Document
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, 2017
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 and posted on its corporate Web site, if any, 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 and post 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  (Do not check if smaller reporting company)
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 November 1, 2017:
Class
  
Number of Shares
Common Stock, $0.0001 par value
  
34,536,251

 


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 CONSOLIDATED FINANCIAL STATEMENTS
Ellie Mae, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(in thousands, except share and per share amounts)
 
 
September 30,
2017
 
December 31,
2016
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
246,832

 
$
380,907

Short-term investments
119,327

 
41,841

Accounts receivable, net of allowance for doubtful accounts of $270 and $45 as of September 30, 2017 and December 31, 2016, respectively
48,987

 
39,358

Prepaid expenses and other current assets
17,324

 
15,209

Total current assets
432,470

 
477,315

Property and equipment, net
166,864

 
126,297

Long-term investments
112,874

 
45,931

Intangible assets, net
14,056

 
17,289

Deposits and other assets
18,132

 
10,138

Goodwill
74,547

 
74,547

Total assets
$
818,943

 
$
751,517

Liabilities and Stockholders' Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,537

 
$
15,942

Accrued and other current liabilities
21,121

 
39,809

Deferred revenue
20,322

 
23,126

Total current liabilities
55,980

 
78,877

Other long-term liabilities
16,316

 
17,732

Total liabilities
72,296

 
96,609

Commitments and contingencies (Note 8)

 

Stockholders' equity:
 
 
 
Common stock, $0.0001 par value per share; 140,000,000 authorized shares, 34,526,383 and 33,685,649 shares issued and outstanding as of September 30, 2017 and December 31, 2016, respectively
3

 
3

Additional paid-in capital
646,343

 
612,098

Accumulated other comprehensive loss
(211
)
 
(219
)
Retained earnings
100,512

 
43,026

Total stockholders' equity
746,647

 
654,908

Total liabilities and stockholders' equity
$
818,943

 
$
751,517


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

1

Table of Contents

Ellie Mae, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(UNAUDITED)
(in thousands, except share and per share amounts)
 
 
 
 
 
 
 
 
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues
$
107,029

 
$
100,381

 
$
304,156

 
$
264,104

Cost of revenues
39,603

 
32,218

 
112,638

 
87,302

Gross profit
67,426

 
68,163

 
191,518

 
176,802

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
13,522

 
12,654

 
46,762

 
40,446

Research and development
15,901

 
15,081

 
49,354

 
42,196

General and administrative
20,159

 
19,360

 
55,828

 
52,885

Total operating expenses
49,582

 
47,095

 
151,944

 
135,527

Income from operations
17,844

 
21,068

 
39,574

 
41,275

Other income, net
1,140

 
204

 
2,403

 
565

Income before income taxes
18,984

 
21,272

 
41,977

 
41,840

Income tax provision (benefit)
4,465


7,492


(964
)

14,966

Net income
$
14,519

 
$
13,780

 
$
42,941

 
$
26,874

Net income per share of common stock:
 
 
 
 
 
 
 
Basic
$
0.42

 
$
0.43

 
$
1.26

 
$
0.88

Diluted
$
0.41

 
$
0.41

 
$
1.20

 
$
0.84

Weighted average common shares used in computing net income per share of common stock:
 
 
 
 
 
 
 
Basic
34,275,116

 
31,916,910

 
34,004,025

 
30,407,020

Diluted
35,784,972

 
33,482,533

 
35,803,817

 
32,039,083

 
 
 
 
 
 
 
 
Net income
$
14,519

 
$
13,780

 
$
42,941

 
$
26,874

Other comprehensive income, net of taxes:
 
 
 
 
 
 
 
Unrealized gain (loss) on investments
53

 
(107
)
 
8

 
322

Comprehensive income
$
14,572

 
$
13,673

 
$
42,949

 
$
27,196


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

2

Table of Contents

Ellie Mae, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
 
 
 
 
 
Nine Months ended September 30,
 
2017
 
2016
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
42,941

 
$
26,874

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
26,024

 
14,487

Amortization of intangible assets
3,233

 
4,442

Stock-based compensation expense
25,260

 
23,456

Deferred income taxes
(1,259
)
 
9,363

Loss on disposal of property and equipment

 
5

Amortization (accretion) of investments
(948
)
 
779

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(9,628
)
 
(19,267
)
Prepaid expenses and other current assets
(2,115
)
 
(1,381
)
Deposits and other assets
508

 
(2,298
)
Accounts payable
625

 
(349
)
Accrued, other current and other liabilities
(12,271
)
 
1,238

Deferred revenue
(2,749
)
 
3,759

Net cash provided by operating activities
69,621

 
61,108

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Acquisition of property and equipment
(24,919
)
 
(21,074
)
Acquisition of internal-use software
(40,047
)
 
(25,218
)
Purchases of investments
(213,749
)
 
(49,201
)
Maturities of investments
70,276

 
45,494

Sale of investments

 
20,000

Net cash used in investing activities
(208,439
)

(29,999
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Payment of capital lease obligations
(587
)
 
(2,954
)
Proceeds from issuance of common stock under employee stock plans
17,590

 
15,339

Proceeds (payment of issuance costs) relating to common stock issued in public offering, net
(15
)

271,411

Tax payments related to shares withheld for vested restricted stock units
(12,245
)
 
(4,762
)
Net cash provided by financing activities
4,743

 
279,034

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(134,075
)
 
310,143

CASH AND CASH EQUIVALENTS, Beginning of period
380,907

 
34,396

CASH AND CASH EQUIVALENTS, End of period
$
246,832

 
$
344,539

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
431

 
$
213

Cash paid for (refunded from) income taxes
$
(1,292
)
 
$
218

Supplemental disclosure of non-cash investing and financing activities:
 
 
 
