Description

We believe LPL Financial (LPLA) presents a compelling investment at the current price, trading at the lower end of its historical valuation range, and with plenty of double digit earnings growth left, driven by solid MSD to HSD revenue growth, coupled with significant margin leverage inherent in the current business model. We’ll talk about LPL’s core businesses, how we expect the business model to develop over the next few years, the general macro tailwinds that are working in their favor both in the long and near term, and how all that translates into FCF growth. We’ll also discuss some of the bearish arguments we’ve heard about LPL including multiple levels of regulatory uncertainty/risk, as well as the risk of a more generalized stock market decline, and even roboadvisors (!) and why we think that for the most part, they are no big deal.

LPL Financial - Picks and Shovels in the Financial Advisory Goldrush

LPL basically provides the back-end infrastructure for advisors and brokers to ply their trade in relative independence, i.e., not at the wirehouses or regional/independent BDs where they usually get their start. There are many reasons why brokers/advisors (henceforth to be abbreviated B/As) leave the confines of the Morgan Stanleys of the world, but it mostly comes down to the money. Having Morgan Stanley on your business card helps you start out in the business, but after a few years, getting paid somewhere between 30-50% of what you produce when you can switch to LPL/Schwab/Ameritrade and increase that ratio to 80-90% doesn’t make much sense, and so the wirehouses end up as the breeding grounds for B/As that end up going to LPL (though they are working to solve that problem, probably unsuccessfully).

B/As can join LPL in two ways:

• As a “Corporate-Owned” practitioner or practice. In this arrangement, the B/A is essentially an outside contractor for LPL. He can represent himself officially as an LPL rep/advisor, or he can hang his own shingle in the suburbs and call it Smith Advisory Partners, but still essentially be working for LPL on a 1099 basis. This is currently the vast majority of LPL’s business (~85% of brokerage revenue and >95% of its advisory revenue, though that overstates its importance, which we’ll get to). A corporate-owned B/A can choose to be only a broker, only a fee-based advisor, or both.

• Totally independently - in this arrangement, the B/A will go out and start his own practice, but use LPL for back-end systems, custody, execution, technology, etc. LPL filings and conference calls will alternate calling this the “Independent RIA” business and the “Hybrid RIA” business, but they are both the same thing. In this arrangement, as in the corporate-owned arrangements, the B/A can choose to be a broker, fee-based advisor, or both.

It’s important to note here the flexibility that LPL provides to B/As in both types of arrangements, i.e., the ability to generate revenue both through commissions as well as through fee-based accounts. Additionally, a B/A can offer a client the full panoply of services that go under the “financial advisory” moniker, including insurance, annuities, stocks, bonds, alternative investments, etc. This flexibility is a key differentiating point for LPL vs. Schwab and Ameritrade, where the B/A is essentially limited to stocks and bonds, and almost always only through a fee-based model. While it’s true that a B/A can end up doing business with both Schwab AND other financial services providers, LPL is by far the largest entity that allows a practitioner to consolidate everything under one roof AND (very importantly) one account statement.

The Revenue Model

So how does LPL make money? We’ll go through each of the revenue line items and explain what goes where, including some of our estimates/assessments, which we made based on various LPL management statements.

• Commission revenue: In this line go all gross commissions, whether they are generated by corporate-owned brokerage or independent/hybrid brokerage. Over the past decade, gross commissions have been as high as 85-90bp of brokerage assets under LPL’s custody, but in recent years they have trended down to the mid-70s in basis points, and in 2014 were in the low 70’s. The decline is mostly a function of lower interest rates, which make annuities, bonds, and insurance products less attractive (and they have fatter commissions), as well as the decline in sales of private REITs in 2014 due to tighter compliance standards. (Note, we will get to the sleaziness of private REITs and variable-rate-annuities later.)

• Advisory revenue: There are two basic buckets here:

• Advisory revenue generated by corporate-owned advisors - all gross fees generated by these advisors run through the advisory revenue line, and they amount to about 110bp of assets under custody.

• LPL charges the independent/hybrid advisors a fee for the services it provides those advisors. This fee, about 10bp of assets under custody, flows through the advisory revenue line.

• Attachment revenue - this is the catch-all term for all the other revenue that LPL generates as a result of its business. The buckets here are:

• Asset-based revenue, which itself can be subdivided into a few different revenue-streams:

• Most importantly, the cash-sweep fee revenue, which LPL generates from the fees that banks and money market funds pay LPL for sweeping cash into deposits at those institutions. This is kind of a big deal, because the fees LPL receives here are fully tethered to short term rates, and have thus been decreasing every year for the past few years. The difference between 1.25% and 0.4% on $30B in assets (about $250M) is a pretty big deal for a company with $500M in 2014 EBITDA, especially when that revenue falls straight to the bottom line.

