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ELLI > SEC Filings for ELLI > Form 10-Q on 7-Aug-2013All Recent SEC Filings

Show all filings for ELLIE MAE INC

Form 10-Q for ELLIE MAE INC


7-Aug-2013

Quarterly Report


ITEM 2-MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q, including this Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. These statements relate to future events or our future financial performance. Forward-looking statements may include words such as "may," "will," "should," "expect," "plan," "intend," "anticipate," "believe," "estimate," "predict," "potential," "continue" or other wording indicating future results or expectations. Forward-looking statements are subject to risks and uncertainties and actual events or results may differ materially. Factors that could cause our actual results to differ materially include, but are not limited to, those discussed under "Risk Factors" in this report. We also face risks and uncertainties relating to our business including:
the number of Encompass users; the effectiveness of our marketing and sales efforts to attract new and retain existing SaaS Encompass users and Ellie Mae Network participants; transaction volume on the Ellie Mae Network; the level of demand for our Encompass Docs Solution and other services we offer; the timing of the introduction and acceptance of new Ellie Mae Network offerings and new on-demand services; interruptions in Ellie Mae Network service, our hosted Encompass software and any related impact on our reputation; our ability to protect the confidential information of our Encompass users, Ellie Mae Network participants and their respective customers; customer renewal and upgrade rates; fluctuations in mortgage lending volume; the volume of mortgages originated by our Encompass users; the impact of changes in mortgage interest rates; changes in mortgage originator, lender, investor or service provider behavior and any related impact on the residential mortgage industry; our ability to accurately forecast revenues and appropriately plan our expenses; the increased time, cost and complexity that may be required to successfully target larger customers; our ability to scale our operations and increase productivity to support our existing and growing customer base; our ability to successfully manage our growth and any future acquisitions of businesses, solutions or technologies; the timing of future acquisitions of businesses, solutions or technologies and new product launches; the impact of uncertain domestic and worldwide economic conditions, including the resulting effect on residential mortgage volumes; changes in government regulation affecting Ellie Mae Network participants or our business, and potential structural changes in the U.S. residential mortgage industry; the attraction and retention of qualified employees and key personnel; our ability to compete effectively in a highly competitive market and adapt to technological changes; our ability to enhance the features and functionality of our Encompass software and the Ellie Mae Network; our ability to protect our intellectual property, including our proprietary Encompass software; costs associated with defending intellectual property infringement and other claims; our ability to maintain effective internal controls and the risk of natural and man-made catastrophic interruptions to our business. We undertake no obligation to revise or update any forward-looking statements to reflect any event or circumstance that arises after the date of this report, or to conform such statements to actual results or changes in our expectations.
This discussion should be read in conjunction with the condensed consolidated financial statements and notes presented in this Quarterly Report on Form 10-Q and the consolidated financial statements and notes in our Annual Report on Form 10-K for the year ended December 31, 2012, or 2012 Form 10-K. Overview
We provide business automation software for a large segment of the residential mortgage industry in the United States. Our on-demand, technology-enabled software solutions help streamline and automate the process of originating and funding new mortgage loans, increasing efficiency, facilitating regulatory compliance and reducing documentation errors.
Mortgage originators use our Encompass360 software, a comprehensive operating system that handles key business and management functions involved in running a mortgage origination business. Mortgage originators use Encompass360 as a single tool for loan processing, marketing, customer communication and to interact electronically with lenders, investors and service providers over the Ellie Mae Network. It also enables enforcement of rules and business practices designed to ensure loan quality, adherence to processing standards and regulatory compliance.
We also offer Encompass360 users a variety of other on-demand software services, including: Encompass Docs Solution, which automatically prepares the disclosure and closing documents necessary to fund a mortgage; Encompass CenterWise, a bundled offering of electronic document management, or EDM, and websites used for customer relationship management; Total Quality Loan, or TQL, which offers a suite of fraud detection, valuation, validation and risk analysis services tailored to individual aggregator/investor requirements; Encompass Compliance Service, which automatically checks for compliance with federal, state and local regulations throughout the origination process; tax transcript services which provide income verification capability to our customers; and Encompass Product and Pricing Service, which allows Encompass360 users to compare loans offered by different lenders and investors to determine appropriate mortgage programs available to a particular borrower.
As of June 30, 2013, the Ellie Mae Network electronically connects the approximately 89,000 mortgage professionals using Encompass360 to the broad array of mortgage lenders, investors and third-party service providers integral to the origination and funding of residential mortgages. During the mortgage origination process, mortgage originators may order various services


