Rocket Companies (NYSE: RKT) made its public debut in early August with much promise. After pricing its IPO at $18 a share and raising $1.8 billion in cash, optimism surrounding the parent of Quicken Loans and Rocket Mortgage sent the stock price nearly 50% higher by the start of September -- only for it to be grounded again after its second-quarter 2020 earnings report failed to fuel further upside.
As of this writing, Rocket stock trades for a meager 9.4 times trailing-12-month earnings. It looks like a real bargain, one that would even be worth buying if the market has tough times ahead of it. However, "cheap" is generally cheap for a reason.
Rocket's services have become synonymous with tech-driven home loans online, a growing industry. But it's also a highly cyclical industry that goes through bouts of contraction, which means much leaner times lie ahead for Rocket at some point.
The Federal Reserve's zero-interest-rate gift
Rocket's closed loan origination volume during the spring 2020 months was $72.3 billion, up 40% from the first quarter of the year and 126% from the same period in 2019. Thanks to a massive gain on the sale of loans (since Rocket doesn't maintain and service all of the loans it writes), the resulting total revenue was $5.04 billion and net income was $3.46 billion. With a 69% net profit margin, this stock looks like a slam dunk.
But it's not quite that simple. The home mortgage industry is a highly cyclical one. The reason the appropriately named Rocket Companies' results have rocketed higher this year is due to a surge in refinancing activity as the Federal Reserve has lowered interest rates back to near-zero to combat the COVID-19-related economic downturn -- resulting in historically low mortgage interest rates. Put simply, the high volume of loans (and fees Rocket earns when it processes them) isn't going to last forever. The good news is the Fed has no plan to raise rates in the coming years, but eventually, the torrid pace of home loan refinancing will slow.
Even though publicly reviewable business results on Rocket only go back to 2019, it's still enough information to illustrate this point. In early 2019, interest rates were higher than they are now, a product of the Fed raising short-term rates from nearly zero in 2015 to as much as 2.5% through the summer of 2019. And through the first half of 2019, Rocket's revenue was only $1.57 billion -- much less than it was in a single quarter so far in 2020 -- producing a net loss of $353 million. In other words, this is not the all-out growth stock it may appear to be on the surface and explains the seemingly cheap stock price.
Don't expect refinancing alone to take Rocket to the moon
Nevertheless, this isn't to say Rocket isn't a growing business. The mortgage industry is still very fragmented, and the company's goal is to command a 25% share of the market (it claims 9% right now) by offering the convenience of internet-based service. If successful, a higher market share will help offset an eventual easing of the refi boom for Rocket.
Along the way, the company has ample assets to promote its expansion. At the end of June, it had $1.72 billion in cash and equivalents (not including proceeds from the IPO), $17.6 billion in mortgages held for sale, and $2.24 billion in debt. In early September, Rocket did some refinancing of its own, raising an additional $2 billion via debt to retire $1.25 billion in higher interest rate liabilities on its balance sheet.
Rocket is using its lead in tech-driven home lending to invest in the continued development of the industry, and has its hand in other adjacent businesses as well, like real estate valuation and title insurance (via Amrock), and property and real estate agent search (Rocket Homes).
Its stock isn't priced like other financial technology firms, but Rocket Companies is nonetheless a disruptive force that looks poised to continue its expansion. But if the recent surge in home loan activity suddenly dries up, Rocket's stock won't look as cheap as it does right now. Thus, I don't think it's a safe buy that will offer investors downside protection in case of a market crash, nor will it offer a sustained pace of high-growth revenue like it has posted so far in 2020.
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Nicholas Rossolillo has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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