Rocket Cos. (RKT 1.30%), the parent of Quicken Loans, launched into the market this week after pricing its initial public offering at $18 per share. With the help of the Federal Reserve, the mortgage origination industry is in the midst of a feast, with massive refinance opportunities for millions of mortgages. Rocket is certainly striking while the iron is hot. But does that mean the time is right to invest?
Image source: Getty Images.
It's the largest mortgage originator in the U.S. ...
Rocket originated $145 billion of mortgages in the U.S. last year and earned $894 million in net income, making it the nation's largest mortgage originator. Most of Rocket's origination is done in-house, which is a much different business model than most large originators, which buy a good chunk of their production from smaller lenders. The company has been taking share for years. In 2009, Quicken had a 1.3% share. In the first quarter of 2020, it had a 9.2% share.
Quicken pioneered the digital mortgage with its Rocket Mortgage app, which allows the borrower to apply, interact with the Quicken team, e-sign documents, make payments, and upload documents. This technology creates a sticky relationship with clients. In 2019, Quicken achieved retention levels of 63%, compared to the industry average of 22%. Digitizing the origination process also lowers costs and cuts down on errors. So the app has more than just revenue-gathering potential; it can also help increase profitability.
... But the IPO pricing was downsized
The initial price talk for the deal was for the company to issue about 150 million shares at a price of $20 to $22 per share. The IPO was then downsized to 100 million shares at $18 per share. The stock performed well on the first day of trading, rising steadily all day to end up at $21.64, or a 20% premium to the IPO price. So, despite the nice first-day pop, the offering was cut by roughly 43%. That fact should be kept in the back of your mind. Quicken was shopped to pretty much every professional investor on the street. While it is entirely possible that the initial goal of selling $3.1 billion in stock was unrealistic, generally speaking a cut of that size is not a good sign.
Also note that Rocket uses the same kind of dual-voting-class structure we've seen in companies like Alphabet and Facebook. There are basically two classes of Rocket stock: Class A, which was sold to the public, and Class D, which is not publicly traded and is controlled by founder and board chairman Dan Gilbert. The Class D stock has 10 votes per share, while the Class D has one vote per share. This means outside shareholders won't have much say in how the company is run. On one hand, management isn't subject to short-termism, but on the other hand, unhappy shareholders don't have many options other than selling out.
Valuation issues
It might help put Rocket in perspective if we compare it to PennyMac Financial (PFSI 1.10%). Rocket is a larger originator in terms of volume; using 2019 numbers, it beat PennyMac $145 billion to $118 billion. So in terms of volume, PennyMac originates about 81% of what Rocket does. Both reported similar year-over-year growth in origination of around 75%. Rocket is more profitable, however, earning net income of 0.62% on that volume, versus PennyMac, which earned 0.33% of volume. This means Rocket's net income is just over twice what PennyMac earns.
Rocket earns more margin on loans, as well, although that is a function of its business model. Quicken is primarily a retail shop (in other words, making its own loans), while PennyMac is an aggregator, which means it mainly buys completed loans from smaller originators and then resells them. Retail margins are higher, as is compensation. Retail shops also have big marketing budgets that the aggregators don't require.
Now take a look at the valuation difference. While Rocket earns twice what PennyMac earns, its market cap is over 10 times PennyMac's. Rocket trades at a price to earnings ratio of almost 50. For a financial stock, that is gargantuan.
| Market cap | 2019 volume | 2019 P/E ratio | |
|---|---|---|---|
| Rocket | $43 billion | $145 billion | 48 |
| PennyMac | $4 billion | $118 billion | 10 |
Source: Company filings.
Mortgage origination is a pedestrian business that is highly sensitive to interest rate movements. It is incredibly competitive and there really isn't much magic to it. The Rocket App is the sizzle to the mortgage origination steak. Rocket may have found a better way to make widgets, but it still is in the widget business. When the Federal Reserve starts hiking rates, Rocket will see a drop in volume just like everyone else.
Should you put Rocket under contract?
For investors, the environment for origination is the best it has ever been. The potential for improvement is therefore limited, and it pays to keep that in mind. You are paying for steak and sizzle. Ultimately, the investment decision comes down to how much you are willing to pay for the sizzle.
If you value Rocket using traditional financial stock metrics, it will look overvalued. But so is Tesla compared to Ford. So was Amazon compared to Barnes and Noble when it came out over 20 years ago. The market is often willing to pay more for an innovator or a leader, so don't assume a high valuation here will make for a lousy investment. But don't forget: The IPO was downsized by 43%. Many professional investors simply didn't find the valuation that enticing.
