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Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________________
FORM 10-Q
_____________________________
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2018
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission File Number: 001-35140 
_____________________________
ELLIE MAE, INC.
(Exact name of registrant as specified in its charter)
_____________________________
Delaware
 
94-3288780
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
4420 Rosewood Drive, Suite 500
Pleasanton, California
 
94588
(Address of principal executive offices)
 
(Zip Code)
(925) 227-7000
(Registrant’s telephone number, including area code)
_____________________________
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “small reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
x
Accelerated filer
¨
 
 
 
 
Non-accelerated filer
o
Smaller reporting company
¨
 
 
 
 
 
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ¨
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date:
As of October 31, 2018:
Class
Number of Shares
Common Stock, $0.0001 par value
34,841,403

 


Table of Contents

TABLE OF CONTENTS
 
 
 
 
Page
PART I—FINANCIAL INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II—OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


Table of Contents

PART I—FINANCIAL INFORMATION
ITEM 1—CONDENSED FINANCIAL STATEMENTS
Ellie Mae, Inc.
CONDENSED BALANCE SHEETS
(UNAUDITED)
(in thousands)
 
 
September 30, 2018
 
December 31, 2017
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
133,582

 
$
137,698

Short-term investments
138,656

 
103,345

Accounts receivable, net
48,013

 
43,121

Prepaid expenses and other current assets
36,994

 
18,474

Total current assets
357,245

 
302,638

Property and equipment, net
222,769

 
186,991

Long-term investments
69,822

 
107,363

Intangible assets, net
62,179

 
80,874

Goodwill
141,168

 
144,451

Deposits and other long-term assets
37,147

 
9,290

Total assets
$
890,330

 
$
831,607

Liabilities and Stockholders' Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
16,024

 
$
24,913

Accrued and other current liabilities
30,421

 
26,188

Deferred revenues
22,001

 
26,287

Total current liabilities
68,446

 
77,388

Other long-term liabilities
27,901

 
18,880

Total liabilities
96,347

 
96,268

Stockholders' equity:
 
 
 
Common stock
4

 
3

Additional paid-in capital
685,122

 
649,817

Accumulated other comprehensive loss
(1,264
)
 
(880
)
Retained earnings
110,121

 
86,399

Total stockholders' equity
793,983

 
735,339

Total liabilities and stockholders' equity
$
890,330

 
$
831,607


See accompanying notes to these condensed financial statements (unaudited).

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Ellie Mae, Inc.
CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(in thousands, except per share amounts)
 
 
 
 
 
 
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues
$
122,965

 
$
107,029

 
$
364,220

 
$
304,156

Cost of revenues
51,272

 
39,603

 
150,728

 
112,638

Gross profit
71,693

 
67,426

 
213,492

 
191,518

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
18,788

 
13,522

 
62,987

 
46,762

Research and development
20,625

 
15,901

 
67,700

 
49,354

General and administrative
21,062

 
20,159

 
71,270

 
55,828

Total operating expenses
60,475

 
49,582

 
201,957

 
151,944

Income from operations
11,218

 
17,844

 
11,535

 
39,574

Other income, net
1,079

 
1,140

 
2,851

 
2,403

Income before income taxes
12,297

 
18,984

 
14,386

 
41,977

Income tax provision (benefit)
(119
)
 
4,465

 
(8,105
)
 
(964
)
Net income
$
12,416

 
$
14,519

 
$
22,491

 
$
42,941

Net income per share of common stock:
 
 
 
 
 
 
 
Basic
$
0.36

 
$
0.42

 
$
0.65

 
$
1.26

Diluted
$
0.35

 
$
0.41

 
$
0.63

 
$
1.20

Weighted average common shares used in computing net income per share of common stock:
 
 
 
 
 
 
 
Basic
34,559

 
34,275

 
34,348

 
34,004

Diluted
35,828

 
35,785

 
35,775

 
35,804

 
 
 
 
 
 
 
 
Net income
$
12,416

 
$
14,519

 
$
22,491

 
$
42,941

Other comprehensive income, net of taxes:
 
 
 
 
 
 
 
Unrealized gain (loss) on investments
26

 
53

 
(384
)
 
8

Comprehensive income
$
12,442

 
$
14,572

 
$
22,107

 
$
42,949


See accompanying notes to these condensed financial statements (unaudited).

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Ellie Mae, Inc.
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
 
 
 
 
 
Nine Months Ended September 30,
 
2018
 
2017
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
22,491

 
$
42,941

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
36,087

 
26,024

Amortization of acquisition-related intangibles
18,695

 
3,233

Stock-based compensation expense
30,734

 
25,260

Amortization of deferred costs
6,427

 
2,540

Deferred income taxes
(8,132
)
 
(1,259
)
Others
249

 
(948
)
Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(4,892
)
 
(9,628
)
Prepaid expenses, other current assets, and other long-term assets
(12,501
)
 
(946
)
Deferred costs
(5,869
)
 
(3,201
)
Accounts payable
(2,879
)
 
625

Accrued liabilities, other current liabilities, and other long-term liabilities
2,557

 
(12,271
)
Deferred revenues
(3,758
)
 
(2,749
)
Net cash provided by operating activities
79,209

 
69,621

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Acquisition of property and equipment
(21,708
)
 
(24,919
)
Acquisition of internal-use software
(50,730
)
 
(40,047
)
Purchases of investments
(120,894
)
 
(213,749
)
Maturities of investments
122,507

 
70,276

Other investing activities, net
172

 

Net cash used in investing activities
(70,653
)
 
(208,439
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Proceeds from issuance of common stock under employee stock plans
18,671

 
17,590

Payments for repurchase of common stock
(14,740
)
 

Tax payments related to shares withheld for vested restricted stock units
(16,518
)
 
(12,245
)
Other financing activities, net
(85
)
 
(602
)
Net cash provided by (used in) financing activities
(12,672
)
 
4,743

NET DECREASE IN CASH AND CASH EQUIVALENTS
(4,116
)
 
(134,075
)
CASH AND CASH EQUIVALENTS, Beginning of period
137,698

 
380,907

CASH AND CASH EQUIVALENTS, End of period
$
133,582

 
$
246,832


See accompanying notes to these condensed financial statements (unaudited).

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Ellie Mae, Inc.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1Description of Business
Ellie Mae, Inc. (“Ellie Mae,” and the “Company”) is the leading cloud-based platform provider for the mortgage finance industry. The Company’s technology solutions enable lenders to originate and close residential mortgage loans. Banks, credit unions, and mortgage lenders use the Company’s Encompass® all-in-one mortgage management solution (“Encompass”) to originate and fund mortgages and improve compliance, loan quality, and efficiency.
NOTE 2Basis of Presentation and Significant Accounting Policies
The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these condensed financial statements should be read in conjunction with the financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, which was filed with the SEC on March 1, 2018 (“2017 Form 10-K”).
The condensed balance sheet as of December 31, 2017, included herein, was derived from the audited financial statements as of that date but does not include all disclosures, including notes, required by U.S. GAAP.
The presentation of the condensed financial statements in this Quarterly Report on Form 10-Q reflects the merger of all wholly-owned subsidiaries of the Company with and into the Company effective December 31, 2017. The Condensed Statements of Comprehensive Income for the three and nine months ended September 30, 2017 and the Condensed Statement of Cash Flows for the nine months ended September 30, 2017 are consolidated with Ellie Mae’s then-subsidiaries Mavent Holdings Inc. and Mavent Inc. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated.
In the opinion of management, the accompanying unaudited condensed financial statements reflect all normal recurring adjustments necessary to present fairly the financial position, results of operations, and cash flows for the interim periods but are not necessarily indicative of the results of operations to be anticipated for the full fiscal year ending December 31, 2018 or any future period.
Certain prior period amounts reported in the Company’s condensed financial statements have been reclassified to conform to current period presentation.
Use of Estimates
The preparation of condensed financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management evaluates estimates on a regular basis including those relating to the transaction price of customer contracts, constraints of variable consideration, allowance for doubtful accounts, goodwill, intangible assets, valuation of deferred income taxes, stock-based compensation, and unrecognized tax benefits, among others. Actual results could differ from those estimates, and such differences may have a material impact on the Company’s condensed financial statements and footnotes.
Segment Information
The Company operates in one industry—mortgage-related software and services. The Company’s chief operating decision maker is its chief executive officer, who makes decisions about resource allocation and reviews financial information presented as a single segment. Accordingly, the Company has determined that it has a single reporting segment and operating unit structure, specifically technology-enabled solutions to help streamline and automate the residential mortgage origination process in the United States.
Significant Accounting Policies
Except for the accounting policies described below that were updated as a result of adopting Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), as amended (“Topic 606”), there have been no significant changes to the Company’s significant accounting policies described in Note 2 of the Notes to Consolidated Financial Statements in its 2017 Form 10-K.

