Thursday, December 20, 2012

Ellie Mae ( Nasdaq - ELLI ) -- Market Share Expands

Ellie Mae (ELLI $27.50) appears on track to produce excellent on target Q4 results.  We estimate earnings (fully taxed) will more than double on a 50% sales gain.  Ellie Mae acquired its largest competitor (DataTrak) in 2011.  Over the last year the company has been integrating the two software platforms to improve the technology, and to retain DataTrak's installed customer base.  Those users now are shifting to Ellie Mae's "success based pricing" model, which is easier to maintain than a traditional on-site software package.  Updates are made automatically with cloud computing.  That format also aligns the amount of money each customer pays Ellie Mae with the amount of money they earn from new mortgage generation.  Average revenue per loan to Ellie Mae is $100-$110.  Mortgage bankers generally charge $750-$1,000 per loan.  The pipeline of new users has been amplified with direct sales, as well.  Ellie Mae is in the process of doubling its sales force again, a program that should be finished by the end of March.  Existing customers also are adding more seats.  That backlog of active users virtually ensures that revenue growth will be maintained at above average rates even if the U.S. economy stumbles next year.

R&D spending will finish 2012 in the 18%-20% range.  A major investment recently was completed to upgrade the company's network architecture.  That's a private system that lenders, borrowers, and vendors (credit bureaus, etc.) use to share information.  Ellie Mae also spent heavily on the DataTrak integration.  And several new products are under development.  Those are designed to raise Ellie Mae's revenue per loan or enhance productivity.  E-signing and mobile phone apps are likely to be introduced in 2013.  Development of more revenue boosting products is likely to keep R&D spending at an elevated pace next year.  But as a percentage of sales a modest reduction is likely.  One area of savings will be the network.  Ellie Mae is running both its new and old systems currently.  The legacy network will be decommissioned shortly.

Margins are beginning to benefit from the "total quality loan" initiative.  Ellie Mae licenses its technology to Wells Fargo and Citibank, enabling those mega-banks to structure incoming data in a consistent manner.  Both companies have their own mortgage processing computers, and are unlikely candidates to employ Ellie Mae's complete software package.  But just making sure the incoming data arrives correctly is generating about $25 a loan for Ellie Mae.  Start-up costs have consumed most of that to date.  As operations become routine, though, significant incremental income could emerge.  Additional large banks are believed to be investigating the technology.

Federal Government mortgage relief could bolster industry volume.  Tight lending rules have thwarted millions of homeowners from taking advantage of today's low interest rates.  Many prospective borrowers still hold less than 20% equity in their homes or fail to qualify for some other reason.  Looking just at the pool of loans Ellie Mae processes, the average credit score of the people who get loans is 750.  The average for those who don't is 700.  A fairly inexpensive loan guarantee program could help the latter group sharply reduce their borrowing costs. 

The extra paperwork created by the Dodd-Frank financial legislation is boosting demand for Ellie Mae's automation software.  Updates are delivered immediately to the entire user base because the software is cloud computing based.  Users of on-site software have to update each computer with the new and ever changing regulations.  The drumbeat of regulatory changes has begun to draw larger banks to Ellie Mae's technology.  In the past the company made its greatest inroads among smaller banks with limited programming staffs.  The Dodd-Frank rules are threatening to overwhelm much bigger operations, too.

Operating margins could improve in 2013.  Sales and marketing, and product development, will be maintained at high levels.  But revenues are generated with few direct costs.  So every additional sale is highly profitable.  We estimate sales will advance 35% next year to $135 million to support earnings of $.90 a share (+29%).  Average shares outstanding likely will increase 10% due to a stock offering earlier in 2012.  Direct competition has not emerged.  Two companies are believed to be developing mortgage automation products of their own.  By the time those are introduced Ellie Mae could have a majority share of the potential market locked up.  Users are unlikely to switch due to the technology risk, retraining cost, and lost time associated with moving to a different system.  So pricing is likely to remain firm over the long haul.  Margins could rise further in the years ahead as sales volume keeps expanding.

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