Robinhood Markets: Robbing From Retail And Giving To Citadel

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by Dave Kranzler, Investment Research Dynamics

“Robinhood is the poster boy for the craziest, most unregulated stock market era since 1929. That one ended in tears. This one will also.” – WallStreetOnParade.com

HOOD operates a commission-free trading app that became popular in March 2020 with Millennials and Gen-Z’ers who fancy themselves as day-trading geniuses. The Company went public in July 2021 at $38/share. Aside from the fact that HOOD is symbolic of the biggest stock bubble in history, the corporate suite is riddled with fraud and corruption.

As it turns out, the trading service is not exactly free. The bulk of HOOD’s revenues comes from routing its order flow to third-party trading firms rather than the stock exchanges. This increases the execution cost, unknowingly, for HOOD’s retail, stool-pigeon accounts. In Q2 HOOD routed 34% of its order flow Citadel (hedge fund and brokerage) and 21% to Susquehanna (options order flow).

As a former Wall Street junk bond traderl, I can guarantee that Citadel and Susquehanna “front run” the order flow by taking positions, with buy orders for instance, in the stock/options being routed to each firm before executing the HOOD orders. The HOOD orders drive up the price of stocks/call options like AMC and GME. Citadel or Susquehanna then unload their front-running position for a profit that exceeds what was paid for the order flow. The mechanics of this may be akin to “scaling fish” for profits but aggregated over $10’s of billions of orders it’s huge, free money for Citadel and Susquehanna. It’s also easy to hide and hard for regulators to prove (if they bothered trying).  But this is one of the ways in which Wall Street skims money from investors.

HOOD is not the only brokerage that does this but HOOD has built its business model on order flow payments, as 80% of HOOD’s revenues is derived from order flow revenues. It was announced this past week (late September) by the SEC Chairman that banning payments for order flow was “on the table.” If this occurs, HOOD’s stock price will get destroyed.

In June 2020, HOOD was fined $57 million by FINRA and ordered to pay $13 million in restitution to clients affected by app outages and misleading communications in March 2020. It was the largest FINRA penalty in the history of the organization.

In December 2020, the SEC brought charges against HOOD for repeated misstatements that failed to disclose the firm’s receipt of payments from trading firms for routing orders to them and with failing to satisfy its duty to seek the best reasonable available terms to execute customer orders. HOOD settled the charges by paying a $65 million fine.

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The day before this, the Massachusetts securities regulatory agency brought an enforcement action against HOOD for several regulatory violations, including aggressive tactics to attract new, often inexperienced investors and breach of the fiduciary conduct.

And there’s more. This past week (late September) it was revealed that the SEC was looking into whether or not HOOD President/COO, James Swartout, violated securities laws by selling out his position in AMC shares just ahead of HOOD placing a restriction on the trading of AMC.

Where’s there’s the “smoke” of fraud and corruption, there’s usually a “fire”. In HOOD’s case, it’s pretty obvious and there’s multiple wildfires burning. But this is just one aspect that makes HOOD a great short. HOOD’s share price is extraordinarily overvalued based on fundamental metrics and it looks like its business activity may be starting to slide.

For the first six months of 2021, after adding back a $2 billion non-cash charge for the change in the fair value of convertible notes and warrants liability (I normally would include non-cash charges but this particular charge is not a function of HOOD’s operating business) HOOD’s operating income was just $123 million. Giving the Company the benefit of annualizing that number – and there’s good reason to believe it will decline – HOOD’s operating income could be $246 million. After the provision for income taxes ($49.2 million in the 1H 2021, or $98.4 million for the full-year), HOOD might generate net income of $148 million.

On this basis, based on Friday’s closing stock price (October 1st), HOOD’s market cap is $36.6 billion. It’s thus valued at a P/E of 247x and 16x revenues (assuming revenues in 2H 2021 are equal to the 1H). It’s beyond comprehension that anyone would pay those kind of multiples for a cock-roach infested motel like HOOD. But, such is the nature of extreme stock bubbles.

Away from the potential regulatory and legal issues that HOOD faces and likely will face, there’s plenty of reason to believe that its operating business activity will begin to deteriorate. Keep in mind that HOOD is 100% retail-based. Its business activity soared when the stock market crashed during the peak of the virus crisis as Millennials and Gen-Z’ers flocked to HOOD’s app with dreams of getting rich by day-trading meme and tech stocks from their parent’s couch. And HOOD also added the ability to trade cryptos, which also is heavily retail-based.

According to Apptopia data, the number of new Robinhood app downloads in Q3 (a proxy for account openings) is down -78% from 2Q21. This compares with a drop of around 50% for Bitcoin, Coinbase and other crypto apps that rode the retail trading trend. In addition, Q3 daily active users (a proxy for activity levels) have declined -40% from 2Q21. This compares with a 23% decline for crypo peers and 30% for Schwab.

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As stock bubbles start to pop (see 1999/2000 and 2007/2008) retail stock speculators start to lose interest in the market or try to buy the dip until they destroy their account. Most ultimately get wiped out.

When HOOD reported its Q2 numbers on August 18th, it warned that it expected lower trading activity and lower revenue in Q3 as well as “considerably fewer funded accounts” compared to Q2. The Company also has warned twice of a slowdown in crypto trading revenue.

HOOD IPO’d on July 29th so there’s only a little over two months of trading data. The chart above (through 10/1/21) is an hourly chart that goes back to the IPO date. Technically, it looks like continued market turbulence could knock the stock down to $30 this quarter. If the stock market suffers and “accident” this month, HOOD will go below $30. And there’s the constant threat of regulatory torpedoes being launched at the share price.

Of the 875 million shares outstanding, insiders have dumped 464 million. In addition, 98.7 million shares connected to a convertible note owned by insiders will be dumped once the S-1 registration becomes effective. Finally, another 567.9 million shares will become available to sell by insiders as lock-up restrictions expire. Oh, and let’s not overlook the fact that ARKK owns 5.5 million shares and has been adding more shares recently.  ARKK’s endorsement of HOOD alone makes it a fabulous short without knowing the long list of fundamental negatives.

Robinhood to me seems like a no-brainer short. If the stock market falls into a bear market, HOOD will go below $10 and probably below $5. For now, the shares are hard to borrow. I have a big position in December $30 puts. I may also throw on some May 2022 $35’s. Shorting the longer-dated OTM calls is like taking candy from a baby. Once the above-mentioned lock-up expires, the stock will take another leg down and shorting OTM calls will pay off handsomely.

HOOD will report Q3 numbers in mid-November (it reported Q2 numbers on August 18th). I think there’s a good chance it will miss estimates.  I’m guessing it will report Q3 either the Wednesday or Thursday before the November 19th option series expires. I may buy a small amount of November $40’s or $38’s.

 

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