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Revenue Recognition
The Company applies the provisions of Topic 606 for revenue recognition on contracts with customers. Pursuant to Topic 606, the Company recognizes revenues under the core principle to depict the transfer of control to the Company’s customers in an amount reflecting the consideration to which the Company expects to be entitled. In order to achieve that core principle, the following five step approach is applied:
Identification of the contract, or contracts, with a customer;
Identification of the performance obligations in the contract;
Determination of the transaction price;
Allocation of the transaction price to the performance obligations in the contract; and
Recognition of revenue when, or as, the Company satisfies a performance obligation.
The Company generates revenues primarily from hosted software services, transaction-based fees, and related services including professional services and its annual user conference, and recognizes revenues as performance obligations are satisfied. For services where the customer simultaneously receives and consumes the benefit from the Company's performance, revenues are recognized over time using an output method based on the passage of time as this provides a faithful depiction of the transfer of control. Under Company-hosted Encompass software subscriptions that customers access through the Internet, revenues are comprised of fees for software services sold both as a subscription and on a variable basis. Variable fees include fees based on a per closed loan, or success basis, subject to monthly base fees, which the Company refers to as Success-Based Pricing. Other hosted subscription services consist of policy, guideline, data and analytics under the AllRegs brand, lead management, marketing, and customer relationship management. Transaction-based fees are comprised of Ellie Mae Network fees and transaction fees charged for other services, including fees for loan products and the annual user conference. Fees for professional services include consulting, implementation, and education and training services. Sales taxes assessed by governmental authorities are excluded from the transaction price.
In contracts where variable consideration is required to be estimated and included in the transaction price, the Company estimates such amounts at contract inception considering historical trends, industry data, and contract specific factors to determine an expected amount to which the Company expects to be entitled. Estimates are included in the transaction price to the extent that it is considered probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved. The assessment of whether such an estimate is constrained requires the Company to consider methods, inputs, and assumptions relating to the nature of the underlying products, customer-specific trends, and economic factors including industry data. Other forms of variable consideration such as refunds and penalties, which are recorded in accrued and other current liabilities, are estimated at contract inception and are allocated to the performance obligations to which they relate.
The Company enters into arrangements that generally include multiple subscriptions and professional services. For arrangements with multiple services, the Company evaluates whether the individual services qualify as distinct performance obligations. In its assessment of whether a service is a distinct performance obligation, the Company determines whether the customer can benefit from the service on its own or with other readily available resources and whether the service is separately identifiable from other services in the contract. This evaluation requires the Company to assess the nature of each individual service offering and how the services are provided in the context of the contract, including whether the services are significantly integrated, highly interrelated, or significantly modify each other, which may require judgment based on the facts and circumstances of the contract.
When agreements involve multiple distinct performance obligations, the Company allocates arrangement consideration to all performance obligations at the inception of an arrangement based on the relative standalone selling prices of each performance obligation. Where the Company has standalone sales data for its performance obligations which are indicative of the price at which the Company sells a promised good or service separately to a customer, such data is used to establish standalone selling prices. In instances where standalone sales data is not available for a particular performance obligation, the Company estimates standalone selling prices by maximizing the use of observable market and cost-based inputs.
When estimating standalone selling prices, the Company reviews company-specific factors used to determine list price and makes adjustments as appropriate to reflect current market conditions and pricing behavior. The Company’s process for establishing list price includes assessing the cost to provide a particular product or service, surveying customers to determine market expectations, analyzing customer demographics, and taking into account similar products and services historically sold by the Company. The Company continues to review the factors used to establish list price and will adjust standalone selling price methodologies as necessary on a prospective basis.
Hosted Software Subscription Revenues.  Hosted software subscription revenues generally include a combination of the Company’s products delivered as software-as-a-service (“SaaS”) subscriptions that are a performance obligation consisting of a

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series of distinct services and support services. These arrangements are generally non-cancelable and do not contain refund-type provisions. These revenues typically include the following:
Encompass Revenues.  The Company offers web-based, on-demand access to its Encompass loan origination software for a monthly recurring fee. Customers under SaaS arrangements do not take control of the underlying software at any time during the term of the agreement. Fixed fees for subscription revenues are recognized over time, using an output method of the passage of time (or ratably) over the contract terms as performance obligations are satisfied as this method best depicts the Company’s pattern of performance for such services. Contracts generally range from one year to five years.
Alternatively, customers can elect to pay on a success basis. Success basis contracts are subject to monthly billing calculations whereby customers are obligated to pay the greater of a contractual base fee or variable closed loan fee, which is based on the number of closed loan transactions processed by the customer in the specific month.
Monthly base fees are recognized ratably over the contract terms as subscription performance obligations are satisfied.
Closed loan fees in excess of base fees are considered variable consideration. For the majority of contracts that include variable consideration, these fees are recognized in the month in which they are earned because the terms of the variable payments relate specifically to the outcome from transferring the distinct time increment (month) of service, which is consistent with the allocation objective when considering all of the performance obligations and payment terms in the contract (i.e., where “the allocation objective is met”). For certain contracts where the allocation objective would not be met by allocating variable consideration in this way, total variable consideration to be received is estimated at contract inception and recognized ratably over the contract term, with estimates of variable consideration being updated at each reporting date. For these contracts, variable consideration is estimated using the expected value method, utilizing forecast data for each contract to determine the expected value.
The Company evaluates its ability to accurately estimate such variable consideration considering all relevant facts and circumstances associated with both the likelihood of a downward adjustment in the estimate of variable consideration and the potential magnitude of a significant revenue reversal relative to the cumulative revenue recognized to-date under the contract. Because the amount of consideration is highly susceptible to broad economic factors outside the Company’s influence, have a broad range of possible consideration amounts, and the uncertainty is not expected to be resolved for a long period of time, the Company’s ability to accurately estimate the variable consideration is limited. Therefore, the amount of variable consideration included in the transactions price is constrained to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the amount of variable consideration is subsequently resolved.
Other Subscription Revenues.  The Company provides a variety of mortgage-related and other business services, including lead management, marketing, compliance services and customer relationship management. Such services include fixed fee subscriptions and are a single performance obligation consisting of a series of distinct services. The fixed fees are recognized ratably over the contract terms as performance obligations are satisfied as this method best depicts the Company’s pattern of performance for such services.
Online Research and Data Resources Subscription Revenues.  The Company provides mortgage originators and underwriters with access to online databases of various federal and state laws and regulations and forms as well as investor product guidelines. Fixed fees are recognized over time, using an output method of the passage of time or ratably over the contract terms as performance obligations are satisfied as this method best depicts the Company’s pattern of performance for such services.
Transactional Revenues.  Transactional Revenues include the following:
Ellie Mae Network Revenues.  The Company has entered into agreements with various lenders, service providers and certain government-sponsored entities participating in the mortgage origination process to provide those suppliers with access to, and ability to interoperate with, mortgage originators on the Ellie Mae Network. The services delivered are comprised of a performance obligation consisting of a series of distinct services. The Company acts as an agent when it arranges for services to be provided by the supplier to the customer. Fixed fees are recognized ratably over the contract terms as performance obligations are satisfied as this method best depicts the Company’s pattern of performance for such services. Variable fees are recognized in the month in which they are earned because the allocation objective is met by allocating the fees to each distinct month in the series.
Other Transactional Revenues. The Company provides other services delivered on a transactional basis including automated documentation; fraud detection, valuation, validation, and risk analysis; income verification; flood zone certifications; website and electronic document management; compliance reports; and the Company’s annual user conference. Fixed fees are recognized at the point in time when control is transferred.

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Professional Services Revenues.  Professional services, including implementation services for the Company’s subscription products, are performance obligations which are capable of being distinct and are distinct within the context of the contract. Such services are generally provided on a time and materials or fixed price basis. The majority of the Company’s professional services are provided on a fixed price basis, and the Company recognizes revenue over time as the performance obligations are satisfied utilizing an input method based on the proportion of hours incurred to total estimated hours. Any changes in the estimate of progress towards completion are accounted for in the period of change using the cumulative catch-up method. Revenues from professional services contracts provided on a time and materials basis are recognized when invoiced as amounts correspond directly with the value of the services.
Deferred Revenues
Deferred revenues represent billings or payments received in advance of revenue recognition and are recognized upon transfer of control. Balances consist primarily of prepaid subscription services and professional and training services not yet provided as of the balance sheet date. Deferred revenues that will be recognized during the succeeding 12-month period are recorded as current deferred revenues, and the remaining portion is recorded as other long-term liabilities.
Contract Assets
Contract assets represent amounts recognized as revenues for which the Company does not have the unconditional right to consideration. Amounts related to invoices expected to be issued during the succeeding 12-month period are recorded as prepaid expenses and other current assets, and the remaining portion is recorded as deposits and other long-term assets.
Deferred Costs
Deferred costs mainly consist of sales commissions and related fringe benefits that are incremental costs of obtaining contracts with customers, as well as partners’ referral fees. The Company amortizes the costs incurred on initial contracts on a straight-line basis over a period of benefit determined to be approximately five years. The period of benefit is determined based on a review of customer churn rates and technological lifecycles of the underlying product offerings. All deferred costs on renewal contracts are amortized on a straight-line basis over the applicable renewal period. Additionally, the Company exercises the practical expedient to expense commissions on arrangements in which the amortization period is expected to be one year or less. Deferred costs that will be recognized during the succeeding 12-month period are recorded as prepaid expenses and other current assets, and the remaining portion is recorded as deposits and other long-term assets.
Recent Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), as subsequently amended, which requires lessees to put most leases on their balance sheets but recognize the expenses on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. The standard is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The Company plans to adopt this new standard on January 1, 2019, and currently expects that most of its operating lease commitments will be subject to the new standard and recognized as operating lease liabilities and right-of-use assets upon adoption, which will increase total assets and total liabilities that the Company reports relative to such amounts prior to adoption. 
In June 2018, the FASB issued ASU No. 2018-07, Compensation—Stock Compensation (Topic 718), Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from non-employees, with certain exceptions. ASU 2018-07 supersedes the guidance in ASC 505-50, Equity-Based Payments to Non-Employees, which previously included the accounting for non-employee awards. The standard is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The Company does not intend to early adopt and does not expect the adoption of this standard will have a material impact on its financial statements and related disclosures.
In August 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which modifies the disclosure requirements on fair value measurements. The ASU removes the requirement to disclose: the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy; the policy for timing of transfers between levels; and the valuation processes for Level 3 fair value measurements. The standard is effective for interim and annual periods beginning after December 15, 2019, and early adoption is permitted. The Company does not believe the adoption of this standard will have a material impact on its financial statements and related disclosures.

