LPL Financial Holdings Inc. quarterly report, Q3 FY2019

LPL Financial Holdings Inc. — Q3 2019 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 three and nine months ended September 30, 2019, compared with the corresponding 2018 periods.

Key financial metrics

Metric	Q3 2019	Q3 2018	9M 2019	9M 2018
Total net revenues	$1,415.5 million	$1,331.0 million	$4,177.0 million	$3,871.4 million
Pre-tax income	$178.0 million	$147.4 million	$576.8 million	$430.2 million
Net income	$131.7 million	$106.9 million	$433.2 million	$319.2 million
Diluted EPS	$1.57	$1.19	$5.07	$3.49
Gross profit	$542.5 million	$493.2 million	$1,634.1 million	$1,439.9 million
Gross profit as % of net revenue	38.3%	37.1%	39.1%	37.2%
Operating cash flow	Not separately provided for the quarter	Not separately provided for the quarter	$509.8 million	$196.1 million

Q3 net income increased 23.3%, while nine-month net income increased 35.7%. Calculated net margins were approximately 9.3% in Q3 2019 and 10.4% for the first nine months of 2019. The recurring gross profit rate was 87.1% on a trailing-twelve-month basis, compared with 85.0% in the prior comparable period.

Advisory revenue increased 12.3% in Q3 and 9.9% for nine months.
Asset-based revenue increased 17.4% in Q3 and 24.1% for nine months, driven primarily by client cash programs, sponsorship programs, and recordkeeping.
Commission revenue declined 2.4% in both periods, primarily because lower trailing commissions offset growth in sales-based commissions.
Total operating expenses increased 4.7% in Q3 and 4.6% for nine months. Compensation, occupancy and equipment, and promotional costs were notable drivers.

Assets, capital returns, debt, and liquidity

Total brokerage and advisory assets served were $719.3 billion at September 30, 2019, up 6% from $681.0 billion a year earlier. Advisory assets rose 10% to $338.0 billion, representing 47% of total assets served; brokerage assets rose 2% to $381.3 billion.
Q3 net new assets were $9.9 billion, including $9.2 billion of net new advisory assets and $0.6 billion of net new brokerage assets. For nine months, total net new assets were $17.8 billion versus $45.8 billion in 2018.
Total client cash balances were $31.2 billion at September 30, 2019, up 11% year over year.
Operating cash flow for the first nine months was $509.8 million. Investing cash outflow was $129.1 million, including $104.3 million of capital expenditures and $24.9 million for acquisitions. Financing cash outflow was $434.1 million, primarily reflecting share repurchases and dividends.
Cash, cash equivalents, and restricted cash totaled $1.509 billion at September 30, 2019. The company stated that operating cash flow and available credit sources should satisfy working-capital, obligation, and anticipated capital-expenditure needs for the foreseeable future.
Long-term borrowings had a gross principal balance of $2.370 billion, consisting of a $1.470 billion senior secured Term Loan B and $900 million of senior unsecured notes. Net carrying value was $2.360 billion.
At September 30, 2019, the company had no balance outstanding on its revolving credit facility or broker-dealer revolving facility. LPL Financial’s new committed broker-dealer facility permits borrowings of up to $300 million and matures in July 2024.
The company was in compliance with debt covenants. Actual leverage was 2.00 versus a maximum permitted 5.00, and interest coverage was 8.75 versus a minimum required 3.00.
LPL Financial, the broker-dealer subsidiary, had net capital of $178.3 million versus a minimum requirement of $8.9 million. The company reported that applicable regulatory capital requirements were met.

Material changes versus the prior comparable period

Profitability improved substantially, with Q3 pre-tax income up 20.8% and net income up 23.3%; nine-month increases were 34.1% and 35.7%, respectively.
Revenue mix continued shifting toward advisory and asset-based sources, while commission revenue declined.
Net new asset production weakened on a year-to-date basis, mainly because nine-month net new brokerage assets were an outflow of $2.6 billion versus a $23.2 billion inflow in 2018. Q3 brokerage flows improved to a $0.6 billion inflow from a $0.8 billion outflow.
Share repurchases increased to $380.3 million in the first nine months, compared with $300.1 million in 2018. Q3 repurchases totaled $130.3 million for 1.668 million shares. The company had $619.8 million of remaining authorization at September 30.
On August 1, 2019, LPL acquired Allen & Company of Florida for approximately $25 million at closing, with a potential contingent payment of up to $10 million based on asset retention.
The company adopted the new lease standard on January 1, 2019, recognizing $104.3 million of operating lease assets and $144.2 million of operating lease liabilities at September 30.

Outlook, commentary, risks, and unusual items

The filing does not provide a specific quantitative earnings or revenue guidance range. Management expects operating cash flow and available funding sources to remain adequate for foreseeable needs, but future performance remains sensitive to market levels, interest rates, advisor recruiting and retention, asset flows, and client activity.

The Federal Reserve reduced its target federal funds rate twice during the quarter to 1.75%–2.00%. Lower or changing interest rates can affect client-cash revenues, margin income, and floating-rate debt expense.
Regulation BI was adopted by the SEC in June 2019, with a June 30, 2020 compliance date. Implementation may increase compliance, technology, legal, and operational costs and may affect products, pricing, and services. Potential future Department of Labor and state fiduciary rules create additional uncertainty.
The company’s NASAA “blue sky” settlement included approximately $26.4 million of aggregate fines and potential customer remediation. The historical transaction review was complete, but remediation costs were still being calculated and could not be estimated; actual costs could exceed reserves and captive insurance coverage.
Regulatory examinations, customer restitution, legal proceedings, cybersecurity incidents, technology failures, third-party service-provider disruptions, and operational errors could materially affect results.
Credit risks include advisor loans, client margin lending, settlement obligations, and collateral shortfalls. Client margin loans totaled approximately $331.8 million and were collateralized by securities with fair value of approximately $464.5 million.
The company reported no material changes to previously disclosed risk factors and no material changes in contractual obligations outside the ordinary course.
A putative federal class-action lawsuit against the company and certain executives was dismissed with prejudice on April 22, 2019.

Important facts for investors to verify

Progress and ultimate cost of customer remediation related to the NASAA blue-sky settlement, including adequacy of captive-insurance reserves.
Sustainability of advisory and asset-based revenue growth if markets decline or interest rates fall further.
Trends in net new brokerage assets, advisor recruiting, retention, productivity, and the impact of the Allen & Company acquisition.
Remaining debt principal, floating-rate exposure, covenant headroom, and restrictions on dividends and share repurchases.
Execution costs and business effects of Regulation BI and any future fiduciary or state regulatory requirements.
Whether elevated share repurchases and dividends remain consistent with liquidity, regulatory-capital, acquisition, and technology-investment needs.
Operating, cybersecurity, settlement, margin-lending, and third-party service-provider risks described in the filing.