Fixed asset purchases accrued but not paid
$
3,930

 
$
1,196

Stock-based compensation capitalized to property and equipment
$
3,640

 
$
1,927


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

3

Table of Contents

Ellie Mae, Inc.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1Description of Business
Ellie Mae, Inc. (“Ellie Mae,” the “Company,” “we,” “our,” or “us”) is a leading provider of innovative on-demand software solutions and services for the residential mortgage industry in the United States. 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 consolidated 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 consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, which was filed with the SEC on February 22, 2017 (“2016 Form 10-K”).
The condensed consolidated balance sheet as of December 31, 2016, 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.
In the opinion of management, the accompanying unaudited condensed consolidated 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, 2017 or any future period.
Principles of Consolidation
The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated.
Use of Estimates
The preparation of condensed consolidated 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 revenue recognition, 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 consolidated financial statements and footnotes.
Significant Accounting Policies
The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements in its 2016 Form 10-K. There have been no significant changes to these policies during the nine months ended September 30, 2017, except in relation to the Company’s adoption of ASU No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Shared-Based Payment Accounting (“ASU 2016-09”) on January 1, 2017, whereby the Company now records excess tax benefits and tax deficiencies as an income tax benefit or expense when stock awards vest or settle, and the Company no longer classifies the cash flow from excess tax benefits as a reduction from operating cash flows. The Company elected provisions of the standard permitting retrospective restatement of prior period amounts presented in the statement of cash flows related to these transactions. This resulted in a $5.5 million increase in net cash provided by operating activities and a corresponding $5.5 million decrease in net cash provided by financing activities for the nine months ended September 30, 2016 from previously reported amounts.

4

Table of Contents

Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes certain changes in equity that are excluded from net income, specifically unrealized gains on marketable securities. Except for net realized gain on investments, which was not significant, there were no reclassifications out of accumulated other comprehensive income that affected net income during the three and nine months ended September 30, 2017 and 2016.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This standard also requires significantly expanded disclosures about revenue recognition. The effective date for public entities is fiscal years beginning after December 15, 2017 and early adoption is allowed. The Company will adopt the new standard as of January 1, 2018. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method).
The Company currently anticipates adopting the standard using the modified retrospective method and is continuing to evaluate the impact of the new standard on its accounting policies, processes, and systems, including impacts from guidance issued by the FASB Transition Resource Group. The Company has assigned internal resources, engaged a third-party service provider, and is in the process of updating its systems and continuing the evaluation of the quantitative impact to our financial statements.
The Company expects an impact to its Encompass subscription and professional services revenue streams due to the removal of the current limitation on contingent revenue, which may affect the timing and allocation of revenues being recognized for certain contracts. The Company has also identified potential impacts to the costs to obtain contracts, which is primarily comprised of sales commissions and the related fringe benefits associated with non-cancelable contracts. The Company expects to capitalize certain costs that are expensed under the current standard, and the Company expects an increase in the amortization period over which the capitalized costs will be recognized and is continuing to evaluate the impact to the expected period of benefit under ASU 2014-09.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, and early adoption is not permitted. The Company is currently evaluating the impact of this accounting standard update on its consolidated financial statements.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), 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 currently does not intend to early adopt and is evaluating the impact of this accounting standard update on its consolidated financial statements.
In May 2017, the FASB issued ASU No. 2017-09, Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting (“ASU 2017-09”), which provides guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. ASU 2017-09 is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. The Company is currently evaluating the timing of adoption and does not expect the adoption of the accounting standard update to have a material impact on its consolidated financial statements.
NOTE 3Net Income Per Share of Common Stock
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 calculated by dividing net income by the weighted average shares of common stock outstanding and potential shares of common stock during the period. Potential shares of common stock include dilutive shares attributable to the assumed exercise of stock options, restricted stock unit awards (“RSUs”), performance-vesting RSUs, performance share awards (“Performance Awards”), and Employee Stock Purchase Plan (“ESPP”) shares using the treasury stock method, if dilutive.

5

Table of Contents

The components of net income per share of common stock were as follows:
  
Three Months ended September 30,
 
Nine Months ended September 30,
  
2017
 
2016
 
2017
 
2016
 
(in thousands, except share and per share amounts)
Net income
$
14,519

 
$
13,780

 
$
42,941

 
$
26,874

Basic shares:
 
 
 
 
 
 
 
Weighted average common shares outstanding
34,275,116

 
31,916,910

 
34,004,025

 
30,407,020

Diluted shares:
 
 
 
 
 
 
 
Weighted average shares used to compute basic net income per share
34,275,116

 
31,916,910

 
34,004,025

 
30,407,020

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Employee stock options, RSUs, performance-vesting RSUs, Performance Awards and ESPP shares
1,509,856

 
1,565,623

 
1,799,792

 
1,632,063

Weighted average shares used to compute diluted net income per share
35,784,972

 
33,482,533

 
35,803,817

 
32,039,083

Net income per share:
 
 
 
 
 
 
 
Basic
$
0.42

 
$
0.43

 
$
1.26

 
$
0.88

Diluted
$
0.41

 
$
0.41

 
$
1.20

 
$
0.84

The following potential weighted average common shares were excluded from the computation of diluted net income per share, as their effect would have been anti-dilutive:
  
Three Months ended September 30,
 
Nine Months ended September 30,
  
2017
 
2016
 
2017
 
2016
Employee stock options and awards
319,922

 

 
179,091

 
42,036

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, 59,455 and 167,336 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, 2017 and 2016, respectively.
NOTE 4Financial Instruments and Fair Value Measurements
Fair value is defined as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are classified and disclosed in one of the following three categories:
Level 1 — Valuations based on quoted prices in active markets for identical assets or liabilities.
Level 2 — Valuations based on other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 — Valuations based on inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the assets or liabilities.