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In August 2018, the FASB issued ASU No. 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”), which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The standard is effective for interim and annual reporting periods beginning after December 15, 2019, and can be applied either prospectively to implementation costs incurred after the date of adoption or retrospectively to all arrangements. Early adoption is permitted. The Company is currently gathering information and evaluating the impact of this accounting standard update on its financial statements and related disclosures.
Standards Adopted
ASU No. 2014-09
On January 1, 2018, the Company adopted ASU No. 2014-09 (“Topic 606”), as subsequently amended, using the modified retrospective method and applied Topic 606 to those contracts which were not completed as of January 1, 2018.
On January 1, 2018, the Company recognized the cumulative effect of initially applying Topic 606 as an adjustment to the opening balance of retained earnings and the corresponding balance sheet accounts. The impact on the Company’s opening balances is primarily related to the Company’s straight-line calculations for subscription revenue and the capitalization of additional commission costs under Topic 606. The comparative information has not been restated and continues to be reported under the accounting standards in effect in those prior periods. Refer to the tables below and Note 3 “Revenue Recognition” for additional accounting policy and transition disclosures.
The Company recognized the cumulative effect of initially applying ASC 606 as an adjustment to retained earnings in the balance sheet as of January 1, 2018 as follows:
Selected Balance Sheet Line Items
 
Balance at December 31, 2017
 
Adjustments Due to ASC 606
 
Balance at January 1, 2018
 
(in thousands)
Current assets:
 
 
 
 
 
Prepaid expenses and other current assets
$
18,474

 
$
8,900

 
$
27,374

Non-current assets:
 
 
 
 
 
Deposits and other long-term assets
$
9,290

 
$
22,013

 
$
31,303

Current liabilities:
 
 
 
 
 
Accrued and other current liabilities
$
26,188

 
$
3,138

 
$
29,326

Deferred revenues
$
26,287

 
$
(1,706
)
 
$
24,581

Non-current liabilities:
 
 
 
 
 
Other long-term liabilities
$
18,880

 
$
16,546

 
$
35,426

Stockholders' equity:
 
 
 
 
 
Retained earnings
$
86,399

 
$
12,935

 
$
99,334


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The following tables summarize the impacts of Topic 606 adoption on the Company's condensed financial statements for the periods ended September 30, 2018.
Selected Balance Sheet Line Items
 
September 30, 2018
 
(in thousands)
 
As Reported
 
Adjustments
 
Balances without adoption of Topic 606
Current assets:
 
 
 
 
 
Accounts receivable, net
$
48,013

 
$
(629
)
 
$
47,384

Prepaid expenses and other current assets
$
36,994

 
$
(10,149
)
 
$
26,845

Non-current assets:
 
 
 
 
 
Deposits and other long-term assets
$
37,147

 
$
(13,416
)
 
$
23,731

Current liabilities:
 
 
 
 
 
Accrued and other current liabilities
$
30,421

 
$
(2,525
)
 
$
27,896

Deferred revenues
$
22,001

 
$
135

 
$
22,136

Non-current liabilities:
 
 
 
 
 
Other long-term liabilities
$
27,901

 
$
(8,709
)
 
$
19,192

Stockholders' equity:
 
 
 
 
 
Retained earnings
$
110,121

 
$
(13,095
)
 
$
97,026

Selected Statement of Comprehensive Income Line Items
 
Three Months Ended September 30, 2018
 
(in thousands, except per share amounts)
 
As Reported
 
Adjustments
 
Balances without adoption of Topic 606
Revenues
$
122,965

 
$
(1,411
)
 
$
121,554

Gross profit
$
71,693

 
$
(1,411
)
 
$
70,282

Operating expenses:
 
 
 
 
 
Sales and marketing
$
18,788

 
$
320

 
$
19,108

Income from operations
$
11,218

 
$
(1,731
)
 
$
9,487

Income tax benefit
$
(119
)
 
$
(2,111
)
 
$
(2,230
)
Net income
$
12,416

 
$
380

 
$
12,796

Basic net income per share of common stock
$
0.36

 
$
0.01

 
$
0.37

Diluted net income per share of common stock
$
0.35

 
$
0.01

 
$
0.36


9

Table of Contents

 
Nine Months Ended September 30, 2018
 
(in thousands, except per share amounts)
 
As Reported
 
Adjustments
 
Balances without adoption of Topic 606
Revenues
$
364,220

 
$
(1,202
)
 
$
363,018

Gross profit
$
213,492

 
$
(1,202
)
 
$
212,290

Operating expenses:
 
 
 
 
 
Sales and marketing
$
62,987

 
$
985

 
$
63,972

Income from operations
$
11,535

 
$
(2,187
)
 
$
9,348

Income tax benefit
$
(8,105
)
 
$
(2,028
)
 
$
(10,133
)
Net income
$
22,491

 
$
(159
)
 
$
22,332

Basic net income per share of common stock
$
0.65

 
$

 
$
0.65

Diluted net income per share of common stock
$
0.63

 
$
(0.01
)
 
$
0.62

Selected Statement of Cash Flows Line Items
 
Nine Months Ended September 30, 2018
 
(in thousands)
 
As Reported
 
Adjustments
 
Balances without adoption of Topic 606
Net income
$
22,491

 
$
(159
)
 
$
22,332

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
 
 
Amortization of deferred costs
$
6,427

 
$
(1,519
)
 
$
4,908

Deferred income taxes
$
(8,132
)
 
$
(2,028
)
 
$
(10,160
)
Changes in operating assets and liabilities:
 
 
 
 
 
Accounts receivable, net
$
(4,892
)
 
$
629

 
$
(4,263
)
Prepaid expenses, other current assets, and other long-term assets
$
(12,501
)
 
$
554

 
$
(11,947
)
Deferred costs
$
(5,869
)
 
$
1,905

 
$
(3,964
)
Accrued liabilities, other current liabilities, and other long-term liabilities
$
2,557

 
$
1,410

 
$
3,967

Deferred revenues
$
(3,758
)
 
$
(792
)
 
$
(4,550
)
Net cash provided by operating activities
$
79,209

 
$

 
$
79,209

ASU No. 2018-05
In March 2018, the FASB issued ASU No. 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 (“ASU 2018-05”). ASU 2018-05 addresses certain circumstances arising in accounting for the income tax effects of the Tax Cuts and Job Act (“Tax Act”) in conformity with SEC Staff Accounting Bulletin No. 118 (“SAB 118”) including provisional estimates of those effects. The Company adopted SAB 118 in the fourth quarter of 2017 and continues to analyze the impact of the Tax Act on an ongoing basis. Due to the timing of the enactment and the complexity in applying the provisions of the Tax Act, the provisional net charge is subject to revisions as the Company continues to complete its analysis of the Tax Act. Adjustments may materially impact the Company’s provision for income taxes and effective tax rate in the period in which the adjustments are made. The Company expects to finalize the impact analysis in the fourth quarter of 2018. Additional information regarding the accounting for income taxes for the Tax Act is contained in Note 8Income Taxes.”

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Table of Contents

NOTE 3Revenue Recognition
Disaggregation of Revenue
The following table provides information about disaggregated revenue from customers.
 
Three Months Ended September 30, 2018
 
Nine Months Ended September 30, 2018
 
(in thousands)
Hosted software subscription revenues
$
90,847

 
$
262,132

Transactional revenues
23,762

 
76,814

Professional services revenues
8,356

 
25,274

Revenues
$
122,965

 
$
364,220

Contract Balances
The following table provides information about receivables, contract assets and deferred revenues from contracts with customers.
 
Balance Sheet Line Reference
September 30, 2018
 
 
(in thousands)
Accounts receivables, net
Accounts receivables, net
$
48,013

Contract assets - current
Prepaid expenses and other current assets
$
5,036

Contract assets - noncurrent
Deposits and other long-term assets
$
8,948

Deferred revenues - current
Deferred revenues
$
22,001

Deferred revenues - noncurrent
Other long-term liabilities
$
3,935

Changes in the contract assets and the deferred revenues balances during the nine months ended September 30, 2018 are as follows:
 
January 1, 2018
 
September 30, 2018
 
$ Change
 
(in thousands)
Contract assets
$
13,428

 
$
13,984

 
$
556

Deferred revenues
$
29,694

 
$
25,936

 
$
(3,758
)
The increase in contract assets from $13.4 million to $14.0 million as of September 30, 2018 was primarily the result of $3.0 million in increases in estimated transaction price including changes in the assessment of whether estimated variable consideration is constrained and $1.6 million in contract additions, offset by billings of $4.0 million in advance of revenue being recognized. The decrease in deferred revenues from $29.7 million to $25.9 million was due to additional performance on certain arrangements in which billing occurred in advance. During the nine months ended September 30, 2018, $20.0 million of revenues recognized were included in the deferred revenues balance at the beginning of the period, which was offset by additional deferrals during the period.

