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STREAMLINING THE MORTGAGE PROCESS
JUNE 12, 2012
The automation of the residential mortgage process has been one of the holy grails of financial services for twenty years. Despite all the money spent and technology developed it hasn’t happened.
Kris Tuttle email@example.com +1-617-934-1877
Conditions are now ripe for this effort to succeed. The two primary factors are that 1) the industry is ready to adopt new practices in what is a slack market and 2) the availability of cloud-based and mobile computing makes access and use of these solutions practical and incremental. We’ve been following one relatively new public company in this space, Ellie Mae, since they went public in April, 2010. This is our first note on the company, although it has been in the IPO Candy Folio now for some time and has performed very well. The stock has done well in what has been a very slow underlying market in homes and mortgages. There’s no telling when we might see a more robust mortgage lending market, but when we do the additional volume will drive revenue and increase margins at Ellie Mae as their fixed costs will shrink as a percentage of the total. Residential real estate in the US and related mortgage activity remains depressed and faces headwinds from “underwater” homeowners, tighter bank loan standards, increasing property taxes and a growing acceptance of renting as an alternative to ownership. However, even a depressed market offers large expansion opportunity for Ellie Mae since penetration today remains very limited. This brief note goes into more detail regarding the opportunity, the company, comparable companies and valuation.
Mortgages were once a common topic of conversation. People were all getting them to buy a new home, then refinancing them frequently to obtain better terms and/or receive spending cash based on the “excess equity” available. The process was time consuming and the final closing often required a day off to participate in a half day session where six or seven people, all representing different entities, gathered around a table to sign, sign, sign and sign some more papers. If everything went well the few hours would end with checks distributed, handshakes and general relief that the process was over. What many consumers don’t realize is that for the banks the process leading up to the closing is just as complex and daunting. In fact, the actual closing is just the tip of the iceberg in terms of how to effectively run the mortgage process from application through approval, then closure and subsequent packaging, securitization and servicing. The end-to-end mortgage application includes a daunting array of major processes including sourcing/application, documentation, underwriting, insurance, closing and servicing. Each one of these is big enough to be a market opportunity and enterprise application in its own right. Most of these systems also suffer from multiple data sources, manual processes and few, if any, external interfaces. According to the Mortgage Bankers Association the very large “mega banks” comprise about 50% of the market. The other half is made up of regional banks, savings & loans, specialty finance companies, credit unions and brokers. It’s this part of the market that lacks the resources and scale to build their own solutions and will rely on third party solution providers like Ellie Mae for their software and services. Ellie Mae Note 1 June 12, 2012
THE GROWTH EQUATION Beyond simple execution we like to observe real strategic transactions. The Ellie Mae software suite provides these services to the bank with a combination of software and transaction services that the bank licenses for use.com/news/pdf/americas_home_forecast. the Independent Community Bankers of America and the National Association of Home Builders concluded that the market for housing would go up without interruption and reach a level of 8. An industry rule of thumb is to budget at least $500/loan for direct processing costs. As it stands. (There’s more available market based on inefficiencies but we’re setting that aside for now.1 With the benefit of hindsight we can see that a more reasonable base figure to use that is very sustainable is 6M per year. For customers Ellie Mae delivers a more streamlined and responsive platform for business processing. The other element is a developing platform and network of providers that plug into the Ellie Mae “Encompass” software platform. From a customer perspective. 2012 . Changing regulations and increasing compliance burdens are driving many institutions to third party solutions and the on-demand model since even keeping packaged software current is becoming a challenge.pdf 1 Ellie Mae Note 2 June 12. At the same time. If all goes well the next few phases involve the closing. Generally speaking it’s a solu- America’s Home Forecast: The Next Decade for Housing and Mortgage Finance http://www. Freddie Mac.27M to 8. It’s a good way to get penetration and overcome the standard objections of institutions about having to “invest” in applications and platforms. WHAT ELLIE MAE DOES There are two main components to what Ellie Mae provides. The result is a $300M to $600M annual revenue opportunity versus our current estimate of $250M for 2017. which consists of gathering the basic information. There are probably some who would suggest these figures understate the opportunity because in time the US housing market will recover and loan volumes will rise to over 7M/year at that point. the National Association of Realtors. Today