The Uncommon Idea in Brief
Buy mortgage software company Ellie Mae (ELLI) stock for the long term. (Published July 5, 2017)
-In the near term, revenue and net income may be volatile as interest rates and expectations for interest rate changes fluctuate. We’d begin building a position below $110 and any pullback in price driven by the near-term concerns that rising interest rates will halt revenue and earnings growth.
The Industry Opportunity
Real estate’s contribution to the U.S. economy is hard to overstate. Housing averages a 15% to 18% contribution to gross domestic product (GDP), according to the National Association of Home Builders.
Of course, there are times when the real estate market softens. It’s been less than two decades since a bubble burst in the sector. Rising rates may cool the scorching growth, but that should present opportunity. Real estate will continue as one of the drivers of the domestic economy even as rates slowly increase over the next several years.
The process of obtaining a mortgage is a stressful, cumbersome process for most. It can be intimidating and dreadfully long. There is a large opportunity for companies looking to simplify the mortgage process.
What Ellie Mae Does
Ellie Mae provides on-demand software services for the residential mortgage industry via its Encompass all-in-one mortgage product. Encompass is a subscription-based platform for mortgage professionals to connect with one another. This includes mortgage lenders of all sizes, real estate agents, underwriters and appraisers.
The company aims to offer a fully-integrated product for the entire loan life cycle with one system of record to maximize efficiency and minimize frustrations and complications. Recently, Ellie Mae won the HDI Pinnacle of Excellence Award. HDI is the first professional association create for the tech support industry.
While not all corners can be cut, Ellie Mae’s subscription-based Encompass has made it possible for borrowers to verify assets without clunky document uploads. Also, consumers can search loan options and rates on the web and follow-up with an online loan application. Lenders can tailor mortgage solutions to meet specific business strengths and needs to help attract and retain clients. It’s human nature to want to avoid pain and avoid waiting.
In March 2017, Ellie Mae joined in a partnership with tech financial services company Plaid to provide users with a near-instant verification of assets. Borrowers are able to verify assets in seconds without the cumbersome process of manual uploads. This ability will save time and should translate to a more positive and satisfactory experience.
Ellie Mae also announced Encompass Consumer Connect, which permits a customized web experience to reach loan options, rates and complete a loan application online. Putting power in the consumer hands, creating a simplified and unified solution and speeding the process from researcher to applicant will help keep Ellie Mae at the forefront of acquiring sticky users.
Ellie Mae also introduced the Encompass Developer Connect where lenders can build solutions to meet specific business needs and deliver new capabilities to customers. Just as consumers can have an all-in-one time-saving platform for their needs, lenders have the same availability.
The Uncommon Market Position
The areas where Ellie Mae does business in real estate don’t look overheated.
Yet while Ellie Mae’s platform creates sticky clients, it still needs to attract new ones. It stands to reason some may resist moving to the Encompass platform for the same reason they would resist moving away from it. Being best-of-class sometimes isn’t enough to overcome the risks associated with switching from an existing method to Encompass.
That’s where the strength and reach of Ellie Mae’s newest partner comes into play.
In January, ELLI announced a joint business relationship with PwC. The companies will work together with enterprise customers to customize processes, workflow and support internal change as organizations replace outdated tech with Ellie Mae’s Encompass.
The advisory and consulting strengths of PwC will help ease any initial burden for companies to implement the upgrade to Encompass.
What Sets Ellie Mae Apart
Ellie Mae may not be the only residential software solution for the mortgage industry, but they are currently best in class. Encompass is the leading platform to create business for professionals in the real estate market. This extends from mortgage brokers to underwriters, appraisers and real estate agents.
Once immersed in a particular modern platform like Ellie Mae’s Encompass, it’s unlikely a mortgage professional would start looking for a competitor. Switching involves time, money and the headache of learning a new system.
Ellie Mae’s strong platform attracts new clients while the high switching cost creates sticky clients.
Financials – Ellie Mae by the Numbers
ELLI delivered a strong 1Q in 2017. The company increased revenue by 26% to $93 million. Net income soared to $9.6 million from only 2.5 million in the same quarter of 2016. Non-GAAP earnings per share of $0.25 exceeded consensus expectations of $0.21 and ELLI saw 12,100 new Encompass seats booked. This was a slight tick higher from 12,000 last quarter, even while industry-wide mortgage volume fell 34%.
Management projected 2Q revenue of $109 million to $111 million and adjusted net income of $18.2 million to $19.2 million. This equates to $0.50 to $0.53 per share. For the full year, the company sees revenues of $433 million to $440 million and adjusted net income of $65.6 million to $70.7 million, which translates to $1.79 to $1.92 per share.
Focus should be two-fold: internal and comparative.
