On the surface, Detroit-based Rocket Companies (NYSE:RKT) is what contrarian investors would consider an ideal company. Formerly known as Quicken Loans, it is one of the largest mortgage lenders in the U.S. Its business consists of personal finance and consumer service brands. RKT stock is down nearly 22% year-to-date.
Contrarian investing is about buying a stock when most investors are selling it, thinking that potentially mispriced equities are an opportunity for gains. The same applies to selling stocks, as contrarian investors actively go against the prevailing market patterns. Stocks that are out of favor now may fall into favor soon, and that would boost their share price for a nice profit.
RKT stock seems cheap with a trailing 12-month (TTM) price-to-earnings (P/E) ratio of 5.37x, according to Yahoo! Finance. Comparatively, the S&P 500 index is estimated to have a TTM P/E ratio around 34x.
Some might see RKT stock as a bargain. However, I do not fully agree — there are several factors at play that investors should consider before buying these shares.
RKT Stock’s Relative Valuation Is Mixed
A P/E ratio itself is not the only indicator of whether a stock is cheap or expensive. It is always advisable to rigorously check other key financial metrics.
Comparing the relative valuation of RKT stock to the rest of the banking services industry, we get mixed results. RKT stock has a price-to-sales (P/S) ratio of 1.9x, which is less than the overall industry’s P/S ratio of 2.1x.
But when we compare Rocket Companies’ price-to-book (P/B) value of 61.9x and price-to-cash-flow ratio of 3.2x to the banking services industry, which has a P/B value of 0.9x and price-to-cash-flow ratio of 2.1x, we get another story. These numbers indicate RKT stock is relatively overvalued.
Also, Rocket Companies sports a worrying debt-to-equity ratio of 4.91x. That’s much higher than the industry’s debt-to-equity ratio of 2.66x.
RKT stock’s price drop throughout 2021 shows investors are reluctant to to buy into the company. But there are more aspects of the stock to consider besides the numbers.
The Business Is More Than Just Mortgages
Rocket Companies owns several brands, including its flagship Rocket Mortgage, fintech-focused Nexsys Technologies and Rocket Homes, a real estate search platform. The company also offers a virtual car marketplace, an advertising brand and client services.
To diversify even more, Rocket Companies announced that it will enter the solar energy industry by providing financing and installation services.
While this is an interesting market opportunity to explore, the main focus of Rocket Companies is still mortgages. And what happens to its core business if the U.S. housing market becomes weak?
For context, mortgage lenders make money through several avenues, including mortgage-backed securities, loan servicing and loan closing fees.
But they get most of their funds through yield spread premiums. According to SFGate, “This is the difference between what they charge you in interest and what they pay in interest for replacing the money.”
RKT Stock and the Booming Housing Market
RKT stock is and will be largely impacted by how it achieves and sustains high yield premiums. Looking ahead, the Federal Reserve has announced that interest rates might rise in 2022. But depending on market conditions, tapering might begin by the end of 2021.
The 30-year fixed-rate mortgage average in the U.S. is near historic lows since its peak in 1981. On Oct. 7, it was 2.99%. If interest rates are set to rise, what does this tell us about the U.S housing market and the business prospects of Rocket Companies?
Could it be that now is the best time to refinance a former mortgage or lock in an attractive rate to buy a home? If new or existing homeowners do this, it will add more revenue to Rocket Companies in the form of loan servicing, closing fees and mortgage-backed securities.
Looking at the industry’s performance in 2021, existing home sales are weak compared to last year. Mortgage applications are also down from last year, especially since this summer. On top of that, the U.S. house price index has skyrocketed since 2018.
On Sept. 2, a CNBC article attributed the housing market’s recent activity to the Covid-19 pandemic:
“During the pandemic, home prices have climbed at a record pace. The median price for an existing home reached over $363,000 in June 2021, a 23.4% year-over-year increase.”
If this strong trend persists, then RKT stock may benefit as well.
The Bottom Line on RKT Stock
I am skeptical about one or two factors. The 2020 annual report for Rocket Companies showed huge adjusted revenue growth of $16.9 billion compared to adjusted revenue of $5.9 billion in 2019. But the net income of $9.4 billion fell to only $198 million after deducting net income attributable to non-controlling interest.
I would like to see the net income attributable to Rocket Companies increase in the next quarters and years. Additionally, its 2019 and 2020 operating activities produced a net cash loss. In the future, I would look for Rocket Companies to earn cash through its operations.
My verdict on RKT stock is that despite its robust revenue growth, I have considerable doubts as to whether it’s a worthwhile buy. The U.S. housing market is not cheap now, and although it might not be a bubble, I would wait and see how the company handles rising interest rates.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.