about half of the business is SaaS with the bulk of that being charged on a price-per-loan-processed basis. As described above. the post-closing documentation. selecting the terms and then creating a package that can be sent for processing and underwriting. our forecast through 2017 doesn’t include either a robust recovery in the US housing market nor “another leg down” in the path to recovery. there is more “room” between current estimate processing costs and the $150 per loan mid-point estimate we are using. in the case of Ellie Mae.Before the housing crash a group of experts that included the chief economists at Fannie Mae.freddiemac. There’s the front-end. Each of these has multiple steps and related systems with which to coordinate. and finally packaging and delivery to downstream parties. the mortgage origination and closing process is complicated but can be broken down into multiple phases.) To arrive at a reasonable market opportunity for ELLI we consider the 50% of the market outside of the megabanks and use a fee amount of $100 to $200 per loan. reviewing loan terms and rates. the success-based pricing model of $50-100 per loan makes it easy to determine ROI based on current margins and volume. which amounts to a $3B annual spending level.85M per year based on their study. In the past few years the company has been shifting their solution and business model to be more cloud based and use a SaaS model based on volume and incremental utilization. which is one of the leading alternative systems used in the market. credit checking. The first is enterprise application software that supports the mortgage process from beginning to end. their acquisition last year of DataTrac.
All in all.) They are further developed than Ellie Mae at this point but are illustrative of where we think ELLI may go over time. Guidewire came public more recently in January 2012 and has enjoyed a warm reception in the markets. Although it’s “obvious. both organically and via acquisition. Their revenue mix is already international as the P&C business is less geographically unique. There is a gold mine of not just financial and transactional data but also location-based intelligence and leveraging multiple data sources for improved underwriting.000 users and a greater number of on-network originations into which high-margin network-based transactions can be added.tion with less scope and no real network effect but the acquisition was done efficiently for $17M in cash and another $8M in potential earn outs. We had occasion to meet David when he was with NetApp and he presented their IT strategy and he is a very strong hire for this position. They promoted Jonathan Carr to COO from within and added outside executives – Cathleen Schreiner Gates out of Hyperion for Sales. With the acquisition. COMPARABLE COMPANIES & VALUATION We’ve put together a table of comparable and related companies. They do have a variable revenue component. 2012 . Lisa Schreiber from BofA and American Home Mortgage to focus on lender development. STRATEGY CORNER Ellie Mae is not an advisory client.com/reports/ 2 Ellie Mae Note 3 June 12. Company targets are a bit higher. Finally. The strategy is fairly clear. but in looking at their business it’s fairly clear that they have some large adjacent opportunities tied to greater use of information and data. That’s a major plus in our analysis. but one in particular stands out as being the most direct: Guidewire Software (GWRE. Our model puts top line growth in the 25% range with operating margins expanding with volume to 20%.” it’s not clear that the large residential mortgage firms are doing this. ELLI achieves critical mass: an additional 20. In terms of numbers.http://ipocandy.3 GWRE does for property and casualty (P&C) insurance what Ellie Mae does for mortgages. We know that it’s possible to actually pursue this strategy simultaneously with what the company is already doing and that it would add an additional source of revenue and also expand the valuation multiple. So far the company has been doing the right things in terms of building the management team. providing a suite of software to sell and manage policies. and the number of loans processed and additional network services used as part of each loan. David Robbins2 from NetApp as CIO. the culture of the company has fit well with their business plan and target market. They have adopted cloud-based software but still charge fairly large upfront prices. Guidewire gets some additional benefit from investors for clearly understanding and going after the “big data” opportunity in their area of business expertise. All this is summarized in our IV model shown below. which is to increase the number of users on the network. The result will be a client base and a network that scales up without much additional cost. the company is still small at $55M 2011 revenue but already profitable and increasingly so. The board of directors is fairly strong although it could do with one or two changes to bring some additional expertise and technology innovation into the mix. which in their case is tied to revenues generated rather than number of policies. 2012 . and a team of technology operational executives to build out their datacenter and hosting operations. collect premiums and pay claims. Guidewire offers a slightly better total value proposition and has built a larger customer base. We do know that large commercial enterprises like Starbucks are using these techniques. 3 Guidewire Software (GWRE) IPO Note January 25. This would be consistent with the company growth plans.
