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Edited Transcript of ELLI earnings conference call or presentation 9-Feb-17 9:30pm GMT

Thomson Reuters StreetEvents

Q4 2016 Ellie Mae Inc Earnings Call

PLEASANTON Feb 10, 2017 (Thomson StreetEvents) -- Edited Transcript of Ellie Mae Inc earnings conference call or presentation Thursday, February 9, 2017 at 9:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alex Hughes

Ellie Mae, Inc. - VP of IR

* Jonathan Corr

Ellie Mae, Inc. - CEO

* Ed Luce

Ellie Mae, Inc. - CFO

* Matt Levay

Ellie Mae, Inc. - SVP of Finance

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Conference Call Participants

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* Sterling Auty

JPMorgan - Analyst

* Saket Kalia

Barclays Capital - Analyst

* Brian Essex

Morgan Stanley - Analyst

* Brian Schwartz

Oppenheimer & Co. - Analyst

* Brett Bracelin

Pacific Crest Securities - Analyst

* Mayank Tandon

Needham & Company - Analyst

* Richard Baldry

ROTH Capital Partners - Analyst

* Brandon Dobell

William Blair & Company - Analyst

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Presentation

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Operator [1]

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Good day everyone, and welcome to the Ellie Mae's Q4 2016 earnings call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Alex Hughes, Vice President of Investor Relations. Please go ahead, sir.

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Alex Hughes, Ellie Mae, Inc. - VP of IR [2]

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Thank you, operator. Good afternoon, and thank you for joining us on today's conference call this call to discuss Ellie Mae's fourth-quarter and FY16 results. This call is being broadcast live over the web, and can be accessed for 90 days in the Investor Relations section of Ellie Mae's website, www.elliemae.com. Joining on today's call are Jonathan Corr, Chief Executive Officer; Ed Luce, Chief Financial Officer; and Matt Lavay, Senior Vice President of Finance.

We would like to remind you that during the course of this conference call Ellie Mae's management team will make projections and other forward-looking statements regarding future events or the future financial performance of the Company. We wish to caution you that such statements are simply predictions, and actual events or results may differ materially.

We refer you to the documents that the Company files from time to time with the Securities and Exchange Commission, specifically the Company's forms 10-K and 10-Q. These documents identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

I also want to inform our listeners that management will make some reference to the non-GAAP financial measures during the call. You will find supplemental data in the Company's press release, which includes reconciliations of the non-GAAP measures to the comparable GAAP results. Now I'd like to turn the call over to Jonathan Corr.

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Jonathan Corr, Ellie Mae, Inc. - CEO [3]

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Great. Thanks, Alex. Good afternoon everybody, and thanks for joining us today. I am pleased to report that we finished the year with strong bookings, revenue and profitability as lenders continue to embrace the all-in-one solution of Encompass.

It's not only been a great year for bookings and financials, but the technology team has completed significant milestones in the delivery of our next generation open lending platform, which we believe delivers increased value to our customers and partners and will extend our leadership position even further. As we enter 2017 we remained well positioned to grab additional market share. On today's call I'll cover some fourth-quarter highlights and then discuss our priorities and focus for 2017.

Turning to the highlights, we continue to see strong and healthy bookings across the business. Bookings were 12,000 for the fourth quarter and approximately 53,000 for the full year, bringing total contracted seats to nearly 216,000. Bookings showed a healthy mix between new customer wins and seat additions through existing growth from customers.

Looking forward our pipeline remain solid, with the majority of seats continuing to be skewed towards strategic and enterprise segments and well balanced among banks, credit unions and independent mortgage bankers. In addition we continue to see strong interest in our platform from lenders within the mid-market segment.

Through the fourth quarter, we also continued to drive strong financial results with Q4 revenue increasing 48% year over year and adjusted EBITDA growing 72%. The fourth quarter benefited from increased volume, as consumers moved to refinance before a potential rise in rates.

At the same time our technology portfolio is gaining momentum, as the team continues to execute on the development and delivery of our next generation lending platform. Our next generation platform leverages a new, open, secure and scalable architecture so that lenders and partners across the network can work more efficiently and seamlessly.

So in addition to releasing foundational elements through the recent versions of Encompass this year, the team has also launched initial offerings in our new Encompass Connect Solutions Suite, which helps improve visibility and collaboration between loan officers, third-party originators, developers and homebuyers. In January we released Loan Officer Connect so that loan officers can originate and move loans forward quickly, while gaining instantaneous and secure access to Encompass from any device. This comes on top of TPO Connect, Third-Party Originator Connect, which provides wholesale and correspondent lenders an easy and collaborative platform to do business with their third-party partners.

As we turn to 2017, we are on track to roll out additional solutions. At the end of the first quarter we will be releasing Consumer Connect and Developer Connect.

Encompass Consumer Connect enables lenders to deliver a state-of-the-art, engaging, self-service online origination experience for homebuyers, and one that lenders completely control and easily create.

Encompass Developer Connect provides developers with APIs, tools and a comprehensive developer portal. Developers will be able to create new features for Encompass, easily integrate Encompass with external systems and data, and build and deploy custom applications in the cloud. This will generate greater value across the network and increase the stickiness of the Encompass lending platform.

