LPL Financial Holdings Inc. quarterly report, Q3 FY2018

LPL Financial Holdings Inc. — 2018 Q3 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 with technology, custody, clearing, compliance, research, and practice-management services. This unaudited Form 10-Q covers the three and nine months ended September 30, 2018, compared with the corresponding 2017 periods.

Financial performance and key metrics

Metric	Q3 2018	Q3 2017	Change
Total net revenue	$1,331.0 million	$1,064.1 million	+25.1%
Pre-tax income	$147.4 million	$96.6 million	+52.5%
Net income	$106.9 million	$58.1 million	+83.8%
Diluted EPS	$1.19	$0.63	+88.9%
Gross profit	$493.2 million	$386.9 million	+27.5%
Gross profit as percentage of revenue	37.1%	36.4%	+70 bps
Effective tax rate	27.5%	39.8%	Lower by 12.3 pts

For the nine months ended September 30, 2018, revenue was $3,871.4 million, pre-tax income was $430.2 million, net income was $319.2 million, and diluted EPS was $3.49, compared with $3,165.0 million, $284.7 million, $174.8 million, and $1.90, respectively, in the prior-year period.

Q3 revenue growth was led by advisory revenue of $458.1 million, up 28.3%; asset-based revenue of $248.9 million, up 35.3%; and commission revenue of $486.9 million, up 20.8%.
Cash sweep revenue increased primarily because of Federal Reserve rate increases. Total cash sweep balances were $28.2 billion at September 30, 2018, broadly unchanged from the prior year.
Recurring gross profit rate was 85.0% for the trailing twelve months, compared with 82.2% a year earlier.
Operating expenses increased 22.6% in the quarter, including higher compensation, promotional, occupancy, professional-services, and regulatory-related costs. Amortization of intangible assets increased 67.6% because of the National Planning Holdings acquisition.
Net income benefited from the Tax Cuts and Jobs Act, stock-option exercise tax benefits, and lower settlement contingencies.

Assets, growth, cash flow, debt, and liquidity

Total brokerage and advisory assets served were $681.0 billion at September 30, 2018, up 22% from $560.0 billion a year earlier. Advisory assets were $306.1 billion, up 22%; brokerage assets were $374.9 billion, up 21%.
Q3 net new assets totaled $4.4 billion, including $5.1 billion of net new advisory assets and a $0.8 billion net outflow of brokerage assets. The nine-month total was $45.8 billion.
Net cash provided by operating activities for the first nine months was $196.1 million, versus $123.6 million in 2017. Investing cash outflow was $86.4 million, compared with $413.6 million, primarily reflecting the absence of the $325.0 million NPH acquisition payment made in 2017.
Financing cash outflow was $341.9 million, driven largely by $300.1 million of share repurchases and $66.8 million of dividends. Cash, cash equivalents, and restricted cash ended at $1.393 billion.
Long-term borrowings had a principal balance of $2.385 billion and a net carrying value of $2.375 billion at September 30, 2018. Debt consisted primarily of a $1.485 billion Term Loan B and $900.0 million of 5.75% senior unsecured notes due 2025.
The company had no revolving credit facility borrowings, although it had $10.6 million of irrevocable letters of credit supported by the facility. Management stated that operating cash flow and available borrowing capacity should satisfy foreseeable liquidity needs.
LPL Financial, the regulated broker-dealer subsidiary, had net capital of $166.1 million versus a minimum requirement of $8.5 million. The company reported compliance with applicable regulatory capital requirements.
Debt covenant ratios were within requirements: actual leverage was 2.24 versus a maximum of 5.00, and interest coverage was 8.09 versus a minimum of 3.00.

Material changes versus the prior comparable period

The NPH acquisition, completed in waves in late 2017 and early 2018, expanded the advisor and asset base and contributed to higher commission, advisory, and asset-based revenue. No contingent payment was due after the conversion period.
Advisor count increased 13% to 16,174, while average employee headcount increased 16.2% to 4,078 in the third quarter.
Share repurchases increased substantially: 4.6 million shares were repurchased for $300.1 million during the first nine months, compared with $83.7 million in the prior-year period. An additional $200.0 million remained authorized at September 30.
The company paid a quarterly dividend of $0.25 per share and returned $144.4 million to shareholders during the third quarter through dividends and repurchases.
Debt-related refinancing costs and the 2017 loss on extinguishment of debt did not recur in 2018. The prior-year nine-month period included a $22.4 million loss on extinguishment of debt.
The company adopted ASC Topic 606 in 2018 using the modified retrospective method; management reported no material effect on revenue timing, revenue amounts, or opening retained earnings.

Outlook, commentary, risks, contingencies, and unusual items

The filing does not provide a specific quantitative revenue, earnings, or margin forecast. Management expects liquidity to remain adequate for foreseeable needs and expects continued effects from advisor growth, asset levels, interest rates, and the NPH integration. Cash sweep revenue is sensitive to short-term interest rates, while advisory, trailing commission, recordkeeping, and sponsorship revenue are sensitive to market values and client assets.

The company agreed to a settlement structure with the North American Securities Administrators Association concerning historical state “blue sky” compliance. Administrative orders in 53 jurisdictions are expected to result in approximately $26.4 million of aggregate fines, plus customer remediation, consultant, and review costs over several years. Management expects most costs to be covered by its captive insurance subsidiary or expense plans, but ultimate costs could exceed accruals and insurance.
Regulatory uncertainty remains significant following the invalidation of the Department of Labor fiduciary rule and the SEC’s proposed best-interest standard. Changes affecting retirement and non-retirement accounts could increase compliance, technology, litigation, and operating costs or affect revenue streams.
The company faces litigation and regulatory risks, including a putative federal class action alleging misstatements and omissions related to share repurchases and financial performance in late 2015. The company intends to defend the action.
Approximately $1.485 billion of debt was subject to floating interest rates. A 100-basis-point increase was estimated to increase annual interest expense by approximately $14.8 million, before considering rate-lock effects and offsetting asset sensitivity.
Operational, cybersecurity, third-party service-provider, settlement, margin-lending, collateral, and client-default risks could cause financial losses, disruptions, regulatory sanctions, or reputational damage.
The board declared a subsequent $0.25-per-share dividend on October 23, 2018, payable November 26, 2018.

Important facts for investors to verify

Whether the company sustains strong advisory and net new asset growth after the NPH integration and during periods of market volatility.
The sensitivity of cash sweep revenue and net interest expense to Federal Reserve policy, deposit pricing, and LIBOR or other floating-rate changes.
The adequacy of accruals, captive insurance coverage, and expense plans for the blue sky settlement, customer remediation, and other regulatory matters.
Compliance with debt covenants and the effect of ongoing share repurchases and dividends on leverage, liquidity, and capital allocation.
Whether higher employee, technology, promotional, regulatory, and amortization costs remain proportionate to revenue growth.
The company’s future balance-sheet impact from adoption of the new lease standard and non-employee share-based compensation guidance.