Rocket companies (RKT), which owns Rocket Mortgage and Quicken Loans, is facing squeezed margins and falling profits. The reason is that real estate refinance volumes and new mortgage applications are drying up.
Rocket Mortgage is a leading direct-to-consumer mortgage lender. It uses the same business model as Geico uses to sell car insurance without agents. However, this is do not profitable enough to keep RKT’s stock from falling even further.
The reason is, as the The Wall Street Journal just announced, 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, September 10. This is mainly due to new refinances being down 40% year-on-year and purchases of issued mortgages being flat. The WSJ said this was due to the Federal Reserve’s two rate hikes, the latest being a 50 basis point hike on May 4.
As a result, Rocket Companies is suffering. He earns most of his money by flipping the mortgages he generates. Rocket Mortgage and/or Quicken loans return the loans they originate within days of closing. This is called “gain on sale” (GOS) revenue, and it is down significantly.
Additionally, Rocket retains the right to service the loan (MSR or Mortgage Service Rights). This MSR revenue is stable but not growing as fast as GOS revenue. Historically, MSR revenue has been Rocket’s second largest line of business. But GOS revenues are falling so dramatically that the MSR line may actually overtake GOS. This is not a good sign for RKT stocks.
Poor results at rocket companies
On May 10, Rocket Companies announced that its GOS revenue fell to $687.17 million, now below its MSR revenue of $796.6 million. This is the first time the GOS has fallen below the MSR line, as the last quarter its GOS line was $993.5 million against $926.8 MSR revenue. This implies that over time, the MSR revenue line could also drop.
Moreover, the underlying reason is that its GOS revenue margins have dropped. In the first trimester, they went from 3.74% to 3.01%. As rates rise, the company cannot cover its increased earnings on financing costs as quickly. Moreover, the volume of mortgages it generates is starting to plummet. People are pulling out of refinancing and buying homes.
Where That Leaves RKT Stock
The problem for RKT stocks is that there is still no end in sight for further rate increases. Today, the Bureau of Labor Statistics reported that inflation has been stubbornly high at 8.3% over the past 12 months. As a result, the Fed will have to keep raising rates to destroy inflationary expectations.
As a result, it is very possible that RKT stock will fall further and easily fall below its book value. As of March 31, this amount had fallen to $8.7 billion, down $1 billion in 3 months from the end of December 31, 2021.
Given that the market capitalization of RKT stock is currently $15.5 billion, this implies that it could drop 43.8% just to reach a price-to-book multiple of 1.0x at 8.7. billions of dollars.
Also, the book value could continue to drop, I estimate RKT stock could drop 50% from here. Value investors generally want to see a margin of safety. They like to wait for a stock to trade at two-thirds of its book value. So for now, defensive investors are going to let it drop until it drops 50-60% further to $3.00-$3.50.
What can investors in RKT shares do?
First, investors who are already in the stock might be willing to lower the average and continue to lower their base in the stock as it falls. Another strategy, which can be implemented in conjunction with this, is to write covered call options.
For example, for every 100 shares you hold, you can sell 1 out-of-the-money call option a few weeks later. Here is an example of how it could work. Look at the table below.
This shows that a month later, calls on June 17 allow you to sell your 100 shares for $8.99. That’s over 22% more than today’s price. In addition, you receive, at the midpoint, 20 cents per share, or $20 per contract (before expenses). It goes into your account and stays there immediately.
This is actually a hedge that provides a dividend of 2.7% (i.e. $0.20/$7.33) on the current price of $7.33. If RKT stock does not reach $8.99 before the close of business on June 17, your shares will not be sold. If the stock goes above that price, you can sell it at $8.99 and keep the capital gain.
In effect, you receive coverage during the following month. This helps you hold onto your stock and weather the storm if RKT stock continues to drop.
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This is not financial advice and you should not rely on my analysis when buying or selling stocks. I do not undertake to encourage you to buy or sell securities.
I rely on the “editor’s exclusion” of the Investment Advisers Act 1940 to provide this information without any personalized or individualized investment advice.