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Time to Deconstruct Robinhood

Zechariah Chapter 14 verse 9 states, "The Lord will be king over the whole earth. On that day there will be one Lord, and his name the only name."


The Bible is clear regarding who God is. Jesus Christ died and rose from the dead to absorb all the sins of humanity. He also stated that there is only one way to God through Him. This is controversial for the world as there are other religions. But if I am to believe in Jesus Christ, I must acknowledge His authority over all.


From an investing perspective, this conjures the thought of can one company be king? For the topic of discussion, can Robinhood sustain its success and outperform many of competitors and peers? These are important questions, however, there are no perfect answers for the future. Hopefully I can shed some light on how to deconstruct and approach Robinhood as a potential investment.


The Matter at Hand - Robinhood

Most investors are familiar with Robinhood Markets, Inc. (HOOD) whether a direct user or hater. Haters beware that your sentiments illustrate the generation you hail from! The company is not without controversy, and some may have their opinions of the CEO. Regardless, Robinhood is going to be a highly anticipated IPO.


The most recent comparable IPO in my opinion is Coinbase Global (COIN).

Since going public, Coinbase has met hard times. The Stock Price, SP has dropped into a trading range from $220 - $255 over the past six weeks. This trend is definitely on my mind and makes me wonder, will Robinhood see a similar fate?


It has been published that Robinhood is targeting a valuation at $40 billion or higher. Coinbase hit the market on its first trading day with an Enterprise Value, EV as high as $87 billion - today it sits at $48 billion, off by 45%.


Another recent IPO I like to point out of late is Affirm Holdings (AFRM).

This one has seen an much harder fall than Coinbase. Affirm witnessed a peak equaling an EV at $35 billion, which now stands at $16.2 billion - a 54% drop. Robinhood's financial performance is more akin to Coinbase with the proliferation of trading activity, so it's prudent to focus more on Coinbase. But it is also important to keep a broad Fintech perspective with newer entrants going public, others including Marqeta, Inc. (MQ) and SoFi Technologies (SOFI).


Fundamental Snapshot

Anytime that a company files an S-1 to go public, the first step I take is to construct the company's financials to get a sense of the fundamentals. While we don't have important information yet - Shares Outstanding and Cash to be raised, it's always good to start early. All my sources for data are directly from the S-1, which can be found here.

I've taken the liberty to assume 350 million Shares Outstanding, which will change. This change will have a corresponding impact on the SP and further down, on the preliminary forecast. I'll make sure to post an update once this information becomes more clear. In addition to the Shares Outstanding assumption, I've included a SP equating to a roughly $40 billion EV.


What is important from the Balance Sheet, B/S is getting a sense of whether Robinhood is a Cash generator, or whether leverage is being utilized. Clearly, the brief history for 2020 and 2019 has seen the company as a Cash generator, but Q1 2021 has shifted with debt being taken on. There is a reason why, and we'll get to that soon. There are important line items that I'll highlight below to illuminate key relationships.

From a valuation perspective, Robinhood, assuming a $40 billion EV, would be trading around 30 times Last Twelve Month, LTM Revenue, and 75 times Adjusted Operating Cash Flow, OCF per share, including an Adjusted OCF margin at nearly 40%.


We can see that Robinhood has witnessed substantial Revenue growth, similar to Coinbase, although not as extreme, as Robinhood has higher exposure to non-Cryptocurrencies. Operating Income has concurrently been improving strongly, but Cash Flow has taken an interesting turn in Q1 2021.


This is an important point, as by now, some should realize that I don't waste time with P/E ratios or EBITDA. I strictly use OCF and/or Free Cash Flow, FCF per share as the core valuation metric for aggressive growth companies. In the event a company does not generate positive OCF/FCF, I will rely upon an EV/Revenue metric. My opinion is that too many investors don't value public companies appropriately, falling victim to Wallstreet's games - musical chairs comes to mind.


That being said, I have taken the liberty of adjusting Robinhood's OCF/FCF line items due to the more complicated nature of how B/S line items relate to Robinhood explicitly for financial analysis, versus customer-related accounts/line items.

Key metrics can be broken down by various operations, Transaction-Based Revenue being the largest contributor to overall Revenue growth. This clearly being driven by options, equities, and cryptocurrencies.


Net Cumulative Funded Accounts have grown dramatically, with minimal churn, as have Assets Under Custody, AUC, and Average Revenue per User, ARPU. Net Cumulative Funded Accounts and ARPU are key metrics driving Revenue. Both Equities and Cryptocurrencies have continued to surge in Q1 2021, while Options and Cash Held by Users has remained stable for AUC.


Important Considerations

Now to the good part, it's very important to read between the lines closely from Robinhood's B/S and corresponding Cash Flow performance. As is becoming quite clear, not all Fintech's are equal when it comes to Cash Flows. Some as in the case of Affirm and SoFi, have loans and funding/debt used for these loans can be offset against one another. Excluding these Assets and Liabilities affords an Adjusted OCF/FCF metric that provides better visibility for investors. For the case of Robinhood, this offset does not exist.


