Rocket Companies IPO

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Introduction

Rocket Companies (NYSE: RKT), the parent company of Quicken Loans, is a mortgage lender in the US. Its mission (broadly) is to help its clients achieve the American dream of home ownership and financial freedom.

The company was founded in 1985 by Dan Gilbert and has since grown to be the largest retail mortgage lender in America (both online and offline). Today it counts over 20,000 employees and has originated over $1 trillion in loan volume since inception. To get an idea of its scale, on an average day, it processes approximately $1.8 billion in loan applications. But despite its size, it still only represents 9.2% of the $2 trillion US retail mortgage market.

Description

The company boasts a broad ecosystem of products which is best visualised in the diagram below. It consists of its flagship Rocket Mortgage and other home related products, its product extensions (auto and unsecured lending) as well as products offered internationally:

Rocket Mortgage

Rocket mortgage is the company’s flagship product and is really the heart of the company. In 2019, it originated over $145 billion in residential mortgage loans compared to just $25 billion in 2009. A large part of this growth has been achieved on the back of its strong digital offering, where customers can apply for mortgages from its app rather than visiting a bank branch or loan office. Many parts of the banking industry, due to legacy, are still far behind in being able to provide a truly digital end-to-end experience, which has allowed Rocket Mortgage to capture market share.

Digitalisation not only helps attract and retain customers, but it also makes the loan origination process more efficient and thereby more profitable. The company estimates that it is able to process 2.9x the number of loans per production team member compared to the industry average. It is also able to close loans on average within 32 days compared to the industry average of 43 days.

In terms of distribution, the company not only uses direct-to-consumer channels but also a Partner Network to extend its reach. These partners may want to take advantage of the company’s loan servicing capabilities, for example, particularly if mortgages are not their main product (Charles Schwab, American Express, State Farm are partners).

Other offerings with its Home Platform

In addition to Rocket Mortgage, the company provides services that compliment the mortgage origination platform. For example, Amrock is a national provider of title insurance services, property valuations and settlement services. Since the majority of mortgage applications require an independent appraisal, Amrock helps streamline and integrate this process. Additionally, ‘Rocket Homes’ is an online portal where prospective clients can search for homes and find real estate agents. This helps merge the home buying experience with the loan origination process, creating a sort of ‘one stop shop’ for home buyers.

Product Extensions & Geographic Expansion

The company has also branched out from its core mortgage product, into unsecured lending in the form of ‘Rocket Loans’ as well as auto finance in the form of ‘Rocket Auto.’ These extensions are enabled by ‘Rocket Connections’ which is a sales and support platform that provides contact center services. Many of its core strengths (e.g. mortgage loan servicing) can be replicated in these product extensions without large start up costs that a new player would face. Finally, Lendesk and Edison Financial mark the company’s international expansion into Canada, which at the moment has a focus on the home buying experience.

Business Model

The company generates revenue in 4 main ways: gain on sale of loans, loan servicing income, interest income and other income:

1. Gain on sale of loans – since the company has an ‘originate to distribute’ model, it largely makes money on the sale of loans it originates to investors. In other words, it generally does not keep loans on its balance sheet (like European banks) but rather warehouses the loans until it can distribute them. It sells it for a mark up to compensate for loan origination costs such as underwriting and processing fees. 
2. Loan Servicing Income – although the company is not generally a creditor (after it has distributed the loan), it generally still acts as a servicer. It therefore generates fees in servicing loans and other ancillary revenue, such as late fees. 
3. Interest Income – income it earns on mortgages that are held for sale (not yet distributed out). The company generally keeps the average loan on its balance sheet for 20 days before it can turn it around and sell it to investors. 
4. Other income – revenues generated from its complimentary product offerings such as Amrock, Rocket Connections and Rocket Homes. 

Financials

Revenue from the gain on sale of loans is by far the largest component of revenue. In 2019, this revenue stream generated $4.9 billion in revenue, which is up ~70% since 2018. Total net revenue for the company in 2019 was $5.1 billion which corresponded to a net income of $893 million.

