LPL INVESTMENT HOLDINGS INC LPLA
May 24, 2011 - 5:44pm EST by
tdylan409
2011 2012
Price: 34.38 EPS $1.54 $1.61
Shares Out. (in M): 114 P/E 22.4x 21.3x
Market Cap (in $M): 3,905 P/FCF 0.0x 0.0x
Net Debt (in $M): 747 EBIT 330 367
TEV ($): 4,652 TEV/EBIT 14.1x 12.7x

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Description

    
LPL Financial
LPLA
 
 
INVESTMENT SUMMARY
LPL Financial is a very well-positioned and well-run company that serves independent financial advisors with an integrated platform of technology, back-office, custodian, and self-clearing services. As an independent broker-dealer, LPL serves approximately 12,500 advisors who have both brokerage and advisory assets. LPL's advisors who manage brokerage assets are paid largely through commissions while those who manage advisory assets are paid fees based on assets under management (AUM). LPL's scale, ability to self-clear, and significant investment in technology provide LPL with a tremendous low-cost competitive advantage which enables the company to serve relatively small advisors profitably. The company is in a prime position to take advantage of the continuation of the breakaway-broker trend: advisors leaving wirehouses and banks for more autonomy and better economics by setting up their own independent business. This trend, along with attracting advisors from insurance, regional and other independent broker-dealers, will likely be a nice tailwind for LPL for many years. Additionally, LPL's business is extremely sticky because of the paperwork required and hassle involved in switching client assets to a new custodian.
 
It is important to note that LPL will benefit significantly from a rising interest rate environment, which will provide a windfall to earnings should rates increase.  (LPL receives a fee from banks that is tied to the fed funds rate for sweeping its clients' cash into said banks.)
 
LPL's management has executed well through tumultuous markets over the last few years and is extremely smart and driven. The company has a good history of capital allocation and should be able to continue making highly-accretive acquisitions given the company's advantages of scale and ability to cut costs from acquired firms. Note that LPL was purchased by Hellman & Friedman (H&F) and TPG in 2005 and went public through an IPO in November 2010. Neither H&F nor TPG sold any shares in the IPO or recent secondary offering and maintain a combined 60% ownership in LPL. 
 
LPL's stock currently trades at a 14X normalized P/E, which we believe is a significant discount to intrinsic value. The current price does not reflect the company's sticky, scalable business model; strong competitive position; robust 19% EBITDA CAGR and 26% EPS CAGR over the next 5 years; and top-tier management.  We believe an investment in LPL is an excellent risk/reward with a likely 5 year compounded annual return in the low-to-mid twenties and low risk of permanent capital loss.
 
THE BUSINESS
LPL serves many different types of independent advisors that have left a broad range of firms including wirehouses (e.g. BofA/Merrill Lynch, UBS, Morgan Stanley Smith Barney), regional broker-dealers (e.g. RBC, Oppenheimer), insurance broker-dealers (e.g. AXA, NYLIFE Securities), banks (e.g. Citizens Bank, Fifth Third Bank) and independent broker-dealers (e.g. Raymond James, Commonweath). LPL competes with all these types of firms as well as large Registered Investment Advisors and RIA custodians, such as Charles Schwab, Fidelity and TD Ameritrade. 
 
LPL services advisors with the front, middle and back-office support they need to serve the large and growing market for independent investment advice, particularly in the mass affluent market ($100,000 to $1 million in investable assets). LPL's advisors often offer their clients both advisory accounts (i.e. the client pays a fee based on assets under management) and brokerage accounts (i.e. the client pays fees through commissions on product sales and trading activity).  LPL's advisors have an average of $25 million in AUM and earn ~$220,000 per year in gross production revenue (i.e. commissions and fees). As compared to other custodians, LPL's advisors are quite small (e.g. the average Schwab advisor has $100 million in AUM). LPL's advisor services include portfolio management tools, prepackaged managed portfolio programs, online management of daily investment operations, trade-related services, research for individual securities and mutual funds, performance reporting, compliance support, clearing services, marketing materials and support, and training and education. Approximately 80% of LPL's advisors use their own brand while 20% market themselves under the LPL brand.
 
LPL generates revenue by charging its advisors 10%-15% of their production revenue (inversely, from an advisor's point of view, the company pays out 85%-90% of production revenue). The company has set up its pricing grid such that the firm is gross margin agnostic to the products sold by its advisors. The company offers a higher payout ratio for higher commission products and vice-versa. For example, the company would receive less gross revenue on a low-commission rate mutual fund sale than on a high-commission rate annuity product sale, but LPL would earn a lower gross margin percentage on the annuity sale. Thus, both product sales generate equivalent gross margin dollars for LPL. Similarly, management has structured ETF asset-allocation wrap products in order to maintain similar profit dollars regardless of whether advisors' clients are invested in commission-generating products or passively-managed products (e.g. ETFs). The product-agnostic design of LPL's business model insulates the company from material fluctuations in cash flows as certain investment products are more or less in favor. LPL also alters its payout if advisors hit performance metrics including asset growth, business mix (mix of investment products as well as advisory vs. brokerage assets), tenure and gross production. LPL reduces the payouts to brokers when asset prices decline, which helps to stabilize LPL's profits in a declining market.
 
