LPL Financial Holdings Inc. quarterly report, Q1 FY2013

LPL Financial Holdings Inc. — Form 10-Q Summary

Reporting period: Three months ended March 31, 2013; comparison period is the three months ended March 31, 2012. Financial statements are unaudited and prepared under U.S. GAAP.

Business Context

LPL provides brokerage, investment advisory, custody, clearing, technology and related services to independent financial advisors, financial institutions and retirement-plan advisors. At March 31, 2013, it supported 13,377 advisors, approximately 700 financial institutions and approximately 4,500 advisors affiliated with insurance companies. The Company reported approximately 2,900 employees.

Advisory and brokerage assets: $394.0 billion, up 11.3% year over year.
Advisory assets under custody: $130.2 billion, up 17.5%.
Net new advisory assets: $3.0 billion, up from $2.5 billion.
Recurring revenue represented 65.4% of net revenue, compared with 63.0% in the prior-year quarter.

Financial Performance and Liquidity

Metric	Q1 2013	Q1 2012	Change
Total net revenue	$974.8 million	$901.8 million	8.1%
Income before taxes	$90.6 million	$66.9 million	35.4%
Net income	$54.7 million	$41.2 million	32.9%
Diluted EPS	$0.51	$0.37	Increase
Gross margin	$305.1 million	$274.9 million	11.0%
Gross margin percentage	31.3%	30.5%	80 basis points
Adjusted EBITDA	$135.9 million	$125.0 million	8.8%
Adjusted EBITDA margin	13.9%	13.9%	Stable
Adjusted earnings	$68.1 million	$63.2 million	7.8%
Adjusted diluted EPS	$0.64	$0.56	Increase

Net income margin was approximately 5.6%, compared with approximately 4.6% in Q1 2012. The effective tax rate increased to 39.6% from 38.4%, partly because the prior-year period benefited from incentive stock option deductions and higher option exercises.

Commission revenue increased 4.7% to $485.6 million, driven by mutual fund activity and trail revenues; fixed annuity and fixed-income revenue declined amid low interest rates.
Advisory revenue increased 12.1% to $281.2 million, reflecting growth in advisory assets.
Asset-based revenue increased 6.7% to $103.8 million, although cash sweep revenue declined 8.4% to $31.5 million because of contract repricing.
Transaction and other revenue increased 19.9% to $89.4 million, including $3.6 million from Fortigent and $2.5 million from conference-timing effects.
Production payout ratio improved to 86.01% from 86.39%.
Operating expenses increased 8.7%, including restructuring charges of $6.0 million versus $1.7 million.
Non-operating interest expense declined 24.2% to $12.2 million following the March 2012 refinancing and expiration of a $65 million interest-rate swap.
Q1 2012 included a $16.5 million loss on extinguishment of debt; no comparable charge was recorded in Q1 2013.

Cash Flow, Debt and Capital

Cash provided by operating activities was $7.3 million, compared with cash used of $28.1 million in Q1 2012. Operating cash flow was affected by client trading and settlement activity and working-capital movements.
Capital expenditures were $13.7 million, compared with $4.3 million in Q1 2012. Investing cash outflow was $16.2 million.
Financing cash outflow was $21.3 million, including $10.7 million of term-loan repayments, $14.4 million of dividends and $4.9 million of share repurchases, partially offset by $7.1 million of stock-option exercise proceeds.
Cash and cash equivalents declined to $436.0 million from $466.3 million at December 31, 2012.
Senior secured debt was $1.307 billion at March 31, 2013, consisting of Term Loan A of $698.3 million and Term Loan B of $608.9 million. The loans mature in 2017 and 2019, respectively.
The $250.0 million revolving facility supported $21.3 million of letters of credit, leaving $228.7 million undrawn. No balances were outstanding on the uncommitted credit lines.
Debt fair value was approximately $1.317 billion versus carrying value of $1.307 billion.
The Company was in compliance with its debt covenants. Actual leverage was 2.29 versus a maximum of 4.00, and interest coverage was 9.97 versus a minimum of 3.00.
LPL Financial had regulatory net capital of $134.1 million, $127.6 million above its $6.5 million minimum requirement.

Material Changes, Outlook and Unusual Items

The expanded Service Value Commitment, announced February 5, 2013, is intended to improve advisor service and operating efficiency through outsourcing, technology transformation, staffing changes and investment in human capital and marketing. The program is expected to be completed in 2015, with estimated total charges of approximately $65 million. Q1 costs incurred were $5.5 million, including $0.8 million of non-cash asset impairment, and $2.8 million remained accrued at March 31, 2013.
Management expects the Company’s cash flow from operations, available borrowing capacity and other funding sources to satisfy working-capital needs, obligations and anticipated capital expenditures for the foreseeable future.
Management expects contingent consideration payments of approximately $20 million to $30 million for NRP in Q1 2014, $0 million to $7 million for Concord in 2014, and an aggregate $5 million to $18 million for Veritat over its performance measurement dates. These estimates remain subject to business performance and other assumptions.
Management declared a $0.135 per-share dividend on April 24, 2013, payable May 20, 2013.
Management noted that equity-market levels supported asset-based and commission revenue, but low interest rates continued to pressure cash sweep revenue and demand for fixed-income products and fixed annuities.

Risks, Contingencies and Other Matters

Revenue is sensitive to equity-market levels, client asset values, investor sentiment, interest rates, advisor recruiting and retention, transaction activity and cash sweep pricing.
All outstanding senior secured debt was subject to floating-rate risk at March 31, 2013. A 100-basis-point increase in applicable rates was estimated to increase annual interest expense by approximately $8.1 million.
The Company relies on technology systems and third-party service providers; failures, cybersecurity or data issues, sourcing problems and execution risk related to the Service Value Commitment could affect operations and results.
The Company is subject to extensive SEC, FINRA and other regulatory requirements. It was discussing an email-surveillance and production matter with its principal regulator and had recorded an estimated probable loss; management did not expect a material impact beyond recorded amounts.
The IRS had issued a proposed adjustment related to withholding taxes on certain stock-option exercises. The Company remitted payment approximating amounts previously accrued and was awaiting final IRS consent.
The Company provides clearing-house guarantees and supports client margin activity. Although potential obligations under certain guarantees are not quantifiable, management considered the likelihood of payment remote.
Contractual cash obligations totaled approximately $1.903 billion, including $1.307 billion of term-loan principal, $382.1 million of leases and other obligations, and estimated variable interest payments.

Important Facts for Investors to Verify

Whether the Service Value Commitment achieves its projected service improvements, savings and approximately $65 million cost estimate by 2015.
The timing and final amounts of NRP, Concord and Veritat contingent consideration payments.
Cash sweep pricing, interest-rate trends and their effect on asset-based revenue and debt service.
Operating cash conversion, capital expenditures and the Company’s ability to reduce $1.307 billion of floating-rate debt while maintaining dividends and repurchases.
Market-sensitive advisory and brokerage assets, net new advisory flows and advisor retention and recruiting trends.
Resolution and final financial impact of the IRS matter and email-surveillance regulatory matter.
Any changes to debt covenant headroom, regulatory capital requirements or the availability of revolving and uncommitted credit facilities.