Mortgage originators tend to not get a lot of respect from Wall Street analysts. The companies are shunned because they operate in highly cyclical business environments, which ebb and flow with changes in interest rates and their direct effect on mortgage rates. Mortgage rates had been dropping steadily throughout 2019 and 2020, but they began to rise again in January of 2021.
Recently, Rocket Companies (RKT 2.01%) reported record first-quarter earnings, and yet the stock sold off heavily on the news. Why did investors slam the company so hard? Was it the recent rise in forecasts on mortgage rates? Or was there something else in the report that caused investor concern?
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Strong Q1 earnings...
Rocket reported first-quarter earnings per share of $1.07 in accordance with Generally Accepted Accounting Principles (GAAP). Revenue rose 236% year over year to $4.6 billion. Adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) rose from $922 million to $2.4 billion. Rocket's adjusted net income surged 170% to $1.8 billion.
...But weak guidance related to falling volume and margins
The reason why investors were so negative on the report revolved around guidance, especially the gain-on-sale margin. Take a look at the table below, which shows Rocket's interest rate lock volume and gain-on-sale margins since the beginning of 2020. Interest rate lock volume is used as a proxy for production volume, while gain-on-sale margin is the gross profit that Rocket makes on each loan.
| Quarter ending ... | Lock volume | Gain-on-sale margin |
|---|---|---|
| March 31, 2020 | $56 billion | 3.25% |
| June 30, 2020 | $92 billion | 5.19% |
| Sept. 30, 2020 | $95 billion | 4.52% |
| Dec. 31, 2020 | $96 billion | 4.41% |
| March 31, 2021 | $94 billion | 3.74% |
| June 30, 2021 (guidance) | $82 billion-$88 billion | 2.65%-2.95% |
Data source: Company filings.
For the quarter ending June 30, 2021, the expected volume is projected to fall 18% at the midpoint of estimates, and the gain-on-sale margin will fall even more. This is a double whammy to gross margins, and that is what drove the negative sentiment on the stock. This would translate into a 32% drop in gross margins based on lock volumes.
It is important to keep in mind that 2020 was the best year for mortgage originators since 2003, so all of the year-over-year comparisons for the rest of 2021 will be difficult.
There are also fears of a price war
Rocket is currently in a price war with rival UWM Corp. (UWMC 3.12%), better known as United Wholesale. United Wholesale told its brokers that they had to choose to do business with either United Wholesale or Rocket. These two mortgage heavyweights were engaged in a price war before COVID-19 began, and the fear is that a new one will begin as business becomes more competitive.
Not all mortgage activity will be affected by higher rates
The rapid rise in mortgage rates over the past four months has reduced the number of loans that will be eligible for refinance activity. While this is certainly a reasonable fear, it ignores the effect of rising home values. Home price appreciation has been hitting double-digit percentages, driven by a shortage of inventory and insatiable demand. Rising home equity makes cash-out refinance activity more attractive.
Home purchase loans are much less rate-sensitive than traditional refinancing loans. Between purchases and cash-out refinances, Rocket estimates that about 50% of its loans are from borrowers who are not rate-sensitive. Finally, Rocket also has some other activities, such as auto loans and sales, closing services, and realty services, that won't be affected by rising interest rates.
Investors are fighting negative sentiment
Analysts expect Rocket to earn $2.29 per share in 2021, which is a 9% decline from the consensus estimate before the earnings announcement. That said, Rocket is trading at 7.7 times the expected 2021 earnings per share. Rocket paid a special dividend of $1.11 per share in March. However, it doesn't currently pay a regular quarterly dividend.
Rocket has made some impressive investments in technology and operations, and in the long term, it will remain the dominant player in its industry. Investors will have to face negative sentiment from mortgage originators for the near term, however.