Later this year we'll introduce the first release of Encompass NG, focused on mid-market compass customers, and then progressing to subsequent releases as we move into 2018 to address both strategic and enterprise customers. These are incredibly exciting new solutions.

We believe that by creating an open lending platform we can accelerate the industry's transition to automation, which is essential to reducing costs and complexity that plagues loan origination today. In addition, lenders realize that they need to adopt technology, not only to overcome cost and complexity but to become more responsive and competitive for their customers.

An increasing population of borrowers expect better digital tools, an easy to use web-based experience, and a much smoother and faster closing process. We believe our open next-generation lending platform puts lenders in a position to better meet these needs. In fact, we're excited to showcase our technologies with customers this March at our annual user conference Experience, which is expected to draw 3,000 attendees from across the country, which will be almost 40% larger than our 2016 conference, as well as more than 100 industry exhibitors and sponsors will be joining us.

For the industry, overall mortgage volume is expected to decline in 2017, with forecasters expecting the percentage of purchase loans to continue to increase. Although the decline in mortgage volume represents a headwind for our business, the strength of our value proposition and the value we provide lenders in improving their operating efficiencies gives us confidence that we can expand our footprint and continue to book 8,000 to 10,000 seats per quarter.

These bookings, along with our record bookings from 2016 and ongoing adoption of existing services, lay a foundation for solid growth as we move into 2017. We're excited about the year ahead as we continue to deliver innovative technology that allows customers to drive productivity in new and transformative ways.

With a solid new business pipeline, we see continued opportunity to expand our market share and make progress on our vision of automating the entire mortgage industry. With that, I'll hand it over to Ed to cover the financials one last time before Matt assumes the role next quarter. Ed?

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Ed Luce, Ellie Mae, Inc. - CFO [4]

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Thank you, Jonathan. I will try not to get too sentimental here. We had a great fourth quarter and a tremendous year, as you've heard.

For the full year 2016, total revenue grew 42% to $360.3 million. Net income increased 70% to $37.8 million, and adjusted net income grew 43% to $74.8 million. Adjusted EBITDA increased 51% to $113.1 million.

For the fourth quarter of 2016, total revenue was $96.2 million, an increase of 48% from the fourth quarter last year. Contracted revenue in the fourth quarter increased 39% year over year to $58 million, representing 60% of total revenue.

Revenue per active Encompass user increased 24% year over year to $587 for the quarter. We continue to expand our market share with fourth-quarter bookings of 12,000 new seats. The number of contracted seats on our platform finished the year at nearly 216,000, as Jonathan indicated, and the number of active users finished at over 164,000.

You continue to see contracted seats outpace active seats, mainly because of our increased bookings from larger lenders who typically bring longer implementation times, as well as from the winter seasonality in the fourth quarter. Implementation and professional services revenue also increased year over year, driven by our strong booking and the onboarding of new customers.

For the full year professional services and training revenue grew by 66% and represented approximately 7% of revenue. In the fourth quarter it grew by 94% on increased implementation activity from the recent bookings.

Gross margin for the fourth quarter was 66%, down 2 points sequentially on seasonally lower transactional revenue, and up 2 points year over year on higher volumes. Net income for the fourth quarter was $10.9 million, or $0.31 per diluted share, compared to $4.8 million, or $0.16 per diluted share in the fourth quarter of 2015, and reflects the effect from an additional 3.2 million shares issued in our August follow-on offering.

The tax rate on a GAAP basis was approximately 26% in the fourth quarter, which benefited from the timing of annual R&D tax credits. For the full-year our tax rate was approximately 33%.

On a non-GAAP basis, adjusted net income for the fourth quarter was $20 million, or $0.57 per diluted share, compared to $13.5 million, or $0.44 per diluted share in the fourth quarter of 2015, and also reflects the impact from the additional shares. Adjusted EBITDA for the fourth quarter was $29.4 million compared to $17.1 million in the fourth quarter 2015.

Now shifting to the balance sheet and cash flow. We finished the year with cash and investments of $469 million, up $36 million from the third quarter. Cash flow from operations was nearly $103 million for the year, while CapEx, including both capitalized development costs and hard capital purchases, was approximately $60 million for the year. So we had a very strong free cash flow of $42 million for the year just ended.

Now turning to the guidance, our 2017 annual guidance takes into consideration industry forecasts for mortgage origination volume. We use the composite estimates of mortgage origination volume as published by Fannie Mae, Freddie Mac and the Mortgage Bankers Association to forecast certain portions of our business. For 2017 this composite now shows an estimated 21% decline in origination volumes from 2016, which is driven entirely by an expected decline in refinance activity.

For the first quarter, origination volumes are expected to decline 31% sequentially with seasonality, and decline 7% year over year. The detailed blended forecast data can be found on our supplemental data sheet is posted on the Investor Relations section of our website.

As Jonathan also noted, we've had a tremendous year of seats bookings and believe our pipeline remain solid going into 2017. We should see new users that we added in 2016 begin to ramp activity and production this year.

This combined with seat additions at the rate of 8,000 to 10,000 per quarter should help drive solid revenue growth in 2017. With mortgage volumes expected to be down 21% in 2017 however, we are taking a prudent approach to our guidance, and anticipating slower growth in variable revenue components, primarily for loan fees and network transactions.

That being said, we are pleased to post our expectation for top-line revenue growth for 2017 in the range of 20% to 22%. This leads to a 2017 revenue range of $433 million to $440 million.

