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It’s Time to Get Greedy With Ellie Mae Inc

The most recent quarterly report for Ellie Mae (NYSE: ELLI) -- which offers the Encompass platform for the mortgage business -- was brutal. Mortgage volume fell 8%. In the face of rising interest rates, refinancing fell off of a cliff. Guidance was cut significantly. And it appears home buying could be constrained for the foreseeable future.

As a result, shares plunged as much as 20% in a single day last week. Immediately, I doubled my position in the company. It now accounts for almost 4% of my real-life holdings. To understand why I'd do such a thing, it's important to get our head above the clouds and take a decades-long approach.

Take the long-view. Image source: Getty Images

The nuts and bolts of the business

The Encompass platform does two critical things: it helps mortgage professionals abide by all the relevant regulations without getting bogged down in them, and it connects professionals from all different sides of the business: banks, real-estate pros, title and licensing companies, and even appraisers. That means that once these professionals sign on to start subscribing to Encompass, there are two powerful forces that will likely keep them there for a long time.

The first is high-switching costs. Imagine that you are a small regional lender. You have trained all of your staff on Encompass, can rely on it to help you meet regulations, and have tons of data stored on the platform. Not only would switching to another platform be expensive, but it would be an enormous headache. As long as Encompass is good enough (it is), and not outrageously expensive (it isn't), you'll be staying on.

Furthermore, because the platform also connects those in the business, it benefits from the network effect. In other words, if I'm a lender that needs to find an appraiser, I can use Encompass to do that. With each lender that signs on to Encompass, other professionals have incentive to join. And when those folks join, more lenders have incentive to join. It's a virtuous cycle that keeps on going.

Here's the key: knowing that you've got two very powerful moats surrounding the business, what's the most important thing for long-term success?

Image source: Getty Images

The answer: grab market share as fast as possible. Already, it is predicted that 25% of all mortgages that are closed (refinancing and purchases) are completed via Encompass. That's hefty, but it also means there's lots of room for growth. And knocking any potential competition out would greatly improve Ellie Mae's long-term success.

A blessing in disguise?

To me, it seems like the ending of the refinancing cycle -- and the tight housing market constrained by the lack of supply -- is a classic case of short-term volatility making a company dominant in the long term.

At this point, an upstart looking to challenge Ellie Mae would be silly to increase spending: the markets are drying up. Unless they have a stellar balance sheet with lots of cash to burn, I think Ellie Mae will be able to grab incrementally more of the mortgage market precisely because of the slowdown. With over $450 million in cash and investments on hand, and only $16 million in long-term debt, Ellie Mae will be just fine.

Even during the most recent quarter, the company added 9,600 seats to the platform -- a number that would have been even bigger if larger clients were onboarded by the end of the quarter. If we back up, the long-term trends look like this.

Increasing Market Share -- Active Encompass Users
Infogram

Proceed with (some) caution

Lest you think my head is buried in the sand, I'm fully aware that Ellie Mae's stock could continue to trend downward for some time. If home builders don't bring more units online, we could be looking at a lengthy slowdown in the housing market. Because Ellie Mae counts on loan closing volume for a portion of its revenue, that could have serious implications for the top and bottom lines.

But those are things out of the company's control. The mortgage cycle will always go up and down. The key is having the most market share to enjoy the good times, and having a strong enough balance sheet to extend that share in the bad ones.

Trading for 49 times trailing earnings, the company might look expensive. But that's why I'm still holding a lot of cash on hand, and am willing to add more at better and better price points as time goes on. For investors with a long-term time horizon and a stomach for volatility, I suggest considering the same.

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Brian Stoffel owns shares of Ellie Mae. The Motley Fool owns shares of and recommends Ellie Mae. The Motley Fool has a disclosure policy.