Rocket Companies (RKT), which owns Rocket Mortgage and Quicken Loans, faces margin compression and lower earnings. The reason is home refinancing volumes and new mortgage applications are drying up.
Rocket Mortgage is a massive direct-to-consumer mortgage lender. It uses the same business model as Geico uses to sell car insurance without agents. However, this is not profitable enough to prevent RKT stock from dropping even further.
The reason is, as the Wall Street Journal just reported, new mortgages are down 25% from a year ago. This is based on data released by the Federal Reserve Bank of New York on Tuesday, Sept. 10. This is mainly because new refinancings are down 40% year-over-year, and purchases mortgages issued are flat. The WSJ said this is due to the two rate hikes by the Federal Reserve, the latest being a 50 basis point hike on May 4.
As a result, Rocket Companies is hurting. It makes most of its money by flipping mortgages it generates. Rocket Mortgage and/or Quicken loans flip the loans they generate within a few days after they close them. This is called “Gain on Sale” (GOS) revenue, and it is down significantly.
In addition, Rocket keeps the right to service the loan (MSRs or mortgage servicing rights). This MSR revenue is steady but not as fast-growing as GOS revenue. Historically, MSR revenue has been Rocket’s second-largest line of business. But the GOS revenue is dropping so dramatically that the MSR line might actually overtake GOS. That is not a good sign for RKT stock.
Poor Results At Rocket Companies
On May 10, Rocket Companies reported that its GOS revenue fell to $687.17 million, now lower than its MSR revenue at $796.6 million. This is the first time the GOS fell below the MSR line, as last quarter its GOS line was $993.5 million vs. $926.8 MSR revenue. This implies that over time the MSR line of revenue could tank as well.
Moreover, the underlying reason is that its GOS revenue margins have fallen. In Q1 they fell from 3.74% down to 3.01%. As rates rise, the company can’t cover the increase in its funding cost gains as fast. Moreover, the volume of mortgages it generates is starting to crater. People are stepping back from refinancing and buying homes.
Where This Leaves RKT Stock
The problem for RKT stock is that there is still no end in sight to further rate increases. Today, the Bureau of Labor Statistics reported that inflation is stubbornly high at 8.3% over the last 12 months. As a result, the Fed is going to have to keep raising rates to destroy inflationary expectations.
As a result, it’s very possible that RKT stock could fall further and could easily fall below its book value. As of March 31 that was down to $8.7 billion, down $1 billion in 3 months from the end of Dec. 31, 2021.
Given that RKT stock's market cap right now is $15.5 billion, that implies that it could fall 43.8% just to reach a 1.0x price-to-book value multiple at $8.7 billion.
In addition, book value may keep falling, I estimate RKT stock could fall 50% from here. Value investors typically want to see a margin of safety. They like to wait until a stock trades for two-thirds of its book value. So for the time being, the defensive investors will take a pass until it falls 50 to 60% more at $3.00 to $3.50.
What Can Investors In RKT Stock Do?
First, investors who are already in the stock might be willing to average down and keep lowering their basis in the stock as it falls. Another strategy, which can be done in conjunction with this is to sell covered calls.
For example, for every 100 shares owned you can sell 1 out-of-the-money call option some weeks in the future. Here is an example of how that could work. Look at the table below.
This shows that one month out, the June 17 calls allow you to sell your 100 shares at a price of $8.99. That is over 22% higher than today's price. In addition, you receive, at the mid-point 20 cents per share, or $20 per contract (before expenses). That goes into your account and stays there immediately.
This is effectively a hedge that provides a 2.7% dividend (i.e., $0.20/$7.33) on today's price of $7.33. If RKT stock does not rise to $8.99 before the June 17 close of business, your shares won't be sold. If the stock goes over that price you get to sell them at $8.99 and keep the capital gain.
In effect, you get to receive a hedge over the next month. This helps you keep your stock and weather the storm if RKT stock keeps falling.
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This is not financial advice and you should not rely on my analysis to buy or sell any stock. I am not undertaking to induce you to buy or sell any securities.
I am relying on the “publisher’s exclusion” in the Investment Advisers Act of 1940 to provide this information without any personalized or individualized investment advice.