Net income on a GAAP basis is expected to be in the range of $45 million to $50, or $1.23 to $1.36 per diluted share. Adjusted EBITDA is expected to be in the range of $139.5 million to $147.4 million, and adjusted net income for the year is expected to be in the range of $65.6 million to $70.7 million, or $1.79 to $1.92 per diluted share.

Let me remind you about two accounting rule changes that have taken place for 2017. One is by the Financial Accounting Standards Board and applies to the accounting surrounding employee share-based compensation.

This has the effect of increasing our GAAP net income in 2017 by reducing our tax expense. However, it is excluded from the calculation of adjusted net income so there is no impact on a non-GAAP basis.

This brings me to the second change, which is from the Securities and Exchange Commission. As we mentioned last quarter, starting this year we are conforming our definition of adjusted net income with the most recent guidelines around non-GAAP reporting issued by the SEC, which asks that companies tax-affect the add-back of stock-based compensation and the amortization of intangibles. To assist with your models we have posted an historical bridge on our Investor Relations website that reconciles the old method with the new method for adjusted net income.

Now turning to the first quarter of 2017. Revenue is expected to be in the range of $92 million to $93 million, despite industry volumes forecasted to be down 7% year over year and 31% sequentially. Net income is expected to be $4.5 million to $5 million, or $0.13 to $0.14 per diluted share.

Adjusted net income is expected to be in the range of $7.4 million to $7.5 million, or approximately $0.21 per diluted share. Adjusted EBITDA is expected to be in the range of $19.3 million to $19.5 million. Operating margins tend to run a little lighter in the first quarter, primarily because of the timing of our annual user conference that Jonathan mentioned.

For the year we expect to continue to make capital investments in several key areas, most notably in next generation development, security and the data centers. In addition, given the tremendous growth we are experiencing, we're expanding our office footprint.

Total CapEx and investments should be in the range of $90 million to $95 million for the year. When the investments for our office expansion are backed out, CapEx as a percentage of sales is up slightly compared to last year, and is fairly evenly split between capitalized development costs and hard CapEx.

For the full-year we expect free cash flow in the range of $55 million to $65 million. The first quarter will continue to be the low point for free cash flow due to seasonality, investment commitments and the timing of performance-based compensation payments. Total free cash flow for the first quarter should be in the range of a minus $20 million to $25 million.

Finally before we turn to your questions, I would like to remind you that we will be hosting our Analyst Day in Las Vegas on March 7 in conjunction with the annual Experience user conference, and we hope to see some of you there. In addition, we will be participating in the JMP Technology Conference in San Francisco on February 28, the Morgan Stanley Technology and Media Conference also in San Francisco on March 2, and the Roth Annual Conference in Laguna Beach the week of March 13.

One final note. As this is my last earnings call at Ellie Mae, I want to add that it has been a real pleasure getting to know many of you on Wall Street over the past six years since our IPO. I know Matt is going to be terrific in his new role at CFO here at Ellie, and I look forward to continue to be a resource for Matt, for Jonathan and for the entire team. And now we'd like to open the lines for questions, operator.

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Questions and Answers

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Operator [1]

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Thank you.

(Operator Instructions)

Sterling Auty, JPMorgan.

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Sterling Auty, JPMorgan - Analyst [2]

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Thanks. Hi, guys. Ed, it has been a short tenure getting a chance to work with you, but I really appreciate it, and good luck with all the future endeavors.

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Ed Luce, Ellie Mae, Inc. - CFO [3]

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Thanks, Sterling.

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Sterling Auty, JPMorgan - Analyst [4]

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To kick off in terms of questions. Obviously we've had tons of questions that you're getting, we're getting as well, around mortgage volumes, et cetera. I actually wanted to ask it this way. One of the questions that we get frequently is, you see the 8,000 to 10,000 seats that you're expected to add.

What do you think is happening to headcount and the number of potential seats in the industry as a whole, as well as the seat count at your customers? Is there any concern that we would see headcount reductions and a squeeze on just the number of seats, like I said, in the industry and at your customers in 2017?

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Jonathan Corr, Ellie Mae, Inc. - CEO [5]

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Great question, Sterling. This is Jonathan. As we look out and we talk to our broad array of customers, there obviously our customers adding seats as well as customers maybe reducing seats here or there. We definitely see more folks have kind of positioned themselves, and have been really prudent I'd say, in terms of how they've gone out there, thought about expansion of their businesses, because there was an expectation that refi has been expected to go down for a while.

They got a little bit of extra juice, I think, in 2016 but they really have been managing their businesses to focus on the purchase side of the business. And so they really manned themselves with a set of expectations.

We're actually seeing people start to actually expand the number of seats that they have, because one thing to remember is that, all things being equal, you actually need more people to effectively do purchase business because you need loan officers out there with relationships with real estate agents really working it versus refi, which in many cases, can be a call center where calls are just coming in and people are refi'ing.

Even with the dynamic of the volume in refi going down, the number of folks working at driving purchase actually probably slightly goes up. So it ends up becoming, more than anything, probably pretty much a net neutral.

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Sterling Auty, JPMorgan - Analyst [6]

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Got it. And one follow-up question. On some of the newer things you talked about, Consumer Connect, Developer Connect, especially in Developer Connect, how do you monetize that opportunity?

