On July 12, Jefferies analysts downgraded Rocket Companies (NYSE:RKT) from buy to hold while cutting their price target for RKT stock by 31% to $18.
As I write this, the mortgage originator’s stock is trading at or near the analysts’ target, suggesting it could be dead money over the next 12 months.
The cause for concern? A price war is brewing on the wholesale front that would crush margins. It’s so troubling; the class action lawyers are pounding the pavement looking for plaintiffs to take down the company.
If you’ve owned RKT stock since the initial public offering (IPO) in August 2020, you’re sitting on a small loss. Compared to the 35% gain by the S&P 500, it’s a gut punch, for sure.
But that’s not the toughest part of Rocket’s lack of performance. The real difficulty is deciding what to do at this point. Do you hang tight? Buy some more? Sell completely?
I’ll look at all three options.
You Should Hang Tight
The issue at hand is that it’s hard to know what’s currently happening in the mortgage origination space. But, as my InvestorPlace colleague, Chris Markoch, said recently, RKT stock should be booming given the housing market is relatively robust here in July 2021.
But it’s not. It’s down 12% year-to-date (YTD) through July 16. Investors are trying to figure out who will benefit more from a mortgage market that leans toward new home financing rather than refinancing existing homes.
Markoch reminds readers, with an assist from Ian Bezek, that Rocket competitor UWM Holdings (NYSE:UWMC) would see the greater benefit because it focuses on new mortgage applications.
He concludes his late June article by suggesting Rocket’s future direction is too murky. As a result, investors should stay away until the mortgage marketplace is easier to evaluate.
To a certain extent, I would tend to agree. But, unfortunately, there appears to be little in the way of catalysts to move Rocket’s stock higher at this point.
That would explain why a majority of analysts covering RKT rate it a hold at the moment — 12 out of 16 with a median target price of $19.25 — but if you do own the stock, the fact the target price points to a 10% upside suggests you might want to hang tight until more information is in.
Buy Some More RKT Stock
I learned from the March 2020 correction that it pays to buy on the dip. In Rocket’s situation, I don’t think you can characterize its performance as a falling knife. It seems more like a beginner’s hill at the local ski resort.
InvestorPlace contributor Nicolas Chahine — ranked the number four blogger at TipRanks — pointed out at the beginning of July that every time Rocket’s stock’s fallen below $20, buyers have jumped in to push it back up. Long-term, a trade at current prices should deliver outsized gains because it’s got a strong balance sheet and great fundamentals.
I would argue that he’s right to a point. However, should a price war heat up, those fundamentals won’t appear to be nearly as strong in 12-18 months. So that’s the risk you take at this point.
In late May, I suggested that RKT stock was a good bet in the teens for speculative investors. As long as you buy under $18, I think your downside shouldn’t be more than a couple of dollars.
As Chahine suggests, any good news will quickly push RKT into the $20s.
The third option is to get out while RKT is still in the teens.
How is it possible that the company added $886.5 million in cash to its balance sheet in Q1 2021 and trades at less than 12x cash, yet investors are actually contemplating its stock at less than $10?
Well, consider that United Wholesale Mortgage’s parent sells for 7.9x cash based on a market cap of $12.5 billion divided by $1.59 billion in cash at the end of March. Thus, UWMC is currently valued at a discount of 34% to Rocket on a price-to-cash basis.
So, the question you have to ask yourself is whether Rocket’s deserving of this premium.
If you annualize Rocket’s Q1 2021 net revenue of $4.58 billion, it trades at 1.9x sales. Do the same for UWMC, and you get 2.6x sales based on Q1 2021 net revenue of $1.19 billion. In terms of pre-tax income, UWMC has a pre-tax margin of 73.4% compared to 62.0% for Rocket.
A big part of the difference in margins has to do with total expenses. For example, UWMC’s salaries are 17.9% of net revenue while Rocket’s salaries are 18.4%.
However, the biggest difference is that Rocket’s marketing and general & administrative expenses are considerably higher than UWMC because it has a direct-to-consumer business that requires a lot more leg work and cost but generates far more revenue and profits.
If there’s one thing I’ve learned from companies such as Nike (NYSE:NKE) is that it’s far more profitable to go direct to the end consumer than work through go-betweens.
For this reason, I believe Rocket deserves a significant premium to UWM Holdings.
If you own, do not sell at least until it’s back in the $20s.
On the date of publication, Will Ashworth 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.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.