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through the Ellie Mae Network, including credit reports, product eligibility and pricing, automated underwriting, secure data transmission to and from lenders and investors, appraisals, title reports, insurance, flood certifications, compliance review, fraud detection, document preparation and verification of income, identity and employment.
We were formed as a California corporation in 1997 and reincorporated in Delaware in November 2009. From inception through 2000, we developed consumer-facing websites and initial versions of our network. We launched our first transaction platform in late 2000, the present version of which is the Ellie Mae Network. In 2003, we introduced our internally developed loan origination software solution, the present version of which is Encompass360. Our revenues consist of on-demand and on-premise revenues. On-demand revenues are generated primarily from software subscriptions we host that customers access through the Internet, including customers who pay fees based on the number of loans they fund, or success basis, subject to monthly base fees, which we refer to as Success-Based Pricing. On-demand revenues also include software services that are sold transactionally as well as Ellie Mae Network transaction fees paid by lender-investors, service providers and certain government-sponsored entities participating on the Ellie Mae Network. On-premise revenues are typically generated from customer-hosted software licenses and related implementations, training and maintenance services. For further discussion of the sources of our revenue and our revenue recognition policy, please see "Critical Accounting Policies and Estimates" in Part I, Item 7 of our 2012 Form 10-K.
Our on-demand revenues generally track the seasonality of the residential mortgage industry, typically, but not always, with increased activity in the second and third quarters and reduced activity in the first and fourth quarters as home buyers tend to purchase their homes during the spring and summer in order to move to a new home before the start of the school year. Approximately 50% of our revenue historically has been sensitive to factors that impact mortgage volumes, such as interest rate fluctuations, home sale activity and general economic conditions. Increases in mortgage interest rates could reduce the volume of new mortgages originated and, in particular, the volume of mortgage refinancings. For example, in the last two months of the second quarter of 2013, mortgage interest rates increased by approximately one percentage point, which impacted the number of transactions completed over the Ellie Mae Network as the number of mortgage applications decreased.
We are investing aggressively in initiatives that we believe will help us continue to grow our business and improve our products and services. During the second quarter of 2013, we accelerated our investment in our sales and client services capabilities, as well as in technology infrastructure to support our user seat additions and overall business growth. These investments included expanding our talent across the organization by hiring additional personnel especially for our client services and implementation teams, building out new office facilities and upgrading our telephony system.
The residential mortgage industry has undergone significant changes since 2007, largely in response to the hundreds of billions of dollars of loan defaults and massive losses suffered by lenders and investors. Our business strategy has evolved to address recent industry trends, including:
expected lower lending volume;

increased quality standards imposed by regulators, lenders and investors;

increased regulation affecting lenders and investors;