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Jonathan Corr, Ellie Mae, Inc. - CEO [7]

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So Developer Connect you can of almost think of it as an extension of what we have been doing over the years relative to the Ellie Mae network, as well as the software development kit that we have. We have an ecosystem of thousands of providers, whether they be service providers or software developers, that utilize the mechanisms that are already in place.

We monetize those through either transaction fees or a small percentage of the revenue stream that's received by those providers. This really takes it up a level and increases the number of things that lenders, partners, whether they be network partners or ISVs can do on the platform.

And as they do more things and create more value for the ecosystem, we take a small percentage of that as part of the business model. So it's really just an extension of what we've already been doing. Our expectation is that it's going to increase the number of things that are done across the platform, which ultimately should drive additional incremental revenue.

It's going to create stickiness of the platform, and then there are things that we'll be surprised at what people will do. And I think we'll be surprised in many positive ways. It's not like a new thing for us, it's an extension of what we've already been doing.

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Sterling Auty, JPMorgan - Analyst [8]

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Got it. Thank you, guys.

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Jonathan Corr, Ellie Mae, Inc. - CEO [9]

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Sure.

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Operator [10]

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Saket Kalia, Barclays Capital.

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Saket Kalia, Barclays Capital - Analyst [11]

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Hi, guys. Thanks for taking my questions here, and congrats, Ed, on a great run.

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Ed Luce, Ellie Mae, Inc. - CFO [12]

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Thanks, Saket. Appreciate it.

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Saket Kalia, Barclays Capital - Analyst [13]

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Yes. So first, Jonathan, maybe I will start with you. I think one of the drivers that you and Ed talked about for the better growth next year versus overall volumes is really the ramping productivity for some of the seat bookings, for some of the growing seat bookings that you've done this year. So the question is, how do you think about the contracted user base in terms of how many of them are maybe above, quote unquote, normal productivity versus still ramping?

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Jonathan Corr, Ellie Mae, Inc. - CEO [14]

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So what we do, and we've talk about it before, it's a very comprehensive model. You can probably think about things into three broad buckets.

One is customers that have been with us for an extended amount of time, which is a minority percentage. They've been here, say, three-plus years in terms of the success-based model.

They're at probably a maturity level, or a productivity level at this point that loan volume coming down will have some effect on the margin. Now, we're still penetrating them with services that are on the network and new services, but on a volume basis they will be affected a little bit.

You have another group that is in the middle that has already been deployed but is going through their ramp. And that ramp of productivity to what we'll will call full productivity is a multi-year round. So they're growing at a pace, in many cases, that is greater than any volume headwind.

And then you have the big chunk, again at the bottom of that, which are customers that have not even been deployed yet, or are in the early stages of deployment. So anything that they do in terms of loans per user adds to the picture because it's just incrementally adding it.

We really take all that into our model, and that's what drives the core growth in terms of users and loan volume. Remember on top of that you've got a lot of activity going on in terms of people continuing to move up the network adoption curve, that other services that we have that have already been in place that people have been adopting, whether it will be AllRegs or CRM or some of the other subscription services we have in terms of pricing, et cetera that continue to fall an adoption or penetration curve.

And then the new products I just talked about, TPO Connect, Consumer Connect, Loan Officer Connect, the early Connect solutions that are going to be adopted by the base. Now, all of those don't necessarily have a brand-new price associated with them, but they fuel, if you remember, the fact that as time goes on, prices tend to go up both on a user basis on our platform and a per loan basis.

It's kind of the idea of, as we deliver more value we can drive that up. Those are all the components that really drive that picture.

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Saket Kalia, Barclays Capital - Analyst [15]

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That's really helpful, and actually great segue into my follow-up. And I think you kind of answered it a little bit, but just to be completely clear. You had so many new product announcements over the last couple of quarters, how do you think about those products contributing to both seat count and overall revenue in 2017?

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Jonathan Corr, Ellie Mae, Inc. - CEO [16]

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They, I think -- haven't broken it out per se, but what we are definitely seeing is we are seeing folks embrace these new solutions, which again as we do renewals and as prices go through their natural -- as we raise them in terms of seats and per loan, that is going to contribute on that side. One of the things that folks have asked in the past is, what about the regulatory environment? As it potentially loosens, what is going to happen there? What we are seeing is actually most folks don't think that regulation is going to change dramatically.

They're hopeful that there's going to be some level of loosening, which I think will be good for the entire system. But really our customers are focused on investing in innovation. That is why so many of the things we announced are really driven by what our customers want to do and the kind of capabilities they want to utilize to better position themselves with the purchase business, new homebuyers. And at the same time it's those capabilities, the open platform and some of the things that we're talking about with Encompass NG, that are attracting many of the new prospects, especially in the strategic and enterprise segments.

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Saket Kalia, Barclays Capital - Analyst [17]

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Quick housekeeping, if I can. Ed, can you remind us what the closed loans per active SaaS user was this quarter?

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Ed Luce, Ellie Mae, Inc. - CFO [18]

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This quarter it was about 1.45, a little over 1.4.

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Saket Kalia, Barclays Capital - Analyst [19]

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Very helpful, guys. Thanks a ton.

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Jonathan Corr, Ellie Mae, Inc. - CEO [20]

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Thanks, Saket.

