Rocket Companies (NYSE:RKT) went public on Thursday. In the IPO, the company sold 100 million shares at $18. The company started trading on Thursday under the symbol RKT, which in my imagination looks a lot like REKT, or wrecked.
When zooming-in, the company’s performance does not look as stellar as it appears on first sight. Furthermore, the company is heavily dependent on macroeconomic conditions and government agencies and this exposure warrants a value of just north of $8 per share in my opinion.
Let’s list some basic facts we can all agree on before we dive in. The figure below shows the proposed corporate structure of RKT, based on 150 million shares issued.
Some investors can become confused here as the company says that there should be only 150 million shares outstanding after the IPO. This is technically true, but the other shares are the ones that Rock Holdings (RHI) has in the actual operating company. Formally, the net income attributable to RHI holdings will be recorded as non-controlling interest. However, for the purpose of this article, I will not adjust the earnings numbers down, but rather use the underlying total number of shares outstanding to keep it simple.
An important change versus the prospectus is that there were not 150 million but 100 million shares issued at a lower price of $18 per share instead of the $20 to $22 envisioned.
The tables from the amended S-1 form below provide an overview of the company as it was and how it was supposed to be after completing the IPO.
Source: amended S-1.
Though the pro forma figures above look complicated, the use of proceeds is very simple: it goes to Rock Holdings Inc., or RHI, from which RKT buys the ownership interest in RKT Holdings.
Below, I have summarized some basic numbers and valuation multiples based on the pro forma figures. Note that because this is a financial stock, there is no EV, and also no EBIT or EBITDA. Earnings and book value matter more.
Source: Author’s own calculations based on a share price of $21.51. *Basic pro forma 2019 EPS as listed on the S-1 form. **The book value of RKT is $1.83 per share according to the S-1 form.
Now that we got the basics out of the way, we can take a look at the actual business behind these numbers.
The primary business model of RKT is to provide consumer mortgages through its brands of which Quicken Loans is perhaps the most well-known. The company is not a traditional bank, as it sells all the mortgages it originates. Also, the mortgage application takes place online. Another important element of the business is mortgage servicing over the lifetime of the mortgage, for which the company receives recurring fees.
The company operates two segments: Direct to Consumer and Partner Network. The first segment is the company’s own mortgage business and brand. The Partner Network consists of third parties who use the platform of RKT. The company receives a lower fee on the loan volume of these third parties and it also does not record mortgage servicing fees in that segment.
Aside from the mortgage business, the company has various other minor activities, including dictionary.com, to which I linked earlier for the definition of REKT. Revenues and key performance indicators of these miscellaneous activities are detailed in the overview shown below under ‘Other Rocket Companies’.
It seems like RKT is doing something right, as the market cap is twice the size of the balance sheet of the company. The market share growth of the business seems to offer a clue.
These market share gains should be put in context. On each loan sold, RKT records a gain on sale and this figure has dropped from 3.97% in 2017 to 3.19% in 2019. There is a reason behind this and that is that the market share growth mostly comes from an increase in partner revenue. If we look at the direct origination volume, the market share was 4.3% in 2019, up from 4% in 2017.
RKT has been stepping its recruitment of partners in 2019, as the data below shows. This also explains the lower gain on sale margins, as PN delivered an average gain on sale of only 0.77% of origination volume in 2019, lower than the gain on sale of 4.45% in the company's DTC segment.
In fact, the company probably lowered its margin in 2018 and 2019 in order to attract more partner networks. If this was the strategy, it was clearly a success, but lowering margins to gain business is not a very sustainable business model.
At $350m, PN's impact on profitability is also modest. By comparison: the contribution margin of DTC is $2.4bn. The contributions of both segments have to cover unallocated expenses of $1.4bn. Because of the unallocated expenses, I find it highly questionable whether these partners have really been profitable to the business in 2019. In theory, if RKT used partners to increase its market share to 50% of mortgage originations (using 2019 figures), that would net the PN segment a contribution margin of $6bn. However, I highly doubt whether much of that will trickle through to the bottom line.
Source: RKT S-1.
In my analysis, the DTC market share went from 2.5% in 2012 to 3.8% in 2015 and it has been quite stable since, reaching 4% in 2017, dropping back to 3.8% in 2018 on lower market refinance activity, but rebounding to 4.3% in 2019 on higher refinance activity. Taking refinance originations into account, the DTC market share growth has been slowing since 2015. Investors probably shouldn’t count on high DTC market share gains going forward.
There are several factors that obscure the performance of RKT. One of them is valuation changes of mortgage servicing rights due to valuation assumptions. The reader has to realize that MSRs represent a string of future cash flows but that these cash flows are not fixed. As is standard practice in the financial industry, MSRs are on the balance sheet and can change in value depending on valuation assumptions. For example, borrowers can repay their mortgages early and this is detrimental to the value of an MSR. Prepayments generally increase with lower interest rates, which means that lower interest rates can lead to a negative valuation change of MSRs through prepayment assumptions.
