Description

We think Ellie Mae (ELLI) is a very compelling short at today’s levels.  In our opinion, ELLI has benefitted from several multi-year tailwinds that we believe are set to reverse and ultimately drive downward estimate revisions to consensus forecasts.   As ELLI disappoints on overly optimistic buy and sell-side assumptions, we think there is significant downside in the stock. Our thesis is based on the following tenets:

1)      ELLI is heavily exposed to the non-bank lending channel which is beginning to lose share in the mortgage origination process.  Dodd-Frank caused many large traditional banks to pull away from the mortgage and refinancing market while non-bank lenders (large ELLI customers) filled the void.  The share gains from non-bank lenders combined with an intense regulatory environment (TILA and RESPA) drove significant revenue growth at ELLI. As bank lenders take back share in the mortgage market (or at the minimum stop ceding share), ELLI volumes (revenues) are at risk.  

2)      The current rising interest rate environment is leading to significantly lower refinance volumes, which will be an ongoing headwind for ELLI.  The low interest rate environment drove a once in a lifetime refinancing surge that benefited the non-bank lenders.  ELLI has called out on conference calls the shift from a “refi-centric market to a purchase centric one” (Q2 2017 call) has caused the company to revise lower their outlook.  The stock re-rated notably after Q2 2017. According the Mortgage Bankers Association, refinance volumes are projected to fall nearly 30% in 2018 versus 2017.

3)      Mortgage lender employment trends have reversed, and now slowing – a dynamic that could pressure ELLI user growth as ELLI generates revenue per seat.

*Elli has been previously submitted by Mason, please refer to that write up for more detail about the company as well as bull case.

Company Overview

ELLI is a leading provider of on-demand software solutions and services for the residential mortgage industry in the U.S. Banks, credit unions, mortgage lenders, and mortgage brokers use ELLI's Encompass product for an all-in-one mortgage management solution to originate and fund mortgages and improve compliance, loan quality, and efficiency.  

ELLI's software handles most functions involved in running the business of originating mortgages including: customer relationship management, loan processing, underwriting, preparation for mortgage applications, disclosure agreements, and closing documents. ELLI's value-add is helping streamline the mortgage process and allow lenders to increase output per mortgage professional.  

The company generates revenue from subscription services and usage-based fees, transactions fees, and fees from professional services. Users pay a monthly base fee (~$80 per month) with incremental fees based on usage (credit reports, closed loans). The average contract length is 3 to 5 years.  

Key Facts:  

·         Handles ~30% of total mortgage loans in the U.S.  

·         ELLI has no exposure to the top 5 banks

·         Has ~1,700 of the approx 8,000 mortgage lending institutions as customers  

·         67% sales subscriptions based / 33% transactional  

·         Total loans: 70% purchase / 30% refinance  

·         Generates approx $145 per loan  

·         Competition: Cadence (Accenture), Black Knight, Calyx, DH corporation, LendingQB, Altisource  

Mortgage Origination

The mortgage origination purchase market has grown at a steady pace while the refinance market surged as consumers rushed to refinance loans in an ultra-low interest rate environment. We expect that purchase originations will grow at a moderate pace, however, the ongoing rise in interest rates will contribute to ongoing pressures in the refinance market. Below are the Mortgage Banker Association (MBA) forecasts.

In addition, the 1Q18 Fannie Mae Lender Survey was released and shows that lenders remain pessimistic about future trends. (see below)

Market Share Gains to Reverse

ELLI has outperformed their own revenue growth guidance due to massive share gains in non-bank lenders, who in the wake of the financial crisis and Dodd frank, has seen their market share rise to over 50%. We believe this dynamic has left ELLI heavily reliant to non-bank lending.

As this market slows in seat growth this will be a considerable headwind for ELLI to meet lofty expectations. We also believe that the concentration of production among originators where over 75% of volume is generated off nearly 20% of the seats effectively subsidizes seat growth will eventually lead to a shrinking TAM for ELLI.

CITI: 2/13 CSFB Conference

“In other areas such as mortgages, commercial Banking, we believe we have the opportunity to grow faster than the market to drive additional share gains.”

JPM 1/12 earnings call:

“Yeah. So and we haven’t changed our standards very much. And the one exception that might change over time, which I hope it does actually is in mortgage lending”

Bank of America: 1/17 Earnings call

“At a more detailed level, we feel like we've been growing well in mortgage and we're going to continue to do that”

Mortgage Lender Employment Headwind

https://www.nationalmortgagenews.com/news/tough-competition-drives-negative-mortgage-lender-profit-outlook

https://www.nationalmortgagenews.com/news/drop-in-nonbank-mortgage-jobs-may-signal-market-shift-back-to-banks

https://www.forbes.com/sites/greatspeculations/2017/11/28/wells-fargo-u-s-bancorp-see-rare-growth-in-mortgage-servicing-portfolios/#23546b661665

Mortgage TAM expectations lofty

The second major bear point is the mortgage market TAM.  Ellis has stated in the past that their total available market revenue is just over $6.25b. They contend that they can earn $625 per loan (also high vs the industry) in a world where there are 10m loans. For context, in the year 2005 where the peak in loan originations happened, there was 6m in purchase loans and only during 2001-2006 period did purchase loans and refinances surpass 10m in volume.  In 2016 there was 7.7m loans originated (purchase and refi). We will argue that is closer to blue sky for ELLI and a normalized market would be closer to 6.5m loans, 35% lower than ELLI’s projected TAM.

Elevated Valuation

Elli’s valuation is unsustainable for the various headwinds; you are paying 6.5x EV/Sales for 6% organic revenue growth. Mortgage origination market is expected to be down again in 2018 largely driven by lower refi’s per MBA forecast.

 As of 3Q, organic revenue growth has slowed to 6% y/y, profits are declining. More concerning, total revenue per average user is now declining. Down 8% in 3Q. New customer growth (bookings) decelerating.

New competition at high-end from BlackKnight, largest mortgage servicing company in the U.S.. All of this….yet the “street” forecast an acceleration in sales and profit growth.

*White: P/E 55x

*Brown: EV/EBITDA 23x

Building Competition

https://www.housingwire.com/articles/39589-black-knight-targets-smaller-mid-tier-lenders-with-new-empower-los-platform

https://www.housingwire.com/articles/42446-black-knight-unveils-end-to-end-digital-mortgage-solution

Conclusion

ELLI is a compelling short.  We think that there is significant risk to revenue and earnings expectations in 2018 and 2019.  As these expectations are reset, we expect the stock rerate significantly lower. Our base case is the stock should trade at 25x 2019 EPS of $2.00 or $50 per share.

Catalyst

Bank lenders take back share in the mortgage market (or at the minimum stop ceding share). Rising interest rate environment leading to significantly lower refinance volumes. Mortgage lender employment trends reverse.