I remember talking to an older investor before the Rocket Companies (RKT 1.23%) initial public offering in August 2020, and I asked him for his thoughts on the stock's potential. He said mortgage bankers will always break your heart.
After seeing the stock of so many mortgage banking firms, including Rocket, get pummeled over the past year or so, it's easy to see why he would think that way. Rocket stock is trading down nearly 68% from its 52-week high but is trading basically flat year to date. Is it time to consider this stock as a turnaround play? Or is it time to give up on its potential for outsized growth?
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Technology without the tech multiple
It is tempting to look at a fintech and wonder why a market leader in financial technology like Rocket can't get a higher multiple. Rocket was the pioneer in using technology to engage the borrower, and the saying "push button, get mortgage" is a powerful marketing tool. Its technology gives it a much lower cost of production than other lenders.
Instead, mortgage banking companies seem to always trade at a deep discount to the average market multiples. Rocket is expected to earn $1.18 per share this year, which could be a difficult year for the industry, given that the Federal Reserve is raising rates. This means Rocket is trading at just under 12 times (depressed) earnings per share. If you look at 2021 earnings, Rocket is trading at six times trailing earnings per share. If you compare that to a bank, it is a deep discount.
Why don't mortgage bankers get any love?
Earnings are highly volatile
The answer is evident in Rocket's earnings release. Mortgage banking earnings are highly volatile. In 2020, the stock earned $4.16 per share. In 2021, it earned $2.26, and the Wall Street estimate for 2022 earnings is $1.18 per share. This is a massive swing in earnings, and most financials generally have steady earnings over the economic cycle.
Mortgage banking earnings are driven by two things: volume and margin. In 2020, when the COVID-19 pandemic caused the Fed to dramatically lower interest rates, a massive refinancing boom was kicked off, and demand overwhelmed capacity. This meant that mortgage bankers had all the business they could handle without cutting fees and margins. In other words, that $4.16 per share that Rocket earned in 2020 should be considered a high-water mark for the foreseeable future.
Earnings are declining as we head into a down year
In the fourth quarter of 2021, Rocket's origination volume fell by 29% year over year to $75.9 billion. Gain on sale, which is the gross margin for a mortgage bank, fell from 4.41% to 2.8%. The gain on sale margin (actual dollars) fell from $4.2 billion to $1.9 billion. While Rocket might not be considered a cyclical stock per se, its earnings are highly cyclical. This means that its multiple can be mid-single digits during good years and will expand during tough years.
Rocket has a lot going for it besides the mortgage origination operations. It has been expanding into real estate and financial services, which should help reduce earnings volatility. These ancillary services include title insurance, auto loans, and tech solutions. It recently bought Truebill, which helps consumers manage online subscriptions, among other services. This allows Rocket to maintain contact with potential borrowers and cross-sell different products.
Rocket also announced a special dividend of $1.01 per share, the second such dividend they have paid. The company does not pay a regular dividend but has returned cash to shareholders via buybacks and special dividends.
Investor takeaway
Rocket has been one of my CAPS picks, and I have been dead wrong about it. It's still a relatively young company and I like it long-term, and the failure of me-too app-driven lenders to launch makes me think Rocket's first-mover advantage is real. But I also now think Rocket will probably never garner a fintech-comparable valuation multiple. The best that investors can hope for is the price-to-earnings ratio again expanding as earnings volatility declines.