6

Table of Contents

The following tables set forth by level within the fair value hierarchy the Company’s financial assets that were accounted for at fair value on a recurring basis:
 
September 30, 2017
 
December 31, 2016
  
Level 1
 
Level 2
 
Total
 
Level 1
 
Level 2
 
Total
 
(in thousands)
 
(in thousands)
Cash equivalents:
 
 
 
 
 
 
 
 
 
 
 
Money market funds
$
4,363

 
$

 
$
4,363

 
$
2,733

 
$

 
$
2,733

Corporate notes and obligations

 
17,327

 
17,327

 

 

 

U.S. government and government agency obligations
6,575

 
14,829

 
21,404

 
151,660

 
149,976

 
301,636

 
 
 
 
 
 
 
 
 
 
 
 
Investments:
 
 
 
 
 
 
 
 
 
 
 
Certificates of deposit

 
8,140

 
8,140

 

 
12,088

 
12,088

Corporate notes and obligations

 
73,713

 
73,713

 

 
28,892

 
28,892

Municipal obligations

 
10,475

 
10,475

 

 
11,361

 
11,361

U.S. government and government agency obligations
51,021

 
88,852

 
139,873

 
4,579

 
30,852

 
35,431

 
$
61,959

 
$
213,336

 
$
275,295

 
$
158,972

 
$
233,169

 
$
392,141

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, 2017 and December 31, 2016, the Company did not have any assets or liabilities that were valued using Level 3 inputs. For the three and nine months ended September 30, 2017 and 2016, there were no transfers of financial instruments between the levels.
Realized gains and losses from the sale of investments were not significant during the three and nine months ended September 30, 2017 and 2016.
The carrying amounts, gross unrealized gains and losses and estimated fair value of cash and cash equivalents and both short-term and long-term investments consisted of the following:
 
September 30, 2017
 
December 31, 2016
 
Amortized Cost
 
Unrealized Gains
 
Unrealized Losses
 
Carrying or Fair Value
 
Amortized 
Cost
 
Unrealized Gains
 
Unrealized Losses
 
Carrying or
Fair Value
 
(in thousands)
 
(in thousands)
Cash and cash equivalents:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash
$
203,738

 
$

 
$

 
$
203,738

 
$
76,538

 
$

 
$

 
$
76,538

Money market funds
4,363

 

 

 
4,363

 
2,733

 

 

 
2,733

Corporate notes and obligations
17,327

 

 

 
17,327

 

 

 

 

U.S. government and government agency obligations
21,403

 
1

 

 
21,404

 
301,631

 
8

 
(3
)
 
301,636

 
$
246,831

 
$
1

 
$

 
$
246,832

 
$
380,902

 
$
8

 
$
(3
)
 
$
380,907

Investments:
 

 
 
 
 

 
 

 
 
 
 
 
 
 
 
Corporate notes and obligations
$
73,754

 
$
26

 
$
(67
)
 
$
73,713

 
$
28,978

 
$
1

 
$
(87
)
 
$
28,892

Certificates of deposit
8,138

 
3

 
(1
)
 
8,140

 
12,094

 
13

 
(19
)
 
12,088

Municipal obligations
10,471

 
11

 
(7
)
 
10,475

 
11,422

 
1

 
(62
)
 
11,361

U.S. government and government agency obligations
140,050

 
2

 
(179
)
 
139,873

 
35,502

 
8

 
(79
)
 
35,431

 
$
232,413

 
$
42

 
$
(254
)
 
$
232,201

 
$
87,996

 
$
23

 
$
(247
)
 
$
87,772


7

Table of Contents

The following table shows the gross unrealized losses and the related fair values of the Company’s investments that have been in a continuous unrealized loss position. The Company did not identify any investments as other-than-temporarily impaired at September 30, 2017 or December 31, 2016 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, 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
$
31,732

 
$
(32
)
 
$
7,710

 
$
(35
)
 
$
39,442

 
$
(67
)
Certificates of deposit
2,452

 

 
245

 
(1
)
 
2,697

 
(1
)
U.S. government, government agency, and municipal obligations
124,336

 
(154
)
 
5,500

 
(32
)
 
129,836

 
(186
)
 
$
158,520

 
$
(186
)
 
$
13,455

 
$
(68
)
 
$
171,975

 
$
(254
)
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
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
$
26,076

 
$
(87
)
 
$

 
$

 
$
26,076

 
$
(87
)
Certificates of deposit
5,651

 
(19
)
 

 

 
5,651

 
(19
)
U.S. government, government agency, and municipal obligations
180,138

 
(144
)
 
385

 

 
180,523

 
(144
)
 
$
211,865

 
$
(250
)
 
$
385

 
$

 
$
212,250

 
$
(250
)
The following table summarizes the maturities of the Company’s investments at September 30, 2017:
 
 
 
 
 
Carrying or
Fair Value
 
 
 
 
 
(in thousands)
Remainder of 2017
 
 
 
 
$
28,276

2018
 
 
 
 
102,878

2019
 
 
 
 
72,308

2020
 
 
 
 
28,739

Total
 
 
 
 
$
232,201

Actual maturities may differ from the contractual maturities because borrowers may have the right to call or prepay certain obligations.

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NOTE 5Balance Sheet Components
Property and Equipment, net
Property and equipment, net, consisted of the following:
 
September 30,
 
December 31,
 
2017
 
2016
 
(in thousands)
Computer equipment and software(1) (2)
$
66,871

 
$
54,029

Internal-use software(2)
96,022

 
62,573

Furniture and fixtures
9,218

 
6,838

Leasehold improvements
29,389

 
18,532

Property and equipment
201,500

 
141,972

Accumulated depreciation and amortization(1)
(75,015
)
 
(48,991
)
Subtotal
126,485

 
92,981

Internal-use software and other assets not placed in service
40,379

 
33,316

Property and equipment, net
$
166,864

 
$
126,297

________________
(1) Includes computer equipment and software under capital leases
(2) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements.
Computer equipment and software under capital leases, net, consisted of the following:
 
September 30,
 
December 31,
 
2017
 
2016
 
(in thousands)
Computer equipment
$
8,715

 
$
8,715

Software
1,517

 
1,517

Accumulated depreciation and amortization
(8,676
)
 
(6,522
)
Net computer equipment and software under capital leases
$
1,556

 
$
3,710

Depreciation and amortization expense for the three and nine months ended September 30, 2017 was $9.7 million and $26.0 million, respectively. Depreciation and amortization expense for the three and nine months ended September 30, 2016 was $5.8 million and $14.5 million, respectively. Depreciation and amortization of assets under capital leases which is included in the depreciation and amortization expense for the three and nine months ended September 30, 2017 was $0.6 million and $2.2 million, respectively. Depreciation and amortization of assets under capital leases which is included in depreciation and amortization expense for the three and nine months ended September 30, 2016 was $0.8 million and $2.4 million, respectively.

