Ellie Mae Marches On, Still A Buy

| About: Ellie Mae, (ELLI)
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Well, in a a more extensive analysis of which this is an update, we argued that you should accumulate shares in Ellie Mae (NYSEMKT:ELLI) in May, saying that we absolutely love Ellie Mae.

We're happy to see that the love is returned. The company produced another stellar quarter. First, a little recap. Ellie Mae is one of those companies that streamline processes that span different organizations, and they do this by electronic means.

The industry is the fragmented mortgage industry. The number of steps, sign-offs, and parties involved when you apply for a mortgage is large, and the process was ripe for "re-engineering."

The average loan is handled by 61 people, and requires 45 days to travel from application to funding. (Source: Tom Peters.)

This is what Ellie Mae does, it brings these parties together with the help of internet technology and streamlines the whole process, saving everybody involved a lot of time and money, reducing the average cost per mortgage by a whopping $3000, according to that Tom Peters case study (which we have to say is from 2004).

And of course, an increasing amount of this goes via the Internet via their software as a service (SaaS) Encompass service, the revenues of which increased 191% in the quarter. The Internet model provides further advantages:

  • There are network effects where ELLI reaps new customers because they have a large installed base already offering benefits to users
  • Much of it is high fixed cost, low (or near zero) marginal cost business in which profits grow disproportionately with revenues

And basically they're firing out of all cylinders. Revenues increased 106% for the quarter (year-on-year) with the company earning 21 cents a share (or 27 cents non-GAAP, which was 125% above analyst expectations of 12 cents). CEO Sig Anderman could therefore conclude that:

Our second quarter results were strong across the board, driven by the activation of nearly 8,000 Encompass SaaS users over the two previous quarters, and the steady increase in revenue per user

Indeed, nobody disputes this. And with such a successful business model and the mortgage industry still in a downturn, the future looks very bright. We can't figure much, if any reason why ELLI wouldn't be able to continue in this way.

The shares encountered a slight bump on a secondary offering at $17 (which raised the company nearly $56M), but that was a mere blip in the inexorable move upwards, which has accelerated Thursday midday (the time of writing) with the stock up another 15% at the moment of writing.

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Needham apparently raised the price target to $30 (from $24), and we can only agree. No, the shares aren't cheap anymore, but this is one of the very few business models we absolutely love (and we're far from the only ones). Looking at the earnings history and analyst forecast, yesterday's positive earnings surprise isn't reflected in the estimates going forward, so it's less expensive than you might think.

Indeed, ELLI itself predicts 18-20 cents in earnings for Q3, rather than the 6 cents expected by analyst (see figure below). For the year as a whole, earnings are expected to be between 68 and 72 cents per share, which gives it a price-earnings ratio of 35.

No, that's still anything but cheap. But this is a self-propelling profit machine with few clouds on the horizon.

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We have little, if any reason to change our more extensive coverage and advice: buy on dips and hold. We're really hard pressed to think of any significant risks.

The business model is essentially self-propelling, with more of their business shifting to the internet (the SaaS Encompass), network effects and the high fixed cost, low marginal cost realities will likely propel earnings forward for some time to come.

The only significant risk we can think off is a severe lurch downward in the economy, rather than any competition. It is possible for the market to shift from small to mega lenders, which have the capability to disintermediate the mortgage process themselves and have an advantage in their large retail presence.

But so far, there is little to suggest that this is anywhere near a serious threat.

Disclosure: I am long ELLI.