Ellie Mae ( NYSE - ELLI ) -- Margins Remain High

Ellie Mae (ELLI $19.50) reported excellent better than expected Q2 results.  The company had indicated costs would rise sharply in the June period to lay the groundwork for further expansion.  Sales came in above target, though.  So those expenses were swallowed up with ease, enabling pretax margins to remain at superior levels (25%).  Earnings advanced 800% as a result to $.18 a share (fully taxed).  Sales climbed 106% to $23.6 million. 

Customer adoption of Ellie Mae's unique "success based" pricing model continued to rise.  The company charges a small amount to implement its technology at customer locations.  But most revenue is generated on a variable basis when mortgages are completed.  Lenders typically earn $750-$1,000 per loan and pay Ellie Mae a piece of that for the work performed.  The company still has a sizable installed base which uses licensed versions of the technology.  Those customers pay annual fees and don't participate in the recurring revenue scheme.  That group is transitioning to the pay as you go format.  That arrangement is more profitable for Ellie Mae because the ups and downs among its customers are averaged out.  Customers prefer it because the downside risk is reduced.  There's no potential for loss.

Revenues are being reinforced by Ellie Mae's service business.  The company operates a network that links mortgage originators with outside vendors that deliver services electronically.  Those include appraisals, title searches, income verification, and fraud detection.  The company charges for those transactions, but the price usually is far less than what it would cost to do manually.  The software checks the work, moreover, to ensure consistency and accuracy.  A recent stock offering raised $58 million in fresh capital.  Some of that might be deployed to purchase some of those providers, allowing the company to retain those incremental fees.

We are raising our full year earnings estimate by a dime to $.50 a share.  Our estimate assumes a modest decline in margins over the second half of the year due to moderating unit volume.  Refinancing activity has begun to slow.  While new mortgage activity is improving, the poor economy may inhibit its growth rate.  Our sales estimate has been lifted, too, by 12% to $90 million.  Next year $.65 a share represents a realistic target even if the economy remains in the doldrums.  Implementation of a broad-based Federal mortgage re-write program could provide substantial leverage.  Acquisitions might yield additional impetus.

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Ellie Mae ( Amex - ELLI ) -- Market Share Gains Continue

Ellie Mae (ELLI $15.50) appears on track to produce excellent on target Q2 results.  Total mortgage volume in the United States has exceeded industry predictions so far in the June quarter.  And Ellie Mae is continuing to expand its share of the market.  Revenue per loan is expanding, as well.  Customers are adopting the company's "success based pricing" model in lieu of perpetual software licenses, laying the groundwork for recurring revenue gains in the future.  Margins jumped in the March period as fixed costs were leveraged by a big pick up in volume.  Further expansion is achievable over the long haul.  The company is spending heavily in Q2 and Q3 to expand its computer infrastructure, though.  It also is boosting sales and marketing efforts.  So further margin improvement is unlikely before the end of the year.  Still, a strong showing appears to be in the cards.  Our full year estimates are unchanged due to the weakening macroeconomic outlook.  Ellie Mae may have the horsepower to overcome those obstacles, however.  So a stronger performance is possible.

Above average growth is likely to be sustained in 2013.  Industry mortgage volume is predicted to decline as refinancings fall as a percentage of total activity.  Home purchases might not accelerate as much as some experts forecast, either.  Despite that, Ellie Mae could show gains of 25%-50% next year by expanding its market share, boosting revenue per transaction, and by adding new features via acquisition.  The company actively is pursuing companies with mobile, marketing, and risk management abilities.  A public offering is likely to be pursued before long to finance those deals and to support the overall expansion of the business.  That could dilute earnings somewhat in the short run.  But it should make Ellie Mae much more difficult to overcome by competitors.  In 2-3 years Ellie Mae could hold 75% of the non-major mortgage market.  (The 20 largest banks hold about 50% of the entire market, which is off limits to Ellie Mae.)  That's about twice the company's current market share.  If the housing market recovers within that time period these shares could trade at substantially higher levels than they are now.

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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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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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