LPL Financial Holdings Inc. quarterly report, Q1 FY2018

LPL Financial Holdings Inc. — Q1 2018 Form 10-Q Summary

Business context and reporting period

LPL Financial is a leading independent broker-dealer and provider of brokerage, advisory, custody, clearing, technology, compliance, and practice-management services to more than 16,000 financial advisors, including advisors at approximately 800 financial institutions. This unaudited Form 10-Q covers the three months ended March 31, 2018, compared with the first quarter of 2017.

The second wave of advisors and client assets from the National Planning Holdings, Inc. acquisition was onboarded during the first quarter. The NPH conversion period concluded with no contingent payment due to the sellers.

Financial and operating highlights

Metric	Q1 2018	Q1 2017	Change
Total net revenues	$1,241.6 million	$1,035.4 million	+19.9%
Income before taxes	$119.9 million	$75.3 million	+59.3%
Net income	$93.5 million	$48.2 million	+94.1%
Diluted earnings per share	$1.01	$0.52	+94.2%
Gross profit	$464.0 million	$376.2 million	+23.3%
Gross profit as a percentage of net revenue	37.4%	36.3%	+110 basis points
Effective tax rate	22.0%	36.0%	Down 14.0 percentage points
Operating cash flow	$(22.3) million	$7.2 million	Declined

Commission revenue increased 12.7% to $474.8 million, primarily from higher trailing commissions. Advisory revenue increased 28.1% to $422.4 million.
Asset-based revenue increased 39.5% to $219.3 million. Cash sweep revenue increased to $104.1 million from $59.7 million, benefiting from higher federal funds rates.
Operating expenses increased 19.5% to $1.092 billion. Promotional expense rose 84.0%, compensation and benefits increased 9.1%, and intangible-asset amortization increased 39.3%, primarily reflecting NPH-related onboarding and integration costs.
The prior-year period included a $21.1 million loss on extinguishment of debt; no comparable charge was recorded in Q1 2018.
Advisory assets increased 25.6% to $283.5 billion, brokerage assets increased 19.5% to $364.1 billion, and total brokerage and advisory assets served increased 22.1% to $647.5 billion.
Total net new assets were $38.9 billion, compared with $2.6 billion in Q1 2017. Net new brokerage assets were $25.8 billion versus a $3.4 billion outflow in the prior-year period.
Average cash sweep balances were $29.3 billion, compared with $29.9 billion. Total cash sweep balances at March 31, 2018 were $29.6 billion.
Cash, cash equivalents, and restricted cash were $1.526 billion at March 31, 2018, compared with $1.521 billion at March 31, 2017 and $1.626 billion at December 31, 2017.

Liquidity, capital, and debt

Net cash used in operating activities was $22.3 million. Net cash used in investing activities was $21.7 million, including $22.9 million of capital expenditures. Net cash used in financing activities was $55.8 million.
Long-term borrowings had a principal balance of $2.393 billion and a net carrying value of $2.382 billion at March 31, 2018. Debt consisted primarily of a $1.493 billion senior secured Term Loan B and $900.0 million of 5.75% senior unsecured notes due 2025.
The revolving credit facility had no outstanding balance, although $11.1 million of irrevocable letters of credit were supported by it. Three uncommitted lines of credit were available; no balances were outstanding at quarter-end.
The company remained in compliance with its financial covenants. Actual leverage was 2.46 versus a maximum of 5.00, and interest coverage was 8.18 versus a minimum of 3.00.
LPL Financial, the broker-dealer subsidiary, had net capital of $87.5 million versus a minimum requirement of $7.2 million. The company stated that applicable regulatory capital requirements were satisfied.
The company returned $83.4 million to shareholders during the quarter through $22.6 million of dividends and $60.8 million of share repurchases. It repurchased 967,500 shares at a weighted-average price of $62.84 and had $439.2 million remaining under authorized repurchase programs.

Material changes, outlook, and unusual items

The NPH acquisition contributed $36.0 billion of brokerage and advisory assets during the quarter. The company recorded $112.7 million of advisor-relationship intangible assets and $49.0 million of goodwill related to the second onboarding wave.
Management expected most NPH onboarding, advisor assistance, account-transfer, staffing, and technology-capacity costs to be substantially complete by mid-2018, while amortization of acquired intangibles would continue.
The federal corporate tax rate reduction under the Tax Cuts and Jobs Act contributed to the lower effective tax rate. The company continued analyzing the law and its financial statement effects.
The company adopted ASC Topic 606 using the modified retrospective method on January 1, 2018. Management reported no material impact on revenue recognition, timing, or retained earnings.
Management stated that cash flows from operations and available borrowing sources should be adequate for working capital, obligations, capital expenditures, and anticipated growth for the foreseeable future.
Management noted sensitivity to market levels, interest rates, cash sweep pricing, advisory and brokerage asset balances, advisor recruiting and retention, regulatory developments, cybersecurity, technology performance, and third-party service providers.

Risks, contingencies, and legal matters

On May 1, 2018, after quarter-end, LPL agreed to a NASAA settlement structure concerning historical compliance with state blue-sky laws. If all 52 jurisdictions participate, aggregate fines would be approximately $26 million, plus consultant, review, customer remediation, and other costs. The company expected most costs to be covered by its captive insurance subsidiary.
The company remains subject to regulatory examinations, investigations, fines, customer restitution, remediation, legal claims, and potential losses exceeding accruals or insurance coverage.
A putative federal class action lawsuit alleges misstatements and omissions relating to share repurchases and financial performance in late 2015. The company stated that it intends to defend the lawsuit vigorously.
The status and future requirements of the Department of Labor fiduciary rule remained uncertain after its vacatur by the Fifth Circuit. The SEC had proposed a best-interest standard for brokerage accounts, creating potential future compliance and operating costs.
Client margin lending, settlement obligations, guarantees to clearing organizations, regulatory capital requirements, and reliance on technology and third-party providers create credit, liquidity, operational, and compliance risks.

Most important facts for investors to verify

Whether NPH onboarding and integration costs declined as expected after mid-2018 and whether projected synergies were realized.
The sustainability of cash sweep revenue as interest rates, bank pricing, and client cash allocations change.
Future regulatory, remediation, and legal costs associated with the NASAA settlement and other matters, including the extent of captive-insurance coverage.
Debt repayment capacity, covenant compliance, floating-rate exposure, and the effect of higher interest rates on interest expense.
Trends in advisory and brokerage net new assets, advisor recruiting and retention, market-sensitive asset balances, and recurring gross profit.
The effect of evolving fiduciary, best-interest, retirement-account, and state regulatory requirements on products, pricing, revenue, and compliance costs.