2% $21 20.0% $80 17.98 2011 $12 $52 $55 28.2% 75.94 22 1% $344 $30 $0 35% 20 15% Ticke r Exchange Re v Growth Curre nt Price Share s Out Avg. Despite the fact that all these companies have slightly different models. Inc. Fleetcor Technologies (FLT).23 22 $1 $56 $23 $80 $3.2x to 4.32 2010 $6 $43 $43 14. Additional companies included in the peer analysis include Higher One (ONE).0% $50 $33 $650 $160 23 $28 $20.0% $34 5.0% $31 41. It also happens that this is a multiple of 4. add services providers to the network and probably make a few more acquisitions.81 31% 2012 $23 $79 $78 40.4% $13 44.0% $2 $1 $25 $15.1% -$1 -$1 -$18 $34 $34 Price IV Delta 2009 $4 $38 $38 12.9x sales.0% $64 14.0% $1 $1 $11 $30 22 $1 $98 $31 $129 $5.0% 76. the Guidewire target model is less aggressive than what has been put forward at Ellie Mae. and SPS Commerce (SPSC). error-prone and manual process that has characterized mortgages in the past.0% $69 22. In the future we know that this process will become streamlined and far more automated. 2012 . Over the next several quarters we will be looking for Ellie Mae to continue to build out the number of users.0% $21 43.3% 67.8% 73. which provides a set of solutions for high education payments and student finance. which gives companies a simple platform upon which to integrate for online B2B commerce. Our intrinsic valuation (IV) estimate for ELLI comes in at $20.5% $7 44.1% $8 41. Ellie Mae Note 4 June 12.81 31% Intrinsic Value Up/Downside ELLI Nasdaq 24% $15.70 61.6% 72.0% $8 $5 $99 $41 22 $4 $372 $91 $463 $20.0% $193 18.0% $98 20.0% $38 40. If they take hold of the opportunity in “big data” and analytics related to this industry it will be icing on the cake.0% $4 $3 $51 $33 22 $2 $253 $63 $316 $14.8x projected sales of $95M for that year.7% $15 -4. which gives companies a streamlined solution for managing vehicles.94 $20. Dilution Cap (M) Cash De bt Tax Rate P/E Multiple Discount Rate CONCLUSION Ellie Mae is emerging as a leader in the shift of mortgage lending to the online world.0% $18 44.81 2014 $25 $120 $120 26.8% $19 2.0% $152 19.2% $10 44.0% $41 8.3% 74.0% $45 39.39 2013 $17 $93 $95 21.4% $25 3. industries and stages of development the price/sales range is fairly tight at 3.0% $116 20.1% $31 24.6% $16 5.Interestingly.8% $2 $1 $27 $30 22 $1 $161 $43 $205 $9.0% $34 $22 $442 $110 23 $19 2017 $50 $500 $250 25.0% $50 11.4% 71.0% $22 $14 $282 $76 23 $12 2016 $45 $500 $200 29.0% $25 42. When the housing market does recover we know that “digital natives” will recoil at the inefficient. ELLI 7-Feb-12 2008 Change in Re ve nue Conse nsus Re ve nue Re ve nue YoY Growth Gross Margin% Gross Profits R&D% R&D Expe nse SG&A% SG&A Expe nse Ne t Ope rating Margin Ope rating Income Taxe d Ope rating Income Marke t Value Using P/E Cash Position Share s (M) Pe riod Share Price PV of MV 4 Ye ars Out PV of Cash 4 Ye ars Out PV MV + Cash PV Value Pe r Share 22 -$1 $29 $19 $48 $2. Ellie Mae.0% $56 23.80 for 2013.7% 71. As befitting a $200M revenue company the management team and the board of directors at Guidewire are much expanded and upgraded.6% $40 23. Time will tell and there are certainly important differences in the structure of the two businesses.0% $13 $9 $172 $54 22 $8 2015 $35 $500 $155 29.0% 77.7% $26 21.0% $89 21.
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