The table below shows the adjusted net income, cleaned for several items, including MSR valuation assumptions. Taxes are also taken into account as these are expected to be an actual expense going forward.
Source: RKT S-1.
I would like to make further adjustments to the overview above because stock-based compensation expense is an actual expense to shareholders. Note that there is a difference between 2019 and '2019 pro forma'. The latter should be seen as the most comparable result for forecasting purposes.
Source: Author’s own calculations based on data in the RKT S-1 form. The figures in orange are author’s estimates based on historical data by the company over the years of 2016 and 2015 and should provide an indication of profitability in those years; tax-affected net income assumed a 35% tax rate in 2015 and 2016. P/E is based on a market cap of $42.7bn throughout.
To me, it looks like the underlying net income is quite volatile, and unlike the market share RKT presents, it is not an impressive stable growth story at all. I believe that RKT for a large part relies on refinance mortgages as these are generally more simple and easier to arrange online. The chart below shows the net income of RKT in the context of the total mortgage refinance origination volume in the US.
Source: Mortgage Bankers Association (mortgage refinance market size), author’s own calculations.
Lower interest rates are favorable for new mortgage originations. People tend to prefer to refinance their mortgage if they can get a better rate than the rate they already have. This caused the mortgage refinance activity to be higher in years with decreasing rates. This also partly explains the poor performance of the company in 2017 and 2018.
From a macro view, rates have been declining for decades and this year looks to be a new bottom for mortgage rates following massive stimulus from the Federal Reserve. This does not bode well for the medium-term outlook. In its prospectus, the company included estimates of the mortgage market size that show that 2020 will be a peak year and that originations will fall in 2021 and 2022.
Source: RKT S-1.
I would not be surprised if refinance activity shows an even sharper peak in 2020. From a seller’s perspective, now looks like a great time to sell shares in this company.
There is yet another element to the business model to discuss, which is government agencies.
The table below gives an idea about the loan volume RKT originated in Q1, the loan types, average credit metrics, and who bought the loans. GSEs stands for Government Sponsored Enterprises and this comes down to mostly Fannie Mae and Freddie Mac.
Source: RKT S-1.
Rocket Mortgage almost exclusively offers GSE-conforming and government insured mortgage loan products, according to the company. That explains the high percentage of loans sold to GSEs and the government in the table above. This reliance is an obvious risk and limiting factor. As the risk factors section in the S-1 filing states:
"Our business is highly dependent on Fannie Mae and Freddie Mac and certain U.S. government agencies, and any changes in these entities or their current roles could be detrimental to our business."
Somewhat related to this, I found a very interesting story in The Washington Post about the risky mortgages that the US federal government takes on. From that perspective, it looks like RKT is riding a massive home-ownership stimulus program.
The government agencies keep buying regardless of economic conditions. The former CEO of Freddie Mac explains the cyclicality of different mortgage funding sources really well in his piece for Harvard University’s Center For Housing Studies. That piece brings us closer to the real point of pain for RKT, which is the end of conservatorship of the two GSEs. According to different sources, this could be as early as 2022 or by 2024. News in May reaffirms that the FHA is determined to release Fannie and Freddie from government control.
There are some similarities to LendingClub (LC) which is a struggling company in the personal loans business. Riding low rates, LendingClub has also grown spectacularly over the past decade. However, its stock declined by 92% over the past 5 years as the growth never materialized into substantial profitability. It is my opinion that the market now values LC according to its liquid assets and not P/E. Needless to say, LC trades at a substantial discount to its book value. I have written about LC earlier this year.
Luckily for shareholders of RKT, the situation at RKT is not that bad. Important difference is that LC cannot profit from government-backed loans as there are no such large scale programs available in the personal loan market. Another difference between LC and RKT is that RKT has reached a stage of structural profitability. Nevertheless, LC shows how valuations can change over time if an innovative finance company doesn't deliver on its expectations.
Institutional investors balked at the proposed valuation of $42bn and the company has reduced its offering size and price to adjust to the weak demand. The stock has performed well on the first day of trading, which is likely fueled by retail buying.
The underlying results of RKT are not as stable as they appear on first sight and heavily susceptible to macroeconomic factors such as interest rates. In addition, the company is heavily dependent on government agencies for its mortgage production. The company’s market share growth over the last few years has been very dependent on mortgage volume at partners, which are far less profitable than proprietary mortgage volumes. When I look at this company, I see a macro-driven business that admittedly has done very well up to 2015/2016.
Looking at the growth prospects and the profitability of the company, I think that an adjusted P/E (using 2019 adjusted pro forma income) of 15 is the best we can hope for, considering that 2019 was a peak year, following a very bad one. This implies a value of $8.28 per share. As suggested in the introduction of this piece, RKT sounds a lot like wrecked. I would invite anyone to refrain from wrecking their investment portfolios with this rather expensive stock by staying away from it.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in RKT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.