Rocket Companies: Don’t Buy Yet

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

“I’d prefer to invest with more fear in the valuation, so I suggest waiting to see if Rocket can be bought below $15. There should be no hurry – the odds are high that over the next year or more the news will get worse.”

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

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

What we know – We can ignore “Rocket the Fintech”

Management passionately pitches itself as a fintech. For example, from its annual report:

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

And:

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

This kind of hype was helpful to stocks last year, when investors clamored for disruptor stories, however unlikely. But disruptor stories are so over – see the stock charts of 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 turn out. But the fact is that today they are tiny compared to Rocket’s mortgage banking business, and will be so for many, many years. I tend to worry that Rocket and its peers will spend more money chasing these dreams than they will ever earn. But the expenses and revenues are rounding errors for many years.

What we know – the mortgage origination cycle has nearly bottomed

My article last year focused on the certainty that mortgage originations would plummet from their $4.4 trillion annual pace at that time, as mortgage refinancing inevitably ended. Oddly enough, the inevitable occurred. The plunge in refinancing has brought the Mortgage Bankers Association’s (MBA’s) projected 2022 originations to $2.5 trillion, a nearly 40% year-over-year decline.

But this chart shows that mortgage originations are near bottom:

Source: Mortgage Bankers Association (MBA)

While there is no growth for the foreseeable future, at least the risk of another sickening sharp decline is limited. For example, the $552 billion of home purchase originations Fannie Mae expects for this Q3 is 34% above the pre-COVID Q3 ’19 volume, in line with home price increases over that period. And the $145 billion of refis Fannie expects for Q3 is actually below the pre-COVID norm.

What we know – the needed supply shrinkage has begun

A 40% decline in demand obviously creates excess capacity. That excess has taken a toll on Rocket’s loan origination profit margin (in mortgage banker-speak, the “gain on sale margin”), as this chart shows:

Source: Rocket Companies financial reports

Returning to normal profit margins requires a large decline in supply, which means firing a lot of mortgage bankers. That has begun happening – even at Rocket! – as this partial list from web site The Truth About Mortgage shows:

“Amerifirst Home Mortgage layoffs in Kalamazoo, MI / Homeowners Financial Group layoffs in Arizona / Costco Mortgage program no longer available as of May 1st, 2022 / U.S. Bank cut 200 mortgage operations jobs / Mr. Cooper cut roughly 250 jobs / Flagstar Bank cut 20% of mortgage staff (420 jobs) / Rocket Mortgage offering buyouts to 8% of staff / Wells Fargo cutting unspecified number of mortgage jobs / USAA Bank cut 90+ mortgage jobs / PennyMac to cut 227 jobs in Agoura/Moorpark/Westlake, CA / Better Mortgage to cut additional 3,000 jobs in United States and India / Redfin to acquire Bay Equity Home Loans, 121 layoffs”

Etc.

I expect the supply shrinkage will be fully done a year from now.

What we know – Rocket stands out from its peers

Mortgage banking is a miserably competitive business. There are thousands of mortgage lenders nationally, and they all sell the same core product, namely 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 calculation, the mortgage bankers’ HHI is barely above 100. Compare that to the U.S. auto making industry at a 1,100 HHI, and the internet search business at 5,500.

As one would expect, then, industry leadership is tenuous. When I first starting tracking the industry in the mid-‘80s, the market share leader was Lomas & Nettleton. It went bankrupt in 1989. Then Wells Fargo and Countrywide Credit battled for leadership, both achieving 20%+ market shares. Countrywide was staggered by the Great Financial Crisis (“GFC”), was bought by Bank of America and ended up costing B of A tens of billions of dollars. Wells steadily shrank, to a 5% share in Q1.

Meanwhile, Dan Gilbert founded Rock Financial in 1985. It pitched itself as an internet play during the late ‘90s, and got bought out by Intuit in 1999 and rebranded as Quicken Loans. Management then bought it back in 2002 after Intuit couldn’t stomach the end of a refinancing boom. Rocket survived the GFC because it avoided the subprime lending that killed off hundreds or even thousands of peers, and got rewarded by an ‘08/’09 refi boom. It grew steadily since to its grandeur today.

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

What we now know – 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 latest earnings presentation:

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

“Come on, Gordon, hop on the bandwagon. Rocket is growing to the moon.” I was actually buying this story until Rocket added this forecast to its Q1 earnings press release:

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

This implies a Q2 market share of only 5.5%! A major drop from last year’s 8.8%. Not to be rude, but that is very un-Amazon-like. What gives?

What gives is that Rocket’s sales strength is direct to the consumer. That works very well during a refinancing boom, when homeowner loyalties are up for grabs. But the home purchase mortgage decision is heavily influenced by realtors, who have their own lender loyalties. Rocket bizarrely refuses to break out its home purchase and refinancing volume in print, but it clearly has much greater refi than home purchase share.

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

My Rocket earnings estimates

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

Source for historical data: Rocket financial reports

My key assumptions are:

• National loan originations are the Mortgage Bankers Association’s forecasts.
• Rocket’s share bottoms this quarter at 5.5% and gradually rises as Rocket spends money to grow its home purchase market share.
• The gain on sale of mortgage originations also bottoms this quarter and rises to its 2019 level by 2024 when I assume the industry’s excess capacity is fully squeezed out.
• MSR value changes represent changes in the expected life of the loans Rocket services (collects payments). The odds are that Rocket will write up the value of its MSRs if interest rates stay flat or rise, but because this is a non-cash item, I don’t include them in operating income.
• Operating expenses have down and up drivers. Rocket’s down driver is reducing capacity because of the mortgage origination decline. The up drivers are (a) efforts to gain mortgage purchase share, and (b) Rocket’s fintech diversification efforts. My expense estimates hopefully reasonably reflect these cross-currents.

Wrapping up – Still too early to buy

Rocket is going to have a challenging 12-18 months ahead of it. Earnings should be near zero for three or more quarters, excluding MSR marks. There is no reason to hurry into the stock. At $7, or 20% below the current price, you should have a solid long-term investment.