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Wednesday, December 7, 2022

Robinhood: The Path Gets Trickier From Here

 

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An 80% rally from June lows raises fundamental concerns around HOOD
Rising interest rates and lower costs could get the company to profitability
From here, however, investors are relying on management — and that seems worrisome

At the moment, it’s difficult to make the fundamental case for Robinhood Markets (NASDAQ:HOOD). A few months ago, however, it was much easier.

Back in June, HOOD hit an all-time low under $7. Its market capitalization of roughly $6 billion actually dipped under the cash on Robinhood’s balance sheet — its corporate cash, not the cash held in customer accounts.

Even with the myriad challenges facing the business, that price in retrospect (and even at the time) was far too low. There is some value here, and the operating business is burning little of the cash on hand.

Since those lows, however, HOOD has rallied about 80%. After those gains, the fundamental picture looks notably different. The company’s market cap is back above $10 billion. Its enterprise value (market cap less cash on hand) is over $4 billion.

Robinhood: The Path Gets Trickier From HereHOOD Weekly Chart

Source: Investing.com

Even with a surprising adjusted profit in the third quarter, that valuation is difficult to support looking solely at current numbers. But, to be fair, that’s not what investors are doing. They are looking forward.

Higher interest rates promise a second source of revenue in addition to the controversial payment for order flow model. Reduced costs add to the potential for profitability in the not-too-distant future. Robinhood probably is not going to be what investors hoped when the company briefly had a $60-billion market cap after last year’s initial public offering. But even after the strong rally since June, it doesn’t have to be.

The rally to this point, thus, makes some sense. Keeping the rally going, however, is the hard part.

Net Interest Revenue and Cost Cuts

Higher interest rates offer a benefit to Robinhood. They allow the company to generate higher revenue through margin loans, as well as interest paid to users on uninvested cash. The latter revenue source, known as cash sweep, provides profit for the brokerage, which keeps a portion of the interest income it generates for users.

Cash sweep can be a big deal. In 2019, for instance, Charles Schwab (NYSE:SCHW) generated more than 60% of its total revenue from net interest revenue. Even after the 2020 acquisition of TD Ameritrade, the proportion still sits above 50%.

In its history, Robinhood faced historically low interest rates — and, thus, had relatively low net interest revenue. In 2021, for instance, net interest revenue was just 14% of its total. Even in 2019, before trading volumes went wild, barely one-fourth of total revenue came from net interest sources.

That’s changing. In Q3, net interest revenue climbed to more than one-third of the total. Importantly, it kept the business afloat even as trading volumes plunged. Transaction-based revenue declined 22% year-over-year. Robinhood as a whole saw revenue fall just 1%.

The company was able to keep stable revenue with a much lower cost base. Thanks to a pair of layoffs this year, operating expenses fell sharply. While revenue was flat, adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) was $47 million. That compares with a loss of $84 million the year before — and a loss of $80 million the quarter before.

The Case for HOOD

In that sense, Q3 highlights the case for broader optimism here. This is the first quarter in which both cost cuts and net interest margin provided a benefit; even the cost cuts didn’t affect the entirety of the quarter. With EBITDA positive, valuation should get more reasonable with each passing quarter. Longer-term, Robinhood still has more levers to pull, such as a move into retirement products.

In other words, if Robinhood can turn a profit in this environment, investors should be comfortable that it can do so consistently going forward. That in turn should make those investors more comfortable in applying a multi-billion dollar valuation to the operating business.

The focus from the market clearly is on the positives: HOOD gained 8% after earnings, and closed the week just off a seven-month high. But it’s worth noting some of the concerns in the quarter as well.

Volume Concerns

Most notably, Robinhood’s account growth has flat-lined. Net cumulative funded accounts were 22.9 million in the quarter; they were 22.5 million five quarters before. Obviously, the end of pandemic lockdowns and the bear market both have hurt customer acquisition, but this still is a business young enough to show some growth in that metric.

The account holders who have stayed are not doing well. Robinhood’s assets under custody declined 32% year-over-year. Yet, average revenue per user fell just 3%.

There’s a real disconnect there. The average Robinhood account has about $3,000 in it — and generated $63 in revenue in the quarter.

The average investor on Robinhood is churning through roughly 2% of her capital in trading costs every quarter. That’s simply unsustainable in anything but a roaring bull market. This market clearly is not that.

Even with help from net interest revenue and cost cuts, sustainable growth requires more. It requires sustainable growth in transaction volume. That in turn means:

a) the platform is acquiring new users;
b) Robinhood users aren’t churning their accounts;
c) those existing users are growing their accounts (which in turn boosts net interest revenue)

That’s not happening — and Robinhood numbers show why. Options trades still drive over half of transaction-based revenue. Equities generated less than $100 million in Q3, 15% of the total. (Cryptocurrency accounts for nearly all of the remainder.)

As its reputation suggests, Robinhood to some degree remains a platform for traders and gamblers, not long-term investors. That simply can’t last forever. To fully take advantage of its better cost structure and higher interest rates, it needs to transition to serving more diversified, more stable investors.

To be sure, the company can do so. It plans to do so. But it’s not an easy shift to make. For Robinhood, the hard work lies ahead.

Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.

Source: Investing.com

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