Update: Guild Mortgage & Block Inc.

August 8, 2022 | Premium Service | Earnings season continues to roll along, with some notable surprises and also disappointments. This week, The Institutional Risk Analyst looks at Block (SQ) and Guild Mortgage (GHLD), two story situations that have important messages for investors in financials. Both were punished in the first half of 2022 but both names have significant value outside of the current noise in the financial markets.

With SQ, we see the negative impact of the deflation of crypto as the FOMC raises real interest rates, but the core business continues to grow. We think the Street is dead wrong about an impending pivot by Fed Chairman Jerome Powell and remind one and all that a sea change has occurred at the central bank. While the threats and bullying from the progressives in Congress is tough to take, restoring credibility in terms of inflation is now the Fed’s focus.

Investors in the credit markets ought to consider how some of these platforms and strategies will look when the Fed goes into 2024 and into the general election with short-term interest rates still elevated. Housing costs, for example, are going to continue rising into 2023, thwarting hopes for an early pivot by the Fed. And across the universe of financial assets, the upward demand pull on valuations by investors is striking.

The evidence of systemic inflation abounds. While it is “different this time,” the basic cycle of employment and inflation that has governed US financial markets remains intact, albeit with much higher volatility. We expect the FOMC to maintain elevated interest rates through to 2024, a dire message for equity managers that are betting the house on a pivot by the Fed before year-end. We look for many credit metrics to normalize over the next year as volumes remain low and default rates are rising.

Guild Mortgage

The volatility caused by the FOMC's shift to fighting inflation was very much in evidence in financials and particularly mortgages in Q2 2022, thus we were pleased to see GHLD deliver a strong quarter in terms of managing loan production expenses and other costs. The fact that rates rallied into the end of the quarter provided a bit of lift for GHLD and many other mortgage lenders and issuers.

The first thing to notice about GHLD is that while the industry is down 60-70% on volumes, the purchase mortgage lender is only down less than 40%. GHLD has smartly reduced expenses 30% YOY, keeping this traditional retail lender solidly in the black while continuing to grow its servicing book, now $76 billion in unpaid principal balance (UPB) or about 315,000 loans.

Source: EDGAR

Likewise gain-on-sale volumes fell very modestly, again attesting to the strength of the GHLD model and their focus on retail purchase mortgage volumes. Total in-house originations of $11.8 billion compared to $17.9 billion in the first six months of the prior year. In addition, net revenue of $769.3 million compared to $820.3 million in the first six months of 2021. Net income of $266.3 million compared to $169.5 million in the first six months of 2021.

“We delivered solid financial results for the second quarter of 2022 despite higher interest rates, excess capacity and limited inventories,” said CEO Mary Ann McGarry. “Despite shifting market conditions, our tenured management team has a proven track record across cycles and our differentiated purchase-focused business model positions us well, as refinancing volumes continue to weaken. In fact, purchase loans accounted for 84% of our total origination volumes in the second quarter.”

GHLD has obviously given up a lot of ground since the end of 2021, but it has outperformed all of its mortgage peers save Mr. Cooper (COOP), as shown in the chart below:

GHLD is down 17% YTD, a better performance than many other stocks in the mortgage group with the exception of COOP. The next year is going to be challenging for mortgage issuers, but we look for GHLD to continue to out-perform the group and perhaps even be a buyer of struggling mortgage firms. If you want upside exposure for the next Fed rate easing, names like GHLD and COOP ought to be part of your basket.

Block Inc. (f/k/a Square)

The results for Block were actually good in Q2 2022, but for the distraction of the crypto market. With the Fed raising interest rates, MMT and its techno hell spawn bitcoin are being deflated by rising real returns. Crypto tokens, NFTs and other collectibles only made sense in a zero rate environment. So long as central banks were removing trillions of dollars in duration from the markets, humans created new games from which to profit.

The same crypto cachet that made SQ soar during the past two years has now become a bit of a headwind in the near term. As SQ stated in its shareholder letter:

“Total net revenue was $4.40 billion in the second quarter of 2022, down 6% year over year, driven by a decrease in bitcoin revenue. Excluding bitcoin, total net revenue in the second quarter was $2.62 billion, up 34% year over year. Gross profit was $1.47 billion, up 29% year over year and up 47% on a three-year CAGR basis, and included $18 million in amortization of acquired technology assets.”

We were involved in SQ early, but exited at the end of 2018 after returns went into double digits. The stock then proceeded to double and more during COVID. Since January of 2022, however, SQ has been cut it half, making us wonder if now is not an opportune time for re-entry based upon the core payments business as opposed to crypto fluff. Names such as Visa (V), Mastercard (MA) and Fiserve (FISV) are better comps in our view.

We were more than a little disappointed when SQ co-founder Jack Dorsey got involved with crypto and even changed the name of the company to give the firm a blockchain flavor. We think such short-term behavior detracts from the excellent results that Dorsey and his team have delivered on the core business.

As we’ve noted in previous missives, we got into SQ half a dozen years ago because we knew that the roving hoard of equity managers seeking fintech would eventually find the stock. And they did. We loved the new approach to vendor transaction clearing for small business and that aspect of SQ remains the most attractive part of the business.

Now, however, we think that a more constructive way to think about SQ is in comparison to the other credit card and payments players, which is hardly a bad thing but not quite so hyperbolic as the fintech sector has been in the past several years. The chart below shows SQ's results through Q2 2022.

Source: EDGAR

We like the positioning of the company and the fact that they are growing their business on larger accounts. CFO Amrita Ahuja addressed this issue:

“We have obviously a diverse base of sellers, millions of sellers. From a vertical perspective, we span a range of verticals. So, 40% of Square GPV comes from a range of services verticals in 2021. The remaining 60% is across some of those discretionary areas like food and beverage, retail and other smaller, but growing verticals where we've continued to see stability from a three-year CAGR perspective. From a seller size perspective, as I said, continue to grow upmarket. In the second quarter, two-thirds of our volume in the Square business is from larger sellers, $125,000 in annual GPV or more. And historically, those larger sellers have been more resilient through downturns. And as we've said, larger seller, broader retention within the Square business, even including our smaller sellers, has been positive across GPV and gross profit in the second quarter and into July.”

The major negative with SQ is the childish dalliance with crypto and the equally ill-considered name change. There does not seem to be any appreciable contribution to Block's business from blockchain technology. More, Square is how the firm is known inside the company and in the consumer payments community. Since Block has not yet changed its ticker symbol, perhaps Mr. Dorsey will eventually change the company's name back to Square and slowly distance himself from the crypto world and the equally unimpressive blockchain morass.

While SQ is down 45% YTD, it rallied over 30% in the past month, along with names such as PayPal (PYPL), SoFi Technologies (SOFI). We suspect that concerns about the economy and the intentions of the FOMC with respect to interest rates are going to remain a drag on many consumer finance stocks. But we are impressed by SQ's progress in building its core business and think a long-term perspective that de-emphasizes the crypto component may be appropriate.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.