Five Reasons This Rocket May Plummet

Summary

• Rocket Companies Inc is aptly named, up 71% yesterday in a post earnings short squeeze.
• Astute investors however will want to know not just the reason for the squeeze but also the reason 40% of the shares outstanding were short in the first place.
• Also key to understand is the huge share overhang that is not currently counted as shares outstanding but can be converted into common and sold.
• Looking for a helping hand in the market? Members of Cash Flow Kingdom get exclusive ideas and guidance to navigate any climate. Get started today »

Rocket Companies, Inc (NYSE:RKT) claims to be the largest mortgage lender in the US. In addition to providing mortgages through Rocket Mortgage, Rocket offers title insurance through Amrock, real estate services through Rocket Homes, auto loans and services through Rocket Auto, and other complementary services. The company seeks to combine these and third-party providers into one holistic platform and website to assist Americans with some of the largest transactions of their lives. You may have seen their ads while watching the Super Bowl.

Earnings:

Rocket reported stellar earnings after close Thursday, February 25 and as a result the Rocket Companies stock doubled in the following few trading days (closed at $41.60 yesterday with 357 million shares traded on the day). The Q4 earnings press release title gave a pretty strong hint why, “Rocket Companies Experiences Explosive Growth, Revenue Increases 144% year-over-year to $4.7 Billion in Fourth Quarter, Company Announces Special Dividend of $1.11 per Class A Share of Common Stock”. The conference call was equally enthusiastic with the CEO, Jay Farner, indicating that their Super Bowl ads,

“...ranked numbers one and two on USA Today's ad meter… [and] resulted in more than 3.3 billion consumer impressions…[that] Morgan Stanley and E*Trade have entered into a new agreement with Rocket Mortgage where our company will originate, close, and service conforming mortgages for their clients…[while] Rocket Labs will further accelerate our focus on expanding the business in ways that leverage our platform and serve our client base”.

In addition, they posted a rosy outlook for the first quarter of 2021, guiding toward:

• Closed loan volume of between $98 billion and $103 billion compared to $51.7 billion in the first quarter of 2020, an increase of 90% to 99%.
• Net rate lock volume of between $88 billion and $95 billion compared to $56.0 billion in the first quarter of 2020, an increase of 57% to 70%.
• Gain on sale margins of 3.60% to 3.90% compared to 3.25% in the first quarter of 2020, an improvement of 35 to 65 basis points.

So naturally, management is “excited about the continued strength and momentum of the Rocket Platform” and reports from Wall Street Journal and other analysts came out with a significantly positive slant.

Those who follow me will remember that I too was excited about opportunity in the mortgage origination space when I published the short blog, “Mortgage Originators” back in March 2020. So, it came as no surprise that Rocket and other originators have generated a lot of positive cash flow since then. In fact, almost every mortgage origination firm had a fantastic year, powered by low mortgage rates, record mortgage originations, and high gain on sale margins across the space. This is why P/E ratio's are so low. The E (earnings) being used in that ratio are at cyclical highs.

Data by YCharts

The reader however has to decide whether Rocket is really worth about triple the valuation multiple of its peers (Mr. Cooper 'COOP', Flagstar 'FBC' and PennyMac 'PMT').

To be fair, Rocket is not only the largest, but also clearly one of the best performers in the sector from an earnings point of view. It showed more growth than most and posted a record $5.25 billion in profits just in the second half of 2020. For perspective, that’s a 12.8% EPS yield run rate on its $82 billion market cap (=$5.25 billion *2 / $82 billion).

So, their is obviously a whole lot of cash rolling in right now. However, the shrewd investor needs to look not just at the past, but also into the future.

Risks:

Rocket is a fine mortgage company operated by capable and experienced management. The Chairman of the Board, Dan Gilbert, is a billionaire who made his money off Rocket and still owns about 73%. The firm receives a significant premium to the sector due this expertise, growth and a well articulated strategy that espouses achieving the holy grail of the lending world, capturing loyal return customers for all their major financing and transaction needs.

The astute investor however may want to look beyond the obvious short squeeze to understand why the Rocket Companies stock was trading with almost a 40% short interest position in the first place. The answer you come up with, if you do your own independent research and forecast a bit more into the future, may be some variation on the following.

