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Could Rocket Companies Be a Millionaire Maker Stock?

By Brent Nyitray, CFA – Oct 15, 2020 at 9:15AM

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Is Wall Street underestimating the opportunity of this financial services company?

The year 2020 has been a memorable one for mortgage originators. The COVID-19 crisis prodded the Federal Reserve to cut interest rates down to the floor, which triggered a massive refinancing boom. Black Knight Financial estimates there are 19.3 million "high quality" refinance opportunities out there, which works out to be roughly $8 trillion in potential volume.

There are only a limited number of companies currently operating that will have the wherewithal to take advantage of this opportunity. One of them is Rocket Companies (RKT 0.12%). During the summer, this parent company to Quicken Loans and Rocket Mortgage went public at $18 per share.

Could this refinancing boom in the making help Rocket Companies become a millionaire-maker stock? 

Image of a rocket launch

Image source: Getty Images.

Rocket Companies' business model is different

Rocket Mortgage is not your typical mortgage originator. The Rocket Mortgage App is much more than a marketing gimmick to appeal to millennial-age and younger borrowers. The app allows Rocket to be a more profitable originator than the typical mortgage banker. This is because one of the single biggest expenses for mortgage originators is commission payments for loan officers. The mortgage loan officer typically finds the borrower and then takes the borrower through the entire loan process until closing. This involves helping the borrower gather the necessary paperwork, liaising with the mortgage operations staff, dealing with the inevitable hiccups that happen, and then showing up to the closing table. The typical loan officer then will get paid anywhere from 0.5% to 2% of the loan amount.

Rocket Mortgage uses the app to find the borrowers who then upload all the necessary information electronically and without the intervention of a traditional loan officer. Rocket doesn't really need loan officers, which represents huge operational savings. By automating most of the loan process, Rocket can take advantage of economies of scale. This advantage translated into a profit of 4.79% in the second quarter of 2020. The Mortgage Bankers Association (MBA) estimates that the typical mortgage banker made 1.67% in profit. 

Another 6 years of record volumes?

Black Knight Financial's estimate of 19.3 million high quality loans is based on a few constraints: The borrower's credit score must be above 720, the borrower must have at least 20% equity in the home, and the borrower must be able to lower the rate by at least 0.75%. If the credit and equity constraints are removed, the Black Knight estimate rises to 32.4 million potential mortgages (or about 75% of the entire mortgage universe) that can lower their rate by 0.75%.

The MBA is forecasting that roughly 5.5 million refinancings will happen this year. With the industry more or less operating at capacity, that suggests that the mortgage borrowing boom has anywhere from three to six more years to run. The MBA estimates that refinance volume will slow in 2021 as interest rates potentially rise. The questions are whether rates will actually increase and what the catalyst will be. The Fed's latest forecast shows the Fed Funds rate stuck at its current range of 0% to 0.25% through 2023. In addition, the Fed is buying Treasuries and mortgage-backed securities to keep longer-term rates low. 

The Fed is on your side

The only thing that will start to put upward pressure on longer-term interest rates is a resurgence of inflation. So far, the Fed is more concerned about low inflation than high inflation. Fed Chairman Jerome Powell has stressed that the Fed is targeting an average rate for inflation. Since inflation has been well below the Fed's 2% target for years, it will need to let inflation run higher than 2% in order to get the average to 2%.

Note that the Japanese Central Bank has been trying (and failing) for a generation to create inflation in that country. The Fed is running the same playbook, and low inflation (and 0% interest rates) for an extended period of time is a distinct possibility.

For a company like Rocket, that means the refinancing boom may indeed have many more years to run. 

The Street is betting the party ends early

Rocket Companies is currently trading at seven times its expected 2020 earnings. Wall Street analysts expect 2021 earnings per share to decline by more than 50%. For earnings per share to decline by that much, refinance activity needs to dry up. Since the industry is operating at close to capacity, there is little competitive pressure to lower rates.

If Black Knight is indeed correct, and 32 million borrowers can cut their mortgage rates by 0.75%, and rates stay at current levels, then we have potentially another six years of activity. Since Rocket is so much more profitable, it can continue to grow by taking share. Analysts seem to be betting that rates are going to increase despite everything the Fed is saying.

While Rocket stock is trading at a higher multiple compared to competitors like PennyMac Financial Services or Mr. Cooper, its different business model probably warrants that premium. Regardless, if we are at the beginning of a multi-year refinance boom, a P/E of 7 is probably on the low side.

Investors who take the Fed guidance at face value will probably be rewarded. If the company finally starts trading at fintech-level P/E rates, Rocket could indeed be a millionaire-maker stock.

Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Stocks Mentioned

Rocket Companies Stock Quote
Rocket Companies
$8.26 (0.12%) $0.01
PennyMac Financial Services Stock Quote
PennyMac Financial Services
$58.59 (2.63%) $1.50
Mr. Cooper Group Inc. Stock Quote
Mr. Cooper Group Inc.
$43.25 (2.08%) $0.88

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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