LPL Financial Holdings Inc. quarterly report, Q3 FY2012

LPL Financial Holdings Inc. — Form 10-Q Summary

Reporting period: Quarter and nine months ended September 30, 2012. The interim financial statements are unaudited and should be read with the 2011 Form 10-K. LPL provides brokerage, advisory, custody, clearing, technology and related services to independent financial advisors, financial institutions and their clients.

Financial performance and position

Metric	Q3 2012	Q3 2011	9M 2012	9M 2011
Net revenues	$907.2 million	$882.9 million	$2.717 billion	$2.651 billion
Income before taxes	$54.2 million	$62.1 million	$188.4 million	$219.1 million
Net income	$34.3 million	$36.4 million	$115.0 million	$130.9 million
Diluted EPS	$0.31	$0.32	$1.02	$1.15
Net margin	3.8%	4.1%	4.2%	4.9%
Adjusted EBITDA	$108.0 million	$111.6 million	$344.5 million	$358.9 million

Q3 net revenue increased 2.8%; nine-month revenue increased 2.5%. Growth was led by asset-based fees and transaction and other fees, while commissions and advisory fees were broadly stable.
Q3 net income declined 5.8% and nine-month net income declined 12.2%, primarily because operating expenses grew faster than revenue. Net margin decreased approximately 30 basis points in Q3 and 70 basis points for the nine-month period.
Non-GAAP gross margin increased to $277.1 million in Q3 and $829.7 million for nine months; gross margin as a percentage of revenue was 30.5% in both periods, versus 29.3% and 29.7%, respectively, in the prior-year periods.
Recurring revenue represented 66.5% of Q3 revenue and 65.2% of nine-month revenue, compared with 63.1% and 61.9% in the comparable 2011 periods.

Revenue and operating drivers

Q3 commissions increased 0.9% to $442.1 million; nine-month commissions increased 0.2% to $1.353 billion. Variable annuity, mutual fund and alternative investment revenues increased, while fixed annuity, equity and fixed-income revenues declined.
Advisory fees were essentially flat in Q3 and increased 1.3% for nine months. Advisory assets under custody reached $118.6 billion, up 23.2% from $96.3 billion.
Asset-based fees increased 11.5% in Q3 and 11.1% for nine months, supported by higher market levels, eligible asset growth and the UVEST conversion. Cash sweep revenue increased despite the low interest-rate environment.
Advisors increased 2.9% to 13,170. Advisory and brokerage assets increased 17.4% to $371.4 billion. Net new advisory assets were $8.2 billion for nine months, down from $9.8 billion in 2011.
The nine-month production payout ratio increased to 86.85% from 86.23%, reflecting higher advisor payout tiers, larger practices and UVEST-related payout changes.
Compensation and benefits increased 18.1% in Q3 and 12.5% for nine months. General and administrative expenses increased 30.3% and 22.7%, respectively, driven by acquisitions, professional fees, business development, contingent consideration and a $3.9 million IRS-related charge.

Cash flow, debt and liquidity

Cash provided by operating activities was $101.4 million for the first nine months, down from $363.7 million in 2011. The decline primarily reflected client settlement and funding activity, compared with a net source of funds in the prior-year period.
Investing activities used $67.6 million, including $43.7 million for acquisitions and $32.5 million of capital expenditures.
Financing activities used $308.6 million, including $235.8 million of dividends and $107.5 million of share repurchases. Cash and cash equivalents declined to $446.0 million from $720.8 million at December 31, 2011.
Senior secured debt totaled $1.329 billion at September 30, 2012, consisting primarily of a $716.6 million Term Loan A and a $611.9 million Term Loan B. The $250 million revolving facility was undrawn, although it supported $31.3 million of letters of credit.
The March 2012 refinancing extended maturities to 2017 and 2019 and reduced interest expense. Nine-month interest expense declined 20.1% to $42.3 million, but the refinancing generated a $16.5 million loss from extinguishment of prior debt.
Management stated that operating cash flow and available borrowing capacity should be adequate for working capital, obligations and planned capital expenditures for the foreseeable future. The company was in compliance with debt covenants; actual leverage was 2.27x against a 4.00x maximum and interest coverage was 8.27x against a 3.00x minimum.
LPL Financial reported net capital of $128.7 million against a $7.0 million minimum requirement.

Material changes, acquisitions and capital allocation

Fortigent was acquired in April 2012 for approximately $38.8 million in cash, net of cash acquired. Veritat was acquired in July 2012 for approximately $4.9 million in cash; total estimated consideration, including contingent consideration, was approximately $13.3 million.
Contingent consideration liabilities increased to $34.4 million. The company recorded a $15.3 million increase related to NRP and a $5.4 million decrease related to Concord during the nine-month period.
The UVEST consolidation continued, with $1.2 million of Q3 restructuring charges and $5.0 million for nine months. Total expected restructuring costs were approximately $31.1 million, excluding certain capitalized software costs.
The company paid a $2.00 per share special dividend totaling $222.6 million and a $0.12 per share quarterly dividend totaling $13.2 million. A further $0.12 per share dividend was declared on October 29, 2012.
The company repurchased 3.6 million shares for $110.5 million during the first nine months and authorized an additional $150 million repurchase program in September 2012.

Outlook, risks and unusual items

No formal revenue or earnings guidance is provided in the filing. Management expects approximately $10 million of annual pretax profitability improvement after completion of UVEST integration activities.
Management noted continued exposure to market levels, retail investor sentiment, interest rates, cash sweep economics, advisor recruitment and retention, competition, regulation and the integration of acquired businesses.
All outstanding debt was subject to floating-rate risk at quarter-end. A 100-basis-point increase in applicable rates was estimated to increase annual interest expense by approximately $8.3 million, assuming debt balances were unchanged.
Low interest rates pressured cash sweep revenue economics and demand for fixed-income securities and fixed annuities. Market volatility and asset values affect advisory fees, trail commissions and asset-based fees.
The IRS issued a proposed adjustment concerning allegedly untimely withholding-tax deposits related to 2010 stock-option exercises. The company recorded an estimated probable loss and stated that the outcome is not expected to be material.
Potential contingent consideration from NRP, Concord and Veritat is dependent on revenue, gross-margin, assets-under-management and employee-retention targets. Estimated future payments include $20 million to $30 million for NRP, $5 million to $12 million for Concord and up to $20.9 million for Veritat, subject to achievement of applicable targets.
The company is subject to litigation, regulatory examinations, client margin and settlement risks, operational and technology risks, and approximately $1.95 billion of contractual cash obligations, including debt principal, estimated variable interest and leases.

Investor verification checklist

Reconcile GAAP net income and EPS with management's non-GAAP Adjusted EBITDA, gross margin and Adjusted Earnings measures.
Assess whether revenue growth and advisor and asset growth can offset rising compensation, professional, acquisition and contingent-consideration expenses.
Review cash generation after dividends, repurchases, acquisitions and capital expenditures, including the substantial decline in cash balances.
Monitor floating-rate debt exposure, covenant headroom, scheduled amortization and refinancing requirements.
Verify the assumptions and valuation of contingent consideration liabilities and the integration benefits expected from Fortigent, Veritat, Concord, NRP and UVEST.
Evaluate sensitivity to equity markets, interest rates, cash sweep balances, advisor recruitment, regulatory developments and the IRS matter.