Opportunities for growth in a stock’s value frequently derive from refinements in the market’s perception of the organization from which it originates. For example, if a company generates earnings of $5 per share and the market selects an earnings ratio of 10, this results in a share trading for $50. Yet, consistent improvement in earnings growth may persuade investors that the stock deserves a ratio of 12, increasing the share price to $60. The challenge for investors lies in identifying these improvements ahead of the market’s notice. Here we discuss two stocks that have potential for such rerating due to their recent acquisitions.
Let’s start with Capital One Financial Corporation’s (NYSE: COF), which recently acquired Discover Financial Services. Capital One is a leading credit card provider, and its acquisition of Discover marks a major event in the finance industry. The crown jewel of this deal is the closed-loop payment system that Discover had in place, a feature that is seldom seen on the market today.
The landscape for payments is intricate. Each credit and debit card transaction relies on a network to facilitate it. The giants in this domain, Visa and Mastercard, utilize open payment networks, meaning they allow partners such as banks to dispatch cards designed to function on their networks. In these open systems, the incurred fees are shared among the participating entities. However, with Discover’s closed-loop system, the cards are issued by the company itself, which also maintains the network; this allows the company to retain the majority of the fees.
Hitherto, Capital One issued credit and debit cards through Visa and Mastercard’s networks, but with the recent acquisition of Discover, they plan to transition all their debit cards to Discover’s network by 2027 and possibly some credit cards. The management anticipates an expense synergy of $1.3 billion and network synergies worth $1.2 billion by 2027. However, the challenge lies in the fact that Discover’s network is not as broadly accepted as its more established competitors like Visa, Mastercard, and even American Express.
Management must focus on enhancing the brand reputation and acceptance of Discover’s network on a global scale, a task that is expected to be challenging. Despite having a reputable track record, Capital One’s share still trades at a significantly lower ratio than Visa, Mastercard, or American Express. However, payment companies have conventionally received higher ratios than consumer credit card companies.
Comparatively speaking, it would take a complete transformation for Capital One to trade at similar ratios as American Express. Still, if Capital One can successfully leverage the aforementioned synergies and expand Discover’s payment network, it stands to reason that company earnings will rise, thereby potentially closing the valuation gap and providing a rewarding turnout for its investors.
Moving onto Rocket Companies’ (NYSE: RKT) proposed acquisition of Mr. Cooper Group (NASDAQ: COOP), which is yet to be finalized. Rocket Companies is a mortgage behemoth and announced earlier this year that it was intending to acquire the extensive mortgage service provider, Mr. Cooper Group, in a deal worth an estimated $9.4 billion.
Since Rocket Companies became a public entity in 2020, it has struggled with its share value, which has decreased by nearly 50% since its initial public offering. Being in the mortgage industry inherently makes a company highly sensitive to fluctuations in mortgage rates, as these rates are heavily influenced by the Federal Reserve’s interest rates. The lenient rates observed in 2020 and 2021, coupled with the implementation of quantitative easing, incited a boom in the mortgage sector as more people sought to become homeowners.
Additionally, extraordinarily low-interest rates triggered a boom in refinancing. Still, anyone currently holding a mortgage at a rate of 3% to 4%, or less in some instances, would be financially hard-pressed to consider purchasing a new home with a mortgage rate as high as 6% to 7%. Consequently, home sales in March experienced their lowest rate since 2009, and refinancing activity has shown a significant decrease since 2021, a trend that continued into 2022.
With the acquisition of Mr. Cooper Group, Rocket Companies gains an additional source of revenue that is more resilient against a rising-interest-rate environment. Mortgage servicing, which involves the management of mortgages from collecting monthly payments to conducting administrative tasks, performs better in higher-rate environments because less people seek refinancing, leading to more consistent fees for services.
Upon completion of the acquisition, Rocket projects that its servicing revenue will expand from 17% of total revenue to roughly 28%. Furthermore, this acquisition stands to strengthen Rocket’s position in the often fragmented mortgage market. Coupled with Mr. Cooper Group, Rocket aims to facilitate one in every six U.S. mortgages, leading to the creation of an all-inclusive platform that could potentially assist someone from buying their first home to cashing out equity for a home improvement project.
Rocket’s earnings have been inconsistent since its stock went public. The company is confident that a more diversified and stable stream of earnings that comes with an expanded portfolio could result in higher earnings and hence, lead to an eventual growth in valuation.