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Accrued and Other Current Liabilities
Accrued and other current liabilities consisted of the following:
 
September 30,
 
December 31,
 
2017
 
2016
 
(in thousands)
Accrued payroll and related expenses
$
15,281

 
$
31,848

Accrued commissions
643

 
1,832

Accrued royalties
1,828

 
1,395

Sales and other taxes
1,298

 
2,327

Other accrued liabilities(1)
2,071

 
2,407

 
$
21,121

 
$
39,809

________________
(1) Certain reclassifications of prior period amounts have been made to conform to the current period presentation, such reclassification did not materially change previously reported consolidated financial statements.


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NOTE 6Goodwill and Intangible Assets, Net
The carrying value of goodwill at September 30, 2017 was $74.5 million. There were no changes in the carrying value of goodwill during the three and nine months ended September 30, 2017.
Intangible assets, net, consisted of the following:
  
September 30, 2017
  
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Intangibles
 
Weighted Average Remaining Useful Life
 
(in thousands)
 
(in years)
Assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
11,535

 
$
(9,181
)
 
$
2,354

 
2.1
Trade names
331

 
(331
)
 

 
0.0
Customer relationships
19,400

 
(11,928
)
 
7,472

 
3.4
Order backlog
370


(179
)

191


2.1
Total assets subject to amortization:
31,636

 
(21,619
)
 
10,017

 
3.1
Assets not subject to amortization:
 
 
 
 
 
 
 
Trade name
4,039

 

 
4,039

 
 
 
$
35,675

 
$
(21,619
)
 
$
14,056

 
 
 
 
 
 
 
 
 
 
  
December 31, 2016
  
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Intangibles
 
Weighted Average Remaining Useful Life
 
(in thousands)
 
(in years)
Assets subject to amortization:
 
 
 
 
 
 
 
Developed technology
$
11,535

 
$
(8,183
)
 
$
3,352

 
2.7
Trade names
331

 
(331
)
 

 
0.0
Customer relationships
19,400

 
(9,762
)
 
9,638

 
4.0
Order backlog
370

 
(110
)
 
260

 
2.8
Total assets subject to amortization:
31,636

 
(18,386
)
 
13,250

 
3.6
Assets not subject to amortization:
 
 
 
 
 
 
 
Trade name
4,039

 

 
4,039

 
 
 
$
35,675

 
$
(18,386
)
 
$
17,289

 
 
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. Amortization expense associated with intangible assets for the three and nine months ended September 30, 2016 was $1.5 million and $4.4 million, respectively.
Future amortization expense for intangible assets at September 30, 2017 was as follows:
  
Amortization
 
(in thousands)
Remainder of 2017
$
1,061

2018
3,443

2019
3,166

2020
1,778

2021
314

2022
255

 
$
10,017


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NOTE 7Income Taxes
The Company computes its interim provision for income taxes by applying the estimated annual effective tax rate to the year-to-date income from recurring operations and adjusts the provision for discrete tax items recorded in the period. The Company evaluates and updates its estimated annual effective income tax rate on a quarterly basis. The estimated annual effective tax rate as of September 30, 2017 and 2016 was 35.9% and 36.5%, respectively.
  
Three Months ended September 30,
 
Nine Months ended September 30,
  
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
 
(dollars in thousands)
Income tax provision (benefit)
$
4,465

 
$
7,492

 
$
(964
)
 
$
14,966

Effective tax rate(1)
23.5
%
 
35.2
%
 
(2.3
)%
 
35.8
%
________________
(1) The impact to the effective tax rate due to the excess tax benefits of stock-based compensation from the adoption of ASU 2016-09 was 12.0% and 37.0% for the three and nine months ended September 30, 2017, respectively.
The Company’s effective tax rate was 23.5% and (2.3)% for the three and nine months ended September 30, 2017, which was lower than the U.S. federal statutory rate of 35%. The lower tax rate was primarily due to the discrete impact of excess tax benefits of stock-based compensation from the adoption of ASU 2016-09 and the federal R&D credit, partially offset by the non-deductible stock-based compensation.
As described in Note 2 “Basis of Presentation and Significant Accounting Policies”, the Company adopted ASU 2016-09 on January 1, 2017, which requires the excess tax benefits or deficiencies to be reflected in the Consolidated Statements of Comprehensive Income as a component of the provision for income taxes, which were previously recognized in equity. Total excess tax benefits recognized for the three and nine months ended September 30, 2017 was $2.3 million and $15.5 million, respectively.
The Company’s tax positions are subject to income tax audits by multiple tax jurisdictions. The Company accounts for uncertain tax positions and believes that it has provided adequate reserves for its unrecognized tax benefits for all tax years still open for assessment. The Company also believes that it does not have any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next twelve months.
The Company has a policy to classify accrued interest and penalties associated with uncertain tax positions together with the related liability in the balance sheet, and to include the expenses incurred related to such accruals in the provision for income taxes. There were no interest or penalties included in the provision for income taxes during the nine months ended September 30, 2017 and 2016.
NOTE 8Commitments and Contingencies
Leases
As of September 30, 2017, the Company leased eight 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 and has recorded deferred rent for the difference between rent payments and rent expense recognized.
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 9Equity and Stock Incentive Plans
The Company recognized stock-based compensation expense related to awards granted under its 2009 Stock Option and Incentive Plan (the “2009 Plan”), 2011 Equity Incentive Award Plan (the “2011 Plan”), and ESPP.