The following line items and corresponding definitions are of the utmost importance to clearly recognize how to adjust Cash Flows:

  • Transaction-Based Revenues

  • Net Interest Revenues

  • Other Revenues

  • Cash and Securities Segregated Under Federal and Other Regulations

  • Receivables from Brokers, Dealers, and Clearing Organizations

  • Receivables from Users, Net

  • Deposits with Clearing Organizations

  • Payables to Users

  • Securities Borrowed and Loaned

Revenue

It is always important to have a clear sense of how any company derives its Revenue. As seen above, Robinhood primarily recognizes Revenue through its Transaction-Based Revenue. This occurs when Robinhood routes user orders for options, equities, and cryptocurrencies to market makers when the performance obligation is satisfied. This occurs at the point in time when a routed order is executed by the market maker.


The transaction price for options is on a per contract basis, while for equities it is primarily based on the bid-ask spread of the underlying trading activity. For cryptocurrencies, the transaction price is a fixed percentage of the notional order value. For each trade type, all market makers pay the same transaction price. Payments are collected monthly in arrears from each market maker.


Robinhood earns and incurs interest revenues and expense on securities lending transactions for Net Interest Revenues. They also earn interest on margin loans to users, which constitute the majority of receivables from users, net in the B/S, and on segregated cash, cash and cash equivalents, and deposits with clearing organizations. They also incur interest expenses in connection with our revolving credit facilities.


Other Revenue primarily consists of Robinhood Gold, a paid subscription service that provides customers with premium features, such as enhanced instant access to deposits, professional research, Nasdaq Level II market data and, upon approval, access to margin investing. Contracts with users are for a term of 30 days and renew automatically each month. Subscription revenue is recognized ratably over the subscription period as the performance obligation is satisfied.


This is fairly straight forward, as Transaction-Based Revenue is driven by Options, Equities, and Cryptocurrencies. For Net Interest Revenues, it is also clear that Securities Lending and Margin Interest are the key drivers, while Other Revenue has benefitted from increasing user paid subscriptions.


B/S Assets

Cash and Securities Segregated Under Federal and Other Regulations are required to segregate cash and/or qualified securities for the exclusive benefit of customers and proprietary accounts of brokers in accordance with the provision of Rule 15c3-3 under the Securities Exchange Act of 1934.


It is important to recognize that this B/S line item is excluded from the Adjusted OCF/FCF metric as it is directly related to customer and proprietary broker accounts. To be clear, this line item should never be included in Robinhood's Cash and Cash Equivalents - it is not an explicit measure of the company's financial strength.


Receivables from Brokers, Dealers, and Clearing Organizations include receivables from market makers for routing user orders for execution and other receivables from third-party brokers. Orders are trades which users have not specifically instructed to be routed to a particular venue for execution. These receivables are short term and settle within 30 days.


Clearly, this is a Working Capital item for Cash Flow that should be included in the Adjusted OCF/FCF metric as it is the core driver for Robinhood's Revenue.


Receivables from Users, Net is primarily made up of margin receivables. Margin receivables are adequately collateralized by users’ marketable securities balances and are reported at their outstanding principal balance, net of an allowance for credit losses. Robinhood monitors margin levels and requires users to deposit additional collateral, or reduce margin positions, to meet minimum collateral requirements and avoid automatic liquidation of their positions.


This is another B/S line item that is excluded from the Adjusted OCF/FCF metric as it is directly tied to user accounts.


Deposits with Clearing Organizations are necessary as Robinhood is required to maintain cash collateral as deposits with clearing organizations such as Depository Trust & Clearing Corporation and Options Clearing Corporation which allows the company to use their security transactions services for trade comparison, clearance and settlement. The clearing organizations establish financial requirements, including deposits, to reduce their risk. The deposits may fluctuate significantly from time to time based upon the nature and size of users’ trading activity and market volatility.


As mentioned above, Robinhood earns interest on these deposits which is included as Net Interest Revenue. Despite this, the primary function of this line item is geared towards user accounts, so it is excluded from the Adjusted OCF/FCF metric.


B/S Liabilities

Payables to Users represent users’ funds on deposit, and/or funds accruing to users as a result of settled trades and other security related transactions. This line item is excluded from the Adjusted OCF/FCF metric as it is directly tied to user accounts.


Securities Borrowed and Loaned result from transactions with other brokers, dealers or financial institutions. Securities borrowing transactions require Robinhood to deposit cash with the lender whereas securities lending transactions result in Robinhood receiving cash collateral, with both requiring cash in an amount generally in excess of the market value of the securities.


Robinhood earns Net Interest Revenue on cash collateral deposited with them, and can earn or incur additional revenue or expense for lending certain securities based on demand for that security. All securities borrow and loan transactions have an open contractual term and, upon notice by either party, may be terminated within three business days.