greater focus on operational efficiencies; and

customers adopting multi-channel strategies

We are responding to these trends as follows:
Expected lower lending volume. Mortgage lending volumes are expected to be lower in 2013 as compared to 2012, as forecasted by Fannie Mae, Freddie Mac and the Mortgage Bankers Association. Since late 2009, we have focused our marketing and sales efforts on our on-demand SaaS Encompass360 offering, and particularly our SaaS Encompass360 Success-Based Pricing model, in contrast to our on-premise license model. In our on-demand SaaS Encompass360 offering, the customer does not pay the significant up-front licensing fee associated with our license model, which we believe is particularly attractive in the present climate of the residential mortgage origination market. Our SaaS Encompass360 Success-Based Pricing model builds on this value proposition by aligning customers' payments for our software solutions with their own receipts of revenues. Our focus on our SaaS Encompass360 offering is important in light of lower lending volumes because we typically generate greater revenues per user through our on-demand SaaS Encompass360 offering than through our on-premise license offering. We are also focusing on increasing use of our Ellie Mae Network offerings and our other services, which were introduced from late 2009 through late 2011. These offerings include our TQL initiative, Encompass Compliance Services, Encompass Product and Pricing Services and Encompass Docs Solution. At June 30, 2013 and 2012, Encompass360 users employed the Ellie Mae Network to process on average approximately six and five transactions per loan file, respectively. By continuing to enhance our service offerings and encouraging providers of settlement services to deliver their services electronically through the Ellie Mae


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Network, we will continue to build value for Ellie Mae Network participants while increasing the number of transactions for which the Ellie Mae Network is used.
Increased quality standards imposed by regulators, lenders and investors. Encompass360 is designed to automate and streamline the process of originating mortgages to, among other things, satisfy increased quality requirements of investors. Relevant features of Encompass360 include enabling customers' management to impose processing rules and formats, providing milestone and process reminders, automated population of forms with accurate data, and accurate and automated transmission of loan files and data from originators to investors and lenders. Our TQL initiative is designed to further enhance the quality, compliance and saleability of loans that are originated through Encompass360, and at June 30, 2013, we had two TQL investor customers. TQL is intended to reduce the opportunities for errors in the process of transferring information from originator to investor and give investors confidence in the accuracy and regulatory compliance of the information that is underlying loan files.
Increased regulation affecting lenders and investors. Regulatory reforms have significantly increased the complexity and importance of regulatory compliance. We devote considerable resources to continually upgrading software to help customers address regulatory changes. We offer Encompass Compliance Service, which automatically checks loan files for compliance with the myriad of federal, state and local regulations and alerts users to possible violations of these regulations. In addition, we have a staff of attorneys and work with compliance experts who help assure that documents prepared using our software and the processes recommended by the Encompass360 workflow comply with applicable rules and regulations. We believe we are well position to help our customers with additional regulations from the Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act, that will be effective in January 2014. Greater focus on operational efficiencies. Mortgage originators experienced an approximately 40% increase in direct production costs per loan between 2009 and 20111, and we expect this trend to continue due to continued increased regulation and heightened quality standards. By automating many of the functions of mortgage origination, we enable our users to comply with regulations and process quality loans more efficiently and effectively. This reduces the cost of originating a loan and lowers the risk of buy back demands from investors resulting from poorly originated or documented loans and/or loans that fail to comply with applicable regulations.
With an eye towards providing customers with ever-greater tools to enhance efficiency, we will continue to develop new service offerings through the Ellie Mae Network and pursue adoption of our services through initiatives such as our TQL initiative. By integrating and expanding our current and new services, we will provide a more comprehensive benefit to our users.
In addition to providing efficiency-enhancing solutions, delivery of our Encompass360 software in an on-demand SaaS environment provides customers with the added benefits of lower up front implementation costs and reduced need for an infrastructure of servers, storage and network devices as well as providing access to the most current release of an application, periodic upgrades and regulatory updates.
Customers adopting multi-channel strategies. Customers are developing multi-channel strategies beyond a single retail, correspondent or wholesale channel in order to grow their businesses. The requirements of these different channels vary and in order to maintain a single operating system, customers must use a robust system with highly configurable functionality. We continually address the changing needs of our customers by developing and enhancing tools to allow for simplified and consistent regulatory compliance, enhanced system functionality for each channel and increased workflow flexibility. Operating Metrics
Revenue per average active Encompass360 user and SaaS Encompass360 revenue per average active SaaS Encompass360 user are key operational metrics we use to evaluate our business, determine allocation of our resources and make decisions regarding corporate strategy. The revenue per average active Encompass360 user metric is calculated by dividing total revenues by average active Encompass360 users during the period. The SaaS Encompass360 revenue per average active SaaS Encompass360 user metric is calculated by dividing total SaaS Encompass360 revenues by average active SaaS Encompass360 users during the period. We focus on these metrics to determine our success in leveraging our user base to increase our revenues. We track active Encompass360 users and active SaaS Encompass360 users as well as related revenues generated by each group at the end of a period to gauge the degree of our market penetration. The components used to calculate these metrics are defined below.
Active Encompass360 users. An Active Encompass360 user is a mortgage origination professional who has used Encompass360 at least once within a 90-day period preceding the measurement date. An Encompass360 user is a mortgage origination professional working at a mortgage lender, such as a mortgage bank, commercial bank, thrift or credit union, which sources and funds loans and generally sells these funded loans to investors; or a mortgage brokerage, which typically processes and submits loan files to a mortgage lender or mega lender that funds the loan.