1. The bloom is off the rose. Joel Kan, the Mortgage Bankers Association ‘MBA’ Associate Vice President of Economic and Industry Forecasting indicates, “Mortgage rates have increased in six of the last eight weeks, with the benchmark 30-year fixed rate last week climbing above 3 percent to its highest level since September 2020. As a result of these higher rates, overall refinance activity fell 11 percent to its lowest level since December 2020…”. While Q4 was strong for Rocket, it also showed considerable weakness vs. Q3. Despite increased lending volume, revenue fell, and expenses became a larger burden. Revenue dropped from $4.74 billion in Q3 to $4.66 billion in Q4. Meanwhile total expenses rose more than 10% from $1.64 billion in Q3 to $1.81 billion in Q4. As a result, earnings dropped a whopping 24.5% from $2.99 billion in Q3 to $2.26 billion in Q4. My expectation is for earnings to drop even further in Q1 2021. Many knowledgeable investors may have chosen to buy puts because of where Rocket is going, rather than where it has been.
2. Gain on sale margins are shrinking. Looking backward for reference, COVID, and the Federal Reserve’s response to it, caused mortgage rates to plummet, creating so much demand that mortgage originators couldn’t keep up. They literally didn’t have the personnel to handle the demand and couldn’t hire and train people fast enough. Thus, originators restricted mortgage demand by maintaining their offered rates rather than decreasing them in step with their funding costs. This wasn't just of benefit to Rocket, it occurred across the space resulting in less price competition and much higher gain on sale margins when they sold a loan. Also, we are not talking they made 30 or 40% more profit from loans, but more like 300% to 400% more than the normal profit. Rocket processed more than twice the number of loans, with more than a 60% increase in profit per loan, and without anywhere near as much an increase in processing costs being necessary. The firm went from 3.23% gain on sale margin in Q2 2019 (already a strong spread) to 5.19% in Q2 2020, and closed loan volume increase by 126%. However since then, gain on sale margins have been dropping, from 5.19% in Q2, to 4.52% in Q3, and now to 4.41% in Q4. They are expected to drop further to 3.75% in Q1 and based on the trend and potential for increased competition, I expect them to drop further to below 3% in Q2. Visually, one can see this trend by comparing the 30-year mortgage rate (rate sold) to the 10-year Treasury rate (proxy for funding cost).Understand, mortgage rates have now risen back above 3%. So, while this is still a great rate historically, its significantly higher than the 2.375% and 2.5% 30 year fixed mortgage rates we have been seeing. It’s only logical that higher rates will result in lower origination volume even as all the originators including Rocket have been ramping up personnel and capacity. That will result in increased price competition, much less gain on sale margin, higher processing costs as a percentage of revenue, and in turn, declining profits.
3. Insider pre-IPO shares just unlocked. Rocket's IPO occurred a little more than 6 months ago. This means a lot of early investor shares (for example Dan Gilbert's units) were unlocked the first week of February, but they couldn’t convert and sell because then they were in blackout for Q4 earnings. Now that earnings have been released, insiders who prepped the situation will be free to start selling on Tuesday, March 2^nd. Believe me, Dan Gilbert and other inside shareholders will be very aware of spreads and refi volumes starting to come back to earth.
4. There are a lot more shares “behind the scenes’” than many are aware of. This one's a little harder to understand, but also key. Some individual investors may think Rocket only has 115.4 million shares outstanding. After all, this is exactly what Yahoo and other popular services show. However, those are only the class A shares, representing a mere 6% of the true diluted share count. What is not being counted in that 115.4 million number is pre-IPO unit holdings and class D shares, which in combination can be converted into an additional 1.8 billion class A shares and sold (See 10Q, page 38, item 14). That’s right, the market holds a mere 6% of the total share count while insiders hold 94%. (Dan Gilbert owns most of these, roughly 73% of the firm.) This is why you will see the market cap listed as $80 billion, not $4.8 billion (=$41.60*115.4 million shares). So, if insiders convert and sell even 10% of their holdings the outstanding share count more than doubles. I note almost 100 million shares traded hands between 9:15am and 12:45pm ET today without much movement in the stock price. One potential explanation of this could be insiders utilizing limit orders to sell.
5. Competition for shareholders in the space is growing. Not only have Rocket (RKT) and Guild (GHLD) already joined Flagstar (FBC), Mr. Cooper (COOP), PennyMac (PFSI) and Impac (IMH) to go public, but a whole slew of other originators are looking to do so. These include:
   1. United Wholesale Mortgage (went public via SPAC UWM Holdings 'UWMC')
   2. Finance of America (went public via SPAC Replay Acquisition 'RPLA')
   3. Caliber Home Loans (delayed in October but 'HOMS' is still pending)
   4. LoanDepot.com (filed registration statement to go public with SEC)
   5. AmeriHome (updated registration statement to go public with SEC)

This is future competition for the mortgage space investor dollar.

When considering a purchase of RKT understand the rose may be off the bloom here and insiders may be filling your order. When industry investors begin their 'cashing out' process, individual investors should think twice before taking the opposite side of the transaction.

Takeaway: Should you invest in Rocket Companies stock?

Rocket is a fine mortgage company operated by capable and experienced management. They may be able to achieve the holy grail of the lending world, capturing loyal return customers for all their major financing and transaction needs. However, they are now priced as if they already did.

Thus one must ask, is now the time to entrust Rocket managers with our hard earned dollar? Sometimes investing is all about timing, and now is not the time to invest in this mortgage company. Origination volumes are falling, competition is increasing, margins are coming down, and profits will suffer. In the boom-and-bust world of mortgage origination there is a time to get in and a time to get out.

Analyst’s Disclosure: I am/we are short RKT. 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.

Darren bought RKT puts. I would not suggest naked shorting of the name due to the unlimited loss potential of making that kind of investment during a short squeeze. RKT is a speculative stock. I do not know your goals, risk tolerance, or particular situation; therefore, I cannot recommend any specific investment to you. Please do your own additional due diligence.