Similar to the above B/S Asset, despite generating Revenue, this line item is excluded from the Adjusted OCF/FCF metric as it is directly tied to user accounts.


Tying it All Together

So some may ask, why go through this, and does it really make sense? If we take Robinhood's OCF/FCF at face value, the shift is dramatic. Performance of $1.3 billion and $1.9 billion respectively for 2019 and 2020, to negative $2.2 billion after Q1 2021. This result was the primary trigger for the company raising $3.6 billion in convertible notes and warrants.


But for me, it's all about the explicit metrics that measure Robinhood's financial strength and fundamentals. It is to this point that excluding the line items from the B/S that relate mostly if not completely to user accounts being excluded is justified.


A key driver for this is Robinhood's Cash and Cash Equivalent growth. Even when OCF/FCF were substantial during 2019 and 2020, Cash and Cash Equivalents were not growing accordingly. This is a direct result from OCF line items driving other B/S user account-based line items. Unfortunately, there is no math that can equate to the increase in Cash and Cash Equivalents from 2019 to 2020, but this is actually an indication that my assumptions are on the conservative side, and a better indication of a return on investment.


Preliminary Forecast

This is a preliminary forecast which means that Shares Outstanding may have significant impacts on the numbers currently presented, notably related to the SP - additionally, we will inevitably get the IPO SP range. That being said, it is an initial sample from my financial model, and I will tweak it accordingly once amended S-1s are filed.


The key drivers are Net Cumulative Funded Accounts and ARPU, and as can be seen, I am modeling them both to grow annualized by greater than 30%. This in turn equates to a 55% annualized Revenue growth rate.


Depending on Shares Outstanding and SP, I am assuming that this pricing will represent valuation for 2021. I am also assuming that the current 40% OCF margin will contract to 30% over the mid-term. I always assume a minimum of 5% share dilution for growth companies, which may be adjusted higher over time.


Regardless, in this scenario, Robinhood is a lucrative investment at a $40 billion valuation. The challenge is those bringing the company public are going to game this and this is a direct reason why the SP pre-IPO range will likely trek higher before it locks in.


Therefore, the trick becomes making a realistic assumption on the premium that the first trading day will afford. I'm not going to begin this process now, until I get more direct information for Shares Outstanding, and SP range, but based on a $40 billion EV, I wouldn't be surprised seeing a 20-40% premium immediately.


Conclusion

So where's the risk/competitive market assessment? And why will Robinhood be capable of growing towards the preliminary forecast? I always save the best for last. But seriously, these are the two main questions that I'm thinking about as I've deconstructed the financials and fundamentals. As I illustrated above, both Coinbase and Affirm saw extreme drops after their first/early trading days/weeks.


From a competitive perspective, there is a clear disconnect with future investors whether Millennials, or Generation Z from legacy trading platforms. I myself use Merrill Edge, with access to the Intercontinental Exchange terminal, but the definitions of sophisticated/active investors is changing. Companies like Robinhood, Square, Inc. (SQ), SoFi, Bakkt, Inc. (VIH) among others are looking to change the dynamics of the customer relationship.


This is all too familiar, most physical businesses offered superb customer service in the past, but as the Internet and digital services have grown, notably e-commerce, physical businesses now are no longer recognized for superb customer service. This has created a massive opportunity for digital and app-based business models.


The clearest indication of Robinhood's future potential is the current success that is proliferating. The pandemic has impacted families in multiple positive ways. First, spending more time with family is highly important and beneficial to a better life balance. Second, many younger generations got into investing and saving.


As is the case with technology-based companies, market leaders become highly formidable competitive moats simply from their scale and not easily replicated human capital laser-focused on a core vision. It is debatable whether legacy trading platforms can pivot to slow Robinhood's growth, but for the reasons above, I will be looking at companies like Robinhood versus legacy players.


Another concern are newer innovators that will look to compete against Robinhood whether already here, or not yet as well known. This is the more concerning threat versus legacy businesses, but like Coinbase and Robinhood, I see market leader momentum being very difficult to offset. As Robinhood continues to scale, it will be tougher for newer competitors to take market share.


I've been around long enough to hear the "no moat" claim or "anyone can replicate the business model", and I've scrutinized many technology-based companies that have simply bucked these trends. What has become apparent is the most important moat element, the management team and overall employees working at the company. There isn't another Roku, Inc. (ROKU) that exists for the simple fact that there isn't a team focused on what Roku does - this affords successful companies long runways.


Robinhood's management has had controversy, but much of this controversy is tied to legacy-based expectations, versus next generation interests and approaches towards investing. I don't believe that the future is YOLO, but the aggressiveness of younger generations is testament, to their shift towards more sophisticated progression.


The bottom line for me is that Robinhood is going to be highly anticipated. I am going to strongly consider initiating a position. But it will all boil down to the company's valuation. One thing for sure, I'll be ready!

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