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1 Mortgage Bankers Association, Annual Mortgage Bankers Performance Report 2011 Data, Net Loan Production Income and Expense, $ per loan, Copyright June 2012.


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Average active Encompass360 users. Average active Encompass360 users during a period is calculated by averaging the monthly active Encompass360 users during a period.
Active SaaS Encompass360 users. An active SaaS Encompass360 user is a mortgage origination professional who has used the SaaS Encompass360 system at least once within a 90-day period preceding the measurement date.
Average active SaaS Encompass360 users. Average active SaaS Encompass360 users during a period is calculated by averaging the monthly active SaaS Encompass360 users during a period.

The following table shows these operating metrics as of and for the three and six months ended June 30, 2013 and 2012:

                                           Three months ended June 30,           Six months ended June 30,
                                             2013               2012              2013               2012
Revenues (in thousands):
Total revenues                         $      34,270       $      23,569     $     65,125       $     44,475
Total SaaS Encompass360 revenues       $      18,608       $      10,713     $     35,090       $     19,091
Users at end of period:
Active Encompass360 users                     88,688              62,487           88,688             62,487
Active SaaS Encompass360 users                55,952              32,114           55,952             32,114
Active SaaS Encompass360 users as a
percentage of active Encompass360
users                                             63 %                51 %             63 %               51 %
Average users during period:
Active Encompass360 users                     86,045              61,394           82,144             59,167
Active SaaS Encompass360 users                53,376              31,171           49,622             29,349
Active SaaS Encompass360 users as a
percentage of active Encompass360
users                                             62 %                51 %             60 %               50 %
Revenue per average user during
period:
Revenue per average active
Encompass360 user                                398                 384              793                752
SaaS Encompass360 revenue per average
active SaaS Encompass360 user                    349                 344              707                650


Basis of Presentation
General

Our consolidated financial statements include the accounts of Ellie Mae, Inc. and our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated upon consolidation. Revenue Recognition
We generate primarily on-demand revenues and on-premise revenues. Sales taxes assessed by governmental authorities are excluded from revenue. On-demand Revenues
On-demand revenues are revenues generated from software subscriptions we host that customers access through the Internet as well as revenues from a small number of customers that have opted to self-host a portion of the software but pay fees based on a per closed loan, or success, basis subject to monthly base fees, which we refer to as Success-Based Pricing. On-demand revenues are also comprised of software services sold transactionally and Ellie Mae Network transaction fees.
On-premise Revenues
On-premise revenues generally are revenues generated from customer-hosted software licenses and related implementation (except for customer-hosted Success-Based Pricing revenues included in on-demand revenues described above), training and maintenance services.