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Table of Contents

Revenues Allocated to Remaining Performance Obligations
Remaining performance obligations represent contracted revenues that have not yet been recognized, which includes deferred revenues and amounts that will be invoiced and recognized as revenues in future periods.
The Company expects to recognize revenues on the remaining performance obligations as follows:
  
September 30, 2018
 
(in thousands)
Within 1 year
$
280,094

2-3 years
257,759

Thereafter
50,758

 
$
588,611

Remaining performance obligations exclude variable consideration allocated entirely to future distinct services as well as variable consideration in most arrangements that involve services revenues priced on a transactional basis and professional services invoiced on a time and materials basis as these arrangements include revenue recognized under the as billed expedient. Additionally, in instances where an estimate of variable consideration is constrained, the amount of such constraint is not included in revenues allocated to remaining performance obligations.
Deferred Costs
Deferred costs, which consist of deferred sales commissions, were $22.8 million as of September 30, 2018 and $8.5 million as of December 31, 2017. For the three and nine months ended September 30, 2018, amortization expense for deferred costs was $2.2 million and $6.4 million, respectively. For the three and nine months ended September 30, 2017, amortization expense for deferred costs was $0.9 million and $2.5 million, respectively. There was no impairment loss related to the costs capitalized during these periods.
NOTE 4Net Income Per Share of Common Stock
Basic net income per share of common stock is calculated by dividing net income by the weighted average shares of common stock outstanding during the period. Diluted net income per share of common stock is computed by dividing net income by the weighted average shares of common stock outstanding plus the additional shares of common stock that would have been outstanding if potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, unvested restricted stock unit awards (“RSUs”), unvested performance-vesting RSUs, unvested performance share awards (“performance awards”), and shares to be purchased under the Employee Stock Purchase Plan (“ESPP”). The dilutive effect of potentially dilutive securities is reflected in diluted net income per share of common stock by application of the treasury stock method.
The components of net income per share of common stock were as follows:
  
Three Months Ended September 30,
 
Nine Months Ended September 30,
  
2018
 
2017
 
2018
 
2017
 
(in thousands, except per share amounts)
Net income
$
12,416

 
$
14,519

 
$
22,491

 
$
42,941

 
 
 
 
 
 
 
 
Weighted average common shares outstanding used to compute basic net income per share
34,559

 
34,275

 
34,348

 
34,004

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Employee stock options, RSUs, performance-vesting RSUs, performance awards, and ESPP shares
1,269

 
1,510

 
1,427

 
1,800

Weighted average common shares outstanding used to compute diluted net income per share
35,828

 
35,785

 
35,775

 
35,804

Net income per share of common stock:
 
 
 
 
 
 
 
Basic
$
0.36

 
$
0.42

 
$
0.65

 
$
1.26

Diluted
$
0.35

 
$
0.41

 
$
0.63

 
$
1.20


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Table of Contents

The following potential weighted average common shares were excluded from the computation of diluted net income per share of common stock, as their effect would have been anti-dilutive:
  
Three Months Ended September 30,
 
Nine Months Ended September 30,
  
2018
 
2017
 
2018
 
2017
 
(in thousands)
Employee stock options and awards
11

 
320

 
22

 
179

Performance-vesting RSUs and performance awards are included in the diluted shares outstanding for each period if the established performance criteria have been met at the end of the respective periods. However, if none of the required performance criteria have been met for such awards, the Company includes the number of shares that would be issuable if the end of the reporting period were the end of the contingency period. Accordingly, in addition to the employee stock options and awards noted above, 86,903 and 59,455 shares underlying performance-vesting RSUs and performance awards were excluded from the dilutive shares outstanding for each of the three and nine months ended September 30, 2018 and 2017, respectively.
NOTE 5Financial Instruments and Fair Value Measurement
As of September 30, 2018 and December 31, 2017, the Company’s cash, cash equivalents, and investments were primarily comprised of cash and investment-grade, fixed maturity interest-bearing debt securities, such as money market funds, certificates of deposit, commercial paper, corporate bonds, municipal and government agency obligations, and guaranteed obligations of the United States government. Cash equivalents and investments are recorded at fair value. All investments are considered available for sale.
The following table summarizes cash and investments in financial instruments that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy by investment type:
 
September 30, 2018
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Carrying or Fair Value
 
(in thousands)
Cash
$
112,602

 
$

 
$

 
$
112,602

Level 1:
 
 
 
 
 
 
 
Money market funds
2,275

 

 

 
2,275

U.S. government and government agency obligations
69,725

 

 
(577
)
 
69,148

 
184,602

 

 
(577
)
 
184,025

Level 2:
 

 
 

 
 

 
 

Corporate notes and obligations
70,972

 
2

 
(432
)
 
70,542

Certificates of deposit
3,992

 

 

 
3,992

Municipal obligations
5,405

 

 
(25
)
 
5,380

U.S. government and government agency obligations
78,352

 
1

 
(232
)
 
78,121

Total financial instruments
343,323

 
3

 
(1,266
)
 
342,060

Less investments
209,741

 
3

 
(1,266
)
 
208,478

Cash and cash equivalents
$
133,582

 
$

 
$

 
$
133,582


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Table of Contents

 
December 31, 2017
 
Amortized 
Cost
 
Unrealized Gains
 
Unrealized Losses
 
Carrying or
Fair Value
 
(in thousands)
Cash
$
119,035

 
$

 
$

 
$
119,035

Level 1:
 
 
 
 
 
 
 
Money market funds
3,623

 

 

 
3,623

U.S. government and government agency obligations
52,255

 

 
(266
)
 
51,989

 
174,913

 

 
(266
)
 
174,647

Level 2:
 

 
 
 
 

 
 

Corporate notes and obligations
81,062

 

 
(304
)
 
80,758

Certificates of deposit
6,527

 
2

 

 
6,529

Municipal obligations
10,274

 

 
(46
)
 
10,228

U.S. government and government agency obligations
76,510

 

 
(266
)
 
76,244

Total financial instruments
349,286

 
2

 
(882
)
 
348,406

Less investments
211,588

 
2

 
(882
)
 
210,708

Cash and cash equivalents
$
137,698

 
$

 
$

 
$
137,698

The Company classifies its money market funds that are specifically backed by debt securities and U.S. government obligations as Level 1 instruments due to the use of observable market prices for identical securities that are traded in active markets.
Valuation of the Company’s marketable securities investments classified as Level 2 is achieved primarily through broker quotes when such investments exist in a non-active market.
At September 30, 2018 and December 31, 2017, the Company did not have any assets or liabilities that were valued using Level 3 inputs.
Realized gains and losses from the sale of investments were immaterial during the three and nine months ended September 30, 2018 and 2017.
The following table shows the gross unrealized losses and the related fair values of the Company’s investments in a continuous unrealized loss position. The Company did not identify any investments as other-than-temporarily impaired at September 30, 2018 or December 31, 2017 based on its evaluation of available evidence, such as the Company’s intent to hold and whether it is more likely than not that the Company will be required to sell the investment before recovery of the investment’s amortized basis. The Company expects to receive the full principal and interest on these investments.
 
September 30, 2018
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
(in thousands)
Corporate notes and obligations
$
43,069

 
$
(315
)
 
$
12,431

 
$
(117
)
 
$
55,500

 
$
(432
)
Certificates of deposit

 

 
746

 

 
746

 

U.S. government, government agency, and municipal obligations
94,863

 
(266
)
 
53,846

 
(568
)
 
148,709

 
(834
)
 
$
137,932

 
$
(581
)
 
$
67,023

 
$
(685
)
 
$
204,955

 
$
(1,266
)

14

Table of Contents

 
December 31, 2017
 
Less than 12 Months
 
12 Months or Greater
 
Total
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
Fair Value
 
Unrealized Losses
 
(in thousands)
Corporate notes and obligations
$
62,099

 
$
(253
)
 
$
7,574

 
$
(51
)
 
$
69,673

 
$
(304
)
Certificates of deposit
482

 

 
1,348

 

 
1,830

 

U.S. government, government agency, and municipal obligations
119,456

 
(492
)
 
13,070

 
(86
)
 
132,526

 
(578
)
 
$
182,037

 
$
(745
)
 
$
21,992

 
$
(137
)
 
$
204,029

 
$
(882
)
The following table summarizes the contractual maturities of the Company’s investments at September 30, 2018:
 
Amortized Cost
 
Carrying or
Fair Value
 
(in thousands)
Due within one year
$
139,050

 
$
138,656

Due after one year through three years (1)
70,691

 
69,822

Total
$
209,741

 
$
208,478

________________
(1) Maximum maturity of individual investments is three years.
Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.
NOTE 6Property and Equipment, Net
Property and equipment, net, consisted of the following:
 
September 30, 2018
 
December 31, 2017
 
(in thousands)
Computer equipment and software
$
79,691

 
$
67,068

Internal-use software
159,741

 
108,710

Furniture and fixtures
9,542

 
8,311

Leasehold improvements
32,433

 
27,356

Internal-use software and other assets not placed in service
53,700

 
52,659

Property and equipment, gross
335,107

 
264,104

Accumulated depreciation and amortization
(112,338
)
 
(77,113
)
Property and equipment, net
$
222,769

 
$
186,991

Depreciation and amortization expense for the three and nine months ended September 30, 2018 was $12.9 million and $36.1 million, respectively. Depreciation and amortization expense for the three and nine months ended September 30, 2017 was $9.7 million and $26.0 million, respectively. These amounts include amortization of assets under capital leases of less than $0.1 million and $0.9 million for the three and nine months ended September 30, 2018, and $0.6 million and $2.2 million for the three and nine months ended September 30, 2017, respectively.