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Total stock-based compensation expense recognized consisted of:
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Cost of revenues
$
1,810

 
$
1,381

 
$
4,929

 
$
3,483

Sales and marketing
1,346

 
1,243

 
3,780

 
3,180

Research and development
2,043

 
1,969

 
6,002

 
5,417

General and administrative
3,700

 
4,155

 
10,549

 
11,376

 
$
8,899

 
$
8,748

 
$
25,260

 
$
23,456

2009 Stock Option and Incentive Plan and 2011 Equity Incentive Award Plan
Stock Options
The following table summarizes the Company’s stock option activity under the 2009 Plan and 2011 Plan:
 
Number of
Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
 
 
 
 
 
(in years)
 
(in thousands)
Outstanding at January 1, 2017
1,885,332

 
$
26.21

 
6.34
 
$
108,356

Granted
6,601

 
94.66

 
 
 
 
Exercised
(365,573
)
 
23.23

 
 
 
 
Forfeited or expired
(20,646
)
 
40.48

 
 
 
 
Outstanding at September 30, 2017
1,505,714

 
$
27.03

 
5.70
 
$
83,042

Ending vested and expected to vest at September 30, 2017
1,498,599

 
$
26.93

 
5.69
 
$
82,809

Exercisable at September 30, 2017
1,259,159

 
$
23.53

 
5.40
 
$
73,791

There were no stock options granted during the three months ended September 30, 2017. Stock options granted during the nine months ended September 30, 2017 were made under the 2011 Plan. There were no grants under the 2009 Plan during the nine months ended September 30, 2017.
The aggregate intrinsic value of the stock options outstanding at September 30, 2017 represents the value of the Company’s closing stock price of $82.13 on September 30, 2017 in excess of the exercise price multiplied by the number of options outstanding for options that were in-the-money. Options outstanding that are expected to vest are net of estimated future option forfeitures.
As of September 30, 2017, total unrecognized stock-based compensation expense related to unvested stock options, adjusted for estimated forfeitures, was $4.9 million and is expected to be recognized over a weighted average period of 1.3 years.

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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, 2017
1,025,115

 
$
64.47

 
407,650

 
$
46.77

Granted
504,699

 
100.90

 
41,992

 
94.66

Released
(309,089
)
 
57.11

 
(145,651
)
 
39.53

Forfeited or expired
(100,817
)
 
79.20

 

 

Outstanding at September 30, 2017
1,119,908

 
$
81.59

 
303,991

 
$
56.86

Ending vested and expected to vest at September 30, 2017
977,940

 
 
 
303,991

 
 
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, 2017 and 2016 had an aggregate intrinsic value of $32.0 million and $16.8 million, respectively, and had an aggregate grant-date fair value of $17.7 million and $8.3 million, respectively. Performance-vesting RSUs and Performance Awards released during the nine months ended September 30, 2017 and 2016 had an aggregate intrinsic value of $13.7 million and $21.6 million, respectively, and had an aggregate grant-date fair value of $5.8 million and $6.8 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, 2017, total unrecognized compensation expense related to unvested RSUs, performance-vesting RSUs, and Performance Awards was $72.3 million and is expected to be recognized over a weighted average period of 2.5 years.
Employee Stock Purchase Plan
For the nine months ended September 30, 2017 and 2016, employees purchased 121,010 shares and 101,816 shares, respectively, under the ESPP for a total of $9.1 million and $6.7 million, respectively. As of September 30, 2017, unrecognized compensation expense related to the current semi-annual ESPP offering period, which ends on February 28, 2018, was $1.4 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 2009 Plan, the 2011 Plan, 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,
 
Nine Months ended September 30,
  
2017
 
2016
 
2017
 
2016
Stock option plans:
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate

%
 

%
 
2.04
%
 
1.38
%
Expected life of options (in years)

 
 

 
 
6.08
 
 
6.08
 
Expected dividend yield

%
 

%
 
%
 
%
Volatility

%
 

%
 
48
%
 
47
%
Employee Stock Purchase Plan:
 
 
 
 
 
 
 
 
 
 
 
Risk-free interest rate
1.12

%
 
0.46

%
 
0.58
%
 
0.36
%
Expected life of options (in years)
0.49

 
 
0.50

 
 
0.49
 
 
0.50
 
Expected dividend yield

%
 

%
 
%
 
%
Volatility
37

%
 
33

%
 
35
%
 
38
%

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Common Stock
The following numbers of shares of common stock were reserved and available for future issuance at September 30, 2017: 
  
Reserved
Shares
Options and awards outstanding under stock option plans
2,929,613

Shares available for future grant under the 2011 Plan
5,225,211

Shares available under the ESPP
1,614,689

Total
9,769,513

In February 2017, 336,856 additional shares were reserved under the ESPP, and 1,684,282 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. As of September 30, 2017, the Company had not repurchased any shares under this program.
NOTE 10Segment 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 on a consolidated basis. 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 for its network participants.
NOTE 11Subsequent Events
On October 2, 2017, the Company acquired all of the shares of Velocify, Inc. (“Velocify”), a leading cloud-based intelligent sales automation platform that provides customers the capabilities to generate and manage leads and customer relationships, in exchange for total cash consideration of approximately $130.0 million plus contingent payments of approximately $2.8 million.
Given the timing of the completion of the acquisition, the Company is currently in the process of valuing the assets acquired and liabilities assumed. As a result, the Company is unable to provide the amount recognized as of the acquisition date for the major classes of assets acquired and liabilities assumed. The Company will provide these disclosures in its Annual Report on Form 10-K for the year ending December 31, 2017.
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. These forward-looking statements include, but are not limited to, statements concerning our strategy, future operations, future financial performance, future revenues, future profitability, future products and services, projected costs, expectations regarding demand and acceptance of our products and services, growth opportunities, our reputation, future economic conditions, trends in the market in which we operate, the plans and objectives of management and the statements set forth in this Item 2 and the section captioned “Risk Factors” in this report.
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. Forward-looking statements are subject to risks and uncertainties, and actual events or results may differ materially. These forward-looking statements involve risks and uncertainties that could cause our actual results to differ materially from those described in the forward-looking statements, including, without limitation:
outages and other system interruptions in our Encompass software, the Ellie Mae Network service or our other services and any related impact on our reputation;
fluctuations in mortgage lending volume;
the volume of mortgages originated by our Encompass users;