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Cost of Revenues and Operating Expenses
Cost of Revenues
Our cost of revenues consists primarily of: salaries and benefits, including stock-based compensation; royalty expenses for document preparation, income verification and compliance services; customer support; data centers; depreciation on computer equipment used in supporting our hosted software solutions; amortization of acquired intangible assets; professional services associated with implementation of our software; and allocated facilities costs. We expect that our cost of revenues will continue to increase in absolute dollars as our revenues increase, as we make additional investments in our technology infrastructure and as we continue to hire additional personnel in our SaaS operations, professional services and customer support departments to support new customers and new service offerings. Sales and Marketing
Our sales and marketing expenses consist primarily of: salaries, benefits and incentive compensation, including stock-based compensation and commissions; allocated facilities costs; expenses for trade shows, public relations and other promotional and marketing activities; expenses for travel and entertainment; and amortization of acquired intangible assets such as customer lists and contracts. We expect that our sales and marketing expense will continue to increase in absolute dollars as increased revenues generate additional commission expense and as we continue to hire additional sales personnel in order to address anticipated demand for our software solutions as we expect an increased number of mortgage lenders to assess new platform options and replace their legacy systems. We also intend to increase marketing activities focused on SaaS Encompass360, our Ellie Mae Network offerings and our other Encompass services. Research and Development
Our research and development expenses consist primarily of: salaries and benefits, including bonuses and stock-based compensation; fees to contractors engaged in the development and support of the Ellie Mae Network infrastructure, Encompass360 software and other products; and allocated facilities costs. We expect that our research and development expenses will continue to increase in absolute dollars as we continue to invest in our products and services and infrastructure, including hiring additional engineering and product development personnel.
General and Administrative
Our general and administrative expenses consist primarily of: salaries and benefits, including bonuses and stock-based compensation, for employees involved in finance, accounting, human resources, administrative and legal roles; consulting, legal, accounting and other professional services by third-party providers; and allocated facilities costs. We expect general and administrative expenses in 2013 to exceed those in 2012 both in absolute dollars and as a percentage of revenues with a significant increase related to greater amounts of stock-based compensation expense relating to awards granted to attract and retain employees as well as increases in headcount and facilities to support the continued growth of our business.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income earned on investments, cash accounts and notes receivable, offset by investment premium amortization and imputed interest expense related to the Del Mar Datatrac, Inc., or DMD, acquisition holdback payments and interest expense paid on equipment and software leases.
Income Taxes
On a quarterly basis, we evaluate our expected income tax expense or benefit based on our year-to-date operations, and we record an adjustment in the current quarter. The net tax provision is the result of the mix of profits earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates. We are required to estimate deferred tax assets and liabilities based on the differences between the financial reporting and tax bases of assets and liabilities measured using the enacted tax rates that will be in effect when the differences are expected to reverse. In general, deferred tax assets represent future tax benefits to be received when certain expenses previously recognized in our consolidated statements of operations become deductible expenses under applicable income tax laws or loss or credit carry forwards are utilized. Accordingly, realization of our deferred tax assets is dependent on future taxable income against which these deductions, losses and credits can be utilized. We use management judgment to assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than not, we must establish a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized.


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Critical Accounting Policies and Estimates Deferred Commissions
Deferred commission expenses are the incremental costs that are directly associated with non-cancelable subscription contracts with customers and consist of sales commissions paid to our direct sales force. Commissions are calculated based on a percentage of the revenue for the non-cancelable term of subscription contracts, which are typically one to five years.
Prior to 2013, commissions were paid and recognized as sales expense when customer payments for contracted services were received on a monthly basis because commissions were earned based on receipt of customer payments. In 2013, we amended our commission plans to provide for payment after the customer's contract is signed. As a result of the change in commission plans, beginning in 2013, commission expense is deferred and amortized to sales expense over the non-cancelable terms of the related subscription contracts. The deferred commission expense amounts are recoverable through the future revenue streams under the non-cancelable customer contracts. The new plans also include claw back provisions, which allow for repayment of a proportionate amount of commissions, should customers cancel their contracts prior to the end of the initial contractual term.
There have been no other material changes during the three and six months ended June 30, 2013 to our critical accounting policies and estimates previously disclosed in our 2012 Form 10-K.
Results of Operations
The following tables set forth our results of operations for the periods . . .

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