In the past year, retail investors have flocked to mobile trading apps to get in on the stock market -- but Robinhood Markets (HOOD -1.39%) and its well-known trading app have had a rough 2021 thus far. Here are four reasons why investors should steer clear of this recent IPO.
1. Robinhood employs a risky business strategy to make money
Options can be difficult for new investors to understand, and in some cases, they present the unlimited risk of financial loss. In the first quarter of 2021, options made up 38% of Robinhood's revenue; on each option trade, the site earned $2.90, compared to $0.40 on each equities trade.
Robinhood's significant earnings from option bets give it an incentive to push inexperienced investors to trade those risky securities -- and potentially lose all their entire investment on a single trade. That's a risky business strategy for Robinhood's users, especially since the company has yet to weather any bearish market conditions.
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2. The company hasn't had the best start since its IPO launch
In its first two quarters, Robinhood has posted mixed financial performance. Year to date, the company has reported a net loss of $1.9 billion and holds $17.9 billion in total liabilities. This is largely because the company had $3.5 billion in debt that it raised in emergency funding in February 2020. Its positive operating income of $122.9 million year to date gets eaten up by over $2 billion in expenses from its convertible notes and warrant liabilities. While Robinhood has been growing its revenues, it is overleveraged and will need to increase revenue growth to reduce its high debt-to-equity ratio of 40.6 and justify its share price.
3. It's had significant problems with the SEC
Robinhood offers "zero commission fees" on every transaction, yet it's still making money from each trade using a taboo practice called "payment-for-order flow" (PFOF).
When its customers place a trade, Robinhood acts an intermediary, or broker. It negotiates with dealers, or wholesalers, who own shares of many different stocks, to receive a cut of the bid/ask spread -- the difference between what the person on one end of a stock trade is willing to sell that stock for, and how much the person on the other end of the trade is willing to pay to buy it. The bigger that difference, the bigger the reward for Robinhood and wholesalers -- even if it means that customers end up paying more than they could have at another brokerage to buy the same stock.
Robinhood may not charge its customers fees up front, but by collecting a cut from each transaction they make, it's charging them higher prices behind the scenes. Additionally, it presents a conflict of interest for Robinhood to put its partnership with wholesalers before its duty to investors.
The SEC condemned this practice, and it fined Robinhood $65 million for misleading customers about how it earns revenue, plus another $70 million for its poor screening of inexperienced investors interested in options trading. It could take Robinhood years to regain the trust its investors have lost in the wake of these condemnations.
4. Robinhood has broken the public's trust
Robinhood has had a rollercoaster of a year, with many news-breaking transgressions. Last January, Robinhood halted trading after retail investors started rapidly buying and selling shares of GameStop. This angered investors who lost money on halted trades, and the Reddit community took to social media and riled up angry public sentiment, with users asking the CEOs to resign.
In the same year, a teenaged Robinhood user committed suicide, fearing that he was in massive debt based on his unsuccessful options trades. Robinhood's app makes stock trading feel more like a game, which critics blame for contributing to inexperienced investors' highly risky trades and consequent losses. The public's acrimony toward Robinhood limits its ability to build rapport with new users; in a February 2021 survey, nearly 56% of account holders were considering leaving the app.
Despite the reasons above, not everything is going awry for Robinhood. It increased its revenue by 131% from last quarter and has grown its cryptocurrency share of the revenue from 17% to 51%. In fact, it earned $233 million through crypto trades in Q2, more than half of all the transaction-based revenue of $451 million for that period. However, cryptocurrencies fluctuate greatly and are at risk of government regulation, making their importance to Robinhood's revenue a big vulnerability for the company.
Moreover, Robinhood's massive debt remains a huge issue that the company hasn't yet addressed. In August 2021, Robinhood announced it would be acquiring Say Technologies, which lets smaller shareholders easily ask questions of the companies in which they invest. While this addition might help Robinhood improve its customer experience, M&A deals are risky, and this adds $140 million to the company's already enormous debt. With a high reliance on cryptocurrencies and a large amount of debt, investors should be wary of Robinhood.
Why Robinhood is missing the mark
Robinhood has certainly left its mark on the investing community and increased access for retail investors, but it still should be avoided by investors because of its risky business strategy, mixed quarterly results, regulatory concerns, and corporate governance. Notwithstanding the power of its brand, Robinhood is a risky investment and faces intense scrutiny from both the public and regulatory entities. Many users have grown frustrated with the trading platform in the past year, and they've sought alternatives such as Charles Schwab and eToro.
Investors should keep an eye on the headwinds that the company has predicted over the next three months. Less trading activity across the industry may result in lower revenues and considerably fewer newly funded accounts. I believe that Robinhood, while good-intentioned, has failed to "democratize finance for all," making it a risky stock for investors.
