Seeking Alpha
2023-02-03 21:11:19

Robinhood Has Substantial Downside And That's Likely The Only Realistic Scenario

Summary Robinhood financial losses continue, as profits are limited for FY '22 and FY '23 based on our estimates. Robinhood is caught in the middle of controversy tied to the disproportionate ownership of Sam Bankman-Fried who is facing allegations in court tied to the FTX exchange failure. Robinhood is heavily overvalued even if Bitcoin rallies to $60,000+. Robinhood's price target starts at $3.50 which implies -66% downside on FY '24 estimated earnings. We give Robinhood a strong sell rating, given poor metrics and low likelihood of achieving meaningful scale with retail accounts. Robinhood (HOOD) has a difficult set-up heading into its Q4 earnings call in which the company is expected to report earnings February 8th, 2022. Though the company has yet to announce an earnings date, we think a combination of bad press, and tough earnings results will keep the stock price suppressed. We also acknowledge that growth metrics are a bit more compelling when compared to Coinbase (COIN) on a near-term basis as Robinhood reported -1% y/y sales growth in Q3 '22 versus Coinbase -55% sales growth in the prior quarter. Given HOOD's added exposure to equities and the launch of various crypto-specific services, we think the business has improved its positioning in the marketplace, but was unable to drive a compelling enough argument to drive adoption of the stock trading platform as 12.2 million Q3 '22 MAU metrics are weak versus prior-year's 21.3 million Q3 '21 MAUs. We think the company can address some product specific issues, which could bring back users, we're also assuming HOOD can turn profitable on a near-term basis a bit sooner than Coinbase. But, the quality of the business is subjectively worse in some regards when compared to Coinbase, as it has less exposure to a crypto-themed recovery and the on-going fraud investigation of Sam Bankman-Fried has managed to pollute the green retail broker. We estimate that Robinhood will report full-year revenue and diluted EPS results of $1.38 billion FY '22 and -$1.16 loss per share. This compares to consensus estimates of $1.37 billion FY'22 revenue, and a diluted loss of -$1.12 per share. Our Robinhood Bear thesis In terms of underlying fundamentals, we think the retail brokerage has over-extended itself with spending, share based compensation, and various other non-essential expenses. The announcement of layoffs suggests the company could return to profitability, but the pathway to profitability is littered with corpses scattered everywhere. Figure 1. Brokerage profitability in the United States Data by YCharts For the most part, the brokerage business is supposed to be extremely profitable (10%-40% profit margins with 20% being the mid-point for specialized brokers with investment banks). We haven't seen any profits from Robinhood on a GAAP or even on an adjusted basis since going public. Even in an extremely bullish year with risk assets performing well, we haven't seen Robinhood perform all that well. We currently value Robinhood on the basis of FY '24 earnings of $0.20 diluted EPS per share and apply 22x forward earnings to arrive at our $3.44 price target, which implies -66% downside from current levels. Therefore, we have a strong sell rating on the stock based on forward estimates, and our own internal estimates of the stock. We anticipate a quicker return to profitability than consensus analysts on retail fueled demand and Bitcoin (BTC-USD) price recovery, which is why we forecast profits in FY '24. Even in an optimal environment, we believe Robinhood will produce lower margins, which is why our exit valuation is so low when compared to other analysts. Given the added costs of running a retail brokerage, and cryptocurrency exchange, while also offering Bitcoin wallet custody services it will severely hamper the businesses' ability to generate a profit. The lack of trading volumes paired with the lack of deposit growth makes the stock extremely unappealing on a fundamental basis. Figure 2. Robinhood clients perform about as well as ARKK Fund holders lately J.P. Morgan (J.P. Morgan) As a consequence, the J.P. Morgan analyst who measured the performance of client assets and the overall drop in total value to be mostly driven by poor returns among retail investors, which further drives the argument that while Robinhood tries to make itself accessible to lower value accounts, the profit margins from smaller accounts is small, and the lack of institutional services and lack of trust among larger accounts makes it difficult for Robinhood to generate positive ARPU growth despite the large amount of client assets on the platform. Kenneth Worthington from J.P. Morgan goes on to elaborate, "Robinhood's November metrics highlight the significant wealth destruction its users have suffered in recent years, both in good and bad markets. November AUC was $70.2bn, significantly below net cumulative funded deposits of $89.1bn. Since inception, Robinhood customers