LPL's advisors are generally focused on serving the "mass affluent," which are often older upper-middle class families reasonably close to or in retirement. These investors typically have a low risk tolerance, and as a result, LPL advisors sell a lot of fixed and variable annuities. A variable annuity is essentially a mutual fund with downside protection in the form of a guaranteed minimum annual distribution and/or a life-insurance mortality benefit. The products are sold by life insurance companies, and advisors who sell them must be licensed to sell life insurance. Variable annuities have a large load (i.e. up-front fee), paying high commissions to the advisors who sell them. The products generally also have a large early withdrawal penalty. Funds invested in a variable annuity grow tax-deferred, but gains are taxed as ordinary income when funds are withdrawn. Variable annuities are generally poor investment vehicles but can have a place in the portfolios of investors close to retirement. The ability to generate annual income with downside protection and the opportunity for some capital appreciation can be appealing. Sales of the product have surged over the last 5 years and are especially attractive in light of the recent financial crisis.
 
LPL's business model has extremely low capital requirements, especially compared to rivals who own a bank. As a broker-dealer (B/D), LPL has de minimus capital requirements that are regulated by the SEC (<$10mm). Management has indicated that it intends to retain ~$110mm in capital, which is far in excess of minimum requirements.
 
It is important to note LPL has recently focused more intensely on retaining and attracting RIA assets and advisors. LPL advisors have the option of using LPL's corporate RIA license for regulatory purposes or establishing and maintaining their own. Prior to 2008, LPL would lose several large RIAs (~3-5 with $200-300 million in AUM) to Schwab and others because the RIAs wanted to be fully independent. At the time, LPL only offered advisors to be part of the company's corporate RIA (as opposed to being an independent RIA altogether). In the end of 2008, LPL rolled out an independent RIA option, which was designed to stem the departures of large fee-based advisors as well as gain new advisors. LPL's RIA business has grown net new advisory assets at a 21% CAGR over the last 5 years. While the company charges lower fees to fully-independent RIAs, the revenue is twice as profitable because of lower compliance and associated costs. As a result, the company is operating profit-agnostic between advisors who use LPL's corporate RIA and those who are their own RIA.
 
Cash Sweep Program and Interest Rate Sensitivity:
LPL earns fees on its advisors' clients' cash in money market funds as well as on client cash that is swept into insured cash accounts (ICAs). Due to its private equity ownership, LPL is not permitted to own its own bank. As a result, the company has structured a program to sweep client cash into insured accounts at partnering banks. Funds in ICA accounts are allocated into several accounts at different banks in order to remain below FDIC limits. The cash is treated by the bank like a deposit for regulatory purposes. The 15 banks which participate in the program pay a fee to have the funds swept onto their balance sheet. The banks can invest the cash into longer duration assets on which they earn a spread. LPL has 4 "anchor" banks with agreements that pay LPL Fed Funds + 90-120bps and agreements with ~10 other banks that pay Fed Funds + 60bps. LPL structured these agreements during the heart of financial crisis when the banks were eager for capital. If LPL renewed non-anchor bank contracts today, the company would likely feel some compression from the FF + 60bps fee. However, given the current steepness of the yield curve, LPL's partner banks are still able to generate a healthy spread on the LPL-associated cash swept on their books.
 
LPL's management did an excellent job structuring these long-term agreements, which have provided a nice benefit to the company in today's low yield environment. Given current market interest rates on deposit accounts, LPL is able to capture the majority of the fee it earns on client cash balances (85bps), while passing on a competitive rate to its clients. The agreements with the 4 anchor banks cover approximately 80% of insured cash assets. The agreements do not begin to roll off for another 4 years. The capital provided to the banks by LPL's agreement is actually more attractive to banks than regular deposits because a portion of the swept cash carries lighter reserve requirements. Additionally, cash currently represents 5-6% of total client assets, which is a normal amount. This percentage is down significantly from 10-12% during the financial crisis. Given already normal levels, it seems unlikely that cash levels will further decrease materially, even in a bull-market environment. (Note that if client cash levels decreased materially, LPL's earnings would be negatively impacted.)
 
The anchor bank agreements are structured with a sliding scale, so that the margin that LPL earns over Fed Funds will compress as interest rates rise. As a result, the company is less sensitive to interest rate movements than Schwab or other banks especially as Fed Funds increases beyond 2.75%. (As Fed Funds rises above 2.75%, any additional interest is paid to the client.)
 
A smaller portion of LPL's client cash is placed in money market funds (MMF) which earn LPL 15bps today. As Fed Funds increases above 1.25%, LPL will earn approximately 55bps on its money market assets instead of the 15bps which it is earning today. Figure 1 below highlights the sensitivity of LPL's earnings to rising interest rates.
 
Figure 1: Interest Rate Sensitivity 
Fed Funds                   2011 EPS        % Increase
Current (20bps)           $1.61  
50bps                           $1.78               10.6%
100bps                         $2.03               25.7%
150bps                         $2.09               29.6%
200bps                         $2.22               37.6%
250bps                         $2.35               45.6%
300bps                         $2.47               52.9%
350bps                         $2.48               53.5%
 
  
COMPETITIVE POSITION
LPL has an excellent competition position due to its "one-stop shop" capability, low cost position and significant scale, leading market share, conflict-free platform and sticky customer base.
 
