Rocket Companies: Don’t Buy Yet

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I wrote about Rocket Companies on August 23 last year when the stock was at $17.57. At the time, I said:

“I would rather invest with more fear in valuation, so I suggest waiting and seeing if Rocket can be purchased below $15. There’s no rush – there’s a good chance that over the next year or more the news will get worse.

Today, the stock is trading at $8.80. By my calculations, it’s less than $15. Time to buy? Sorry, but I don’t think so. $7 would be a good entry point.

In this article, I’ll go over what we know and why that means Rocket should only earn around $0.50 per share this year and next, and $1.00 in 2024.

What We Know – We Can Ignore “Rocket the Fintech”

The management passionately presents itself as a fintech. For example, from his Annual Report:

“Rocket Companies is a fintech platform company comprised of personal finance and consumer technology brands. We leverage our technology, data, and highly skilled Rocket Cloud Force to provide clients with certainty throughout life’s most complex transactions…”

And:

“Rocket competes in some of the largest and most complex segments of the economy, including mortgages, real estate, automotive, financial services and solar energy. Our markets remain highly fragmented and we We are positioned to gain market share by leading the digital transformation of our industries.”

That kind of hype helped stocks last year, when investors clamored for disruptive stories, however unlikely. But the disruptor stories are so over – see stock charts for Zillow (Z), SoFi (SOFI), Opendoor (OPEN), etc.

I don’t know how Rocket’s forays into real estate brokerage, car sales, and personal finance will end. But the thing is, they’re tiny compared to Rocket’s mortgage banking business today, and will be for many, many years. I tend to worry that Rocket and his peers will spend more money chasing those dreams than they’ll ever earn. But expenses and income have been rounding errors for many years.

What we know – the mortgage origination cycle has almost bottomed out

My article last year focused on the certainty that mortgage lending would fall from its annual rate of $4.4 trillion at that time, as mortgage refinancing inevitably came to an end. Curiously, the inevitable happened. The fall in refinancing brought the Mortgage Bankers Association’s (MBA) projected issuance for 2022 to $2.5 trillion, down nearly 40% year-over-year.

But this graph shows that mortgage originations are close to the bottom:

Mortgage originations, 2019-2023

Mortgage Bankers Association

Source: Mortgage Bankers Association (MBA)

Although there is no growth for the foreseeable future, at least the risk of another sharp and sickening drop is limited. For example, the $552 billion in home purchases that Fannie Mae expects for this third quarter is 34% higher than the pre-COVID volume of the third quarter of 2019, in line with increases in home prices during this period. And the $145 billion in refis Fannie expects for the third quarter is actually below the pre-COVID norm.

What we know – the necessary supply reduction has begun

A 40% drop in demand obviously creates overcapacity. This excess weighed on Rocket’s profit margin on loan origination (in mortgage banker terms, the “sell margin gain”), as this chart shows:

Gain on sales margin

Rocket Financial Reports

Source: Rocket Companies Financial Reports

Returning to normal profit margins requires a sharp drop in supply, which means laying off many mortgage bankers. It started to happen – even at Rocket! – like this partial list from the website The truth about the mortgage shows:

Amerifirst Home Mortgage Layoffs in Kalamazoo, MI/ Homeowners Financial Group layoffs in Arizona / The Costco Mortgage Program is no longer available as of May 1, 2022 / US bank cuts 200 mortgage operations jobs Mr. Cooper cut about 250 jobs / Flagstar Bank cut 20% of mortgage staff (420 jobs) / Rocket Mortgage offering buyouts at 8% of staff / Wells Fargo cut an unknown number of mortgage jobs / USAA Bank cut more than 90 mortgage jobs / PennyMac to cut 227 jobs in Agoura/Moorpark/Westlake, CA / Better Mortgage to cut an additional 3,000 jobs in the US and India / Redfin to acquire Bay Equity Home Loans, 121 layoffs”

Etc.

I expect the supply reduction to be fully complete within a year.

