Mortgage origination and refinancing activity in 1Q14 has been dramatically worse than forecasted which I think will negatively impact Ellie Mae’s earnings that will be reported after the close on today, May 1^st, 2014. Ellie Mae is a software-as-a-service (SaaS) company, which licenses it applications to mortgage brokers and lenders to use in the mortgage origination and refinancing processes. Unlike most SaaS businesses which earn the majority of their revenue from subscription costs, Ellie Mae earns the majority of its revenue from success-based fees, which are directly tied to mortgage origination and refinancing activity. If the mortgage market suffers, so will Ellie Mae’s revenue. The housing market has recovered much of its value, and on average homes prices are equal to where they stood in mid-2004, according to S&P/Case-Shiller. However, unlike the headline home-prices, mortgage origination and refinancing activity has slowed dramatically in 2013 and has been forecasted to continue to decrease in 2014 by the Mortgage Bankers Association (MBA).  While Ellie Mae’s guidance for the first quarter and upcoming fiscal year incorporated a forecasted decrease in mortgage originations and financings, data released since then indicates that the mortgage market is suffering much worse than had been anticipated at the start of the year. I believe that the market may be conflating housing prices and underlying mortgage activity, and thus not identifying the negative impact that the unexpected decrease in mortgage activity may have on Ellie Mae’s revenues.

Success-based pricing is a hallmark of Ellie Mae’s corporate strategy. The Company identifies it as one of their competitive advantages, allowing customers to align their revenues, which are generated from mortgage origination and refinancing, with their expenses. Additionally the company has disclosed that they are actively transitioning customers from subscription based fees to success-based fees. Currently 90% of Ellie Mae’s revenues come from success-based fees. I anticipate this percentage to increase as the company continues to shift its customers from subscription to success-based fees.

Ellie Mae issued quarterly and full year guidance in their last conference call which reflected a 31% decrease in mortgage volume year over year, based on MBA forecasts of $1.26B total mortgage originations and refinances. Since then however, the MBA has reduced its 2014 forecast by 15% following a ruinous first quarter where they reported that volumes were down 57% from the prior year.  Wells Fargo and JPMorgan, the nations’ 1^st and 2^nd largest mortgage lenders reported 67% and 68% decreases in mortgage volumes during 1Q14 compared to the years prior, respectively. I have multiple personal contacts in the mortgage brokerage industry who have suggested their businesses have decreased 50% in 2014 compared to the previous year.

I am expecting Ellie Mae to report lower than expected revenue for 1Q14 as well as to lower full-year guidance to reflect the stagnating mortgage market. The most recent readings of the MBA purchase index are 21 % lower than last year. The MBA Refinance Index (non-seasonally adjusted measure of refinance applications) is down over 70% from its reading in May of 2013 as everyone who could have refinanced seems to have refinanced. Ellie Mae trades at lofty multiples, 56x trailing P/E and 25x trailing EV/EBITDA. While the company has experienced significant growth over the past few years, their revenues and user base is clearly at risk in the face of declining mortgage and refinancing activity. The executives of Ellie Mae seem to agree, as they, as well as two members of the board of directors have sold over $5.3mm worth of stock from January 2014 through today. Taking their cue, I recommend a short position in the stock through earnings which will be reported after the market closes on May 1^st, 2014.