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Table of Contents

NOTE 7Goodwill and Intangible Assets, Net
During the three months ended September 30, 2018, the Company recorded a $3.1 million adjustment to Goodwill related to certain acquired deferred tax assets of Velocify. The adjustment was the result of a change in the provisional amounts to the purchase accounting and was made within the measurement period.
Intangible assets, net, consisted of the following:
  
September 30, 2018
  
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Intangibles
 
Weighted Average Remaining Useful Life
 
(in thousands)
 
(in years)
Assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
53,535

 
$
(15,591
)
 
$
37,944

 
6.8
Trade names
1,931

 
(864
)
 
1,067

 
2.0
Customer relationships
34,900

 
(15,869
)
 
19,031

 
7.3
Order backlog
14,370

 
(14,272
)
 
98

 
1.1
Total assets subject to amortization
104,736

 
(46,596
)
 
58,140

 
6.9
Assets not subject to amortization:
 
 
 
 
 
 
 
Trade name
4,039

 

 
4,039

 
 
 
$
108,775

 
$
(46,596
)
 
$
62,179

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
December 31, 2017
  
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Intangibles
 
Weighted Average Remaining Useful Life
 
(in thousands)
 
(in years)
Assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
53,535

 
$
(10,810
)
 
$
42,725

 
7.5
Trade names
1,931

 
(464
)
 
1,467

 
2.8
Customer relationships
34,900

 
(13,050
)
 
21,850

 
7.7
Order backlog
14,370

 
(3,577
)
 
10,793

 
0.8
Total assets subject to amortization
104,736

 
(27,901
)
 
76,835

 
6.5
Assets not subject to amortization:
 
 
 
 
 
 
 
Trade name
4,039

 

 
4,039

 
 
 
$
108,775

 
$
(27,901
)
 
$
80,874

 
 
Amortization expense associated with intangible assets for the three and nine months ended September 30, 2018 was $6.2 million and $18.7 million, respectively. Amortization expense associated with intangible assets for the three and nine months ended September 30, 2017 was $1.1 million and $3.2 million, respectively.

16

Table of Contents

Future amortization expense for intangible assets at September 30, 2018 was as follows:
  
Amortization
 
(in thousands)
Remainder of 2018
$
2,694

2019
10,499

2020
8,978

2021
7,114

2022
7,055

2023
6,800

Thereafter
15,000

 
$
58,140

NOTE 8Income Taxes
The Company’s tax provision for interim periods is determined using an estimate of its annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, the Company updates its estimate of the annual effective tax rate and, if the estimated annual effective tax rate changes, the Company makes a cumulative adjustment in such period.
The following table presents the income tax provision (benefit) and the effective tax rate for the three and nine month periods ended September 30, 2018 and 2017 were as follows:
  
Three Months Ended September 30,
 
Nine Months Ended September 30,
  
2018
 
2017
 
2018
 
2017
 
(dollars in thousands)
Income tax provision (benefit)
$
(119
)
 
$
4,465

 
$
(8,105
)
 
$
(964
)
Effective tax rate
(1.0
)%
 
23.5
%
 
(56.3
)%
 
(2.3
)%
For the three and nine months ended September 30, 2018, the Company’s effective tax rate differed from the U.S. federal statutory rate of 21% primarily due to income tax benefits from excess stock-based compensation deductions, research and development credits, and a reduction in the state blended income tax rate, offset by income tax expense related to the remeasurement of certain deferred tax assets as a result of the Tax Act. The Company recognized a deferred income tax expense of $1.2 million related to the remeasurement of certain acquired deferred tax assets of Velocify as a result of the reduction in the federal statutory tax rate. For the three and nine months ended September 30, 2017, the Company’s effective tax rate differed from the U.S. federal statutory rate of 35% primarily due to the income tax benefits from excess stock-based compensation deductions and research and development credits, offset by income tax expense for certain nondeductible stock-based compensation.
The Company regularly assesses the realizability of its deferred tax assets and establishes a valuation allowance if it is more-likely-than-not that some, or all, of its deferred tax assets will not be realized in the future. The Company evaluates and weighs all available evidence, both positive and negative, including its historic operating results, future reversals of existing deferred tax liabilities, as well as projected future taxable income. The Company will continue to regularly assess the realizability of its deferred tax assets. Changes in earnings performance and future earnings projections, among other factors, may cause the Company to adjust the valuation allowance on deferred tax assets, which could materially impact the income tax expense in the period the Company determines that these factors have changed.
The Company’s income tax positions are subject to audit by the Internal Revenue Service (“IRS”) and various state tax authorities. The Company recognizes a tax benefit for an uncertain tax position only if it is more-likely-than-not that the tax position will be sustained upon examination, based upon the technical merits of the position by the relevant tax authority. The Company believes that it has adequately provided reserves for its uncertain tax positions for all tax years that remain open to examination. The Company does not believe it is reasonably possible that its gross unrecognized tax benefits will materially change in the next 12 months.
The Company has a policy to classify accrued interest and penalties for its uncertain tax positions together with the related liability in the balance sheet, and to include the expenses incurred related to such accruals as a component of the provision for income taxes. There was no interest nor were there penalties accrued in the provision for income taxes during the three and nine months ended September 30, 2018 and 2017.
In December 2017, the SEC staff issued SAB 118, which allows companies to record provisional amounts for the Tax Act during a measurement period not to extend beyond one year of the enactment date.

17

Table of Contents

In order to complete the accounting for the impacts of the Tax Act, the Company continues to obtain, analyze and interpret additional guidance that becomes available from the U.S. Treasury Department, the IRS, state taxing jurisdictions, the FASB, and other standard-setting and regulatory bodies. New guidance or interpretations may materially impact the Company’s provision for income taxes in future periods. Additional information that is needed to complete the analysis but is currently unavailable includes, but is not limited to, the final determination of certain net deferred tax assets and liabilities subject to remeasurement and when the related temporary differences will be settled or realized, and the tax treatment of such provisions of the Tax Act by various state tax authorities. In addition, the Company is currently examining the recently issued IRS guidance to determine the impact of the “transition rule” related to the Company’s covered employees’ compensation stemming from written binding contracts entered on or before November 2, 2017. The provisional estimates recorded may change in the fourth quarter of 2018 as the Company’s accounting analysis is finalized. As of September 30, 2018, the Company has not completed the accounting for the tax effects of the Tax Act.
For additional information related to the impact of the 2017 Tax Act on the Company’s tax provision and tax rate, please see Note 8 of the notes to condensed consolidated financial statements in the Company’s Annual Report on Form 10-K for the calendar year ended December 31, 2017, filed with the SEC on March 1, 2018.
NOTE 9Commitments and Contingencies
Leases
As of September 30, 2018, the Company leased nine facilities under operating lease arrangements. The lease expiration dates range from September 2019 to December 2025. Certain leases contain escalation clauses calling for increased rents. The Company recognizes rent expense on a straight-line basis over the lease period.
Legal Proceedings
From time to time, the Company is involved in litigation that it believes is of the type common to companies engaged in the Company’s line of business, including commercial and employment disputes. As of the date of this Quarterly Report on Form 10-Q, the Company is not involved in any pending legal proceedings whose outcome the Company expects to have a material adverse effect on its financial position, results of operations or cash flows.
NOTE 10Equity and Stock Incentive Plans
The 2011 Equity Incentive Award Plan (the “2011 Plan”) serves as the successor to the Company’s 2009 Stock Option and Incentive Plan (together with the 2011 Plan, the “Stock Plans”). The Company recognized stock-based compensation expense related to awards granted under the Stock Plans and ESPP.
Total stock-based compensation expense recognized consisted of:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Cost of revenues
$
2,408

 
$
1,810

 
$
6,408

 
$
4,929

Sales and marketing
1,929

 
1,346

 
5,245

 
3,780

Research and development
2,796

 
2,043

 
8,283

 
6,002

General and administrative
3,407

 
3,700

 
10,798

 
10,549

 
$
10,540

 
$
8,899

 
$
30,734

 
$
25,260


18

Table of Contents

Stock Plans
Stock Options
The following table summarizes the Company’s stock option activity under the Stock Plans:
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
 
 
 
 
 
(in years)
 
(in thousands)
Outstanding at January 1, 2018
1,436,031

 
$
27.06

 
5.43
 
$
89,554

Granted
4,641

 
$
92.28

 
 
 
 
Exercised
(281,184
)
 
$
24.49

 
 
 
 
Forfeited or expired
(6,676
)
 
$
48.48

 
 
 
 