What we know – Rocket stands out from its peers

Mortgage banking is a miserably competitive business. There are thousands of mortgage lenders nationwide, and they all sell the same basic product, which is a “conforming” (to Fannie Mae and Freddie Mac standards) 30-year fixed rate loan. Economists have a measure of industry competitiveness, called the Herfindahl-Hirschman Index (HHI). The lower the index, the more competitive the industry. By my calculations, the HHI for mortgage bankers is just over 100. Compare that to the US auto industry at an HHI of 1,100 and internet search activity at 5,500.

Predictably, industry leadership is tenuous. When I started following the industry in the mid-1980s, the market share leader was Lomas & Nettleton. It went bankrupt in 1989. Then Wells Fargo and Countrywide Credit battled for leadership, both achieving over 20% market share. Countrywide was devastated by the Great Financial Crisis (“GFC”), was taken over by Bank of America and ended up costing B of A tens of billions of dollars. Wells has steadily declined, to a 5% share in the first quarter.

Meanwhile, Dan Gilbert founded Rock Financial in 1985. It came as an internet game in the late 90s and was acquired by Intuit in 1999 and renamed Quicken Loans. Management then bought it out in 2002 after Intuit could not endure the end of a refinancing boom. Rocket survived the GFC because it avoided subprime loans that killed hundreds, if not thousands, of peers, and was rewarded with a refi boom in 2008/2009. It has grown steadily since its splendor today.

How did he manage this success in such a difficult sector? A combination of a low interest rate and credit risk strategy, and a focus on technology to reduce operating and marketing costs. Not brain science, but a level of discipline that few peers can maintain.

What we know now – Rocket has a market share problem

What am I talking about ? Rocket has been a market share animal over time as it proudly trumpeted in its final presentation of results:

Rocket Market Share History

Introducing Rocket Q1 ’22

But that’s not enough hype. Apparently, move to Amazon, make room for Rocket:

Rocket Market Share Comparison

Introducing Rocket Q1 ’22

“Come on, Gordon, jump on the bandwagon. Rocket grows towards the moon. I was buying this story until Rocket added this forecast to its First quarter results press release:

We expect the following ranges in Q2 2022: Closed loan volume between $35 billion and $40 billion.”

This implies a market share in the second quarter of only 5.5%! An important drop compared to 8.8% last year. Not to be rude, but it’s very different from Amazon. Which give?

What gives is that Rocket’s sales force is direct to the consumer. This works great during a refinance boom, when owner loyalty is up for grabs. But the home buying decision is heavily influenced by realtors, who have their own loyalties to lenders. Rocket oddly refuses to break down its home buying and refinancing volume in print, but it clearly has a much larger refi than home buying share.

With refinance largely dead for at least a few years, Rocket’s market share has taken a hit that will take years and lots of marketing dollars at best to recoup.

My Rocket Revenue Estimates

I expect Rocket to earn around $0.50 per share this year and next, and $1.00 in 2024. Here is my earnings model:

My income estimates

Rocket Financial Reports

Source of historical data: Rocket Financial Reports

My main assumptions are:

  • Origin of national loans are forecasts from the Mortgage Bankers Association.
  • Rocket’s share bottomed out at 5.5% this quarter and is gradually rising as Rocket spends money to grow its home buying market share.
  • The gain on the sale of the mortgage arrangements also reaches its 2019 level by 2024 when I assume the industry’s excess capacity is fully depleted.
  • MSR Value Changes represent changes in the expected life of loans Services Rocket (collects payments). Chances are Rocket will write up the value of its MSRs if interest rates hold steady or rise, but since it’s a non-cash item, I’m not including it in operating income.
  • Operating Expenses have down and up pilots. Rocket’s bearish engine is reducing capacity due to lower mortgages. The upside drivers are (a) efforts to gain mortgage purchase share, and (b) Rocket’s fintech diversification efforts. I hope my expense estimates reasonably reflect these cross-currents.

Conclusion – Still too early to buy

Rocket is going to have a tough 12-18 months ahead of him. Earnings are expected to be near zero for three or more quarters, excluding MSR brands. There’s no reason to rush into stock. At $7, which is 20% off the current price, you should have a solid long-term investment.