Thursday, October 13, 2011

Ellie Mae ( Amex - ELLI ) -- Automating the Mortgage Industry

Ellie Mae (ELLI $5.00) is the leading provider of software used by lenders to automate the mortgage origination process.  The company provides a wide range of products and services that enable lenders to enhance productivity, reduce costs, comply with regulatory requirements, improve accuracy, and connect directly with various funding sources and investment outlets.  Ellie Mae is the industry's largest independent software provider.  About 50% of all new mortgages written in the U.S. currently are produced by 20 mega-banks.  Those giants handle their technology needs internally.  The rest of the market is served by smaller banks and a host of mortgage brokers.  Ellie Mae focuses mainly on the banking segment (90% of sales), which has been gaining market share at the expense of mortgage brokers (10% of sales) since 2007.  They now generate 39% of all mortgages written, compared to 11% for brokers.  Total industry volume remains depressed, of course, so many banks have reduced personnel over the last three years despite their relatively better performance.  Demand for Ellie Mae's software has climbed as result as customers replace labor with technology to boost productivity.

A recent acquisition cemented Ellie Mae's industry leading position.  In mid-August the company purchased Del Mar Datatrac for $17.2 million in cash, plus $8.0 million in contingent payments.  Before the transaction Ellie Mae's technology was being used to originate 20% of all U.S. residential mortgages.  That figure is expected to reach 30% with the Del Mar acquisition.  Since the mega-banks account for half the total market Ellie Mae actually now holds 60% of its addressable market.  Reported earnings will be impacted by the combination over the next two quarters because GAAP accounting rules prevent the recognition of deferred revenue by an acquiring company.  Ellie Mae will be responsible for the associated cost of fulfilling the backlog, though, putting the squeeze on margins.  Once that obligation is worked off margins should revert to normal, then benefit from economies of scale.

A shift in pricing strategy is restraining near term profitability, as well.  Until two years ago Ellie Mae licensed its software at a fairly high upfront price, and earned additional income from software upgrades and  a variety of transaction fees.  Following the real estate crash the company switched to a success based model ("software as a service") where customers pay each time a mortgage closes, the exact amount depending on how much software is used.  Last year 29% of its customers employed the SAAS model.  By Q2 that figure had risen to 42%.  Within 2-3 years Ellie Mae hopes to convert 90% or more to that transaction based approach.  The reduction in upfront licensing fees is affecting short term profits.  But long term income will benefit from the enhanced recurring revenue stream.

Superior growth is likely even if the housing industry remains depressed.  Only 1% of all loans presently are produced 100% electronically.  Revenue per loan promises to expand as more elements are computerized.  Costs to the originating mortgage banks are likely to decline as a result of that greater productivity, even as the revenue to Ellie Mae expands.  Direct competition is scant, following the Del Mar purchase.  R&D spending is being maintained at elevated levels (25% of sales, enabling the company to enhance its competitive advantage while broadening its revenue potential. 

Mortgage activity could triple from current levels if it returns to the long term trend line.  Mainstream economists have predicted a housing market recovery in each of the last three years.  Now they've thrown in the towel, predicting further malaise in 2012.  Two factors make that unlikely.  First, there is a tremendous pent-up demand to move for job-related and retirement purposes.  After three years of price declines and foreclosures the market now has cleared in many parts of the country, making those moves possible at last.  And second, it's virtually certain the Federal Government will enact legislation allowing homeowners who are current on their loans to refinance at today's lower rates, even though they technically don't qualify due to income or collateral reasons.  A mammoth surge in mortgage activity could rise from the ashes next year and continue to climb well into the decade.

Any pick-up will reinforce demand among lenders.  Most already have cut staff to the bone.  Even servicing today's low level of activity is a strain without computer assistance.  Once the surge begins the rush to automate is virtually certain to accelerate.  With 60% of the market and the best technology available Ellie Mae is likely to be the prime beneficiary.

We estimate 2011 sales will advance a modest 16% to $50 million.  The Del Mar acquisition is likely to contribute little to the top line due to the backlog accounting rules.  Income may in fact decline 23% to $.10 a share (see "Accounting Notes") due to acquisition related costs, elevated R&D spending, stepped up marketing efforts, and 22% more shares outstanding.  The company went public in April, issuing 5.0 million shares at $6.00 apiece.  We estimate revenues will advance 40% in 2012 as the Del Mar acquisition kicks in, margins improve, and further market share gains are realized.  A stronger performance is possible if the mortgage market generally improves.  Our estimates assume a flat comparison with 2011.

In 2-3 years revenues could attain $125-$150 million as the industry rebounds.  Income could reach $.75-$1.00 a share as recurring revenue builds, revenue per loan expands, and R&D costs fall as a percentage of sales.  Applying a P/E of 20x to the low end of the range suggests a target price of $15 a share, potential appreciation of 200%.

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