• Sponsorship fees - fees paid by financial product firms to LPL based on the amount of product that LPL end-clients have invested in the financial products. This would include mutual fund supermarket fees and their equivalents in insurance and annuity products, as well as any other fees that go in the category we label “financial firm pays LPL for the ability to get sold to end-clients.”

• Omnibus, networking, and other aum-based fees paid by mutual fund and insurance companies to LPL in return for LPL serving as the record-keeping go-between facing the end-client.

• Any AUM-based fees generated by the independent advisory business (NOT the independent brokerage business), such as 12b-1 fees or other trailing fees, also go into this bucket. LPL estimates that these are about 10bp of independent advisory assets under custody.

• Transaction fees: exactly what it sounds like, ticket charges, subscription fees, custodian fees, license fees, conference fees, etc. that LPL charges its B/As and their end-clients. Our impression is that this is mostly made up of the subscription fees for technology and other products that LPL offers to its advisors (e.g., performance calculating software, CRM systems, etc).

• “Other” - which includes interest income earned on margin loans, and “marketing allowances” that product sponsors pay LPL directly when they are sold to the end client. Marketing allowances are basically one time fees paid by financial product sponsors to LPL when these products are bought (or sold, as the case usually is).

Expense Structure

The expense structure very much corresponds to the revenue base:

• Payouts - LPL pays out about 90% of commissions generated to both its corporate owned brokers and independent RIA brokers. For corporate-owned advisors, the payout ratio is somewhere in the low 80’s (LPL estimate that advisory fees are around 110bp and it keeps 20bp and pays out 90). The advisory revenue generated by the independent advisory base (that 10bp) has no payout ratio associated with it at all because it is essentially a fee revenue stream.

• Brokerage, clearing, and exchange fees - LPL also has transaction fees it has to pay when it executes transactions or custodies money.

• G&A - rent, employee expenses, technology, etc. goes into this bucket. The other thing that goes here is regulatory expense, which is both what LPL has to pay to maintain its regulatory standing and (much larger) the fines it pays for wrongdoing or alleged wrongdoings that are settled.

• Promotional expense - there are two things that are labeled promotional expense: the conferences that LPL hosts for its advisors, which is basically marketing to its customers, and the acquisition of B/As that end up as LPL-corporate-owned B/As. LPL usually pays around 20% of a year’s worth of production for a B/A to switch over from where he currently is to LPL. If you do the math, it’s basically a two-year payback for brokers and a 1-year payback for fee-based advisors, so in our minds, we’d like them to do as much promotional spending as possible.

This looks much simpler on a spreadsheet

There are lots of puts and takes in all of the line items above, and we tend to try to keep things relatively simple in order to understand what the 2 or 3 major primary drivers of revenues and profits are. So we take all the above messy revenue lines and expenses, and essentially break them down into the following:

• Commission and advisory revenue are as explained above.

• “Net production” is commission and advisory revenue less payouts and clearing, brokerage, & exchange fees.

• Because the cash-sweep revenue is both extremely important, extremely variable, and pretty much pure profit, we break out the non-cash-sweep-associated attachment revenue into a separate line (cash sweep revenue is disclosed by LPL).

• Core G&A is basically G&A, but excluding restructuring expenses, stock-based comp, and other non-recurring expenses (and yes, we’ve scrubbed through these to make sure they are legitimately non-recurring expenses).

• EBITDA is what’s left.

Revenue Drivers

The primary revenue driver here isn’t difficult to figure out: assets under custody (AUC). But there are some peripheral considerations. AUC itself is driven by the growth in the advisor count at LPL, as well as the success of those advisors in growing their own business. On the other side of the equation, actual gross production and attachment revenue is driven by how productive the AUC can be in producing commissions, advisory fees, and other asset-based revenues (Fees/AUC, which we call asset productivity):