LPL is the dominant player for small, newly independent brokers with both fee and commission based business and is uniquely positioned to provide a very attractive way for newly independent advisors to reduce the complexity of running their business. Many wirehouse or bank advisors who break away intend to slowly transition from commission-based brokerage business to advisory fee-based business, which is more stable and often more profitable. Approximately 75% of LPL's advisors have both types of accounts: a brokerage, B/D-affiliated account for commission-based assets and an advisory, RIA account for fee-based assets. Using both types of accounts significantly increases the regulatory and reporting complexities for an advisor operating his own business. The advisor must operate under two different regulatory regimes (FINRA and the SEC) and must comply with two different standards of responsibility (fiduciary and suitability). The advisor must also integrate data from multiple entities for reporting purposes. LPL provides a "one-stop shop" for advisors by providing both RIA and B/D affiliations, as well as the compliance, clearing and reporting services for both.
The company enjoys a low cost competitive advantage due to its significant scale advantage in the small independent advisor niche. LPL is the largest independent B/D and has invested over $500 million in technology systems over the last 10 years, enabling LPL to serve smaller advisors at a much lower cost than competitors and to do so very profitably. (See Cerulli Associates for 3rd party market share data - I can't reprint here.) LPL also has the ability to self-clear (other custodians typically outsource clearing to a firm such as Pershing), which eliminates a significant cost. It is unlikely that a smaller firm would develop the capability to self-clear since it is costly to do and requires massive scale. Additionally, as the largest independent B/D (by advisors and assets), LPL is able to negotiate favorable pricing with a number of product manufacturers (e.g. Vanguard, Franklin, etc). 
  
LPL offers a conflict-free platform, which many advisors find quite attractive and use as a selling point with prospective new clients. Unlike other custodians (e.g. Fidelity) or wirehouses (e.g. Merrill Lynch) which are also product manufacturers, LPL is solely a distributor. This avoids the conflict of interest that in-house advisors face when they are incentivized to sell proprietary products (because in-house products are structured to generate larger commissions for the parent company). Many advisors find this quite attractive and can use this independence as a selling point to new clients. LPL has also built a team to provide investment recommendations and managed products to its advisors, which many advisors find useful. Approximately 60% of LPL's advisors use LPL's managed investment products or investment recommendations.
LPL's business is very sticky. Advisors almost never leave voluntarily because of the paperwork involved in re-authorizing a client with a new custodian. It is a significant administrative hassle for both the advisor and the client. LPL's advisor retention rate is approximately 96%, which includes involuntary advisor departures as well as retirements.
In summary, LPL has built a strong competition position with an excellent service offering and significant scale that allows the company to earn a 40%+ adjusted EBITDA margin serving small advisors that many other custodians do not even want (i.e. Schwab and Fidelity) and that wirehouses do not care too much to keep. This speaks to the power of LPL's low cost business model: this is a very good business with high margins and low capital intensity. 
 
THE INDUSTRY
Over the last several years, increasing numbers of financial advisors have "broken-away" from wirehouses and traditional firms in order to establish an independent practice, and this trend is likely to continue for many years. Going independent can meaningfully improve an advisor's bottom line, assuming he can bring a majority of his assets with him. While advisors at wirehouses, insurance B/Ds, regional B/Ds and banks typically take home 30%-60% of the production revenue that they generate for their parent firm, LPL's advisors earn an average of 85%-90% of their production revenue before overhead. With overhead typically costing ~20% of revenue, an average independent advisor would typically earn ~65-70% of the production revenue he generated, which is considerably higher than the average economics at a wirehouse or B/D. Independent advisors can also build equity in their businesses, which they can monetize by selling their firm upon retirement.
 
Going independent also provides substantial lifestyle benefits: being able to set your own schedule, not having to deal with the bureaucracy of a big financial institution, not having to worry about the financial health of the parent company, etc. As discussed in the "Competitive Position" section, independent advisors are able to offer conflict-free advice and are no longer encouraged or incentivized to sell their own company's proprietary product.  Overall, the share of advisors who are independent has increased from 37% in 2004 to 40% in 2009. An industry source (Cerulli Associates) expects this percentage to increase to 47% by 2014.
The breakaway broker trend paused during and in the immediate aftermath of the financial crisis mainly for three reasons. First, wirehouses began paying large retention bonuses to their top producers. Second, market turmoil makes advisors more hesitant to leave their existing job and take the risk of starting their own business. Third, during poor market performance (and likely losses for clients), it becomes more difficult for advisors to retain client assets when going independent. The trend has started to recover now that markets are more stable and that retention packages are beginning to roll off. Because the primary reasons for going independent before the financial crisis still apply, the trend toward independence should continue going forward. Importantly, LPL serves the two advisor segments that are growing the most rapidly - dually registered advisors and RIAs - as well as the independent B/D channel. LPL has taken market share over the last 5 years and will likely continue to do so going forward. (See Cerulli Associates for the market share data.)
   
MANAGEMENT AND PRIVATE EQUITY OWNERS
Management is smart, driven and likely to grow per share value over many years. The team is led by CEO Mark Casady, and the team has proven to be excellent operators even in changing and tumultuous market conditions. For example, management structured the cash sweep programs with the anchor banks during the depth of the crisis and extracted favorable terms on 5-7 year contracts when the banks were in dire need of capital. Additionally, by structuring the payout grid so that EBITDA is product-agnostic, LPL's cash flow is quite steady and the business is able to handle a reasonable degree of financial leverage. Management also has smartly dealt with potential new products that could have potentially adversely impacted cash flow. Most recently, management found a way to offer ETFs without seeing any decline in cash flow by offering asset allocation wrap products and also introduced an independent RIA platform to stem departures by its highest producing advisors. Most importantly, management has created a wide moat for the business by making smart investments in technology and gaining scale in order to become the low cost leader in their niche.
 
