Best Stocks for 2016: Ellie Mae (ELLI) Is a Runaway Winner

Editor’s note: This column is part of our Best Stocks for 2016 contest. Jason Moser’s pick for the contest is Ellie Mae Inc (ELLI).

As someone who used to work in the home-lending business, I can testify to the brutality of the process, from start to finish, for all involved. If you’ve ever bought a house, I’m sure you can, too.

10BEST2016_final_185x185Ellie Mae (ELLI) is trying to make it better.

The company provides on-demand software solutions and services for the U.S. residential mortgage industry, and its primary offering, Encompass, is a cloud-based one-stop shop for mortgage originators, allowing them to manage the loan process from start to finish.

The Business

Encompass is a single system of record that helps customers streamline and automate the mortgage origination process. This increases efficiency and loan quality, reduces documentation errors, and helps keep everyone out of regulatory trouble.

Ellie Mae’s customers are mortgage originators, lenders, investors, and service providers. With about 517,000 state-licensed or federally registered individuals engaged in originating residential mortgages in the U.S. and more than 26,000 licensed companies or federal institutions for originating mortgages domestically, Ellie Mae’s market opportunity is around $5 billion. With TTM revenue just under $250 million, there’s a lot of room to grow. Below is a breakdown of the growth in Encompass users since 2012:

  2012 2013 2014 Today
Total Users 74,000 92,000 109,000 135,000
SaaS Users 41,000 64,000 85,000 116,000

Note: “Today” is as of Ellie Mae’s most recent conference call for third-quarter 2015 results.

The Opportunity

ELLI possesses a number of characteristics I look for in a great investment:

High barriers to entry – Thanks to the housing crisis we now have the Real Estate Settlement Procedures Act and Truth in Lending Act (RESPA-TILA) Integrated Disclosure Rule (“know before your owe”) which just recently took effect. Ellie Mae’s Encompass solution is widely acknowledged as the clear industry leader in all things compliance and it would be a tremendous challenge for competitors big or small to get up to regulatory speed with what Ellie Mae has already established.

High-switching costs – Assuming Ellie Mae is bringing a quality platform to the table (a safe assumption given the growth in users), the longer these users employ Ellie’s services the less incentive they have to ever switch, particularly if more and more users are signing on. Add to this the network effects that come into play as more sign on and those switching costs grow even higher.

Strong leadership – Ellie Mae was co-founded in 1997 by Anderman and Limin Hu, who remain today as chairman and chief technology officer, respectively. At the helm is CEO Jonathan Corr, an operational leader who previously served as COO and has been with the company since 2002.

The Risks

A big security breach – This risk is part and parcel with any cloud-based business, but that doesn’t make it any less important. Last March, Ellie Mae experienced a one-day outage that brought down its entire platform right at the end of the quarter, giving some mortgage professionals quite a scare.

A housing bust – Interest rates are on the rise now, meaning mortgage origination volume could decline over the next few years. Because Ellie generates a significant amount of variable revenue depending on mortgage volume, this could cause the stock to fall out of favor with investors.

To this point though it’s important to note two things. First, consider the number of lenders who haven’t started using Ellie Mae products yet. One of the toughest things for any lender to do is to switch over systems during extremely strong lending conditions. They’re always busy and switching over means that they would be significantly disrupting their business; not the greatest idea in the world.

Second, just because the refi boom is likely slowing down doesn’t mean there won’t be any more activity. The slide below breaks down how Freddie Mac sees the coming year in mortgage lending compared with previous years:

ellie mae mortgage originations best stocks 2016

Source: Freddie Mac presentation

The Valuation

Shares may look expensive at first glance with a price-to-earnings multiple in the 80s, but that number is somewhat misleading. On a non-GAAP basis, which adjusts for items that can veil the true earnings potential of smaller growth companies like Ellie Mae, that price-to-earnings multiple is a far more palatable 36. Its price-to-free-cash-flow multiple of 40 makes it look more enticing, particularly when we consider the quality of the business.

The Bottom Line

Those who know how we invest here at The Motley Fool know we look for high-quality businesses and invest with a longer timeline than most. Ellie Mae is a business that I really like and I think shares will perform well in 2016. More importantly though, I like it far beyond 2016. In fact Ellie Mae is a holding investors should plan on owning for the next 3-5 years if not even longer. Time is one of our greatest advantages as individual investors; let’s make sure to use it.

Jason Moser is a senior analyst for The Motley Fool’s flagship real-money portfolio service, Million Dollar Portfolio. He’s also a core member of the daily MarketFoolery podcast and the weekly show, Motley Fool Money. At the time of this writing, both Jason and the Million Dollar Portfolio were long ELLI stock. He’s been known to fire off a tweet or ten, and his Twitter handle @TMFJMo is where the magic happens.

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