Outstanding at September 30, 2018
1,152,812

 
$
27.83

 
4.77
 
$
77,172

Ending vested and expected to vest at September 30, 2018
1,152,252

 
$
27.81

 
4.77
 
$
77,153

Exercisable at September 30, 2018
1,094,838

 
$
26.11

 
4.66
 
$
75,172

There were no stock options granted during the three months ended September 30, 2018. The aggregate intrinsic value of the stock options outstanding at September 30, 2018 represents the value of the Company’s closing stock price of $94.77 on September 30, 2018 in excess of the exercise price multiplied by the number of options outstanding for options that were in-the-money.
As of September 30, 2018, total unrecognized stock-based compensation expense related to unvested stock options, adjusted for estimated forfeitures, was $1.5 million and is expected to be recognized over a weighted average period of 11 months.
Restricted Stock Units, Performance-Vesting Restricted Stock Units, and Performance Awards
The following table summarizes the Company’s RSU, performance award, and performance-vesting RSU activity:
 
RSUs
 
Performance Awards and Performance-Vesting RSUs
 
Number of
Shares
 
Weighted
Average
Grant Date
Fair Value
Per Share
 
Number of
Shares
 
Weighted
Average
Grant Date
Fair Value
Per Share
Outstanding at January 1, 2018
1,179,458

 
$
82.84

 
294,464

 
$
56.17

Granted
619,623

 
$
100.67

 
88,513

 
$
92.28

Released
(344,029
)
 
$
74.53

 
(125,253
)
 
$
47.97

Forfeited or expired
(128,438
)
 
$
89.32

 
(29,048
)
 
$
70.33

Outstanding at September 30, 2018
1,326,614

 
$
92.69

 
228,676

 
$
72.84

Ending vested and expected to vest at September 30, 2018
1,171,628

 
 
 
228,676

 
 
RSUs, performance-vesting RSUs, and performance awards that are expected to vest are presented net of estimated future forfeitures.
RSUs released during the nine months ended September 30, 2018 and 2017 had an aggregate intrinsic value of $34.4 million and $32.0 million, respectively, and had an aggregate grant-date fair value of $25.6 million and $17.7 million, respectively.
Performance-vesting RSUs and performance awards released during the nine months ended September 30, 2018 and 2017 had an aggregate intrinsic value of $11.5 million and $13.7 million, respectively, and had an aggregate grant-date fair value of $6.0 million and $5.8 million, respectively. The number of RSUs released includes shares that the Company withheld on behalf of employees to satisfy the minimum statutory tax withholding requirements.
As of September 30, 2018, total unrecognized compensation expense related to unvested RSUs, performance-vesting RSUs, and performance awards, adjusted for estimated forfeitures, was $96.9 million and is expected to be recognized over a weighted average period of 2.6 years.

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Employee Stock Purchase Plan
For the nine months ended September 30, 2018 and 2017, employees purchased 159,692 shares and 121,010 shares, respectively, under the ESPP, resulting in cash proceeds of $11.8 million and $9.1 million, respectively. As of September 30, 2018, unrecognized compensation expense related to the current semi-annual ESPP offering period, which ends on February 28, 2019, was $1.7 million and is expected to be recognized over five months.
Valuation Information
The fair value of stock options and stock purchase rights granted under the Stock Plans, and the ESPP were estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions:
  
Three months ended September 30, 2018
 
Nine Months Ended September 30,
  
2018
 
2017
 
2018
 
2017
Stock option plans:
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate

%
 

%
 
2.63
%
 
2.04
%
Expected life of options (in years)

 
 

 
 
6.08
 
 
6.08
 
Expected dividend yield

%
 

%
 
%
 
%
Volatility

%
 

%
 
45.00
%
 
48.00
%
Employee Stock Purchase Plan:
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate
2.27

%
 
1.12

%
 
2.06
%
 
0.58
%
Expected life of options (in years)
0.48

 
 
0.49

 
 
0.50
 
 
0.49
 
Expected dividend yield

%
 

%
 
%
 
%
Volatility
27.96

%
 
37.25

%
 
27.47
%
 
34.88
%
Common Stock
The following numbers of shares of common stock were reserved and available for future issuance under the 2011 Plan and ESPP at September 30, 2018: 
  
Reserved
Shares
Options and awards outstanding under the Stock Plans
2,708,103

Shares available for future grant under the 2011 Plan
6,455,860

Shares available under the ESPP
1,797,273

Total
10,961,236

In March 2018, 342,276 additional shares were reserved under the ESPP, and 1,711,384 additional shares were reserved under the 2011 Plan, pursuant to the automatic increase provisions in each plan.
Stock Repurchase Program
In August 2017, the Company’s audit committee, under the authority delegated to it by the Company’s board of directors, approved a new stock repurchase program under which the Company is authorized to repurchase up to $250.0 million of its common stock. This authorization expires in August 2020. All shares are retired upon repurchase.
During the nine months ended September 30, 2018, the Company repurchased a total of 159,141 shares for $14.7 million. During the three months ended September 30, 2018, the Company did not repurchase any shares. As of September 30, 2018, $200.0 million remained available for future repurchases under the program.


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ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q and the documents incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. Forward-looking statements may include words such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “target,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “project,” “continue,” or other wording indicating future results or expectations. These forward-looking statements include, but are not limited to, statements about:
expectations regarding demand for home purchases;
the impact of changes in mortgage interest rates, home sale activity and regulatory changes;
the impact of seasonality on our revenues;
estimates of the percentage of our revenues that have direct sensitivities to volume;
changes in mortgage originator, lender, investor or service provider behavior and any related impact on the residential mortgage industry;
our revenue and cost forecasts and drivers;
the number of users of Encompass and estimated Encompass closed loans;
our ability to remediate the material weakness in our internal control over financial reporting;
anticipated benefits of our new solutions;
anticipated timing of roll-out of new solutions and features;
our planned offerings to address regulatory changes;
our planned investments;
the anticipated benefits and growth prospects from our acquisitions;
the timing of future acquisitions of businesses, solutions or technologies and new product launches;
our acquisition strategy;
our belief that our existing cash, cash equivalents, and short-term investments will be sufficient to fund capital expenditures, operating expenses and other cash requirements for at least the next 12 months; and
our planned stock repurchases.
We caution you that the foregoing list may not contain all of the forward-looking statements made in this Quarterly Report on Form 10-Q. You should not rely upon forward-looking statements as predictions of future events. The outcomes of the events described in these forward-looking statements are subject to substantial risks, uncertainties and other factors described in Part II, Item 1A “Risk Factors,” and elsewhere, in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment. New risks and uncertainties emerge from time to time and it is not possible for us to predict all risks and uncertainties that could have an impact on the forward-looking statements contained in this Quarterly Report on Form 10-Q. We cannot assure you that the results, events and circumstances reflected in the forward-looking statements will be achieved or occur, and actual results, events or circumstances could differ materially from those described in the forward-looking statements.
The forward-looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statements made in this Quarterly Report on Form 10-Q to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q or to reflect new information or the occurrence of unanticipated events, except as required by law. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements, and you should not place undue reliance on our forward-looking statements.
In this report, references to “Ellie Mae,” the “Company,” “we,” “our,” or “us” refer to Ellie Mae, Inc., unless the context requires otherwise.

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Overview
We are the leading cloud-based platform provider for the mortgage finance industry. Our technology solutions are used by lenders to originate and close residential mortgage loans. Banks, credit unions, and mortgage lenders use our Encompass® all-in-one mortgage management solution to originate and fund mortgages and improve compliance, loan quality, and efficiency.
Mortgage originators use our Encompass software, a comprehensive digital mortgage solution that handles key business and management functions involved in running a residential mortgage origination business. Mortgage originators use Encompass as a single tool for marketing, loan origination, processing, and customer communication, and to interact electronically with lenders, investors, and service providers over the Ellie Mae Network. Our software also enables enforcement of rules and business practices designed to ensure loan quality, adherence to processing standards, and regulatory compliance.
The Ellie Mae Network electronically connects approximately 192,000 mortgage professionals using Encompass to the broad array of third-party service providers, mortgage lenders, and investors integral to the origination and funding of residential mortgages. During the mortgage origination process, mortgage originators may order various services through the Ellie Mae Network, including credit reports, product eligibility and pricing services, automated underwriting services, appraisals, title reports, insurance, flood certifications and flood insurance, compliance reviews, fraud detection, document preparation, and verification of income, identity, and employment. Mortgage originators can also initiate secure data transmission to and from lenders and investors.
In October 2017, we acquired Velocify, Inc. (“Velocify”), a cloud-based sales engagement platform that provides customers the capabilities to generate and manage leads and customer relationships.
On January 1, 2018, we adopted the Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”) including its subsequent amendments (collectively “Topic 606”) for all open contracts as of January 1, 2018 using the modified retrospective method. Prior period amounts were not adjusted and are reported under Topic 605, Revenue Recognition.
Our revenues are generated primarily from subscriptions to the company-hosted Encompass Software that customers access through the Internet, including customers who pay fees based on the number of loans they close, or success basis, subject to monthly base fees, which we refer to as Success-Based Pricing, and related professional services such as consulting, implementation, and training services. Our revenues also include software-related services that are sold on a transactional basis; Ellie Mae Network fees; fees for education and training; and loan product, policy and guideline data and analytics services that are provided under the AllRegs brand.
Seasonality and current industry trends
Our revenues typically, but not always, track the seasonality of the residential mortgage industry, 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. Mortgage volumes are also impacted by other factors such as interest rate fluctuations, home sale activity, regulatory changes, and general economic conditions, which can lead to departures from the typical seasonal pattern. A combination of tight housing inventory and rising mortgage interest rates resulted in a decline in mortgage volumes in the first three quarters of 2018 relative to the first three quarters of 2017. This had the effect of reducing the number of closed loans per active user on our platform in the first three quarters of 2018 relative to the same period in 2017. Although the market for mortgages is expected to transition to one in which increasing volumes are driven primarily by demand for home purchases, a tight housing supply in certain markets is currently limiting the rate of growth in purchase volumes.
In spite of the lower year-over-year industry volume, we continued to experience year-over-year increases in revenues as our customers use our platform to process an increasing percentage of loans originated in the United States, combined with our ability to increase the revenues we earned per loan in the first three quarters of 2018 compared to the same period in 2017. This was driven by an increase in active users and the adoption of our broader service offerings by our customers.
We currently estimate that approximately 25% to 35% of our revenues have some direct sensitivity to volume. The base fee portion of success based revenues, subscription revenues, and professional services revenues are generally not affected by fluctuations in mortgage origination volume. The impact on our revenues from a substantial decline in mortgage volumes is difficult to predict and subject to risk and uncertainty. Please refer to the risks relating to a decline in mortgage lending volumes described in Part II, Item 1A “Risk Factors” for additional information.

