1 Stock That Could Be Crushed by Rising Mortgage Rates

Ellie Mae (NYSE: ELLI  )  could be in trouble.

Shares of Ellie Mae have crushed the market over the past several years from being in the right place, at the right time, with the right product.

Over this time, the company built a name for itself as the go-to vendor for one-stop software shopping if you are a mortgage broker. Can it do well in the wrong place, at the wrong time, with the right product?

We've seen the mortgage activity slam into a brick wall in the last six months, and there are indications the environment is getting worse.

The bull story is that Ellie Mae's software saves its clients as much as a few hundred dollars per mortgage application by streamlining the process, and this business will continue even during a downturn.

The bear case is that most CEOs say that just before revenue growth crumbles. The company missed estimates in the September quarter; is this the beginning of the end, or the end of the beginning?

The opportunity is huge
According to Ellie Mae, the industry is 20% penetrated, and its platform is only in 4 of the top 20 mortgage banks, including top-dog Wells Fargo. If these numbers are correct, there is significant opportunity out there simply by selling its core platform.

However, Ellie Mae has a revenue opportunity in cross-selling as well. In addition to building out new seats from its existing platform, Ellie Mae is making point-product acquisitions and going back to its existing customers for follow-on sales. This represents a revenue stream just by selling to existing customers. The most recent acquisition is a CRM company that developed its product specifically for the mortgage industry.

All of that sounds great, but there's one large problem: Nobody makes large purchases if their business is under duress, because the cost of failure is too great.

First client's business slows
Refinancing activity dropped as rates bounced off of all-time lows, dramatically reducing mortgage banking business. On January 15th, Bank of America announced that retail-first mortgage originations were down 49% year over year. Wells Fargo went further, stating mortgage originations were down 38%, and perhaps more importantly, volumes are expected to decline further in the coming quarter. Regional banks have been hit even harder as SunTrust said mortgage-lending income dropped 87% to $31 million, down from $241 million a year earlier.

Then come the cuts, first in headcount
Each of these banks saw the beginning of the end and pared back headcount in anticipation of lower revenues. According to several stories in The Wall Street Journal, as of January 2013, the following cuts were announced:

  • Bank of America: 4,000
  • JPMorgan Chase: 11,000
  • WellsFargo: 6,200
  • Citigroup: 1,100
  • SunTrust: 800 

This is just the beginning. The financial impact is just being felt, and while job cuts are the quickest way to respond, vendors servicing these clients will feel the pain in due course.

Weaker customers make for difficult closing
Also, to date, there has not been a slowdown in home purchasing, just the refinancing. If the weaker consumer spending that shocked retailers and restaurants during the Christmas season flows through to home purchasing, this could represent another leg down in mortgage business. Adding more fuel to the fire, interest rates could tick higher.

Advertising Ellie Mae is for sale may have scared the shorts but it wont get a deal done, just ask Blackberry
While in the past, desperate companies, like Palm, have been able to find a suitor, the entire sector is under pressure. A purchaser would want to know what normalized revenue growth and earnings will be for the company before going out on a limb.

Is Ellie Mae a top stock for 2014?
There's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

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David Eller

I started contributing to the Motley Fool in 2013. I have held research positions at two investment banks and two hedge funds before trying more entrepreneurial ventures. I'm passionate about helping people find freedom in financial independence. Feel free to add comments and start a discussion. I hope to use these articles as forums to learn from you as well as share my opinion.

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8/27/2015 4:06 PM
ELLI $74.06 Up +3.33 +4.71%
Ellie Mae CAPS Rating: ****