LPL Financial Holdings Inc. quarterly report, Q3 FY2014

LPL Financial Holdings Inc. — Form 10-Q Summary

Business context and reporting period

LPL Financial provides brokerage, investment advisory, custody, clearing, technology, trust, and related services to independent financial advisors, financial institutions, registered investment advisers, and their retail clients. The company reported unaudited results for the three and nine months ended September 30, 2014, compared with the corresponding 2013 periods.

• Advisors increased 2.6% to 13,910.
• Advisory and brokerage assets increased 12.1% to $464.8 billion.
• Advisory assets under custody increased 20.1% to $169.5 billion.
• Net new advisory assets increased 26.2% to $13.5 billion for the nine-month period.

Financial performance and key metrics

Metric	Three months ended September 30	Nine months ended September 30
Net revenue	$1,089.2 million, up 3.4%	$3,269.4 million, up 7.3%
Net income	$33.3 million, down 11.6%	$129.5 million, down 5.8%
Diluted EPS	$0.33, versus $0.36	$1.26, versus $1.29
Adjusted EBITDA	$108.9 million, versus $120.3 million	$378.6 million, versus $387.2 million
Adjusted EPS	$0.48, versus $0.56	$1.77, versus $1.81
Gross margin	30.4%, versus 30.1%	30.3%, versus 30.5%
Adjusted EBITDA margin	10.0%, versus 11.4%	11.6%, versus 12.7%

GAAP net income margin was approximately 3.1% in the third quarter and 4.0% for the nine-month period, compared with approximately 3.6% and 4.5%, respectively, in the prior-year periods. Recurring revenue represented 70.2% of third-quarter net revenue and 68.1% for the nine-month period, compared with 64.0% and 65.0% in 2013.

• Third-quarter revenue consisted of commission revenue of $520.4 million, advisory revenue of $340.4 million, asset-based revenue of $121.3 million, transaction and fee revenue of $94.7 million, and other revenue of $12.5 million.
• For the nine months, commission revenue increased 4.5%, advisory revenue increased 13.6%, and asset-based revenue increased 11.2%. Other revenue declined 10.8%.
• Third-quarter commission revenue declined 1.3%, primarily because of lower alternative-investment activity, partly offset by higher trailing commissions.
• Cash sweep revenue declined 14.0% in the quarter and 19.5% for the nine months because of contract repricing, lower interest rates, and lower average sweep balances.
• Total production payout was 86.67% in the quarter and 86.68% for the nine months, modestly below the respective 2013 levels of 87.70% and 86.93%.

Cash flow, liquidity, debt, and capital allocation

• Operating cash flow was $224.3 million for the nine months, compared with $141.9 million in 2013.
• Investing cash flow was negative $80.1 million, including $69.8 million of capital expenditures and $9.0 million for purchased intangible assets.
• Financing cash flow was negative $201.2 million, primarily reflecting $150.0 million of share repurchases and $72.1 million of dividends.
• Cash and cash equivalents declined to $459.5 million at September 30, 2014, from $516.6 million at December 31, 2013.
• Senior secured debt was $1.527 billion, consisting of Term Loan A of $459.4 million and Term Loan B of $1.0676 billion. The loans had floating rates with a 2.50% applicable margin; reported rates were 2.65% and 3.25%, respectively.
• The revolving facility had $228.5 million of undrawn availability after supporting $21.5 million of letters of credit. The company was in compliance with its debt covenants, with a 2.56x leverage ratio versus a 4.25x maximum and 10.44x interest coverage versus a 3.00x minimum.
• The broker-dealer had $109.2 million of net capital, $102.5 million above its $6.7 million minimum requirement. Management stated that liquidity and regulatory capital were adequate for anticipated needs.

Material changes versus the prior comparable period

• Revenue growth continued, led by advisory and asset-based revenues, but profitability declined as operating expenses grew faster than revenue.
• General and administrative expense increased 18.7% in the quarter and 21.9% for the nine months, driven principally by higher professional services costs, including estimated costs related to regulatory investigations, settlement, and resolution.
• Restructuring charges increased to $9.9 million in the quarter and $26.5 million for the nine months.
• Interest expense was broadly stable, while the $8.0 million debt-extinguishment loss recorded in the 2013 nine-month period did not recur.
• 2013 included significant NestWise closure charges and related asset write-offs; those charges did not recur in 2014.
• The company repurchased 2.99 million shares for $150.0 million during the nine months, including a $100.0 million repurchase of 1.9 million shares from an investment fund associated with TPG Capital.
• Quarterly dividends increased to $0.24 per share in 2014 from $0.19 per share in the third quarter of 2013.

Guidance, outlook, risks, contingencies, and unusual items

• The Service Value Commitment program is expected to be completed in 2015. Total expected charges are approximately $65.0 million; cumulative costs were $53.2 million at September 30, 2014. Management expected approximately $38.4 million of 2014 expense and annual pre-tax savings approaching $30.0 million by 2015.
• Management expects continued fee compression in cash sweep programs in 2015 and 2016, reflecting low short-term interest rates and contract repricing.
• On October 1, 2014, the company amended its credit agreement, extending Term Loan A and revolving facility maturities to September 30, 2019 and increasing revolving capacity to $400.0 million.
• On October 1, 2014, the board increased the share repurchase authorization by $150.0 million, bringing total remaining authorization to $217.9 million.
• On October 28, 2014, the board declared a $0.24 per share dividend payable November 26, 2014.
• The company had accrued $23.0 million for potential remediation of regulatory matters. Management did not expect pending legal and regulatory matters, in aggregate, to materially affect financial condition, but stated that they could materially affect operating results in a particular period.
• Key risks include market-driven changes in advisory and brokerage asset values, interest-rate and cash-sweep economics, regulatory actions and remediation costs, competition, advisor retention and recruitment, execution of the outsourcing and technology transformation program, third-party service-provider performance, cybersecurity, information technology, operational, and sourcing risks.
• All outstanding debt was subject to floating-rate risk. A 100-basis-point increase in rates would increase annual interest expense by approximately $9.8 million, based on September 30, 2014 balances.

Most important facts for investors to verify

1. Whether advisory-asset growth and net new advisory assets continue to offset declining cash-sweep economics and weaker transaction-based activity.
2. Actual regulatory investigation, settlement, and remediation costs compared with the $23.0 million accrued liability.
3. Progress, final cost, timing, and realized savings from the Service Value Commitment program.
4. Debt refinancing and covenant capacity following the October 2014 credit agreement amendment, including exposure to higher floating interest rates.
5. Whether continued share repurchases and dividends are sustainable alongside capital expenditures, regulatory capital requirements, and debt service.
6. The company’s use of non-GAAP Adjusted EBITDA and Adjusted Earnings, which exclude restructuring, share-based compensation, amortization, and other items and should be assessed alongside GAAP results.