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Operator [21]

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Brian Essex, Morgan Stanley.

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Brian Essex, Morgan Stanley - Analyst [22]

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Hi, great. Thanks, and thank you for taking the question. First of all Ed, congratulations and best of luck. Sorry it's it's only been one call for me on this end. Wish you the best of luck.

If I could actually follow up on Saket's question, maybe cut it a little bit differently way. If we look at the relationship between contracted users and active users, it looks like historically there's been about a six-month lag when active catches up. It looks like that's stretching out a little bit as you sign larger deals.

Is there a way to think about the cohorts of customers that you are signing, small, medium large? And what you anticipate that lead time to look like going forward?

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Jonathan Corr, Ellie Mae, Inc. - CEO [23]

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Yes, it's a great, great question and observation, Brian. We definitely are seeing with the success in the strategic and enterprise segments, those customers taking longer to deploy, just because they go through a change management process, they want to think through it effectively.

I think a good way to think about it is that our mid-market guys are still probably in that six months or less type of bucket. Our strategics, probably closer to nine months. And then our enterprise, probably closer to 12.

The curve has probably shifted more towards that somewhere in that 9 to 12 month timeframe. And that's how, I guess, I would think about it. But as we go forward I would expect that this ratio, as a lot of the implementations that we've been working on, or the people have been ramping over the last 12-plus months start taking traction, that that number starts to go back above 80, and maybe toward it's more historical ratio.

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Brian Essex, Morgan Stanley - Analyst [24]

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Got it. That's very helpful. And then if I could maybe ask on purchase versus refi. Maybe if you could walk me through how the economics on your platform work, one versus the other?

I think you mentioned that there's maybe a little bit more activity, or a lot more activity, for purchase versus refi? And how that translates into economics over your platform?

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Jonathan Corr, Ellie Mae, Inc. - CEO [25]

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Really from our standpoint, the nice thing is that a purchase loan or a refinance loan, really the same set of activities for the most part are happening across the loans. We're getting the same amount on the per loan basis, the transactional services and everything associated with it. We are kind of indifferent there.

The one thing I can say, though, and we've always talked about this is that our base, the profile of our customers, which is in terms of the mid-market, the strategic and enterprise, they have been more skewed to the purchase side, even as we have gone through the last couple years. They did refi, but they were more skewed to the purchase side. And I expect to see that continue on.

And so again, how we've looked at it is, yes refi has kind of come down, probably pretty materially. Purchase is going to grow modestly as we go into the future. And our customers will continue to benefit from that and execute.

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Brian Essex, Morgan Stanley - Analyst [26]

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Very helpful. Thank you very much.

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Jonathan Corr, Ellie Mae, Inc. - CEO [27]

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My pleasure.

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Ed Luce, Ellie Mae, Inc. - CFO [28]

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Thanks, Brian.

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Operator [29]

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Brian Schwartz, Oppenheimer.

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Brian Schwartz, Oppenheimer & Co. - Analyst [30]

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Hi. Thanks for taking my questions this afternoon. And Ed, ditto from me the positive commentary to you. Jonathan, I've got two questions here. I wanted to ask you about the technology and the strategy moving forward, and then I've got a follow-up question for Ed.

So the first question, I wanted to ask you about the technology strategy, Jonathan. It's clearly the innovation cadence, it's speeding up for the business. I also noticed in your script today, you referred to the next generation Encompass platform as an open lending platform.

That seems a broader market positioning for the platform than before. So any comments on that, on the positioning?

And then also, I did notice in the most recent platform release this week that there's construction loan workflow and functionality. Can you talk about the opportunities that you're seeing in that segment, whether it is an increasing stickiness or possibly a new market for the business to enter in the future?

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Jonathan Corr, Ellie Mae, Inc. - CEO [31]

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Yes, it's a great set of questions. Yes, open lending platform, the first place it's going to be open is obviously in the mortgage origination channel. We very much, I have said over the last year or so, is that would take an approach to as we've built the next generation platform open up the optionality for us to be able to pursue other types of lending for our customer base.

We've said in the past, over half of our customers are some type of depository, a bank, credit unions, and they do other types of lending for consumers. So we want to put ourselves in a position as we were introducing the new platform so that it was generalized so that we could go down that path and our partners could go down that path, whether it be getting into home equity lines of credit, personal lending, auto lending, other consumer, student, you name it. Yes, that is how we are thinking about things down the road.

It is a down the road type of thing, but if you want to do those things you have to lay the groundwork. And that's what we've done. That's kind of the technology investment and the thought process strategically.

In terms of the construction capabilities, that's a good observation there. One of the things that we're seeing in the marketplace is that many of our lenders are doing construction lending. As you go into a market that's a purchase driven market, you see two dynamics happening.

One is, we will call builder lenders, which are lenders that are tied to builders that are out building new homes, whether it be a Lennar or a Standard Pacific or a Ryland or any of those. Many of those are our customers and we've been growing that base. That's been a very successful area for us over the last couple of years.

The area that's really starting to see more growth is the average lender that's out there that is doing home loans, they have a portion of their business is doing construction loans for consumers on a one-off basis. As we've seen that demand, we had some capabilities but in many instances our customers would have to use another solution for maybe 5% or 10% of their loans.