Mark Casady is chairman and CEO of LPL. He joined in May 2002 as COO, became president in April 2003, and became CEO and chairman in December 2005. Before joining LPL, Mark was a managing director in the mutual fund group for Deutsche Asset Management, Americas (formerly Scudder Investments). He joined Scudder in 1994 and held roles as the head of global mutual fund group and head of defined contribution services. He is former chairman and a current board member of the Insured Retirement Institute and serves on FINRA's board of governors.
 
Robert Moore is the CFO of LPL. He joined in September 2008. From 2006-2008, Robert served as CEO and CFO at ABN AMRO North America and LaSalle Bank. Before this, Robert worked as CFO of Diageo PLC, Europe and Great Britain.
 
Esther Stearns is the COO and President of LPL. She joined the company in July 1996 as chief information officer. Prior to joining LPL, she was vice president of information systems at Schwab, where she worked for 14 years.
 
It is worth noting that over the last 10 years, LPL management has focused on driving and managing the company's rapid growth, both organically and through acquisitions. The company has recently begun to focus on squeezing inefficiencies out of the business model. During the financial crisis, management reduced general and administrative costs by over $100 million through a 10% headcount reduction, integrating an acquisition and other productivity initiatives. The company's increased focus on expenses should provide an opportunity to improve the company's already high level of profitability.
 
Capital Allocation
Management is likely to prioritize the paydown of the company's debt until it achieves an investment grade rating, which is likely to happen when Debt / Adjusted EBITDA is below 2X. The company intends to refinance its debt once it reaches investment grade, which could save as much as 50% off of current interest expense, assuming that interest rates do not rise from current levels. The refinancing should provide a material boost to earnings.
 
The team has had a successful track record of making acquisitions, which were historically needed to build scale and widen the company's competitive moat. Management has a 40% pretax ROI hurdle (cash on cash returns 3 years out) for acquisitions. Given the scalable nature of its business model, LPL can cut out a number of costs from acquired firms and retain the advisors along with their assets. Additionally, in the current low interest rate environment, LPL's favorable cash management (higher yield on cash) and sponsorship agreements (lower fees to manufacturers) allow it to pay more than many competing firms while at the same time earning more attractive economics from the acquisition. LPL's ability to pay a higher price and generate a higher IRR is a substantial advantage. LPL has a dedicated acquisitions team and CEO Mark Casady is focused on acquisitions going forward.
 
Private Equity and Management Ownership
LPL went public in November of 2010. The management team initiated the IPO process because it expected that taxes would increase in 2011 although neither H&F nor TPG sold any shares in the IPO or the recent secondary offering. The continued ownership of H&F and TPG provides added comfort that the company will maintain disciplined capital allocation going forward.
 
While LPL management retains a significant ownership stake in the company, Casady and Stearns sold some stock in the IPO. While management selling is not a positive, it is noteworthy that both rolled all of their equity in the private equity buyout and this was their first liquidity event. Casady still owns $60 million of LPL stock, which represents approximately 85% of his net worth, while Stearns still owns $20 million of LPL stock. Thus, we are not overly concerned about the management stock sales. Note management's variable compensation will primarily be determined by Adjusted EPS growth.
 
 
PRICE
LPL currently trades at a 14X normalized P/E (assuming a Fed Funds rate of 3%), which we believe is a significant discount to intrinsic value. The current price does not reflect the company's low-risk, scalable business that has the healthy industry tailwind of advisors going independent.  Given the company's strong competitive position, ability to take share and likely robust industry growth, we believe LPL will grow revenue 13%, EBITDA 19%, EPS 26% annually from 2010 through 2015. Note these growth rates assume 4% annual market growth and modest increases in interest rates. We believe an investment in LPL is an excellent risk/reward with a likely 5 year compounded annual return in the low-to-mid twenties with low risk of permanent capital loss.
 
 
RISKS
Market exposure: A material drawdown in the equity markets would have a negative impact on LPL by reducing assets and inhibiting advisor recruitment.
Continuation of the breakaway broker trend: The breakaway broker trend could fail to return to pre-crisis levels. However, the advantages of breaking off have not been dampened. Market conditions have improved and the retention packages paid to advisors are beginning to roll off. New advisor growth has recently improved in the fourth quarter of 2010 and the first quarter of 2011.
Decline in the Commission Rates: Commissions on investment products have declined over time, and may continue to decline in the future. Since 1990, mutual fund commission rates have decreased by approximately 50%. Over the last 5 years, LPL's commission as a % of AUM has decreased slightly. It is worth noting that LPL's robust historical growth has happened in the midst of this market decline in commission rates.
Competition: Schwab and Fidelity could potentially begin to target smaller advisors and/or begin to focus on commission-based and dually-registered advisors, neither of which they have done historically. While LPL's existing customers are sticky, competition could slow growth.
 
Regulation: As one of the largest distributors of variable annuities, LPL is exposed to some future regulatory risk (although the recent Dodd-Frank legislation did not impose any new restrictions). The downside for LPL is mitigated by the company's product-agnostic pricing grid. Nevertheless, variable annuities are a major source of income for LPL's advisors. Increased regulation might make the independent model less viable, and make it harder for LPL to recruit new advisors.
 
Additionally, the regulatory treatment of LPL's cash sweeps could change for banks, which would impact LPL's business model. Again, there is no evidence of any change on the horizon now.
 
CONCLUSION
An investment in LPL is a compelling risk/reward.  LPL's business has an excellent competitive position in an attractive, growing industry. The company stands to benefit from a rising interest rate environment and smart capital allocation. The company is run by a motivated and smart management team. The stock is currently trading at a price that represents a substantial discount to intrinsic value. 

