Robinhood Markets (NASDAQ: HOOD) will be one of the most talked-about IPOs this year. The popular mobile trading app is rumored to be making its initial public offering shortly and is actually giving its users the option to buy pre-IPO shares in the company.
While a lot of investors are likely excited to buy the stock of their favorite trading app, an investment in Robinhood comes with major risks. Here are four reasons investors should avoid the Robinhood IPO.
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Potential regulations and lawsuits
Robinhood's business is based on lowering the barriers to entry for new investors. But in a heavily regulated industry, a disruptive business can face stiff penalties when something goes wrong.
In recent months, Robinhood has had to pay $65 million in fines to the Securities and Exchange Commission (SEC) and $57 million to the Financial Industry Regulatory Authority (FINRA) -- as well as nearly $13 million in restitution to users -- for issues ranging from service outages to basic account information.
The company also faces potential regulations on payment for order flow (PFOF). PFOF is the compensation Robinhood gets for directing customer orders to market makers -- companies that match buyers and sellers. While Robinhood doesn't charge fees to trade stocks, options, and cryptocurrencies, it does profit from its customers' activity -- PFOF made up 81% of the company's revenue in the past quarter. Recently, SEC Chairman Gary Gensler said the agency is reviewing the practice of PFOF, saying it poses a conflict of interest for brokers.
We also learned in Robinhood's recent S-1 filing (the standard SEC document that companies submit before going public) that the company has 50 class action lawsuits stemming from the restrictions Robinhood placed on trading shares of GameStop and other meme stocks in early 2021; 15 lawsuits around its application outages in March 2020; and other lawsuits around its PFOF practices. The PFOF lawsuits allege Robinhood didn't adequately notify its users that it was sending their orders to market makers.
It is unclear how much damage losing these lawsuits would cause Robinhood, but they do add another layer of risk to anyone thinking of investing in the company.
Clearinghouse collateral
Robinhood faces another risk that came to light during the GameStop fiasco earlier this year -- it may need to post collateral when shares of the stocks it owns on behalf of customers trade with heavy volatility.
Market making is ordinarily an invisible part of the financial industry. A big exception is when a huge group of traders simultaneously open a huge number of options positions in a given stock. Because options are based on eventual ownership of underlying shares, those shares have to be accounted for -- and when that happened with GameStop and other meme stocks this year, Robinhood had to provide more liquidity in a shorter time period than it had ever had to before. The company was forced to raise $3.4 billion in convertible notes after the National Securities Clearing Corporation (NSCC) upped its collateral requirements due to the one-sided GameStop trading.
An event of this magnitude may never happen again, and Robinhood is raising more money with this IPO that could help it in one of these scenarios. But another GameStop event is not out of the question. Investors should consider what would happen if the NSCC asked Robinhood to post collateral and it was unable to obtain the necessary funds to do so. That would be bad news for this business.
Reliance on cryptocurrency revenue
One way Robinhood has been able to grow so quickly is its robust cryptocurrency trading platform that it launched back in 2018. In Q1, the company's cryptocurrency transaction revenue (another definition for PFOF) hit $87.6 million, up a whopping 2,000% year over year. It was 17% of Robinhood's revenue in the quarter.
This is fantastic growth, but relying on market sentiment for cryptocurrencies is not a very predictable business model. For example, 34% of Robinhood's cryptocurrency revenue came from Dogecoin, making revenue from the coin 6% of the company's overall sales in the first quarter. Dogecoin was created as a joke, and investors should not bank on the durability of these sales going forward.
Steep valuation
A more classic risk to investing in Robinhood stock is the steep valuation it will likely have when it goes public. Management is planning to price the offering at a market cap of $35 billion, hopefully raising as much as $2.2 billion in the process. With 2020 sales of $959 million, that gives Robinhood a trailing price-to-sales ratio (P/S) of 36.5, which is higher than most fast-growing tech businesses.
Revenue did grow 245% in 2020 versus 2019, so this P/S could come down rather quickly if that growth continues. However, as an investor in Robinhood, you are essentially betting on the sentiment among other retail investors to trade stocks, cryptocurrencies, and options contracts. Maybe that is sustainable, but from my chair, that seems like an unpredictable business model, especially if the market corrects for any significant time period.
Taking all these factors into consideration, any risk-averse investor should stay away from Robinhood stock. The company is growing quickly but has major risks to its business model, which gives huge downside risks to any of its shareholders, especially if it debuts at such a steep valuation.