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the impact of changes in mortgage interest rates;
changes in mortgage originator, lender, investor or service provider behavior and any related impact on the residential mortgage industry;
our revenue and cost forecasts and drivers;
our ability to accurately forecast revenues and appropriately plan our expenses;
the potential impact of ASU No. 2014-09, Revenue from Contracts with Customers, on our revenues and costs;
the number of Encompass users, including contracted Encompass users;
anticipated benefits of our new solutions;
the effectiveness of our marketing and sales efforts to attract new and retain existing Encompass users and Ellie Mae Network participants;
transaction volume on the Ellie Mae Network;
the level of demand for our Encompass Docs Solution, our Encompass Product & Pricing Service, our Encompass Compliance Service, our Encompass CRM service and the other services we offer;
our ability to keep secure the confidential information of the customers of the users of our software and services;
our ability to enhance the features and functionality of our software and services, including the development and successful deployment of our next generation Encompass platform;
the timing of the introduction and acceptance of new software and services;
changes in government regulation affecting mortgage lenders and Ellie Mae Network participants or our business, and potential structural changes in the U.S. residential mortgage industry;
customer retention, renewal and upgrade rates;
the increased time, cost and complexity that may be required to successfully target larger customers;
our ability to scale our operations and increase productivity to support our existing and growing customer base;
our planned investments in our products and services;
our ability to successfully manage our growth and any future acquisitions of businesses, solutions or technologies;
the risk that the anticipated benefits and growth prospects expected from our recent acquisitions may not be fully realized or may take longer to realize than expected;
the timing of future acquisitions of businesses, solutions or technologies and new product launches;
the impact of uncertain domestic and worldwide economic conditions, including the resulting effect on residential mortgage volumes;
the attraction and retention of qualified employees and key personnel;
our ability to compete effectively in a highly competitive market and adapt to technological changes;
our ability to protect our intellectual property, including our proprietary Encompass software;
costs associated with defending intellectual property infringement and other claims; our ability to maintain effective internal controls;
the risk of natural and man-made catastrophic interruptions to our business; and
the risks set forth in the section captioned “Risk Factors” in this report.
We do not assume any obligation to update any forward-looking statements, except as required by law.
In this report, references to “Ellie Mae,” the “Company,” “we,” “our,” or “us” refer to Ellie Mae, Inc. together with its subsidiaries, unless the context requires otherwise.
Overview
We are a leading provider of innovative on-demand software solutions and services for the residential mortgage industry in the United States. 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 mortgage management system that handles key business and management functions involved in running a residential mortgage origination business. Mortgage originators use Encompass

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as a single tool for loan processing, marketing, 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 183,000 mortgage professionals using Encompass to the broad array of mortgage lenders, investors, and third-party service providers integral to the origination and funding of residential mortgages. During the mortgage origination process, mortgage originators may order various services 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, a leading cloud-based intelligent sales automation platform that provides customers the capabilities to generate and manage leads and customer relationships.
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 transaction fees paid by service providers, lenders, investors, and certain government-sponsored entities participating on the Ellie Mae Network; education and training; and loan product and guideline data and analytics services that are provided under the AllRegs brand.
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 such as the TILA-RESPA Integrated Disclosure rule which became effective in October 2015, and general economic conditions, which can lead to departures from the typical seasonal pattern. During the first nine months of 2017, mortgage volumes declined relative to the first nine months of 2016 due to an increase in mortgage interest rates resulting in a lower number of refinancings. This had the effect of reducing the number of closed loans per active user on our platform in the third quarter of 2017 relative to the same period in 2016. Although the market 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. As a result, closed loans per average active user on our platform are expected to continue to be lower for the remainder of 2017 relative to the same period in 2016.
In spite of lower industry volume, we continue to experience period-over-period increases in revenues as our customers use our platform to process an increasing percentage of loans originated in the United States and we are able to increase the revenue we earn per loan. This is achieved by the continued addition of new users and the increased 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.
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 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. We believe this open and simplified architecture will enable us to deploy add-on services more easily and drive significantly more revenue per loan. In addition, lenders are also looking for a technology partner to deliver a better digital mortgage experience to consumers. Here, the acquisition of Velocify accelerates our vision of offering a fully digital mortgage by combining Velocify’s lead management, engagement and distribution capabilities with our Encompass CRM and Consumer Connect service offerings, which allows lenders to provide better digital tools and a more easy-to-use web based experience as a seamless extension of Encompass.
In 2017, we have 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 rollout of our Connect solutions in the first three quarters of 2017, the development of our hybrid cloud infrastructure, and our next generation Encompass platform and capabilities, which we expect to continue to progressively rollout to customers in 2018 and 2019. The amortization expense of capitalized costs associated with our Connect solutions resulted in a decrease in our gross margin percentage and increased operating expenses in the first nine months of 2017 as compared to the same period in 2016. Conversely, capitalized costs associated with solutions that we have not yet introduced are reflected as an asset on our Condensed Consolidated Balance Sheet.

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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 as we grow revenue.
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;
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 $7,774 in the second quarter of 20171. 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.
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, or TPO, partners that promotes compliance, data integrity, and easy bi-directional communication throughout the entire loan process. Additionally, Encompass Consumer Connect 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.
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 (“HMDA”) 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
________________
(1) 
Mortgage Bankers Association, Independent Mortgage Bank Production Profits Improved in 2nd Quarter 2017, August 29, 2017.

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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 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 banking institutions and cloud-service software 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
Our industry is highly fragmented, and we are evaluating strategic opportunities available to acquire technology-based companies that will complement and increase the attractiveness of our solutions. In October 2017, we acquired Velocify, a leading cloud-based intelligent sales automation platform that provides customers the capabilities to generate and manage leads and customer relationships.
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.
These 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 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.
Contracted users. A contracted user is a mortgage origination professional who has a license to use Encompass and has an obligation to pay for this license, but who is not necessarily an active user.
Average active users. Average active users during a period is calculated by averaging the monthly active users during a reporting period.
Revenue per average active Encompass user. Revenue per average active Encompass user is calculated by dividing total revenues by average active Encompass users.

