Rocket Companies: Beware, Short-Squeezers - The Law Of Supply And Demand Has Not Been Overturned
- The recent short squeeze is not a sign of a permanently higher stock, but an aberration.
- Mortgage banking supply and demand is increasing out of balance.
- Demand will drop 40% or so as the current refi boom dies.
- Meanwhile, competition is increasing.
- The result is rapidly declining profit margins along with declining volume.
I wrote my first piece on Rocket Companies (NYSE:RKT) for Seeking Alpha several weeks ago. My article said that while I believed Rocket Mortgage was a very well-run company, the supply/demand dynamics of the mortgage banking business were turning quite negative. In my view, the stock didn't fully reflect that problem. I therefore recommended waiting for a lower entry point to invest in the stock.
Several commentators on my article pointed out that the publicly traded stock (only 6% of total shares, the rest held by the founders) was heavily shorted, and as such subject to a short squeeze. Boy were they right; the stock nearly doubled in the last hour of trading on March 2, apparently after this fact was noted on CNBC.
Dear reader, I am a value investor. I don't watch 90-day moving averages. I don't care about insider buying or selling. I don't check momentum or what's being said on Reddit. If that's how you roll, Godspeed, but I am of no help. As a value investor I focus on one issue - what is the present value of my estimate of future earnings of the company? If the present value I calculate exceeds the current stock price by a sufficient margin, I buy. If the reverse, I at least consider shorting. That's it.
The March 2 short squeeze certainly made a lot of money for those holding the stock at the time. But I strongly suggest that if you still own it you should sell it. The present value of Rocket's future earnings does not come close to justifying the current stock price of, at last look, $28. The problem remains the growing supply/demand imbalance for mortgage banking.
The mortgage banking demand problem - Refis are dying
A mortgage banker gets to originate a home mortgage loan for one of two reasons - a home purchase or the refinance of an existing loan. Since Q2 of last year both have been on a tear, largely because massive Fed easing took the 10-year Treasury rate from 1.9% at the start of 2020 to a low of 0.5%, which in turn took the 30-year mortgage rate from 3.7% at the start of '20 to a low of 2.7%.
But things change. The 10-year Treasury yield is now 1.5% and the mortgage rate is 3.0%. Refinancings disappear very quickly after interest rates hit bottom. In the last three refi booms - '03, '08 and '12 - refis peaked within two quarters of the interest rate bottom. Fannie Mae expects the same for this refi cycle:
Source: Fannie Mae
As a result, even with an assumed continuation of strong home sales, mortgage origination volume will have to decline, and by a lot. From Q4 '20 to Q4 '22 Fannie Mae expects a 40% decline in mortgage origination volume. That is the norm, not a special situation. The declines after the '03, '08 and '12 refi booms were 48%, 36% and 48% respectively.
How many businesses do well when business volume drops by 40%? Ask AMC. Or Carnival Cruise Lines. Or Delta.
The mortgage banking supply problem = Competition is booming
An industry's rational response to a large dive in demand is to sharply reduce capacity. But the exact opposite is happening - the main players want to take market share and brash new entrants are appearing. The thing about market share is that in aggregate it always equals 100%. If I want to take some, then someone must lose some. But at present the aggregate market share plans are way above 100%. It starts with Rocket itself:
"We will continue to invest significantly in our brand, technical capabilities and our award-winning client experience, which we expect will support a considerable increase in our market share…" (Rocket Companies S-1)
"At about 8% to 9%, Rocket still has a way to go to meet its goal of controlling a quarter of the mortgage market by 2030." (CNN Business, November 12, 2020)
Then two of its largest competitors:
United Wholesale Mortgage: "…That's helped us become the number two overall mortgage lender and, hopefully soon, we'll become the number one overall mortgage lender…" (Q4 conference call transcript)
LoanDepot: "We now possess roughly 3% market share of annual mortgage origination volumes…Thanks to our brand investment over time, we are also one of the most recognized brands in the industry today. All of this gives us enormous runway." (Housing Wire)
Then some smaller competitors:
Guild Mortgage: "We believe that we are well positioned to continue capturing additional origination business through our well-recognized brand, internally-developed technology platform and differentiated position in the purchase market." (S-1)
Better Mortgage: "[The company] is looking to gobble up market share through its tech platform and the convenience it provides prospective borrowers." (Housing Wire, November 12, 2020)
Then the new entrants:
Zillow: "We plan to continue to capture the strong refinance demand to invest in building the factory to scale our operations as the purchase business is built out over time." (Q4 conference call transcript)
Redfin: "You should remember that that business isn't just captive to our brokerage. It's not just a subset of our brokerage to customers…If you couple that with the refinancing opportunities of our customer base, I really think the sky is the limit for mortgage." (Q4 conference call transcript)
Getting the idea? Supply is far from shrinking to meet the soon-arriving decline in demand. It is growing!
The mortgage spread - where supply meets demand
Mortgage banking economics can be complicated; I touched on it in my prior Rocket article. But the most important profit driver is simple - the yield spread between the 30-year mortgage rate and the 10-year Treasury bond rate. The wider the spread, the more profitable the origination. Here is what happened to that spread since the start of 2020:
Sources: Federal Reserve and Freddie Mac
Despite stable and record originations since Q2, the spread has steadily narrowed. The most recent reading of 143 bp has only been narrower 4% of the time since 1999! That shows the power of steadily increasingly competition. What happens when demand drops 40%? Spoiler alert - it won't be good.
Rocket is not immune from the industry trend
Rocket recently reported Q4 '20 EPS of $1.09. Yahoo Finance's survey of Wall Street analysts shows estimates of $0.86 for Q1 (lower) and $0.66 for Q2 (even lower!). The full-year estimate of $2.45 suggests that second half EPS will be even lower still. The current estimate of $1.83 will almost certainly prove to be way too high. $1.00 may be more like it.
Maybe 2023 and beyond will be better? In my view, it probably won't be a lot better. The industry first must wipe out a huge amount of capacity, almost certainly including Rocket. And when will the next refi boom occur? When will the 10-year Treasury bond get to 0.5% or lower? Hard to imagine, with the Federal Reserve creating $2 trillion of new money annually.
That leaves Rocket's EPS well under $2 a share for a long time. The present value of that earnings stream is well under $20 a share.
To conclude, the recent short squeeze on Rocket Companies' stock is not a sign of a permanently higher stock, but a blip on the way down. Wait for a much lower entry point. And sell 'em if you get 'em.
This article was written by
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