By having this capability out there, we are now able to capture those loans that they might've been using an alternative solutions for. So we actually think we will continue to invest here and add some additional capabilities around draw management and other areas there. We see it as a nice little additional growth opportunity as the purchase market continues and as more and more construction happens in the broader US.

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Brian Schwartz, Oppenheimer & Co. - Analyst [32]

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Thank you for that color, Jonathan. The question I had for Ed is, very much appreciate the seat bookings guidance for 2017. I just want to ask you how relevant bookings is going to be as a driver for the growth in the financial model moving forward?

If I look at your numbers, you're going to have well north 200,000 active drivers by the end of this year. Typically when a business gets of that size, the model driver tends to start shifting towards increasing share of the customer's wallet than just adding new seats.

Curious to your thoughts on which you think will be a bigger driver of the growth in the financial model over the next couple of years, whether it will be ARPU improvement or signing up new booking seats? Thanks for taking my questions today.

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Ed Luce, Ellie Mae, Inc. - CFO [33]

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Thanks, Brian. I think Jonathan may have alluded to this earlier on the call. It's a combination of factors, but absolutely an important factor is the continuing acquisition of these new seats, new logos and new seats from existing banks.

And if you do a little bit of simple math there, Brian, and if we can continue to add 30,000 to 40,000 seats next year, maybe over the next several years. You do the math on the fixed seat fees for subscription revenues on the expected adoption of the products that those guys will do outside of our existing base of 200,000-plus users, and you get a very nice uptick in revenue. You don't want to discount the continued market share acquisition on the seats.

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Jonathan Corr, Ellie Mae, Inc. - CEO [34]

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Anything to add there, Matt?

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Matt Levay, Ellie Mae, Inc. - SVP of Finance [35]

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No, I think Ed hit on the head. The seats are definitely part of the equation, but as you know we've got seats that we've added in 2015 and 2016 and so forth that continue to ramp in productivity as they come online. So that's a key consideration. Every seat that we add has potential revenue growth going into the future, it's not just an uptick as soon as they hit the contracted fees come online.

So when we talk about 8,000 to 10,000 seats next year, you have to also think about the seats that we added last year and how these all kind of grow together over time. So it's definitely a key -- seat additions are a key growth factor going out into the future beyond the year in which they are added.

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Jonathan Corr, Ellie Mae, Inc. - CEO [36]

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It's a growth factor in terms of base seats, but I think you're right in terms of your question, is that over time it will be less of a driver and more of the driver will be the ongoing products and the adoption. I think that that is probably a good hypothesis, or way to think about it.

They are all important. The penetration of a time becomes probably a bigger weighting, but also I look at it, is it becomes easier because it's a heck of a lot easier to drive more value per existing customers where you have a great relationship versus going off and just adding more. But both are very important.

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Operator [37]

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Brent Bracelin, Pacific Crest Securities.

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Brett Bracelin, Pacific Crest Securities - Analyst [38]

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Great. Thank you, guys. I guess the first question here for Jonathan. I want to go back to the bookings. 12,000 booking seat adds as ads really strong. This is the first quarter we actually saw rising interest rate environment.

I'm sure most of the banks also look at mortgage forecast, 21% decline. In an environment where you have volumes going down, interest rates going up, what were the logic for existing customers to add additional seats? What's the scenarios here that are driving that strength on the seat bookings, at leases this quarter?

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Jonathan Corr, Ellie Mae, Inc. - CEO [39]

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Yes. So I think it's a few things. One is, as I mentioned earlier, when you're really trying to expand your share of the purchase market, and you're computing in a particular market, all things being equal you need a little bit more people, more loan officers to make that happen. So that definitely is an element of it.

I would also say that our customers are tending to be the ones that are going out there and growing while others are maybe being adversely affected. So we're seeing that, where they picking up more business. We're also seeing our customers grow inorganically. They're making acquisitions, and in some cases they're making acquisitions of customers that already have Encompass and in some cases they're making acquisitions of companies that don't have Encompass, which fuels it.

And then lastly, one of the things that we've shared along the way is we -- our strength historically has always been in the retail segment. But many of our enterprise customers actually have other channels, wholesale and correspondent.

We have started to see expansion of channels with some of those customers. So those are all, I think, contributing factors on the side of existing customers adding a bit more seats.

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Brett Bracelin, Pacific Crest Securities - Analyst [40]

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Very helpful color. I have one follow-up for Ed here. If I look at the guide here, 25% growth in Q1. And then the midpoint of the full-year guide of, call it 21%. That in my model suggests growth falls below 20% in the second half of the year.

As we think about sub-20% growth in the second half that's implied to the guide, is that tied to just got tough compares? Is that tied to a higher level of conservatism that you are applying to the model? Just trying to think about the first half/second half dynamics here and what you're baking into the guidance?

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Ed Luce, Ellie Mae, Inc. - CFO [41]

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Sure. The first component in there is what we're seeing in the volume forecast. So you do see a second half that's Q3 maybe a little bit below Q2, and then your seasonally low quarter Q4. We've certainly factor that in. We've also factored in some of the acquisitions of enterprise clients with the longer implementation timeframe to get them fully deployed and then to have them, as Jonathan described, up and running in some period of time after they've been deployed to get them to full production.