Basically, we think the overall trends for every piece of this equation are going the right way for LPL. The number of B/As can continue to grow low single digits for a very long time - the market share for independent B/As is still relatively small. We’re not claiming that there will be an exodus out of the wirehouses, just that the 7% share loss that wirehouses have sufferred over the past 5 years will most probably continue, and perhaps accelerate a bit due to larger advisors leaving (see here, for example: http://www.reuters.com/article/2015/04/02/us-usa-brokerage-departures-idUSKBN0MT0BW20150402). Wirehouses, Regional BDs, and Independent BDs still have 45-50% of total market share in terms of advisor-count, and even more in terms of asset-numbers, so we see the runway here in terms of share gains as still pretty long. Beyond advisor growth, AUM/advisor should also continue to grow mid-single digits with financial market returns, as well as LPL’s advisory practices themselves growing their client base, and of course the tailwind that is the retirement market over the next decade. Finally, asset productivity is heading in the right direction, as the advisory AUC has been growing significantly faster than brokerage AUC, and the net to both the Advisor and LPL from advisory assets is significantly better than the net in the brokerage business (and generally less sleazy).

The Independent/Hybrid RIA Business and the Margin Structure

The discussion above is focused on the corporate-owned LPL B/As, which LPL labels “corporate-owned advisors” (they are very inconsistent in when they decide to differentiate between “brokers” and “advisors” which we try to fix in this writeup by being more specific). Their number has consistently grown low-to-mid-single digits, and we believe will continue to do so because the nature of this business is that the moderately successful B/As at the wirehouses, who “only” raise $20-50M can’t make a good living at the wirehouses with that asset base, but can make a very good one if they can get 70-80% of their clients to go with them to LPL/Schwab/Ameritrade. These B/As and their commissions/fees are the primary revenue drivers at LPL, but the independent RIA business is gaining in significance very quickly:

The average LPL-owned B/A has about $27M in AUM. As discussed above, this is precisely the type of advisor that thrives under the corporate-owned LPL high-payout model. But larger B/As have mostly stayed at the wirehouses, where their payout ratios (still low by by LPL standards) still amount to large absolute numbers. That is now slowly changing (see the article referenced above) as LPL, Schwab, and Ameritrade, as well as many outside advisor-oriented service providers, are making it easier for the larger wirehouse B/A to build a totally independent RIA practice with the aforementioned vendors providing them with the infrastructure and products needed to do so. As you can see in the above table, this business has been growing like a weed for LPL (growth rates are highlighted in yellow with the rest of the table self-explanatory).

The revenue that these independent RIAs bring in on the brokerage side is both on par with what LPL’s corporate-owned advisors bring in for LPL and also accounted for the same way. But on the advisory side, the revenue comes in two buckets - 10bp of AUM that goes into the “advisory revenue” line and about 10bp of trailing fees that come through the “Asset-based revenue” line. While that doesn’t move the needle so much on the revenue side, these revenues are extremely high margin (almost all purely flowing down to the bottom line except for some G&A at the independent RIA segment, which LPL does not break out separately). Assuming, for example, that LPL can double its independent advisory assets over the next 3 years (we think that’s downright conservative), that means an extra ~$100M in revenue that flows almost directly into EBITDA, while having an almost negligible effect on the total revenue line. We think this is a major aspect of the investment case for LPL, and one that is not given sufficient attention by many we’ve spoken with. While revenue should continue to grow high single digits from the entire corporate-owned business as well as the independent brokerage business, we think EBITDA and earnings should be able to grow mid-teens as a result of the growth in the independent advisory business.

Interest Rates and the Cash-Sweep Revenue

Interest rates have very obviously not been very favorable to LPL’s cash-sweep revenue. Here’s how they’ve fared in the past decade:

The cash sweep assets are stated in billions of dollars, and the fee that LPL has been able to generate on average assets has fallen from about 1.3% to about 40bp, and we think it will be closer to 30bp this year. Honestly, we haven’t spent much time on this part of the thesis because it’s not so necessary for this to be a good investment, but just a few notes here:

• The ICA is a more profitable form of cash assets for LPL than money market funds - banks are basically paying LPL for deposits, and the max LPL could earn for this is 185bp at a normalized fed funds rate somewhere between 2.7% and 3.5%.

• LPL says that the max it would earn on this entire thing at that normalized fed funds rate would be an extra $265M vs. the 2014 number (based on current assets, which will increase by the time fed rates normalize, if they ever do).

• The 2014 cash sweep revenue was about $100M, and we expect that to decline to $90M in 2015.

• Notice that our expected decline from 2014 to 2015 is about 25% in terms of basis points of fees, but only 10% in terms of revenue. Here is another place where the rapid growth of independent RIA assets, while not making an enormous dent in gross production revenue, has an abnormally high impact on the cash revenue because LPL earns just as much on the cash assets it custodies on its independent platform as it does on the cash assets on the corporate-owned platform.