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The following table shows these operating metrics as of and for the three and nine months ended September 30, 2017 and 2016:
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
Revenues (in thousands):
 
 
 
 
 
 
 
Total revenues
$
107,029

 
$
100,381

 
$
304,156

 
$
264,104

Total contracted revenues
$
70,994

 
$
54,469

 
$
200,958

 
$
150,007

Users at end of period:
 
 
 
 
 
 
 
Contracted users
234,356

 
205,784

 
234,356

 
205,784

Active users
183,122

 
159,523

 
183,122

 
159,523

Active users as a percentage of contracted users
78
%
 
78
%
 
78
%
 
78
%
Average active users:
 
 
 
 
 
 
 
Average active users during the period
181,413

 
156,912

 
175,151

 
149,289

Revenue per average active user during the period
$
590

 
$
640

 
$
1,737

 
$
1,769

Basis of Presentation
General
Our consolidated financial statements include the accounts of Ellie Mae, Inc. and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated upon consolidation.
Revenue Recognition
We generate revenues primarily from subscription services and usage-based fees, transaction-based fees, and fees from professional services. Sales taxes assessed by governmental authorities are excluded from revenue.
Our revenue is generated from the company-hosted Encompass Software subscriptions that customers access through the Internet. Our revenue is also comprised of fees for software services sold both as a subscription and transactionally, including fees based on a per closed loan, or success basis, subject to monthly base fees, which we refer to as Success-Based Pricing; Ellie Mae Network fees; education and training, loan product, policy and guideline data and analytics services under the AllRegs brand; and professional services which include consulting, implementation, 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 internal-use software, our services, technical support, data security, and data center infrastructure to better support our customers and further differentiate ourselves. This will include development of our next generation Encompass platform, which we expect to continue to progressively rollout to customers in 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.

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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.
Income Taxes
On a quarterly basis, we evaluate our expected income tax expense or benefit based on our year-to-date operations, and we record an adjustment in the current quarter. The net tax provision is the result of the mix of profits earned by us and our subsidiaries in tax jurisdictions with a broad range of income tax rates. We are required to estimate deferred tax assets and liabilities based on the differences between the financial reporting and tax bases of assets and liabilities measured using the enacted tax rates that will be in effect when the differences are expected to reverse. In general, deferred tax assets represent future tax benefits to be received when certain expenses previously recognized in our consolidated statements of operations become deductible expenses under applicable income tax laws or loss or credit carry forwards are utilized. Accordingly, realization of our deferred tax assets is dependent on future taxable income against which these deductions, losses, and credits can be utilized. Management uses judgment to assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not more likely than not, we must establish a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized. We adopted ASU 2016-09 as of January 1, 2017. As a result of the adoption, excess tax benefits are recognized as income tax benefit or expense when stock awards vest or are settled, which reduced our effective tax rate for the first nine months of 2017. Given the inherent uncertainty in predicting future share-based transactions, actual benefits realized may vary and result in volatility to our income tax expense or benefit.
Critical Accounting Policies and Estimates
There have been no material changes during the three and nine months ended September 30, 2017 to our critical accounting policies and estimates previously disclosed in our 2016 Form 10-K except in relation to our adoption of ASU No. 2016-09, Compensation—Stock Compensation (Topic 718): Improvements to Employee Shared-Based Payment Accounting on January 1, 2017, whereby we now record excess tax benefits and tax deficiencies as income tax benefit or expense when stock awards vest or settle, and we no longer classify the cash flow from excess tax benefits as a reduction from operating cash flows. This resulted in a $5.5 million increase in net cash provided by operating activities and a corresponding $5.5 million decrease in net cash provided by financing activities for the nine months ended September 30, 2016 from previously reported amounts.

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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,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Revenues
$
107,029

 
$
100,381

 
$
304,156

 
$
264,104

Cost of revenues(1)
39,603

 
32,218

 
112,638

 
87,302

Gross profit
67,426

 
68,163

 
191,518

 
176,802

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing(1)
13,522

 
12,654

 
46,762

 
40,446

Research and development(1)
15,901

 
15,081

 
49,354

 
42,196

General and administrative(1)
20,159

 
19,360

 
55,828

 
52,885

Total operating expenses
49,582

 
47,095

 
151,944

 
135,527

Income from operations
17,844

 
21,068

 
39,574

 
41,275

Other income, net
1,140

 
204

 
2,403

 
565

Income before income taxes
18,984

 
21,272

 
41,977

 
41,840

Income tax provision (benefit)
4,465

 
7,492

 
(964
)
 
14,966

Net income
$
14,519

 
$
13,780

 
$
42,941

 
$
26,874

________________
(1) Stock-based compensation included in the above line items:
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(in thousands)
Cost of revenues
$
1,810

 
$
1,381

 
$
4,929

 
$
3,483

Sales and marketing
1,346

 
1,243

 
3,780

 
3,180

Research and development
2,043

 
1,969

 
6,002

 
5,417

General and administrative
3,700

 
4,155

 
10,549

 
11,376

 
$
8,899

 
$
8,748

 
$
25,260

 
$
23,456

 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
Revenues
100.0
%
 
100.0
%
 
100.0
 %
 
100.0
%
Cost of revenues
37.0

 
32.1

 
37.0

 
33.1

Gross profit
63.0

 
67.9

 
63.0

 
66.9

Operating expenses:
 
 
 
 
 
 
 
Sales and marketing
12.6

 
12.6

 
15.4

 
15.3

Research and development
14.9

 
15.0

 
16.2

 
16.0

General and administrative
18.8

 
19.3

 
18.4

 
19.9

Total operating expenses
46.3

 
46.9

 
50.0

 
51.2

Income from operations
16.7

 
21.0

 
13.0

 
15.7

Other income, net
1.1

 
0.2

 
0.8

 
0.2

Income before income taxes
17.8

 
21.2

 
13.8

 
15.9

Income tax provision (benefit)
4.2

 
7.5

 
(0.3
)
 
5.7

Net income
13.6
%
 
13.7
%
 
14.1
 %
 
10.2
%

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Comparison of the Three and Nine Months Ended September 30, 2017 and 2016
Revenues
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
Revenues
107,029