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Our investments
We are investing aggressively in initiatives that we believe will help us continue to grow our business, improve our products and services, and strengthen our competitive advantage while bringing sustainable long-term value to our customers. Our recent launch of Developer Connect, Data Connect, and Investor Connect will enable developers to create new features for Encompass, easily integrate Encompass with external systems and data, and build and deploy custom applications in the cloud. In addition, lenders are also looking for a technology partner to deliver a better digital mortgage experience to consumers. We recently made generally available Encompass Consumer Connect, which enables our customers to originate loans directly from borrowers by offering an online loan application that can be accessed by anyone with a web browser. Furthermore, our acquisition of Velocify accelerates our vision of offering a fully digital mortgage by combining Velocify’s lead management, engagement, and distribution capabilities with Encompass Consumer Connect.
In 2017 and the first three quarters of 2018, we increased our investment in our platform, research and development, technology infrastructure, and data security in an effort to support our growing user base. This includes the roll out of our Connect solutions, the development of our hybrid cloud infrastructure, and the development of our next generation Encompass platform and capabilities, which we expect to continue to progressively roll out to customers during the remainder of 2018, 2019, and 2020. The amortization expense of capitalized costs associated with our Connect solutions and intangible assets from the Velocify acquisition resulted in a decrease in our gross margin and increased operating expenses in the first three quarters of 2018 as compared to the same period in 2017. Conversely, capitalized costs associated with solutions that we have not yet introduced are reflected as an asset on our Condensed Balance Sheet.
We have also invested in our sales and client services capabilities to continue to increase sales of our products and to assist our customers in implementing our solutions. To continue to support customers as we grow our business and further differentiate ourselves, we intend to invest in key areas, such as research and development, enterprise sales, services, technical support, data security, and our hybrid cloud infrastructure. We expect that our cost of revenues will continue to increase as our revenues increase, as we make additional and accelerated investments to bolster our infrastructure and enhance our system capacity, reliability, and data security, as we place new internal-use software into service, and as we pursue additional strategic acquisitions. As we continue to invest in these areas, such expenditures may affect our ability to improve our margins.
In addition to our internal initiatives, our business strategy has evolved to address recent industry trends, including:
greater focus on operational efficiencies;
customers adopting multi-channel strategies;
consumer demand for a digital based experience from lenders;
changes in regulation affecting lenders and investors;
increased quality standards imposed by regulators, lenders, and investors; and
greater focus by customers and regulators on data security and consumer privacy.
We are responding to these trends as follows:
Greater focus on operational efficiencies. The average total production cost per loan was $7,877 in the second quarter of 2018 (1). We expect operational costs to continue to be a significant consideration for mortgage originators due to the continuously changing regulatory environment 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 loans and lowers the risk of buy-back demands from investors resulting from poorly originated or documented loans or loans that fail to comply with applicable regulations. We continually address the changing needs of our customers by developing and enhancing tools to allow for simplified regulatory compliance, increased availability of information, and enhanced system functionality and performance.
With an eye towards providing customers with ever-improving tools to enhance efficiency, we currently anticipate that we will continue to develop new service offerings through the Ellie Mae Network and encourage adoption of our services through initiatives such as our Encompass Connect Solutions. By integrating and expanding our current and new services, we aim to provide a more comprehensive solution to our users.

________________
(1) Mortgage Bankers Association, Second Quarter IMB Profits Up over First Quarter, Down Year-over-Year, August 28, 2018.

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Customers adopting multi-channel strategies. Customers are developing multi-channel strategies beyond a single retail, correspondent or wholesale mortgage lending 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 customizable functionality. Encompass includes support for multi-channel workflows, allowing our customers to drive efficiencies and boost productivity by creating distinct workflows for each channel that map to our customers’ business needs. Encompass users can customize workflows based on channel, loan purpose or specific loan criteria - all of which can vary between lending channels. With the introduction of Encompass TPO Connect, Encompass users are able to utilize a customizable and interactive web experience for wholesale and correspondent lending channels, which gives lenders and investors a modern and collaborative web experience for their third-party origination (“TPO”) partners that promotes compliance, data integrity, and easy bi-directional communication throughout the entire loan process. Additionally, Encompass Consumer Connect supports our customers’ retail channel by enabling our customers to originate loans directly from borrowers by offering an online loan application that can be accessed by anyone with a web browser.
Consumer Demand for a Digital Based Experience from Lenders. Borrowers expect transparency, service and speed, and a human touch. To meet these requirements, lenders must offer a seamless, online experience that continues even after the application has been submitted. It is our goal to provide a true digital mortgage process that enables the lender to originate more loans, lower origination costs, reduce the time to close and make smarter decisions through data and predictive analytics, all while ensuring the highest levels of compliance, quality and efficiency. Our digital mortgage vision encompasses all phases of the mortgage loan lifecycle, with each milestone in the mortgage origination process informing the next.
Changes in regulation affecting lenders and investors. Regulations continue to be subject to change, and many regulatory reforms have significantly increased the complexity and importance of regulatory compliance. We devote considerable resources to continually upgrade our software to help our customers address regulatory changes. We offer Encompass Compliance Service, which analyzes mortgage loan data for compliance with consumer protection laws and institutionally mandated compliance policies and also alerts users to possible violations of these laws and policies. In addition, we have a staff of attorneys who work with compliance experts and help ensure that documents prepared using our software and the processes recommended by the Encompass workflow comply with applicable rules and regulations. For example, additional tools and product updates were required to address the Ability-to-Repay/Qualified Mortgage and Federal and State High Cost rules that became effective in January 2014. In addition, we updated certain of our products to comply with the TILA-RESPA Integrated Disclosure rule changes that took effect in October 2015 and we will provide a complete offering of readiness initiatives, tools and training programs in advance of the 2018 Home Mortgage Disclosure Act and Regulation C collection and reporting changes. We believe we are well-positioned to help our customers comply with changing regulatory requirements as they are published and become effective. However, changes to existing laws or regulations or adoption of new laws or regulations relating to the residential mortgage industry could require us to incur significant costs to update our products and services so that our customers remain compliant with such laws and regulations.
Increased quality standards imposed by regulators, lenders, and investors. Encompass is designed to automate and streamline the process of originating mortgages to, among other things, satisfy increased quality requirements of investors. Relevant features of Encompass include enabling customers’ management to impose processing rules and formats, and 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 Total Quality Loan Program (“TQL”) is designed to further enhance the quality, compliance, and salability of loans that are originated through Encompass. Additionally, TQL is intended to reduce the possibility of errors in the process of transferring information from originator to partners and from originator to investor and to give investors confidence in the accuracy and regulatory compliance of the information that is underlying loan files.
In response to the increased quality standards and compliance mandates affecting the industry, we expect many non-Encompass mortgage lenders to assess new platform options and replace their legacy systems. We have increased the size of our customer acquisition, implementation, and support teams in order to address anticipated demand for our software solutions.
Greater focus by customers and regulators on data security and consumer privacy. Recent high-profile data security incidents affecting financial institutions and their service providers have resulted in an increased focus on data security by our customers and our customers’ regulators. We are making significant investments in the security of the Encompass service, as well as our internal systems, processes, and monitoring capabilities to protect our customers’ data and help minimize the risk of data security loss. We expect the industry focus on data security to continue to increase, and we anticipate that our investments in data security will increase substantially over time.
Acquisition Strategy
We evaluate strategic acquisition and investment opportunities within our core mortgage vertical and across complementary fintech verticals. To date, our acquisitions have been focused on enhancing the delivery of an end-to-end digital mortgage experience for our clients and their customers. The acquisition of Velocify accelerates our vision of offering a fully digital mortgage. We expect to continue to evaluate and explore strategic opportunities that will enhance the breadth and depth of our solutions and further our mission of automating the entire end-to-end mortgage process for our customers.

