Why Ellie Mae's Stock Is a Buy

Recently, I made the case that the market's sell-off of Ellie Mae (NYSE: ELLI) was overdone. Concerns about rising interest rates and slower mortgage activity were detracting from the long-term competitive advantages the company was successfully building. I even made a case that now could be a good opportunity for patient investors to initiate or add to a position.

As a follow-up to that article, I'd like to back that claim up and provide a few reasons why I think that.

Market volatility is your friend

To begin, long-term investors such as us thrive on time arbitrage. My colleague Ilan Moscovitz recently pointed out that Wall Street's quarterly earnings game is far crazier than you could imagine. Financial manipulation and twisted expectations are becoming the norm, supporting the claim that short-term investing is a fool's game (and that's with a lower-case "f").

But we Foolish investors are much more interested in the longer-term. We want to find and buy great companies that are selling at a discount to their intrinsic value. It's even better when the market gives us those great companies on sale, especially when due to concerns about short-term conditions that will eventually subside. Our ability to think in terms of years instead of months has been the greatest benefactor to our premium scorecards, which are vastly outperforming the broader market.

So as a primer to my case, great companies coupled with attractive price tags are a recipe for phenomenal long-term gains. Netflix's fall from grace after the Quikster debacle in 2011 or Amazon's Fire phone fiasco of 2014 are two cases that immediately come to mind.

Enter Ellie Mae

This brings us to Ellie Mae, which is also a great company building long-term advantages. Their Encompass software platform automates the mortgage origination process, significantly reducing the $7,300 average cost of a new loan. Ellie Mae is adding a significant number of new users and derives two-thirds of revenue from "fixed" subscription fees. They have an industry veteran as their CEO and are inducing switching costs that will keep their customers around for years.

The 25% sell-off of the past week simply isn't accounting for those long-term advantages. It's much more focused on a slowing US housing market, which is a short-term concern that will eventually about-face.

Ellie Mae shares now trade hands for around $86 per share, giving it a market capitalization of $3 billion. Based on historic multiples, this is one of the most attractive value points we've seen of the past three years.

The valuation

Bear with me, because I'm about to go through a bit of financial terminology mumbo-jumbo. (Feel free to jump ahead to the Foolish Takeaway if this section causes your eyes to glaze over).

Software-as-a-service (SaaS) type businesses like Ellie Mae invest heavily upfront. They need to buy servers and IT infrastructure, as well as pay developers (often in the form of stock-based compensation) to create awesome software that customers actually want to use.

As an analyst, I tend to look at adjusted EBITDA and total enterprise value as the preferred metrics to evaluate these types of enterprises. EBITDA credits back the amount of money a company spends on interest payments, taxes, depreciation, and amortization-and "adjusted" EBITDA also credits back the amount of stock-based compensation.

Total enterprise value refers to all forms of capitalization that a company has raised. It adds the company's market capitalization to long-term debt, but also subtracts out the cash they have on hand.

That said, SaaS companies tend to have limited EBITDA when they're scaling up and growing. But if they successfully add lots of customers who loyally pay them on a recurring basis, adjusted EBITDA can eventually reach around 35% of total revenue.

With as fast as Ellie Mae is currently growing, it's incredible to see the company's adjusted EBITDA margin already reaching nearly 30%. It's similar to replacing a NASCAR race car's tires (optimizing the platform and pulling in profits) at the same time as your stepping on the accelerator (adding new users).

Data provided by S&P Market Intelligence, as of 8/2/17.

Part two of my painstakingly long analyst calculation (hey, I warned you...) is Total Enterprise Value (TEV). Ellie Mae doesn't carry any debt or sit with much cash on the books. But it's good practice to use TEV instead of just market cap.

Data provided by S&P Market Intelligence, as of 8/2/17.

Combining parts one and two, we then consider TEV as a multiple of adjusted EBITDA-to get a feel for how "expensive" Ellie Mae is selling at the moment.

Data provided by S&P Market Intelligence, as of 8/2/17.

The Foolish Takeaway

As I wrote for our Million Dollar Portfolio service last year, long-term investors should be patient in accumulating the finest companies into a portfolio but also take full advantage of opportunities when they arise.

I'm publicly willing to make the case that now is one of those times. Ellie Mae is a high-quality business, and as an enterprise it is selling at the most attractive multiple of earnings power as we've seen in three years. This is an undervalued property in a nice neighborhood, and I think investors should take notice.

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The author(s) may have a position in any stocks mentioned.

Simon Erickson owns shares of Ellie Mae. The Motley Fool owns shares of and recommends Ellie Mae. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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