Ellie Mae (ELLI)has been one of the greatest stocks for investors to hold in recent history. Since going public in 2011 at $6 per share, shares of the mortgage origination software provider have increased more than thirteen-fold in the past six years, providing an incredible 54% average annual return.
But the company's most recent results were met not with fanfare, but trepidation. Shares have plunged nearly 25% during just the past week, as worries about the US housing market have many questioning the company's future growth potential.
Image source: Getty Images.
How worried should investors be about the recent stock price volatility? Let's take a closer look at some important numbers to find out.
The bigger picture
My colleague Dan Caplinger gave an excellent recap of Ellie Mae's second quarter results in this article. He rightly points out the concerns of several investors, as a "transitioning" mortgage market is shifting in focus from refinancing to new purchases. The Fed has now hiked short-term interest rates three times since December, which makes many homeowners a bit less eager to refinance their existing loans.
I check in quarterly with data about the bigger housing picture provided by the Mortgage Bankers Association. Last quarter, we did indeed see a rather significant transition in the US housing market.
| 1Q17 | 4Q16 | 3Q16 | 2Q16 | 1Q16 | |
|---|---|---|---|---|---|
| Total US Mortgage Origination Volume (in billions) | 361 | 470 | 561 | 510 |
350 |
| Purchase Volume (in billions) | 212 | 232 | 298 | 275 | 185 |
| Refinance Volume (in billions) | 149 | 238 | 263 | 235 | 165 |
Source: Mortgage Bankers Association Quarterly Origination Estimates
Aggregate refinance volume fell nearly 10% year-over-year (from $165 billion to $149 billion), while purchases increased more than 14%.
My interpretation of the above is that the US housing market isn't necessarily slowing, but it's changing. Lenders who have traditionally run businesses that offer refinancing will need to shift their focus in the upcoming quarters.
The "SaaS" business
For investors, the aggregate macro numbers aren't as important as how those individual mortgage brokers are actually using Ellie Mae's Encompass platform. The company has succeeded in attracting quite a few new users, and the number of contracted users has doubled in three years.
Encompass Contracted Users. Source: Ellie Mae Investor Presentation
Each quarter, the 232,000 users are generating subscription revenue because they must pay simply for the privilege of using Encompass. It doesn't matter how few or many loans they actually close, because Ellie Mae collects those subscription fees as contracted revenue.
| 2Q17 | 1Q17 | 4Q16 | 3Q16 | 2Q16 | |
|---|---|---|---|---|---|
| Contracted Revenue (in millions) | $67.1 | $62.9 | $58.0 | $54.5 | $49.6 |
| Year-Over-Year Growth Rate | 35% | 37% | 39% | 32% | 39% |
| Contract Users | 232,000 | 225,000 | 216,000 | 206,000 | 193,000 |
| Contract Revenue/Contract User | $289 | $280 | $269 | $265 | $257 |
Source: Company quarterly earnings reports.
The mortgage market is highly regulated and process-driven, so there are significant switching costs to getting rid of Encompass for another solution. As such, the steadily increasing user base will provide a lucrative recurring revenue stream. And Ellie Mae has had no problem in raising prices, as contract revenue per user continues to rise each quarter.
Overall, investors should take note that Ellie Mae's "fixed" contract revenue generated simply by having users on their platform now accounts for two-thirds of the top line and shows no signs of abating even in a transitioning mortgage market.
The variable revenue
Outside of the monthly subscriptions, Ellie Mae also gets paid when its customers use the platform for mortgage-related activities (ordering credit reports, appraisals, etc) or close new loans. This variable revenue much more closely follows the cycle of the US housing market.
When people are buying new homes and refinancing their old mortgages to get better rates, variable revenue is high. But when rates rise and housing activity slows down, variable revenue, too, can dry up.
| 2Q17 | 1Q17 | 4Q16 | 3Q16 | 2Q16 | |
|---|---|---|---|---|---|
| Variable Revenue (in millions) | $37.0 | $30.1 | $38.2 | $45.9 | $40.5 |
|
Year-Over-Year Growth Rate |
(9%) | 9% | 65% | 67% | 35% |
Source: Company quarterly earnings reports.
Interest rates have been essentially at zero for the past several years. In this unusual age of cheap money, variable revenue was on fire-often posting annual growth rates of greater than 60% as the company banked on a flurry of new loans being generated.
Of course, those good times can't last forever, and the market is worried about that 9% drop in variable revenue during the second quarter. We should realistically expect increasing rates to lead to lower refinancing volume -- though this is also offset to some extent by more users and more new purchases.
The foolish takeaway
Ellie Mae's entire history as a publicly traded company has come at the perfect time. Millennials are becoming first-time homebuyers, and extremely low interest rates have surged refinancing volumes. This stock's sell-off this past week was a resetting of expectations, and a belief that a slowing mortgage environment will result in lower returns for shareholders going forward.
But I think it would be wise for us to challenge those pessimistic assumptions. Ellie Mae is assembling the important pieces for long-term success. Their robust, all-encompassing software platform is becoming the de-facto standard of the industry, and high switching costs makes it easy for them to retain their customers for long periods of time. Management is top-drawer, and two-thirds of revenue is coming from subscriptions that aren't cyclical.
The recent sell-off seems to be an overreaction that is far too focused on the short-term state of the economy. There are still plenty of good times ahead for Ellie Mae, and now could be a good opportunity for patient investors to initiate or add to a position.