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Operating Metrics
We use certain operational metrics to evaluate our business, determine allocation of our resources, and make decisions regarding corporate strategy. We focus on these metrics to determine our success in leveraging our user base to increase our revenues and to gauge the degree of our market penetration.
Our key operating metrics are defined below.
Contracted revenues. Contracted revenues are those revenues that are fixed by the terms of a contract and are generally not affected by fluctuations in mortgage origination volume. These revenues consist of the base fee portion of Success-Based Pricing revenues, monthly per-user subscription revenues, professional services revenues, and subscription revenues paid for products other than Encompass.
Active users. An active user is a mortgage origination professional who has used Encompass at least once within a 90-day period preceding the measurement date. A user is a mortgage origination professional working at an Encompass 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.
Average active users. Average active users during a period is calculated by averaging the monthly active users during a reporting period.
Estimated Encompass closed loans. Estimated Encompass closed loans is an estimate of the number of loans originated by Encompass users, calculated as loans originated by our Success-Based Pricing customers, which does not include certain brokered loans or correspondent purchased loans, plus an estimate of the number of loans originated by Encompass customers who are on purely subscription, or SaaS, licenses, which estimate is derived by applying the ratio of active Success-Based Pricing customers to loans originated by these customers to the number of active SaaS users of Encompass for the same period of time.
Revenues per loan. This is all our revenues for the applicable period of time divided by Estimated Encompass closed loans originated during the same period.
The following table shows these operating metrics as of and for the three and nine months ended September 30, 2018 and 2017:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues (in thousands):
 
 
 
 
 
 
 
Revenues
$
122,965

 
$
107,029

 
$
364,220

 
$
304,156

Contracted revenues
$
88,565

 
$
70,994

 
$
260,940

 
$
200,958

Users:
 
 
 
 
 
 
 
Active users
192,296

 
183,122

 
192,296

 
183,122

Average active users during the period
192,445

 
181,413

 
191,053

 
175,151

Loans:
 
 
 
 
 
 
 
Estimated Encompass closed loans
699,000

 
693,000

 
1,973,000

 
1,890,000

Revenues per loan
$
176

 
$
154

 
$
185

 
$
161

Basis of Presentation
Revenue Recognition
Effective January 1, 2018, we apply the provisions of Topic 606 for revenue recognition on contracts with customers. Pursuant to Topic 606, we recognize revenues under the core principle to depict the transfer of control to our customers in an amount reflecting the consideration to which we expect to be entitled. In order to achieve that core principle, the following five step approach is applied:
Identification of the contract, or contracts, with a customer;
Identification of the performance obligations in the contract;
Determination of the transaction price;
Allocation of the transaction price to the performance obligations in the contract; and

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Recognition of revenue when, or as, we satisfy a performance obligation.
We generate revenues primarily from hosted software subscription services, transaction-based fees and related services, including professional services and our annual user conference, and recognizes revenues as performance obligations are satisfied. Sales taxes assessed by governmental authorities are excluded from transaction price.
Our revenues are generated from our hosted Encompass software subscriptions that customers access through the Internet. Our revenues are also comprised of fees for software services sold both as a subscription and on a transactional basis, including fees based on a per closed loan, or success basis, subject to monthly base fees, which we refer to as Success-Based Pricing, as well as Ellie Mae Network fees, fees for loan product, policy and guideline data and analytics services under the AllRegs brand, fees for lead management, marketing and customer relationship management, and fees for professional services which include consulting, implementation, and education and training services.
Cost of Revenues and Operating Expenses
Cost of Revenues
Our cost of revenues consists primarily of: salaries and benefits, including stock-based compensation expense; data center operating costs; depreciation on data center computer equipment; amortization of internal-use software and acquired intangible assets such as developed technology and trade names; customer support; professional services associated with implementation of our software; third-party royalty expenses; 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 and accelerated investments to bolster our infrastructure and enhance our system capacity, reliability, and data security, as we place new internal-use software into service, as we pursue additional strategic acquisitions, and as we continue to hire personnel in our implementation and customer support departments to support new customers and provide new services. We anticipate that we will continue to invest in key areas such as development of internal-use software, professional services, technical support, data security, and data center infrastructure to better support our customers and further differentiate ourselves. This includes development of our next generation Encompass platform, which we expect to continue to roll out to customers throughout 2018 and 2019.
Sales and Marketing
Our sales and marketing expenses consist primarily of: salaries, benefits, and incentive compensation, including stock-based compensation expense and commissions; allocated facilities costs; expenses for trade shows, public relations, our annual user conference, and other promotional and marketing activities; expenses for travel and entertainment; and amortization of acquired intangible assets such as customer relationships. We expect that our sales and marketing expenses will continue to increase as we hire additional sales personnel in order to address anticipated demand for our software solutions, as we pursue additional strategic acquisitions, and as our annual user conference continues to increase in size.
Research and Development
Our research and development expenses consist primarily of: salaries and benefits, including bonuses and stock-based compensation expense; fees to contractors engaged in the development of the Encompass software, Ellie Mae Network, 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 related next-generation enhancements, including hiring additional engineering and product development personnel and as we pursue additional strategic acquisitions.
General and Administrative
Our general and administrative expenses consist primarily of: salaries and benefits, including bonuses and stock-based compensation expense for employees involved in finance, accounting, human resources, administration, information technology, and legal; third-party provider expenses such as general consulting, legal, accounting, and other professional services; and allocated facilities costs. We expect general and administrative expenses to continue to increase in absolute dollars as we expand our facilities and invest in our back-office infrastructure to enhance our system capacity, reliability, and security. We also expect general and administrative expenses to continue to increase as we hire additional personnel and grant stock-based awards to attract and retain the employees needed to continue to grow our business and as we pursue additional strategic acquisitions.
Other Income, Net
Other income, net consists of interest income earned on investments and cash accounts, offset by investment discount amortization, and interest expense paid on equipment and software leases.

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Income Taxes
Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items, if any, that arise during the period. Each quarter, we update our estimate of the annual effective tax rate and, if the estimated annual effective tax rate changes, we make a cumulative adjustment in such period.
We are subject to federal and state income taxes in various jurisdictions and are subject to audit by the relevant taxing authorities. We recognize a tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained, based upon the technical merits of the position, on examination by the taxing authority. The tax benefit recognized is measured as the largest amount of benefit which is greater than 50 percent likely to be realized upon settlement of the position. We recognize accrued interest and penalties related to unrecognized tax benefits as a component of our income tax provision.
Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that are more likely than not expected to be realized based on the weighting of positive and negative evidence. Future realization of deferred tax assets ultimately depends on estimates of future sources of taxable income for the jurisdictions in which we operate and the periods over which our deferred tax assets will be realizable. We will continue to regularly assess the realizability of our deferred tax assets. Changes in earnings performance and future earnings projections, among other factors, may cause us to adjust our valuation allowance on deferred tax assets, which could materially impact our income tax expense in the period we determine that these factors have changed.
Critical Accounting Policies and Estimates
There have been no significant changes during the three and nine months ended September 30, 2018 to our critical accounting policies and estimates previously disclosed in our 2017 Form 10-K except in relation to our adoption of Topic 606 as discussed in Notes 2 and 3 of the Notes to the Condensed Financial Statements.

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Results of Operations
The following tables set forth our results of operations for the periods presented and as a percentage of our revenues for those periods. The period-to-period comparison of financial results is not necessarily indicative of future results.
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Revenues
$
122,965

 
$
107,029

 
$
364,220

 
$
304,156

Cost of revenues(1)
51,272

 
39,603

 
150,728

 
112,638

Gross profit
71,693

 
67,426

 
213,492

 
191,518

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing(1)
18,788

 
13,522

 
62,987

 
46,762

Research and development(1)
20,625

 
15,901

 
67,700

 
49,354

General and administrative(1)
21,062

 
20,159

 
71,270

 
55,828

Total operating expenses
60,475

 
49,582

 
201,957

 
151,944

Income from operations
11,218

 
17,844

 
11,535

 
39,574

Other income, net
1,079

 
1,140

 
2,851

 
2,403

Income before income taxes
12,297

 
18,984

 
14,386

 
41,977

Income tax provision (benefit)
(119
)
 
4,465

 
(8,105
)
 
(964
)
Net income
$
12,416

 
$
14,519

 
$
22,491

 
$
42,941

________________
(1) Stock-based compensation included in the above line items:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
Cost of revenues
$
2,408

 
$
1,810

 
$
6,408

 
$
4,929

Sales and marketing
1,929

 
1,346

 
5,245

 
3,780

Research and development
2,796

 
2,043

 
8,283

 
6,002

General and administrative
3,407

 
3,700

 
10,798

 
10,549

 
$
10,540

 
$
8,899

 
$
30,734

 
$
25,260

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
Revenues
100.0
 %
 
100.0
%
 
100.0
 %
 
100.0
 %
Cost of revenues
41.7

 
37.0

 
41.4

 
37.0

Gross profit
58.3

 
63.0

 
58.6

 
63.0

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
15.3

 
12.6

 
17.3

 
15.4

Research and development
16.8

 
14.9

 
18.6

 
16.2

General and administrative
17.1

 
18.8

 
19.6

 
18.4

Total operating expenses
49.2

 
46.3

 
55.4

 
50.0

Income from operations
9.1

 
16.7

 
3.2

 
13.0

Other income, net
0.9

 
1.1

 
0.8

 
0.8

Income before income taxes
10.0

 
17.8

 
3.9

 
13.8

Income tax provision (benefit)
(0.1
)
 
4.2

 
(2.2
)
 
(0.3
)
Net income
10.1
 %
 
13.6
%
 
6.2
 %
 
14.1
 %

28

Table of Contents

Comparison of the Three and Nine Months Ended September 30, 2018 and 2017
Revenues
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2018
 
2017
 
2018
 
2017
 
(dollars in thousands)
Revenues
$
122,965

 
$
107,029