $5.6 billion, which fuelled its tremendous growth. And while many industries have suffered during the pandemic, Robinhood and other investment platforms have seen a surge in demand as retail investors piled into the stock market, betting on a market recovery.

It is therefore no surprise that Robinhood plans to capitalise on this stock market exuberance through their initial public offering (IPO), which is expected to happen in the second quarter of 2021.

Investors will have to wait to see what valuation will be given to the company, but it will likely be in excess of the $11.7 billion price tag it was given in its latest funding round in September 2020 – which raised $460 million. Latest reports suggest the company may achieve a $40 billion valuation.

Although a number of mergers in the industry have diminished the pool of competitors, the table below compares Robinhood to a few other US investment platforms using April 2021data.

A $12 billion valuation prices Robinhood close to the amount Morgan Stanley paid for E*TRADE, which had fewer clients than Robinhood but 30 times the client assets.

But Robinhood has already managed to beat other brokerages in trading activity, which has helped fuel its trading revenue. In June 2020, Robinhood took $4.3 million daily average revenue trades (DARTs) compared to TD Ameritrade’s $3.8 million, Interactive Brokers’ $1.9 million, Charles Schwab's $1.8 million, and E*TRADE's $1.1 million.

Whether this is sustainable is another question, as market volatility is likely to return to more normal levels, which will reduce levels of client acquisition and trading activity.

What’s more, the market values transactional revenue far lower than annuity-based revenue given their volatile nature. While Robinhood’s expected revenue growth may warrant a higher price multiple compared to other brokers, its reliance on trading revenue should offset this somewhat.

Future challenges

Although its client base is highly active, a major challenge for Robinhood will be encouraging people to entrust it with a larger part of their investing wallet. At present, it has an estimated average client balance of around $1,500 – a fraction of competitors, such as Charles Schwab, have an average of $135,000.

This trust is difficult to build and the company has not helped itself in the way it has positioned its app at the lower end of the market, but offers the same complex products that more informed investors may use.

Robinhood suffered a number of major outages recently as the app was overwhelmed during the coronavirus pandemic, which has led to several investor lawsuits.

Robinhood also faced a civil fraud investigation last year over its failure to disclose its payment for order flow practice. Robinhood chose to settle with the Securities and Exchange Commission, paying a $65 million fine in December 2020.