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Jonathan Corr, Ellie Mae, Inc. - CEO [42]

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I think one thing I'd add, Brett, is that if you really look at the historicals on the model in terms of 2016, 2016 Q1 was probably the softest quarter, it definitely was. So although you're seeing a bigger jump, or a growth rate of 25%-plus in the guide, it is a smaller contributor.

So I actually think if you think about the entire picture, you're probably above that 20% for the entire set of three quarters in the beyond the first quarter just because they are bigger revenue quarters, even though they may grow at a little lower level. I think that balances itself out. I don't really think I see a quarter that is dropping below 20%.

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Brett Bracelin, Pacific Crest Securities - Analyst [43]

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Okay. Well, that's very helpful, I guess. Ed, I will just wish you warm wishes on retirement. And certainly hope our paths cross on a sunny beach somewhere someday.

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Ed Luce, Ellie Mae, Inc. - CFO [44]

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That sounds pretty good, Brett. Thank you.

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Brett Bracelin, Pacific Crest Securities - Analyst [45]

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Take care.

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Operator [46]

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Mayank Tandon, Needham and Company.

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Mayank Tandon, Needham & Company - Analyst [47]

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Thank you, good evening. Jonathan, could you, you touched on this a little earlier, but could you share some additional thoughts on the potential for pricing increments as these contracts come up for renewal? Also how should we thinking about the ARPU transport on a short-term and a long-term basis?

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Jonathan Corr, Ellie Mae, Inc. - CEO [48]

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Sure. As we've said, and I think many of you guys know, is that over time, the idea of Encompass success-based pricing model, we've added more and more value to the footprint and we've brought the price of over time, both on a seat basis and a per loan basis. It started in the $50s, went to $60, $70, $75 over the last period of time since we've roll that with it on a seat basis, and a similar type of trajectory on a per loan basis from $80s to the $100s.

And that, we're kind of hitting another cycle as we go into this year where that will increment again, move its ways into the $80s on a per loan basis -- I'm sorry on a seat basis and a corresponding appropriate number on a per loan side. You can think of it as folks, say, typically on a cycle, it's where we are averaging four-year contracts may be about 25% of them are coming up at any moment in time.

They're going to transition to that new pricing number. And that, again, think about it historically, it will keep going like that as we go into the future every couple of years. And that also obviously holds true for modeling of any new customers. Any new seats, new customers are going to come in at a price that is, again, incremental over where we are today.

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Mayank Tandon, Needham & Company - Analyst [49]

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Right. That's helpful. If I can just squeeze one more in for Ed. In terms of margin expansion, I think if I'm doing the math right, you're building in about 150 basis point of EBITDA margin expansion at the midpoint. How should we think about that in terms of gross margins versus operating leverage? In the past you have said gross margins would probably stabilize in the mid- to high 60%s, but do you think that we could start to see an uptrend as maybe the professional services revenue comes down as a percentage of the total?

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Ed Luce, Ellie Mae, Inc. - CFO [50]

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Sure. A couple of things there. One, professional services is not dominating our margin. They're running anywhere generally around 7% of total revenues. So you're right, that's our lowest margin revenue line item but it's not a dominant piece.

What's really dominating and keeping our gross margins at the levels we've been talking about, and probably will continue to do so until we get into 2018, is this depreciation and amortization flow coming off the next generation development. Most of that expense, that GAAP expense, we charge into cost of sales. So it's hitting us, we're absorbing it in the gross margin.

As we are launching the different solutions and different phases of that development plan all the way into 2018, we start those flows of depreciation and it probably peaks as a cost item in 2018. Then we'll start to see improvement in that gross margin.

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Mayank Tandon, Needham & Company - Analyst [51]

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Got it. That's helpful.

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Ed Luce, Ellie Mae, Inc. - CFO [52]

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Matt, do you want anything?

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Matt Levay, Ellie Mae, Inc. - SVP of Finance [53]

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No that's fine. We're starting to roll out the Connect solutions, as Jonathan mentioned in his script and so forth. And so those depreciation charges actually have started to already roll into our cost of sales. 2017 is really the first year in which we realized a full year of the depreciation of some of these products that we've already rolled out, plus we're rolling out additional products and. So you'll see that pressure maintained through 2017 and into early 2018. Then as we go into later 2018 and into 2019, yes, you see the pressures come off and we start to improve those margins.

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Mayank Tandon, Needham & Company - Analyst [54]

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Right, that makes sense. Ed, good luck. It's been a pleasure working with you. Thank you.

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Ed Luce, Ellie Mae, Inc. - CFO [55]

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Thanks, Mayank.

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Operator [56]

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Richard Baldry, ROTH Capital.

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Richard Baldry, ROTH Capital Partners - Analyst [57]

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Thanks. You talked a little bit quickly about the strength in refis as rates rose, which makes some sense, people will be rushing to finish that before they took off too far. We're halfway through the first quarter.

Was that really a fourth-quarter phenomenon? What have you seen through the first half of Q1, has that sort of tailwind really dissipated?

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Jonathan Corr, Ellie Mae, Inc. - CEO [58]

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I'd say that we saw some acceleration there based on the people seeing rates start to go up. And based on that, there's definitely probably a pull of some of the volume and the activity into Q4.

But we continue to see -- I think what the market is reflecting, which is interest rates are up, refis are going to be -- are down from where they were. And the purchase market will start hitting its stride as we hit the back part of Q1.