have lost $18.9bn or 21% of their investments." Figure 2. Robinhood Average Revenue Per User figures lackluster Robinhood ARPU metrics from Q3 earnings presentation (Robinhood) We think the poor performance among retail traders, and the likely issues tied to its platform, which are numerous, have caused bigger traders to leave the platform. It's why the ARPU metrics are so bad when compared to the peak of the Bitcoin market. But then what else could go wrong with the stock? The Sam Bankman-Fried Episode Sam Bankman-Fried and "his 56 million Robinhood shares" are a big problem for HOOD shareholders currently. While, we are compelled to dislike the broker for a variety of reasons we think investors should steer clear given the overwhelming noise tied to the on-going investigation into SBF. We find ourselves objectively not liking the retail brokerage on numerous fronts, as we think the stock is trading in a precarious position following the recent FTX (FTT-USD) bankruptcy and on-going Sam Bankman-Fried trial . Based on the most recent report, the court case continues and details tied to the investigation suggest that SBF is in the fight for his life. We know the public optics are extremely bad, as he's allegedly done a lot of damage to FTX customers over the past 3-months. SBF allegedly purchased Robinhood shares from a separate fund referred to as Alameda Research to purchase the Robinhood position valued at 56 million shares, and is being ordered to transfer those assets as part of a sale to cover for losses of FTX, which the main creditor BlockFi is litigating and also liquidating assets to resolve. Currently, the courts are in a dispute to allocate Sam Bankman-Fried's Robinhood stake, which is valued at $568.4 million currently. For all we know, 56 million HOOD shares could be sold on the basis of a court ruling, which could have devastating impact on HOOD stock at any given moment. It's too big of a block of shares sold too quickly, as 56 million shares represents 6.34% of the total share outstanding. Assuming there's a sale, it would be equivalent to the amount of liquidation insiders do following an IPO, or the amount of capital raised from a secondary offering, implying an added -30% share price headwind. If Robinhood was sold the way the U.S. Government dumps Bitcoin via public auction, it would have a very material impact on the price of the stock. Reports also suggest that BlockFi is turning to other sources of liquidity like unloading its mining equipment valued at $160 million, thus prompting a sell-off in BTC-USD, as miners continue to unload hardware for a variety of reasons, likely adding pressure to semiconductor names in this environment as well. We anticipate that following the sale of the mining equipment to shore-up financial losses at BlockFi, the firm will continue to battle SBF in court over the rights to his Robinhood shares. The affiliation of Sam Bankman-Fried is bad news for shareholders, because it drags down the perception of the stock, its brand, and trust among retail investors. SBF might have signed a collateral agreement that's binding to FTX and BlockFi, which is why the fallout for HOOD shareholders will be noticeable regardless of which way the court ruling goes. It's worth noting that bears have backed-off Robinhood over the course of the year, as the stock has a short interest of 8.24% currently, versus the 16.45% short interest, which peaked back on May 15th, 2022. We think the stock has the worst trading set-up among many of the stocks we follow, and it's also just as dependent on a cryptocurrency themed recovery when compared to Coinbase. However, we want to emphasize that the issues tied to the on-going settlement of FTX, BlockFi, and SBF should bear no material concern to Robinhood stakeholders. SBF's involvement keeps the stock price suppressed in the near-term given the controversy tied to court hearings and on-going investigations will show up in news headlines related to Robinhood thus pervading a negative news cycle in the stock. Robinhood financial model deep dive We forecast that Robinhood will eventually grow sales following the cryptocurrency winter, assuming client assets start to grow. When determining the long-term performance of Robinhood we value the firm on the basis of a high single digit profit margin figure, which is at the low-end in the brokerage business, but extremely generous given HOOD's historic profitability. Typically, brokerages generate profits in the 10%-40% range. We don't think Robinhood will ever achieve high profit margins with retail type accounts, and the associated costs of providing cryptocurrency custody, cryptocurrency related products, while also offering access to conventional securities, options, and margin trading. Basically, the two products cost a lot to support, and it's why we like the focused and more disciplined approach of Coinbase in the space, as it's easy to get caught between product transition during a difficult environment. The other alternative is Interactive Brokers ( IBKR ), which is a more conventional