The Investment Case

LPL did $516M in EBITDA in 2014, which includes a lot of regulator settlement costs in there. We’ll get to the bear case when we discuss risks in the next section, but we don’t think these fees are a regular feature of the landscape, at least at the levels of 2014, so we’d add $20M, for a 2014 “real” EBITDA number of ~$535M. Subtract $50M in interest and $50M in maintenance capex, tax it, and you get about $260M in what we label normalized free cash flow. For the 2015 fiscal year, here are our estimates for the key inputs:

• Corporate advisor count grows 2.5%

• Advisory assets per advisor grow 5% while brokerage assets per advisor grow a slower 2%.

• The independent RIA channel continues to grow, but decelerates a bit, growing advisors AUC by 40% and brokerage AUC by 30%. We think this is very conservative (seriously). There are lots of reasons we think that more advisors than normal will defect the wirehouses this year including some of the new golden handcuffs that the wirehouses are putting on their advisors as well as what we expect will be a raft of final installments on retention bonuses that were paid out in 2008 but finish up their vesting this year.

• We generally assume that payouts to B/As and the productivity the B/As get from their assets (i.e., fees as a percentage of AUM) will stay steady.

• As discussed above, the cash sweep revenue will be a bit lower.

• G&A grows 6%, which is at the high end of what LPL expects it will need to grow core G&A going forward.

We end up with about $585M of EBITDA and about $290M of FCF on a $4B market cap at present. So we have a company that’s growing mid-teens for the next few years, with little capital intensity, and that has a growth runway for as far as the eye can see, and it’s trading at 15.3x ttm our adjusted earnings number and 13.8x our forward estimates of adjusted earnings. Oh, and if rates just go up to 2.5% sometime...ever... LPL will earn an extra $265M pretax, or 50% more than it earns now. And by that time, the number will be higher as cash balances increase. We find this extremely attractive, much more so than Schwab which, while a great company, sports a valuation that by necessity implies a normalized fed funds rate. By that standard, LPL should trade at over $60 right now.

Risks

Yes, there are risks here, but they don’t overly concern us:

• Variable rate annuities, private REITs, and all other manner of sleazy broker tactics that will come back to haunt LPL.

• Our response: unquestionably, LPL’s brokerage crew has done sleazy things. And LPL paid $35M in fines in 2014 for those things. And they will probably pay more in the future. But we think the wrongdoing is very much in the past given, well, all these fines. Additionally, we think the worst of the fines is in the past and we’ve assumed a run-rate of $15M in “regulatory charges” going forward that will grow at the same rate as the rest of the G&A (and yes, we’ve also included regulatory charges in the G&A numbers across the board).

• For the most part, we don’t think that VRAs and private REITs are going away (for better or worse, probably worse). Brokers will continue to sell this stuff, but probably more carefully. Will sales come down? maybe, but they’ve already been a bit depressed in 2014 because brokers have been self-policing themselves.

• The fiduciary standard - the labor department just came out with a new-rules proposal to make all retirement assets subject to the fiduciary standard. We can discuss this ad nauseum but we think this is much ado about nothing. In fact, it might even help LPL by increasing the growth rate of its advisory business at the expense of the brokerage business, which is fine, because the advisory business earns better margins and has better AUM-productivity anyway.

• General stock market decline - yes, this could happen, but if it happens, all your longs will be down just as much as LPL. And LPL has a high growth rate to somewhat mitigate that outcome, as well as the inevitable everyone-will-go-to-cash response, which will double LPL’s cash-sweep revenue and will make a significant dent in EBITDA and earnings, even at 0 interest rates. Also, if you’d like to hedge against this, it’s fairly simple.

• Roboadvisors - The biggest risk in this business is not really roboadvisors per se, but fees coming down. We do think fees will come down at the lower end of the AUM range (say, if you have $25K to invest). But we’d make the following points (and would be glad to discuss in the Q&A):

• We don’t think roboadvisors are replacing humans any time until the singularity. The reality is that anyone with a few hundred grand is not going to trust his entire life’s work and retirement assets to a computer, and whoever does and ends up selling at the bottom will regret it. The next bear market, we think, will show that roboadvisors are not a standalone product.

• But we do think that technology, in general, can make advisors’ jobs easier and force fees down. By making things easier, though, advisors will be able to manage more money, which will offset the impact of lower fees. LPL, as the gatekeeper here, will be fine either way.

Catalyst

We think this year will be better than expected in terms of advisor-adds, and if interest rates really do start rising, it will get even better for LPL.