LPL Financial Holdings Inc. quarterly report, Q2 FY2016

LPL Financial Holdings Inc. — 2016 Q2 Form 10-Q Summary

Business context and reporting period

LPL Financial Holdings Inc. is an independent broker-dealer, registered investment advisor platform, custodian, and retirement-plan consultant serving more than 14,000 independent financial advisors, including advisors at more than 700 financial institutions. The unaudited filing covers the three and six months ended June 30, 2016, with comparisons to the corresponding 2015 periods.

Key financial metrics

Metric	Three months ended June 30, 2016	Year-over-year change	Six months ended June 30, 2016	Year-over-year change
Total net revenue	$1,019.2 million	(6.6%)	$2,024.5 million	(8.0%)
Pre-tax income	$79.7 million	(5.2%)	$164.3 million	(2.6%)
Net income	$47.8 million	(4.8%)	$98.2 million	(2.7%)
Diluted EPS	$0.53	Up from $0.52	$1.10	Up from $1.03
Gross profit	$344.9 million	1.4%	$700.6 million	0.7%
Gross profit margin	33.8%	Up from 31.2%	34.6%	Up from 31.6%
Recurring revenue as a percentage of net revenue	73.8%	Up from 71.7%	73.8%	Up from 70.4%

Revenue mix for the first six months consisted primarily of commissions of $882.5 million, advisory revenue of $642.4 million, asset-based revenue of $274.0 million, and transaction and fee revenue of $204.5 million.
Commission revenue declined 12.5% in the second quarter and 14.6% for the first six months, primarily because of lower sales of variable annuities, mutual funds, and alternative investments, as well as lower trailing revenue from market-sensitive assets.
Advisory revenue declined 6.4% in the second quarter and 6.5% for the first six months, partly because advisors continued moving to the Hybrid RIA platform, where LPL earns administrative, technology, clearing, and custody fees rather than the full advisory fee.
Asset-based revenue increased 10.2% in the second quarter and 11.5% for the first six months. Cash sweep revenue increased to $40.9 million in the quarter and $84.3 million year to date, supported by higher cash balances and the December 2015 increase in the federal funds target range.
Total brokerage and advisory assets served were $488.0 billion at June 30, 2016, compared with $485.7 billion a year earlier. Advisory assets under custody increased 5.0% to $196.1 billion, while Hybrid RIA assets increased 23.1% to $74.5 billion.
Net new advisory assets were $2.8 billion in the second quarter and $4.8 billion for the first six months, down from $4.3 billion and $9.5 billion, respectively, in the comparable periods.
Operating expenses declined 7.8% in the second quarter and 9.6% for the first six months. Production expenses decreased 10.1% and 12.0%, respectively, reflecting lower revenue and lower payout rates. Restructuring charges were zero in 2016 compared with $4.5 million in the second quarter and $8.4 million in the first six months of 2015.
Non-operating interest expense increased 80.8% in the second quarter and 75.5% for the first six months, reflecting higher interest rates and debt-related factors.

Cash flow, debt, and liquidity

Cash and cash equivalents were $745.8 million at June 30, 2016, compared with $724.5 million at December 31, 2015.
Six-month operating cash flow was $154.6 million, down from $251.0 million in 2015. Investing cash outflow was $56.1 million, primarily reflecting higher capital expenditures for the Fort Mill campus and technology. Financing cash outflow was $77.3 million.
Senior secured credit facilities totaled $2.206 billion before unamortized debt issuance costs, versus $2.215 billion at December 31, 2015. The company also had a $400 million revolving credit facility, with $14.6 million of letters of credit supported by that facility and no reported revolver borrowings.
All outstanding credit-agreement debt was subject to floating interest rates. Management estimated that a 100-basis-point increase would increase annual interest expense by approximately $19.9 million.
The company was in compliance with all debt covenants. The actual leverage ratio was 3.7 versus a maximum of 5.0, and the interest coverage ratio was 6.9 versus a minimum of 3.0.
Management stated that operating cash flow and available borrowing sources should be adequate for working capital, obligations, and anticipated capital expenditures for the foreseeable future.
LPL Financial had $109.0 million of net capital against a $6.0 million minimum requirement at June 30, 2016, and excess net capital was reported at $103.0 million.

Material changes, outlook, and risks

Management attributed earnings-per-share growth primarily to increased cash sweep revenue, lower advisor production bonuses, expense discipline, and a lower share count, despite lower revenue and net income.
Regulatory-related charges decreased $1.2 million year over year in the second quarter. Management expected higher regulatory-related charges in the second half of 2016 than in the first half, but anticipated full-year charges to be meaningfully below 2015 levels.
The Department of Labor’s April 2016 fiduciary rule is expected to affect retirement-account products, advisor and company compensation, compliance costs, and litigation and arbitration exposure. The company was still evaluating the rule’s financial impact.
Management noted that contractual repricing could reduce the average yield of the insured cash account program during the six months ending December 31, 2016 if the federal funds rate remained unchanged.
Management expected production-based bonuses to be higher in the second half of 2016 and promotional expenses to increase in the third quarter because of the annual national advisor conference.
The company continued investing in technology and a Fort Mill, South Carolina campus. It had recorded a $91.6 million fixed asset and an offsetting leasehold financing obligation related to the build-to-suit arrangement, and expected its share of design and construction costs to be approximately $74.7 million through 2017.
Regulatory and legal matters remain significant contingencies. Accruals included estimated costs for probable and reasonably estimable matters, including a matter involving sales of certain securities. Actual losses could exceed accruals and insurance coverage.
A putative class action lawsuit was filed alleging misstatements and omissions related to share repurchases and financial performance in late 2015. The company stated that it intended to defend the lawsuit vigorously.
Other key risks include market-driven changes in brokerage and advisory asset values, interest-rate and cash-sweep economics, advisor recruiting and retention, regulatory developments, cybersecurity and technology failures, reliance on third-party service providers, margin and counterparty credit risk, and execution of expense and technology initiatives.
The board declared a quarterly dividend of $0.25 per share on July 26, 2016, payable August 25, 2016. No shares were repurchased during the second quarter; $225 million remained available under repurchase authorizations at quarter end.

Investor verification checklist

Verify the sustainability of cash sweep revenue as rates, client cash balances, and contractual pricing change.
Assess whether the shift toward Hybrid RIAs improves long-term economics despite reducing reported advisory revenue.
Review the trend in net new advisory assets, advisor recruiting, and asset levels relative to market performance.
Examine debt maturities, floating-rate exposure, covenant headroom, and the company’s capacity to fund dividends, repurchases, technology spending, and the Fort Mill project.
Monitor regulatory accruals, insurance recoveries, the DOL fiduciary rule, and the potential outcome of the securities-related matter and class action lawsuit.
Reconcile non-GAAP gross profit and Credit Agreement EBITDA with GAAP results and confirm that the company’s definitions remain consistent.
Confirm the effectiveness of disclosure controls and internal control over financial reporting; management reported no material control changes and concluded controls were effective as of June 30, 2016.