stock broker that is releasing various cryptocurrency trading products and Bitcoin mini-future contracts to be more competitive in the space. We believe investors can avoid Robinhood by simply allocating to a portfolio of Coinbase, SoFi Technologies ( SOFI ), and Interactive Brokers to achieve the best outcome from both categories rather than getting caught up in a difficult profit narrative transition. Figure 4. Robinhood Worth Less Than You Think Robinhood Valuation Model (Trade Theory) We value HOOD on a blend of P/E, EBITDA, and Sales multiple. HOOD gains momentum from an eventual Bitcoin bottoming and a return to the $60,000+ level. Assuming the Bitcoin market recovers, the accounts recover, and so does the amount of fees on managed assets. We anticipate that these outcomes are fairly likely given the historical nature of cycles in the market, and it's why we forecast that HOOD's revenue and earnings will eventually reach higher than its FY'21 peak year results. Keep in mind our model also forecasts a $4.3 billion valuation, whereas the company has $6.25 billion cash on the balance sheet, so a combination of cash burn, and negative sentiment could cause the stock to trade below tangible book value. Realistically anything could happen over the course of a cryptocurrency winter. What we don't acknowledge is the amount of upside investors might anticipate even in the event of a Bitcoin cyclical recovery mainly because Robinhood's margins aren't going to be at the level of conventional brokers when the market does turn. And, because Robinhood supports so many financial trading vehicles, low operating margins get combined with low value accounts. As a consequence, we arrive at the conclusion that Robinhood will become profitable, but the profit contribution from retail accounts will disappoint investors. We anticipate that the stock will trade at a discount even in the profit scenario, because the growth metrics paired with profitability metrics will illustrate how overvalued the stock is... even as the business profile matures. As a consequence, we value the business on the basis of persistently low operating profit margins until they provide services that appeal to bigger account size customers similar to IBKR and COIN. Until those issues get resolved, HOOD becomes a low margin broker that services the cryptocurrency market and stock market concurrently, thus requiring higher cost to maintain accounts, and also justifying a lower valuation due to the on-going cash burn rate. Keep in mind, we value HOOD using the same exact multiples as we did with our COIN analysis , to arrive at a $3.44 price target upon applying the firm's WACC of 8.4% to arrive at our target price. We think both firms will exit the cryptocurrency winter with great growth comps, and suppressed multiples, as investors will wise-up to the annualized growth trends and cyclical nature of Bitcoin by trading the exchanges at lower valuations. We anticipate that the stock will trade at $3-$5, as the near-term headwinds tied to the SBF fallout, weakness in underlying business fundamentals, and the lengthiness of the Bitcoin bear market limits material upside in the stock. Final thoughts heading into the quarter The company might emphasize that deposits growth, or various other levers could be used to drive stock price performance. Based on the most optimistic scenario we could create, we still come up with an intrinsic value estimate that's lower by -66% when compared to where it's trading. Nothing about the SBF court outcome will benefit Robinhood shareholders as the amount of expected dilution from the case settlement could have a devastating impact on the stock similar to the impact of a secondary offering. We also dislike the lack of cost discipline tied to the business, and how it's being justified to expand both categories concurrently but without any emphasis on it benefiting the retail client's returns. The lack of focus leads to an inferior retail trading product, and a lagging cryptocurrency product that barely got separate wallet functionality in the year 2022. Keep in mind, Coinbase has provided users with their Wallets on the exchange since inception of the cryptocurrency exchange back in 2012. It doesn't make sense how brokers want to maintain custody of cryptocurrencies without providing digital wallets tied to their brokerage account. The announcements of earnings results probably doesn't do much to reassure shareholders until there's a spot price recovery in Bitcoin, or unless there's some announcement of institutional brokerage services. The stock has managed to recover to about $10 per share mostly on broad S&P 500 market recovery. We think the stock trades closer to $3 to $5 over the course of the year, as on-going losses tied to its core businesses, and the poor positioning in the follow-on cryptocurrency cycle puts a pervasive ceiling on the stock until they work out a way to drive margins and volumes in a way that makes sense to more fundamentally minded investors.

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