Catalyst

Although this investment is not catalyst-based, the stock will likely benefit from strong "same-store" sales, rising interest rates, an attractive debt refi, smart acquisitions and healthy new advisor growth.
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    Description

        
    LPL Financial
    LPLA
     
     
    INVESTMENT SUMMARY
    LPL Financial is a very well-positioned and well-run company that serves independent financial advisors with an integrated platform of technology, back-office, custodian, and self-clearing services. As an independent broker-dealer, LPL serves approximately 12,500 advisors who have both brokerage and advisory assets. LPL's advisors who manage brokerage assets are paid largely through commissions while those who manage advisory assets are paid fees based on assets under management (AUM). LPL's scale, ability to self-clear, and significant investment in technology provide LPL with a tremendous low-cost competitive advantage which enables the company to serve relatively small advisors profitably. The company is in a prime position to take advantage of the continuation of the breakaway-broker trend: advisors leaving wirehouses and banks for more autonomy and better economics by setting up their own independent business. This trend, along with attracting advisors from insurance, regional and other independent broker-dealers, will likely be a nice tailwind for LPL for many years. Additionally, LPL's business is extremely sticky because of the paperwork required and hassle involved in switching client assets to a new custodian.
     
    It is important to note that LPL will benefit significantly from a rising interest rate environment, which will provide a windfall to earnings should rates increase.  (LPL receives a fee from banks that is tied to the fed funds rate for sweeping its clients' cash into said banks.)
     
    LPL's management has executed well through tumultuous markets over the last few years and is extremely smart and driven. The company has a good history of capital allocation and should be able to continue making highly-accretive acquisitions given the company's advantages of scale and ability to cut costs from acquired firms. Note that LPL was purchased by Hellman & Friedman (H&F) and TPG in 2005 and went public through an IPO in November 2010. Neither H&F nor TPG sold any shares in the IPO or recent secondary offering and maintain a combined 60% ownership in LPL. 
     
    LPL's stock currently trades at a 14X normalized P/E, which we believe is a significant discount to intrinsic value. The current price does not reflect the company's sticky, scalable business model; strong competitive position; robust 19% EBITDA CAGR and 26% EPS CAGR over the next 5 years; and top-tier management.  We believe an investment in LPL is an excellent risk/reward with a likely 5 year compounded annual return in the low-to-mid twenties and low risk of permanent capital loss.
     
    THE BUSINESS
    LPL serves many different types of independent advisors that have left a broad range of firms including wirehouses (e.g. BofA/Merrill Lynch, UBS, Morgan Stanley Smith Barney), regional broker-dealers (e.g. RBC, Oppenheimer), insurance broker-dealers (e.g. AXA, NYLIFE Securities), banks (e.g. Citizens Bank, Fifth Third Bank) and independent broker-dealers (e.g. Raymond James, Commonweath). LPL competes with all these types of firms as well as large Registered Investment Advisors and RIA custodians, such as Charles Schwab, Fidelity and TD Ameritrade. 
     
    LPL services advisors with the front, middle and back-office support they need to serve the large and growing market for independent investment advice, particularly in the mass affluent market ($100,000 to $1 million in investable assets). LPL's advisors often offer their clients both advisory accounts (i.e. the client pays a fee based on assets under management) and brokerage accounts (i.e. the client pays fees through commissions on product sales and trading activity).  LPL's advisors have an average of $25 million in AUM and earn ~$220,000 per year in gross production revenue (i.e. commissions and fees). As compared to other custodians, LPL's advisors are quite small (e.g. the average Schwab advisor has $100 million in AUM). LPL's advisor services include portfolio management tools, prepackaged managed portfolio programs, online management of daily investment operations, trade-related services, research for individual securities and mutual funds, performance reporting, compliance support, clearing services, marketing materials and support, and training and education. Approximately 80% of LPL's advisors use their own brand while 20% market themselves under the LPL brand.
     
    LPL generates revenue by charging its advisors 10%-15% of their production revenue (inversely, from an advisor's point of view, the company pays out 85%-90% of production revenue). The company has set up its pricing grid such that the firm is gross margin agnostic to the products sold by its advisors. The company offers a higher payout ratio for higher commission products and vice-versa. For example, the company would receive less gross revenue on a low-commission rate mutual fund sale than on a high-commission rate annuity product sale, but LPL would earn a lower gross margin percentage on the annuity sale. Thus, both product sales generate equivalent gross margin dollars for LPL. Similarly, management has structured ETF asset-allocation wrap products in order to maintain similar profit dollars regardless of whether advisors' clients are invested in commission-generating products or passively-managed products (e.g. ETFs). The product-agnostic design of LPL's business model insulates the company from material fluctuations in cash flows as certain investment products are more or less in favor. LPL also alters its payout if advisors hit performance metrics including asset growth, business mix (mix of investment products as well as advisory vs. brokerage assets), tenure and gross production. LPL reduces the payouts to brokers when asset prices decline, which helps to stabilize LPL's profits in a declining market.
     
    LPL's advisors are generally focused on serving the "mass affluent," which are often older upper-middle class families reasonably close to or in retirement. These investors typically have a low risk tolerance, and as a result, LPL advisors sell a lot of fixed and variable annuities. A variable annuity is essentially a mutual fund with downside protection in the form of a guaranteed minimum annual distribution and/or a life-insurance mortality benefit. The products are sold by life insurance companies, and advisors who sell them must be licensed to sell life insurance. Variable annuities have a large load (i.e. up-front fee), paying high commissions to the advisors who sell them. The products generally also have a large early withdrawal penalty. Funds invested in a variable annuity grow tax-deferred, but gains are taxed as ordinary income when funds are withdrawn. Variable annuities are generally poor investment vehicles but can have a place in the portfolios of investors close to retirement. The ability to generate annual income with downside protection and the opportunity for some capital appreciation can be appealing. Sales of the product have surged over the last 5 years and are especially attractive in light of the recent financial crisis.
     