 
100,381

 
304,156

 
264,104

Three months ended September 30, 2017. Total revenues increased $6.6 million, or 6.6%, for the three months ended September 30, 2017 as compared to the same period in 2016, primarily due to a 13.9% increase in contracted users as of September 30, 2017 compared to the same period in 2016, partially offset by lower mortgage origination volumes driven mainly by an industrywide decrease in refinancings due to higher interest rates. The increase in contracted users resulted in a $2.9 million increase in Encompass revenue mainly attributable to a $11.8 million, or 29.9%, increase in base fees, partially offset by a decrease of $8.9 million in additional closed loan fees, which are assessed for loans closed in excess of base fees under our Success-Based Pricing model. Significantly lower refinance origination volumes had the effect of reducing closed loans per average active user in the third quarter of 2017 as compared to same quarter in 2016 resulting in a reduction in revenue per average active user.
The implementation of new users and increased use of training and other technical support offerings also contributed to a $2.4 million increase in revenues from professional services. Finally, we had a $1.3 million increase in network revenues from increased adoption of service offerings with third-party providers.
Nine months ended September 30, 2017. Total revenues increased $40.1 million, or 15.2%, for the nine months ended September 30, 2017 as compared to the same period in 2016, primarily due to a 13.9% increase in contracted users as of September 30, 2017 compared to the same period in 2016, partially offset by lower mortgage origination volumes driven mainly by an industrywide decrease in refinancings due to higher interest rates. The increase in contracted users resulted in a $25.2 million increase in Encompass revenue mainly attributable to a $38.3 million, or 35.8%, increase in base fees, partially offset by a decrease of $13.1 million in additional closed loan fees, which are assessed for loans closed in excess of base fees under our Success-Based Pricing model.
The implementation of new users and increased use of training and other technical support offerings also contributed to a $10.2 million increase in revenues from professional services. We also had a $2.9 million increase in revenues from other software and services due to increased usage by Encompass users. Finally, we had a $2.9 million increase in network revenues from increased usage of third-party providers of services needed to process loans.
Gross Profit
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
Gross profit
$
67,426

 
$
68,163

 
$
191,518

 
$
176,802

Gross margin
63.0
%
 
67.9
%
 
63.0
%
 
66.9
%
Gross profit decreased by $0.7 million and gross margin decreased by 4.9% during the three months ended September 30, 2017 as compared to the same period in 2016. The decrease in gross margin was primarily the result of a $3.6 million increase in amortization expense related to internal-use software and depreciation expense related to infrastructure hardware placed into service, a $2.3 million increase in salaries, employee benefits, and stock-based compensation expenses associated with additional headcount for our professional services and customer support organizations in anticipation of continued increasing demand for our software solutions, and a $1.3 million increase in expenses related to upgrades and services to our data centers hardware and technology as we increase capacity to accommodate new customers through our hybrid cloud architecture.
Gross profit increased by $14.7 million and gross margin decreased by 3.9% during the nine months ended September 30, 2017 as compared to the same period in 2016. The decrease in gross margin was the result of a $11.1 million increase in amortization expense related to internal-use software and depreciation expense related to infrastructure hardware placed into service, a $8.5 million increase in salaries, employee benefits, and stock-based compensation expenses associated with increased headcount in our professional services and customer support organizations in anticipation of continued increasing demand for our software solutions, a $3.5 million increase in expenses related to upgrades and services to our data centers hardware and technology as we increase capacity to accommodate new customers through our hybrid cloud architecture, and a $2.5 million increase in third-party royalty expenses arising from the increased revenues.

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Sales and Marketing
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
Sales and marketing
$
13,522

 
$
12,654

 
$
46,762

 
$
40,446

Sales and marketing as a % of revenues
12.6
%
 
12.6
%
 
15.4
%
 
15.3
%
Sales and marketing expenses increased by $0.9 million, or 6.9%, for the three months ended September 30, 2017 as compared to the same period in 2016. Sales and marketing expenses as a percentage of revenues remained flat. The increase in sales and marketing expenses was primarily due to a $0.5 million increase in expenses related to marketing events.
Sales and marketing expenses increased by $6.3 million, or 15.6%, for the nine months ended September 30, 2017 as compared to the same period in 2016. Sales and marketing expenses as a percentage of revenues remained relatively flat. The increase in sales and marketing expenses was primarily due to a $3.2 million increase in salaries, employee benefits, and stock-based compensation expenses related to increased headcount as we continue to grow our sales and marketing department in an effort to increase our market share and address anticipated demand for our software solutions, and a $1.5 million increase in marketing and promotion expenses, including our user conference.
Research and Development
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
Research and development
$
15,901

 
$
15,081

 
$
49,354

 
$
42,196

Research and development as a % of revenues
14.9
%
 
15.0
%
 
16.2
%
 
16.0
%
Research and development expenses increased by $0.8 million, or 5.4%, for the three months ended September 30, 2017 as compared to the same period in 2016. Research and development expenses as a percentage of revenues remained relatively flat. The increase in research and development expenses was primarily driven by salaries, employee benefits, and stock-based compensation expenses related to increased headcount and fees to contractors as we continue to invest in our products and services.
Research and development expenses increased by $7.2 million, or 17.0%, for the nine months ended September 30, 2017 compared to the same period in 2016. Research and development expenses as a percentage of revenues increased by 0.2%. The increase in research and development expenses was primarily driven by salaries, employee benefits, and stock-based compensation expenses related to increased headcount and fees to contractors as we continue to invest in our products and services.
General and Administrative
 
Three Months ended September 30,
 
Nine Months ended September 30,
 
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
General and administrative
$
20,159

 
$
19,360

 
$
55,828

 
$
52,885

General and administrative as a % of revenues
18.8
%
 
19.3
%
 
18.4
%
 
19.9
%
General and administrative expenses increased by $0.8 million, or 4.1%, for the three months ended September 30, 2017 as compared to the same period in 2016. General and administrative expenses as a percentage of revenues decreased by 0.5%. The increase in general and administrative expenses was primarily due to a $0.3 million increase in professional services.
General and administrative expenses increased by $2.9 million, or 5.6%, for the nine months ended September 30, 2017 as compared to the same period in 2016. General and administrative expenses as a percentage of revenues decreased by 1.5%. The increase in general and administrative expenses was primarily due to a $1.3 million increase in salaries, stock-based compensation, and employee benefits related to increased headcount.

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Income Tax Provision
  
Three Months ended September 30,
 
Nine Months ended September 30,
  
2017
 
2016
 
2017
 
2016
 
(dollars in thousands)
Income tax provision (benefit)
$
4,465

 
$
7,492

 
$
(964
)
 
$