As investors, we’d be willing to tolerate lower growth numbers of active and contracted users, or even average revenue per user, in a rising interest rate environment when industrywide bookings are falling. The company opted not to provide specific user numbers in Q1, but we do know in Q4 there were 216,000 contracted users, with 164,000 being active, an increase of 21%. The revenue per average user was $587, up 25% year over year during the seasonally least active period.
Whether an update on these figures is provided in Q2 or in Q4, it will be worth noting how activity compares to the mortgage industry as a whole. ELLI did note stable bookings, while the mortgage industry as a whole experienced a sharp 34% decrease.
Why the Stock Is a Buy
Ellie Mae is a high-octane growth company, so traditional fundamental metrics will take a backseat. Investors focused on price-to-earnings, book value, price-to-sales, price-to-free-cash-flow, or PEG ratios will likely never see ELLI on their screens.
Shorts have targeted the name as well. The short float has climbed to 8.3% of the outstanding shares, which would take six days to cover at average trading volume.
Growth is key. ELLI has consistently met or exceeded earnings and revenue expectations whether we’ve had static or rising interest rates. Fiscal year 2017 is projecting revenues of $433 million to $440 million, up 20% from $360 million a year earlier. Net income is slated to increase 35% to 40% year over year and adjusted net income of $65.6 million to $70.7 million would produce $1.79 to $1.92 earnings per share.
The company holds no debt and continues to increase its cash position, now around $13 per share. While traditional fundamentals won’t draw investors into ELLI, the strong cash position and aggressive growth translate to a buy for momentum investors with a slightly more aggressive palate.
The Technical Analysis — At $110 or lower ELLI is a BUY; Under $100 is an Aggressive Buy
Given its sensitivity to housing and interest rates, ELLI makes for one volatile stock in terms of price.
Even a weekly chart can smooth the large moves. In the past year, the stock has traded as low as $77.60 and as high as $114.38. Unlike some of the big performers this year, those lower prices were as recent as February.
The trend for the past five months of the year has been higher. A clean bullish channel, albeit a wide one, guided the stock. Shares haven’t closed below the 20-week simple moving average (SMA) since 2016, but intraweek we did dip below both the 13-week and 20-week in early June. Touches of the 13-week SMA have been opportunistic buys during 2017. The question here, or rather the challenge, is whether that will hold here or not as ELLI looks poised to break down.
The challenge of the current pullback in conjunction with the sideways action of the past two months is determining whether this is a pause that refreshes or the end of the previous trend and start of a new one.
The pullback has occurred on average volume, although it has been orderly in comparison with the market, but it’s important to note ELLI holds a higher correlation with long-dated Treasuries than equities.
While we have the makings of a bull flag in terms of price action with the $107 to $114 range, ELLI isn’t flashing a strong buy signal yet. The biggest issue is the bearish crossover (%K line moving below the %D line) in the Stochastics and the indicator’s inability to break back above 80. Furthermore, while price has held in the flag formation, it has fallen below the support level of the bullish channel. Unfortunately, with the secondary indicators trending bearish, buying support is more difficult as resistance is also declining.
Our target on a breakout over $115 is $122 in the next three to six months, with $136 being the 12-month target as we anticipate the extension of the breakout would roughly equal the move of the February reversal to the early June highs. We view $104 as the next level of support should the current level of $107 fail.
If ELLI breaks below $104, we anticipate a new trading range developing between $95 and $104. While this would be concerning, if there are no fundamental changes to the company, we would use support areas to add to our position and take partial opportunistic sales into resistance levels.
Our preference here is to take a small entry and then look to add aggressively on a pullback toward $100 or a breakout over $114. The technical risk vs. reward is not compelling to take a full position yet. But ELLI should present an opportunity for entry into a full position over the second half of 2017.
Catalysts for the Thoughtful Investor
Ellie Mae’s fortunes rest on the broad shoulders of real estate. The more buying and selling and refinancing of loans, the greater likelihood of mortgage professionals subscribing to the Encompass platform. Interest rate risk, while real, has been managed so far by the company. But it will create volatility with shares for the remainder of 2017.
The Bottom Line
-Ellie Mae is the best-of-class on-demand software platform for mortgage and real estate professionals.
-The mortgage market continues to evolve in terms of technology and access. The days of clunky applications and long delays in verification are numbered. Removing the time and frustrations from mortgage applications with streamlined efficiency and strong financial partners has created a mortgage platform that would be costly and difficult for users to replace.
-Ellie Mae’s partners are leaders in the industry. The partnerships with PwC and Wells Fargo (WFC) should help transition new clients. Working with PwC should allow Ellie Mae to expand its enterprise customer base.
-In the range of $90 to $115 we posit ELLI a long-term buy and hold, although the small-cap nature, high short interest and sensitivity to interest rates and the economy will make price action volatile.
At the time of publication, neither the author nor the company held positions in the stocks mentioned, but positions may change at any time.