LPL Financial Holdings Inc. quarterly report, Q3 FY2017

LPL Financial Holdings Inc. — Q3 2017 Form 10-Q Summary

Business context and reporting period

LPL Financial provides brokerage, investment advisory, custody, clearing, technology, and related services to independent financial advisors, financial institutions, registered investment advisors, and retail investors in the United States. The unaudited filing covers the quarter and nine months ended September 30, 2017, with comparisons to the corresponding 2016 periods.

Key financial and operating metrics

Metric	Q3 2017	Q3 2016	Change
Total net revenue	$1,064.1 million	$1,017.4 million	4.6%
Pre-tax income	$96.6 million	$68.2 million	41.7%
Net income	$58.1 million	$52.0 million	11.9%
Diluted EPS	$0.63	$0.58	8.6%
Gross profit	$386.9 million	$346.9 million	11.5%
Gross profit margin	36.4%	34.1%	230 bps
Recurring revenue as % of net revenue	79.6%	74.3%	530 bps

For the nine months ended September 30, 2017, net revenue was $3.165 billion, up 4.0%; pre-tax income was $284.7 million, up 22.4%; net income was $174.8 million, up 16.4%; diluted EPS was $1.90 versus $1.67; and gross profit was $1.152 billion, up 9.9%, with a 36.4% gross profit margin versus 34.4%.

Q3 revenue mix: commission $403.0 million, advisory $356.9 million, asset-based $184.0 million, transaction and fee $104.0 million, interest income net of interest expense $6.2 million, and other revenue $10.0 million.
Commission revenue declined 6.6% in Q3, primarily from lower sales-based annuity activity and continuing uncertainty related to the Department of Labor fiduciary rule. Advisory revenue increased 10.9% and asset-based revenue increased 33.0%.
Cash sweep revenue increased to $81.6 million from $40.7 million, benefiting from higher federal funds target rates, despite lower average cash sweep balances.
Total brokerage and advisory assets served reached $560.0 billion, up 11.5% year over year. Advisory assets increased 21.8% to $250.2 billion, while brokerage assets increased 4.3% to $309.8 billion.
Q3 net new assets were $2.9 billion, including $6.9 billion of net new advisory assets and a $4.0 billion brokerage asset outflow. Nine-month net new assets totaled $5.9 billion.
The company served 14,253 advisors at September 30, 2017, compared with 14,185 a year earlier.

Cash flow, liquidity, capital, and debt

Operating cash flow for the nine months was $134.6 million, compared with $262.1 million in 2016. Investing cash flow was negative $413.6 million, primarily reflecting the NPH acquisition payment. Financing cash flow was positive $109.2 million.
Cash and cash equivalents declined to $578.0 million at September 30, 2017, from $747.7 million at December 31, 2016.
Long-term debt had a gross principal balance of $2.4 billion and a net carrying value of $2.388 billion. This included a $1.5 billion Term Loan B and $900 million of 5.75% senior unsecured notes due 2025. The $500 million revolving facility was undrawn, although $11.1 million of letters of credit were supported by it.
The company refinanced its credit facilities in March and September 2017. The September refinancing included $400 million of additional senior notes, with $200 million used to repay Term Loan B. The refinancing produced a $1.3 million Q3 loss on extinguishment of debt; total year-to-date debt extinguishment losses were $22.4 million.
At September 30, the leverage ratio was 3.21 versus a maximum covenant of 5.00, and interest coverage was 6.88 versus a minimum of 3.00. Management reported compliance with applicable covenants and regulatory capital requirements.
LPL Financial had regulatory net capital of $166.5 million versus a $6.8 million minimum requirement.
The company returned $47.5 million to shareholders in Q3 through $22.5 million of dividends and $25.0 million of share repurchases. Year-to-date repurchases totaled $83.7 million, with $141.3 million remaining authorized at September 30.

Material changes versus the prior comparable period

Profitability improved despite lower commission revenue, driven by higher advisory and cash sweep revenue, asset growth, market appreciation, and improved gross profit margin.
Sales-based commission revenue decreased 18.5% in Q3, while trailing commission revenue increased 3.2%, reflecting a shift toward recurring revenue streams.
Operating expenses increased 1.6% in Q3, while non-operating interest expense increased 11.0% because of higher rates and additional debt. The Q3 effective tax rate rose to 39.8% from 23.8%; the 2016 rate benefited from an approximately $11.7 million software-related tax benefit.
Cash flow from operations declined substantially year over year, and cash balances fell following acquisition spending, capital expenditures, shareholder returns, and changes in client-related working capital.

Acquisition, outlook, risks, and unusual items

On August 15, 2017, LPL paid $325 million to acquire selected assets and advisor relationships from National Planning Holdings. A contingent payment of up to $122.8 million may be payable based on transferred gross dealer concessions; no payment is due below a 72% transfer threshold.
NPH advisor and client onboarding was expected to occur in two waves beginning in Q4 2017, with conversion anticipated by the end of Q1 2018. Management expected elevated staffing, technology, transfer, advisor assistance, and integration costs through approximately mid-2018, as well as higher intangible amortization.
The company provided no formal quantitative earnings or revenue guidance in the filing. Management stated that operating cash flow and available borrowing sources were expected to satisfy working capital, obligations, and anticipated capital expenditures for the foreseeable future.
The DOL fiduciary rule became applicable June 9, 2017. Management expected increased legal, compliance, technology, and other costs, potential changes to offerings and payout structures, and greater litigation exposure. Full implementation requirements were then expected to apply January 1, 2018, subject to a proposed delay.
Material risks include market and interest-rate sensitivity, asset and net new asset volatility, advisor recruitment and retention, execution of the NPH conversion, regulatory investigations and remediation, cybersecurity and operational disruptions, third-party service-provider dependence, margin lending and client settlement exposures, and debt covenant restrictions.
The company accrued for regulatory and legal matters considered probable and reasonably estimable, but stated that losses could exceed accruals and insurance. A putative federal class action alleged misstatements and omissions related to share repurchases and financial performance in late 2015; management intended to defend the case.
The filing reported effective disclosure controls and no material changes in internal control over financial reporting during Q3.

Important facts for investors to verify

Whether NPH advisor and client onboarding achieved the expected transfer percentages, timing, revenue contribution, and cost synergies.
The amount and timing of any NPH contingent payment, integration costs, and acquired-intangible amortization.
The sustainability of cash sweep revenue as interest rates, bank economics, and cash sweep balances change.
Whether advisory asset growth converts into advisory revenue, particularly as assets shift to the lower-fee Hybrid RIA platform.
Future effects of the DOL rule and other regulatory actions on commissions, payout ratios, compliance costs, restitution, and litigation.
Operating cash generation, debt reduction, floating-rate exposure, covenant headroom, and the company’s continued ability to fund dividends and share repurchases.
Developments in regulatory matters and the putative class action, including any exposure beyond recorded accruals and insurance coverage.