    LPL's business model has extremely low capital requirements, especially compared to rivals who own a bank. As a broker-dealer (B/D), LPL has de minimus capital requirements that are regulated by the SEC (<$10mm). Management has indicated that it intends to retain ~$110mm in capital, which is far in excess of minimum requirements.
     
    It is important to note LPL has recently focused more intensely on retaining and attracting RIA assets and advisors. LPL advisors have the option of using LPL's corporate RIA license for regulatory purposes or establishing and maintaining their own. Prior to 2008, LPL would lose several large RIAs (~3-5 with $200-300 million in AUM) to Schwab and others because the RIAs wanted to be fully independent. At the time, LPL only offered advisors to be part of the company's corporate RIA (as opposed to being an independent RIA altogether). In the end of 2008, LPL rolled out an independent RIA option, which was designed to stem the departures of large fee-based advisors as well as gain new advisors. LPL's RIA business has grown net new advisory assets at a 21% CAGR over the last 5 years. While the company charges lower fees to fully-independent RIAs, the revenue is twice as profitable because of lower compliance and associated costs. As a result, the company is operating profit-agnostic between advisors who use LPL's corporate RIA and those who are their own RIA.
     
    Cash Sweep Program and Interest Rate Sensitivity:
    LPL earns fees on its advisors' clients' cash in money market funds as well as on client cash that is swept into insured cash accounts (ICAs). Due to its private equity ownership, LPL is not permitted to own its own bank. As a result, the company has structured a program to sweep client cash into insured accounts at partnering banks. Funds in ICA accounts are allocated into several accounts at different banks in order to remain below FDIC limits. The cash is treated by the bank like a deposit for regulatory purposes. The 15 banks which participate in the program pay a fee to have the funds swept onto their balance sheet. The banks can invest the cash into longer duration assets on which they earn a spread. LPL has 4 "anchor" banks with agreements that pay LPL Fed Funds + 90-120bps and agreements with ~10 other banks that pay Fed Funds + 60bps. LPL structured these agreements during the heart of financial crisis when the banks were eager for capital. If LPL renewed non-anchor bank contracts today, the company would likely feel some compression from the FF + 60bps fee. However, given the current steepness of the yield curve, LPL's partner banks are still able to generate a healthy spread on the LPL-associated cash swept on their books.
     
    LPL's management did an excellent job structuring these long-term agreements, which have provided a nice benefit to the company in today's low yield environment. Given current market interest rates on deposit accounts, LPL is able to capture the majority of the fee it earns on client cash balances (85bps), while passing on a competitive rate to its clients. The agreements with the 4 anchor banks cover approximately 80% of insured cash assets. The agreements do not begin to roll off for another 4 years. The capital provided to the banks by LPL's agreement is actually more attractive to banks than regular deposits because a portion of the swept cash carries lighter reserve requirements. Additionally, cash currently represents 5-6% of total client assets, which is a normal amount. This percentage is down significantly from 10-12% during the financial crisis. Given already normal levels, it seems unlikely that cash levels will further decrease materially, even in a bull-market environment. (Note that if client cash levels decreased materially, LPL's earnings would be negatively impacted.)
     
    The anchor bank agreements are structured with a sliding scale, so that the margin that LPL earns over Fed Funds will compress as interest rates rise. As a result, the company is less sensitive to interest rate movements than Schwab or other banks especially as Fed Funds increases beyond 2.75%. (As Fed Funds rises above 2.75%, any additional interest is paid to the client.)
     
    A smaller portion of LPL's client cash is placed in money market funds (MMF) which earn LPL 15bps today. As Fed Funds increases above 1.25%, LPL will earn approximately 55bps on its money market assets instead of the 15bps which it is earning today. Figure 1 below highlights the sensitivity of LPL's earnings to rising interest rates.
     
    Figure 1: Interest Rate Sensitivity 
    Fed Funds                   2011 EPS        % Increase
    Current (20bps)           $1.61  
    50bps                           $1.78               10.6%
    100bps                         $2.03               25.7%
    150bps                         $2.09               29.6%
    200bps                         $2.22               37.6%
    250bps                         $2.35               45.6%
    300bps                         $2.47               52.9%
    350bps                         $2.48               53.5%
     
      
    COMPETITIVE POSITION
    LPL has an excellent competition position due to its "one-stop shop" capability, low cost position and significant scale, leading market share, conflict-free platform and sticky customer base.
     
