LPL Financial Holdings Inc. quarterly report, Q2 FY2019

LPL Financial Holdings Inc. — Form 10-Q Summary

Business context and reporting period

LPL Financial is an independent broker-dealer and investment advisory platform serving financial advisors and institutions through brokerage, advisory, custody, clearing, technology, compliance, research, and practice-management services. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2019, compared primarily with the corresponding 2018 periods.

Key financial metrics

Metric	Q2 2019	Q2 2018	Change
Total net revenues	$1,389.8 million	$1,298.8 million	+7.0%
Income before taxes	$195.1 million	$162.9 million	+19.7%
Net income	$146.1 million	$118.8 million	+23.0%
Diluted EPS	$1.71	$1.30	+31.5%
Gross profit	$535.7 million	$482.8 million	+11.0%
Gross profit as a percentage of revenue	38.5%	37.2%	+130 basis points
Effective tax rate	25.1%	27.1%	Down 200 basis points

Six-month net revenues were $2,761.4 million, up 8.7%; net income was $301.5 million, up 42.0%; and diluted EPS was $3.50 versus $2.30.
Q2 revenue growth was led by advisory revenue of $481.3 million, up 9.7%, and asset-based revenue of $288.6 million, up 20.9%. Commission revenue declined 1.8% to $479.1 million, primarily because trailing commissions fell 5.5%.
Client cash revenue benefited from higher interest rates and higher average client cash balances. Average client cash balances were $29.9 billion in Q2 2019 versus $28.7 billion in Q2 2018.
Total brokerage and advisory assets served were $706.0 billion at June 30, 2019, up 7% year over year. Advisory assets rose 12% to $327.3 billion, while brokerage assets increased 3% to $378.7 billion.
Q2 net new advisory assets were $6.6 billion, compared with $4.3 billion in 2018. Net new brokerage assets were an outflow of $2.6 billion, compared with an outflow of $1.9 billion.
Cash, cash equivalents, and restricted cash declined to $1,161.3 million at June 30, 2019, from $1,562.1 million at December 31, 2018.
Six-month cash flow from operations was an outflow of $54.4 million versus an inflow of $60.1 million in 2018. Investing cash outflow was $62.2 million, and financing cash outflow was $284.1 million.
Operating cash flow was affected by increased advisor loans and client receivables, lower income taxes payable, and changes in client settlement balances. Capital expenditures increased to $63.5 million from $48.8 million, primarily for technology projects.

Debt, liquidity, and capital allocation

Net long-term borrowing was $2,363.4 million at June 30, 2019. Principal debt consisted of a $1,473.8 million senior secured term loan and $900.0 million of senior unsecured notes. The term loan carried a 4.65% interest rate and the notes carried a fixed 5.75% rate.
The revolving credit facility had no outstanding balance. The Company also maintained three uncommitted lines of credit; no balances were outstanding at quarter-end.
The Company stated that operating cash flow and available borrowing sources were expected to be adequate for working capital, obligations, and anticipated capital expenditures for the foreseeable future.
Debt covenant compliance remained strong: actual leverage was 1.99 versus a maximum of 5.00, and interest coverage was 8.53 versus a minimum of 3.00.
LPL Financial, the broker-dealer subsidiary, had regulatory net capital of $107.2 million versus a $9.5 million minimum requirement.
The Company returned $145.9 million to stockholders in Q2 through $20.8 million of dividends and $125.0 million of share repurchases. It repurchased 1,591,950 shares during the quarter and had $750.0 million remaining under authorized repurchase programs at June 30.
The Board declared a subsequent quarterly dividend of $0.25 per share on July 24, 2019.

Material changes versus the prior comparable period

Profitability improved materially, with Q2 net income up 23.0% and pre-tax income up 19.7%, despite only 7.0% revenue growth.
Advisory and asset-based revenue growth more than offset lower commission revenue. Trailing commissions declined due primarily to market impacts on mutual fund and alternative investment assets.
Total operating expenses increased 5.1%. Compensation and benefits rose 7.7% in Q2 as average employees increased 9.9%; occupancy and equipment expense increased 23.8% due largely to software investments.
The total payout ratio increased to 86.54% from 86.06%, primarily because of higher production-based bonuses.
Six-month net new assets weakened substantially to $8.0 billion from $41.4 billion, reflecting a $3.2 billion brokerage outflow versus $23.9 billion of brokerage inflows in 2018. Market appreciation nevertheless supported asset growth.
The Company adopted the new lease accounting standard on January 1, 2019, recognizing operating lease assets of $105.4 million and operating lease liabilities of $145.6 million at June 30. It also recognized a $5.7 million cumulative-effect adjustment to retained earnings.
On May 17, 2019, the Company agreed to acquire Allen & Company of Florida, with an expected third-quarter closing and purchase price in the mid-$30 million range, including a contingent payment based on transferred assets.

Outlook, commentary, risks, and unusual items

Management characterized the operating environment as sensitive to equity markets, interest rates, client cash balances, advisor recruiting and retention, asset flows, and retail investor sentiment. U.S. equity markets and bonds performed strongly in the first half of 2019, supporting market-based asset growth.
The Company expects advisory and asset-based revenue to remain influenced by market levels, interest rates, client cash balances, and future net new assets. No quantitative earnings or revenue guidance was provided in the filing text.
Regulation BI was adopted by the SEC in June 2019, with a June 30, 2020 compliance date. Implementation may increase legal, compliance, technology, and operational costs and may affect products, pricing, disclosures, and services.
The Company agreed to approximately $26.4 million of aggregate fines under a NASAA settlement concerning historical state “blue sky” compliance. A historical transaction review was incomplete at the filing date, so customer remediation costs could not be estimated and could exceed captive-insurance reserves.
Key ongoing risks include regulatory enforcement and customer restitution, changes in interest rates, market declines, adverse asset flows, advisor attrition, competition, cybersecurity and information-technology failures, third-party service-provider risk, margin lending and collateral risk, and execution risk related to acquisitions and technology investments.
The Company reported no material changes to previously disclosed risk factors and concluded that disclosure controls and procedures were effective as of June 30, 2019.

Important facts for investors to verify

Whether advisory asset growth and net new advisory assets continue to offset brokerage outflows and declining trailing commissions.
The effect of future interest-rate changes on client cash revenue, floating-rate debt expense, and overall margins.
The final scope and cost of customer remediation related to the NASAA blue-sky settlement and whether reserves are sufficient.
Execution, purchase accounting, transferred assets, and expected economics of the Allen & Company acquisition.
Sustainability of share repurchases and dividends in light of cash-flow usage, debt covenants, regulatory capital requirements, and reduced cash balances.
Costs and operational effects of Regulation BI and other federal and state fiduciary or best-interest requirements.
Growth in technology, occupancy, compensation, and other operating expenses relative to revenue and gross profit growth.