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Richard Baldry, ROTH Capital Partners - Analyst [59]

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And then we've talked a lot about the mid-market space. Can you talk -- any updates in the mega-lender, any changes in their behavior? We seem to be moving into a more pro-business, pro-bank oriented environment at the executive level for the country's leadership.

They seem to have backed off of being aggressive in the space while they had some challenges in the last environment. Do you think there is any changes there? Does that help you? Are there ways you can work with them if they were to reengage more aggressively? Thanks.

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Jonathan Corr, Ellie Mae, Inc. - CEO [60]

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Good question. In all the conversations that I've had, and I'm interacting with a number of these folks on a regular basis, and things continue to progress. I do think at some point we will get a retail channel of one of the top five national banks, that's what people like to refer to.

That being said, in all the conversations that I've had both directly and indirectly through other conversations that are going on, I don't think we are going to see a real shift back to doing significantly more volume than they're doing today. Today, you got to remember that the five of them do less than 15% of the retail volume. The other channels, we pick up significant portions of that through our customers that either sell to them, in all cases probably on a correspondent basis.

The basic air that you see out there is that most of the big banks are focusing on deepening the relationship with their best clients, wealth management, and they're focused on if a customer wants a loan, they are there to do it. But they are not really taking an aggressive strategy, and as you talk to them, doesn't seem like that will be part of their business to go and focus on mortgage origination compared to just focusing on penetration of their existing customers.

Obviously there's potential for that to change. But I think the reason they had as much volume as they had probably earlier in 2008, 2009 was all the others kind of fell by the wayside as we came out of the debt crisis. And then as others come back into play, more of the small midsize banks, the independents, I think the business has gotten back to an equilibrium. And there's not a real significant desire to go particularly after that business. I just don't see it.

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Richard Baldry, ROTH Capital Partners - Analyst [61]

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Thanks.

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Operator [62]

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Brandon Dobell, William Blair.

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Brandon Dobell, William Blair & Company - Analyst [63]

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Thanks. I know it's a little bit of a crystal ball, but as you guys think about any potential either CFPB changes or some of the political wrangling around Fannie and Freddie, do you guys see anything that is potentially impactful the next couple of years for how the mortgage process works or what your customers may see?

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Jonathan Corr, Ellie Mae, Inc. - CEO [64]

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It's actually a good question. A lot of things we've been thinking about, talking to key players, actually I was talking to a former Treasury Secretary yesterday. I think that we are going to probably see many of these things, if there are any changes they are going to be incremental. And they are going to take a lot longer to happen because the things that are going to be focused on first by the administration and Congress, et cetera, is going to be ACA and then a very broad and complex tax reform that's going to take a lot of things into consideration relative to the border taxes and repatriation and a whole bunch of things there.

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Brandon Dobell, William Blair & Company - Analyst [65]

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Yes.

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Jonathan Corr, Ellie Mae, Inc. - CEO [66]

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Likely we'll see some level of loosening in the CFPB because eventually there's going to be different leader. Whether that leader changes between now and 2018 or it happens when the term comes up, there is lots of debates around that.

And then the GSEs, something may happen there. I actually, from Ellie Mae's perspective and our customer's perspective, greater diversity is probably not a bad thing. But again, there would be a lot of things that need to happen for that to change.

A big part of what's going on right now is it's working well and a tremendous amount of funds are going into the tax coffers. They're being rolled in to the benefit of the government. If you get rid of that, that goes away.

I think there is lots of talks of it, there is lots of statements. The probabilities are probably low that there is major changes. There's probably modest incremental changes, and I'd say modest incremental changes will be good all the way around. It will be good for borrowers, it will be good for a broad array of lenders, and it'll be good for Ellie Mae.

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Brandon Dobell, William Blair & Company - Analyst [67]

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Okay. And then I know your customer base certainly skews purchase, even in times of a lot of refis. How do you think about your customer base relative to the HELOC dynamic? With all the equity that's been built up, there's probably going to be a decent amount of HELOC activity. Does that skew towards your customer cohorts the same as purchase versus refi, or is it different?

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Jonathan Corr, Ellie Mae, Inc. - CEO [68]

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The HELOC is going to typically be done more often than not by a bank or a credit union. As I said, a little over half of our customers fall into that bucket.

So a big portion of our customers are talking about the alternative to the cash-out refi. That still will be done probably across our entire base. Customers will start to backfill that and offer products in terms of the home equity loan or home equity line of credit.

And we have some capabilities there. We're actually investing more there. Some of the things I mentioned, why we are doing certain things around the platform. I do think we will pick up portions of that business, because as I said, over half of our customers are either banks or credit unions.

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Operator [69]

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And that does conclude our question-and-answer session. At this time, I'd like to turn the call back to management for any additional or closing remarks.

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Jonathan Corr, Ellie Mae, Inc. - CEO [70]

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Well again, thank you, everybody, for joining us. It's always great to be on with you and spend the time answering questions.

We look forward to hopefully seeing many of you at our Investor and Analyst Day at our user experience, which are very excited about again. Over 3,000 attendees are going to be there.

And we'll look forward to seeing a number of you at the various conferences we will be doing. Until next time, be safe out there.

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Operator [71]

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Thank you, and that does conclude today's conference. Thank you for your participation. You may now disconnect.