    LPL is the dominant player for small, newly independent brokers with both fee and commission based business and is uniquely positioned to provide a very attractive way for newly independent advisors to reduce the complexity of running their business. Many wirehouse or bank advisors who break away intend to slowly transition from commission-based brokerage business to advisory fee-based business, which is more stable and often more profitable. Approximately 75% of LPL's advisors have both types of accounts: a brokerage, B/D-affiliated account for commission-based assets and an advisory, RIA account for fee-based assets. Using both types of accounts significantly increases the regulatory and reporting complexities for an advisor operating his own business. The advisor must operate under two different regulatory regimes (FINRA and the SEC) and must comply with two different standards of responsibility (fiduciary and suitability). The advisor must also integrate data from multiple entities for reporting purposes. LPL provides a "one-stop shop" for advisors by providing both RIA and B/D affiliations, as well as the compliance, clearing and reporting services for both.
    The company enjoys a low cost competitive advantage due to its significant scale advantage in the small independent advisor niche. LPL is the largest independent B/D and has invested over $500 million in technology systems over the last 10 years, enabling LPL to serve smaller advisors at a much lower cost than competitors and to do so very profitably. (See Cerulli Associates for 3rd party market share data - I can't reprint here.) LPL also has the ability to self-clear (other custodians typically outsource clearing to a firm such as Pershing), which eliminates a significant cost. It is unlikely that a smaller firm would develop the capability to self-clear since it is costly to do and requires massive scale. Additionally, as the largest independent B/D (by advisors and assets), LPL is able to negotiate favorable pricing with a number of product manufacturers (e.g. Vanguard, Franklin, etc). 
      
    LPL offers a conflict-free platform, which many advisors find quite attractive and use as a selling point with prospective new clients. Unlike other custodians (e.g. Fidelity) or wirehouses (e.g. Merrill Lynch) which are also product manufacturers, LPL is solely a distributor. This avoids the conflict of interest that in-house advisors face when they are incentivized to sell proprietary products (because in-house products are structured to generate larger commissions for the parent company). Many advisors find this quite attractive and can use this independence as a selling point to new clients. LPL has also built a team to provide investment recommendations and managed products to its advisors, which many advisors find useful. Approximately 60% of LPL's advisors use LPL's managed investment products or investment recommendations.
    LPL's business is very sticky. Advisors almost never leave voluntarily because of the paperwork involved in re-authorizing a client with a new custodian. It is a significant administrative hassle for both the advisor and the client. LPL's advisor retention rate is approximately 96%, which includes involuntary advisor departures as well as retirements.
    In summary, LPL has built a strong competition position with an excellent service offering and significant scale that allows the company to earn a 40%+ adjusted EBITDA margin serving small advisors that many other custodians do not even want (i.e. Schwab and Fidelity) and that wirehouses do not care too much to keep. This speaks to the power of LPL's low cost business model: this is a very good business with high margins and low capital intensity. 
     
    THE INDUSTRY
    Over the last several years, increasing numbers of financial advisors have "broken-away" from wirehouses and traditional firms in order to establish an independent practice, and this trend is likely to continue for many years. Going independent can meaningfully improve an advisor's bottom line, assuming he can bring a majority of his assets with him. While advisors at wirehouses, insurance B/Ds, regional B/Ds and banks typically take home 30%-60% of the production revenue that they generate for their parent firm, LPL's advisors earn an average of 85%-90% of their production revenue before overhead. With overhead typically costing ~20% of revenue, an average independent advisor would typically earn ~65-70% of the production revenue he generated, which is considerably higher than the average economics at a wirehouse or B/D. Independent advisors can also build equity in their businesses, which they can monetize by selling their firm upon retirement.
     
    Going independent also provides substantial lifestyle benefits: being able to set your own schedule, not having to deal with the bureaucracy of a big financial institution, not having to worry about the financial health of the parent company, etc. As discussed in the "Competitive Position" section, independent advisors are able to offer conflict-free advice and are no longer encouraged or incentivized to sell their own company's proprietary product.  Overall, the share of advisors who are independent has increased from 37% in 2004 to 40% in 2009. An industry source (Cerulli Associates) expects this percentage to increase to 47% by 2014.
    The breakaway broker trend paused during and in the immediate aftermath of the financial crisis mainly for three reasons. First, wirehouses began paying large retention bonuses to their top producers. Second, market turmoil makes advisors more hesitant to leave their existing job and take the risk of starting their own business. Third, during poor market performance (and likely losses for clients), it becomes more difficult for advisors to retain client assets when going independent. The trend has started to recover now that markets are more stable and that retention packages are beginning to roll off. Because the primary reasons for going independent before the financial crisis still apply, the trend toward independence should continue going forward. Importantly, LPL serves the two advisor segments that are growing the most rapidly - dually registered advisors and RIAs - as well as the independent B/D channel. LPL has taken market share over the last 5 years and will likely continue to do so going forward. (See Cerulli Associates for the market share data.)
       
    MANAGEMENT AND PRIVATE EQUITY OWNERS
    Management is smart, driven and likely to grow per share value over many years. The team is led by CEO Mark Casady, and the team has proven to be excellent operators even in changing and tumultuous market conditions. For example, management structured the cash sweep programs with the anchor banks during the depth of the crisis and extracted favorable terms on 5-7 year contracts when the banks were in dire need of capital. Additionally, by structuring the payout grid so that EBITDA is product-agnostic, LPL's cash flow is quite steady and the business is able to handle a reasonable degree of financial leverage. Management also has smartly dealt with potential new products that could have potentially adversely impacted cash flow. Most recently, management found a way to offer ETFs without seeing any decline in cash flow by offering asset allocation wrap products and also introduced an independent RIA platform to stem departures by its highest producing advisors. Most importantly, management has created a wide moat for the business by making smart investments in technology and gaining scale in order to become the low cost leader in their niche.
     
    Mark Casady is chairman and CEO of LPL. He joined in May 2002 as COO, became president in April 2003, and became CEO and chairman in December 2005. Before joining LPL, Mark was a managing director in the mutual fund group for Deutsche Asset Management, Americas (formerly Scudder Investments). He joined Scudder in 1994 and held roles as the head of global mutual fund group and head of defined contribution services. He is former chairman and a current board member of the Insured Retirement Institute and serves on FINRA's board of governors.
     