The increase in revenue goes hand in hand with the explosion in loan origination volume it has experienced since 2018, mainly fuelled by lower interest rates. In this way, the company is almost like an upside-down bank, as it benefits when rates fall but suffer when rates increase. When rates fall, customers rush to refinance which pushes up origination volumes. However, when rates rise, refinance demand dries up as occurred between 2017 and 2018:

On the positive side, the company does appear to still be gaining market share. In just 3 months, it has increased its market share from 6.7% to 9.2%, which is a testament to the company’s strong product offering. This should help mitigate the impact of increasing rates (at least relative to competitors). Also, its mortgage servicing revenue tends to do better when rates rise, as there are less prepayments.

Ownership Structure

Before getting into the details of the IPO, it’s useful to take a quick look at the ownership structure – since it’s not very straightforward. Rocket Companies Inc is the issuer of the Class A common stock that will be offered to the public. The Class A will maintain a 20% voting power in the issuer, with majority of the voting power (80%) held by Rock Holdings Inc (an entity controlled by Dan Gilbert) and Dan Gilbert himself. However, the issuer only retains an 8% economic interest in the underlying operating subsidiaries (e.g. Quicken Loans) that are owned by RKT holdings inc. In other words, Rock Holdings will retain a 92% economic interest in the operating subsidiaries.

An interesting side note (and not show on the illustration below) is that Rock Holdings Inc owns a number of other operating subsidiaries such as “Dictionary.com” the online dictionary and thesaurus resource. Dan Gilbert is also the majority shareholder of the Cleveland Cavaliers and founder of start up StockX.

Key Features of the IPO

• • The IPO is expected to price tonight (Tuesday 4th August) and begin trading on Wednesday 5th August. Its price range is between $20 and $22 per share. 
  • 150,000,000 shares of Class A stock are being offered of a total 150,322,273 shares of Class A stock (Dan Gilbert owns a small chunk of the Class A). 
  • In addition, there are 1,835,479,966 shares of Class D common stock. Class D’s do not carry any economic interest. However, they are convertible together with a holdings unit, into Class As on a one-for-one basis. (This is not strictly true since the shares first need to convert into Class Bs before they can be converted to Class As). 
  • As a result, using the mid-point of the IPO range, $21 per share, this would value the company at $41.7 billion. 
  • In addition, the underwriters have the option to purchase 22,500,000 shares of Class A common stock within 30 days. 
  • The company expects to net approximately $3 billion from the IPO, which it will use to redeem existing unit holders. In other words, no cash will be made available from the IPO to fund expansion or working capital but instead used to cash out existing owners. 

Conclusion

Overall, you have to be impressed by the company’s growth over the past few years, particularly in the last 12 months. It’s not by accident that it has become the largest mortgage lender in America. However, I will pass on this company for the following reasons:

• A large part of its recent growth has been triggered by a refinancing wave and decreasing costs of home ownership which has been driven by falling rates:

• From the graph above, you can see that 30 year fixed mortgage rates are at the lowest level ever. Although rates may continue to go lower (like Japan’s experience in the ’90s), there is a risk of a reversal that could negatively impact the company. As rates rise, refinancing dries up and home ownership gets more expensive which leads loan originations to fall. When this happens, operating leverage works in reverse and can put a lot of pressure on margins. In this sense, investing in the company becomes a bet on the direction of interest rates (which i have no insight on). 
• Even if rates remain constant, volumes may start to decline as customers have already taken advantage of refinancing. 
• Additionally, the combination of the IPO’s timing (when demand for refinancing is strongest) together with the intended use of the proceeds (existing shareholders are cashing out a portion of their ownership), is relatively unattractive. 
• It also relies heavily on wholesale funding to fund its mortgage origination business. This type of funding is typically much less stable then say, retail deposits, that a regular bank would have access to. In a crisis situation, wholesale funding tends to dry up, which is  what happened to Lehman Brothers in 2008. 

Pass.

Source: https://ipohawk.com/rocket-companies-ipo/?utm_source=rss&utm_medium=rss&utm_campaign=rocket-companies-ipo