Wednesday, November 2, 2011

Ellie Mae ( Nasdaq - ELLI ) -- Let's Rewrite Those Mortgages

Ellie Mae (ELLI $5.25) reported excellent on target Q3 results.  Performance was affected by the acquisition of the company's largest competitor during the quarter.  Ellie Mae had to foot the bill for the new company's operating expenses.  But FASB accounting rules prevented it from recognizing the subscription income the company brought to the table.  The official accounting rules viewed that as a reduction in the selling price.  So revenues associated with the new business essentially were zero in Q3 while the corresponding expense came in at $1.2 million.  Earnings were understated by $.04 a share as a result.  Ellie Mae netted $.05 a share (fully taxed) in the period, nonetheless.  That was achieved despite the fact U.S. mortgage originations declined 20% year to year to a generational low.  Revenues from the company's pre-merger business advanced 23% to $14.7 million.  That figure was diminished, too, by Ellie Mae's ongoing program to convert customers from perpetual software licenses to a per-mortgage fee structure.  Upfront revenue is substantially higher on license sales.  That makes the deal attractive to banks in the current climate.  But income potential to Ellie Mae is greater over the long haul as the recurring revenue stream builds up.  An even greater windfall could develop if the mortgage market returns to a normal level of activity.

The HARP program could provide a lift in 2012.  That's the scheme the Obama Administration recently unveiled to help underwater borrowers refinance at today's lower rates.  Industry experts predict the new rules could generate 1.0 million successful mortgage refinancings over the next two years.  Currently, 50% of the market is controlled by approximately 20 giant banks.  Ellie Mae doesn't participate in that segment.  Those institutions use their own automation software.  With its recent acquisition the company has taken over about 60% of the remainder, though.  So an extra 300,000 deals could go the company's way between now and the end of 2013.  In theory, that could amplify revenues by $20-$30 million a year.

Assuming flat mortgage origination activity, we estimate 2012 revenues will advance nearly 40% to $70 million.  Approximately two-thirds of that is expected to be generated by the recently acquisition.  The balance could come from greater use by existing customers, and the addition of more revenue generating services per mortgage.  Margins are nearly certain to improve as the revenue from the acquired company starts to be reported, not just the expenses.  Some genuine operating leverage is possible, as well.  We estimate fully taxed earnings will advance more than 100% to $.25 a share.  A stronger showing is possible if the HARP program delivers a boost or the overall housing industry picks up.

We think the housing industry will improve in 2012.  Most economists have predicted rebounds in each of the past three years.  They now forecast further malaise.  That is the trend, so they might prove to be correct.  But American households have de-leveraged over the past few years.  Debt to income ratios are down.  There's tremendous pent-up demand to move for personal, business, or retirement reasons.  And the foreclosure overhang is winding down.  House prices probably won't surge.  But real estate activity has the potential to move sharply higher.  Each new mortgage is an opportunity for Ellie Mae.  The company already is well positioned to perform well under depressed conditions.  Income could fly if volume picks up.

In 2-3 years earnings could reach $.75-$1.00 a share.  Applying a P/E multiple of 20x to the low end of the range suggests a target price of $15 a share, potential appreciation of 185% from the current quote.

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