    Robert Moore is the CFO of LPL. He joined in September 2008. From 2006-2008, Robert served as CEO and CFO at ABN AMRO North America and LaSalle Bank. Before this, Robert worked as CFO of Diageo PLC, Europe and Great Britain.
     
    Esther Stearns is the COO and President of LPL. She joined the company in July 1996 as chief information officer. Prior to joining LPL, she was vice president of information systems at Schwab, where she worked for 14 years.
     
    It is worth noting that over the last 10 years, LPL management has focused on driving and managing the company's rapid growth, both organically and through acquisitions. The company has recently begun to focus on squeezing inefficiencies out of the business model. During the financial crisis, management reduced general and administrative costs by over $100 million through a 10% headcount reduction, integrating an acquisition and other productivity initiatives. The company's increased focus on expenses should provide an opportunity to improve the company's already high level of profitability.
     
    Capital Allocation
    Management is likely to prioritize the paydown of the company's debt until it achieves an investment grade rating, which is likely to happen when Debt / Adjusted EBITDA is below 2X. The company intends to refinance its debt once it reaches investment grade, which could save as much as 50% off of current interest expense, assuming that interest rates do not rise from current levels. The refinancing should provide a material boost to earnings.
     
    The team has had a successful track record of making acquisitions, which were historically needed to build scale and widen the company's competitive moat. Management has a 40% pretax ROI hurdle (cash on cash returns 3 years out) for acquisitions. Given the scalable nature of its business model, LPL can cut out a number of costs from acquired firms and retain the advisors along with their assets. Additionally, in the current low interest rate environment, LPL's favorable cash management (higher yield on cash) and sponsorship agreements (lower fees to manufacturers) allow it to pay more than many competing firms while at the same time earning more attractive economics from the acquisition. LPL's ability to pay a higher price and generate a higher IRR is a substantial advantage. LPL has a dedicated acquisitions team and CEO Mark Casady is focused on acquisitions going forward.
     
    Private Equity and Management Ownership
    LPL went public in November of 2010. The management team initiated the IPO process because it expected that taxes would increase in 2011 although neither H&F nor TPG sold any shares in the IPO or the recent secondary offering. The continued ownership of H&F and TPG provides added comfort that the company will maintain disciplined capital allocation going forward.
     
    While LPL management retains a significant ownership stake in the company, Casady and Stearns sold some stock in the IPO. While management selling is not a positive, it is noteworthy that both rolled all of their equity in the private equity buyout and this was their first liquidity event. Casady still owns $60 million of LPL stock, which represents approximately 85% of his net worth, while Stearns still owns $20 million of LPL stock. Thus, we are not overly concerned about the management stock sales. Note management's variable compensation will primarily be determined by Adjusted EPS growth.
     
     
    PRICE
    LPL currently trades at a 14X normalized P/E (assuming a Fed Funds rate of 3%), which we believe is a significant discount to intrinsic value. The current price does not reflect the company's low-risk, scalable business that has the healthy industry tailwind of advisors going independent.  Given the company's strong competitive position, ability to take share and likely robust industry growth, we believe LPL will grow revenue 13%, EBITDA 19%, EPS 26% annually from 2010 through 2015. Note these growth rates assume 4% annual market growth and modest increases in interest rates. We believe an investment in LPL is an excellent risk/reward with a likely 5 year compounded annual return in the low-to-mid twenties with low risk of permanent capital loss.
     
     
    RISKS
    Market exposure: A material drawdown in the equity markets would have a negative impact on LPL by reducing assets and inhibiting advisor recruitment.
    Continuation of the breakaway broker trend: The breakaway broker trend could fail to return to pre-crisis levels. However, the advantages of breaking off have not been dampened. Market conditions have improved and the retention packages paid to advisors are beginning to roll off. New advisor growth has recently improved in the fourth quarter of 2010 and the first quarter of 2011.
    Decline in the Commission Rates: Commissions on investment products have declined over time, and may continue to decline in the future. Since 1990, mutual fund commission rates have decreased by approximately 50%. Over the last 5 years, LPL's commission as a % of AUM has decreased slightly. It is worth noting that LPL's robust historical growth has happened in the midst of this market decline in commission rates.
    Competition: Schwab and Fidelity could potentially begin to target smaller advisors and/or begin to focus on commission-based and dually-registered advisors, neither of which they have done historically. While LPL's existing customers are sticky, competition could slow growth.
     
    Regulation: As one of the largest distributors of variable annuities, LPL is exposed to some future regulatory risk (although the recent Dodd-Frank legislation did not impose any new restrictions). The downside for LPL is mitigated by the company's product-agnostic pricing grid. Nevertheless, variable annuities are a major source of income for LPL's advisors. Increased regulation might make the independent model less viable, and make it harder for LPL to recruit new advisors.
     
    Additionally, the regulatory treatment of LPL's cash sweeps could change for banks, which would impact LPL's business model. Again, there is no evidence of any change on the horizon now.
     
    CONCLUSION
    An investment in LPL is a compelling risk/reward.  LPL's business has an excellent competitive position in an attractive, growing industry. The company stands to benefit from a rising interest rate environment and smart capital allocation. The company is run by a motivated and smart management team. The stock is currently trading at a price that represents a substantial discount to intrinsic value. 

    Catalyst

    Although this investment is not catalyst-based, the stock will likely benefit from strong "same-store" sales, rising interest rates, an attractive debt refi, smart acquisitions and healthy new advisor growth.
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