LPL Financial Holdings, Inc. (NASDAQ:LPLA)
Citi 2013 US Financial Services Conference Call
March 05, 2013, 09:40 am ET
Dan Arnold - CFO
Its good to be here and before we begin, I do want you to please take note and if you pull up, I can do that, our customary Safe Harbor slide and disclosure on the content regarding forward-looking statements that will be made in the presentation. So I still didn't get it there, here we go.
So I think a couple of things, as we start this morning’s dialogue. Its always a good place to start with the overall purpose of our model which is at the end of the day is to really provide advisors with a versatile and cost effective business platform that enables them to deliver personal conflict free financial advice to a wide variety or a range of clients in the marketplace.
And in doing that and with respect to any business line that we ever enter, our aspiration or objective is to be a business leader within that business line and you can see for over the past 17 years we've successfully been that leader in the independent broker-dealer space and then beginning in 2007 we became the largest investment service provider for banks and credit unions. And I think if you look at our trend in advisor recruiting over the past couple of years especially last year where on a net new advisor basis we were the leader in the marketplace. This certainly would suggest that continued churn towards leadership within these two business lines.
Now if you think about beyond that the principles of which we might drive or manage the business by, there is one key characteristic that is critically important to our overall business model and that is ensuring that independent conflict free relationship with both the end investor and the advisor. Now how we do that across the end investor is offering no proprietary product, so there's no sales quota as to drive certain sales of products and in no way former fashion do we ever conflict with the advice that's being disseminated to that advisor with potentially offering investment banking or proprietary trading activity.
With respect to the advisor and our way to avoid ever being in conflict with them is simply just not competing I them and so we don't offer any direct to consumer type services or business activity and at the end of day, our sole purpose is to develop capabilities, functionality to ultimately empower and support that advisor to better service their prospects and clients.
Now, that overall principles and business model and construct has certainly served us well as earning the provider of choice for advisors who are really seeking a true independent environment and I think that certainly is a primary reason for the amassing of the fourth largest number of advisors in the industry today and continued expansion of our market share in the independent space where today we're today two times larger in terms of share than the next largest competitor.
I think just as importantly is where it has us positioned going forward, and as you can see, through some outside research, where advisors rank LPL number one in terms of potential destinations as a service provider in the future and this was again taken for advisors who were exploring potentially some type of re-affiliation. So this model is clearly attractive to those that are exploring this independent approach to disseminating and offering investment advice.
Now with respect to the industry trends and some of the things that I think as we think about the industry and how it impacts our opportunity set, we actually look at it across two different dimensions, the first one to be the size of the addressable assets out in the marketplace and then secondarily, that affiliation preference for advisors. And so if you take the first one, so it really suggest that last year we reached 27 trillion in addressable assets in the retail marketplace; certainly a sizable opportunity set and as you look forward the demographics are in our favour that would continue to positively increase our growth and opportunity set. And if you look at the baby-boomers as one example of demographics, we have over 10,000 baby-boomers retiring on a daily basis and if you look at over the aggregate of this decade, we will increase the number by 50% of people who are in retirement and that tends to obviously create money in motion and opportunity to invest from a retail standpoint. So we certainly like the trends and think they are favourable at the retail investor levels in terms of our model.
With respect to the affiliation of advisors, again so really would suggest that there will be this continued transition from the employee based structure of affiliation to the independent model and so they would suggest the warehouses are likely to loose as much as 7% of their market share over the next couple of years, largely at the expense of the independent model and of your RIA segments of the industry. And I think if you look at some additional in terms of the pace or the momentum behind advisors looking to re-affiliate, we think we are much in the third or fourth ending of this overall secular structural trend and as many as 22% of the advisors in the marketplace are potentially looking to re-explore, re-affiliate with another provider over the next couple of years. So again, I think you have that continued and consistent trend towards this independent model and the pace of which is we expect to remain consistent over the next couple of years.
So with that in mind and with the belief that these long-term structural trends will stay favorable to the market, over the last couple of years we have made the investment to plant the seeds for future growth and continue to invest into the model notwithstanding some less favorable market conditions, right; when you look at interest rates, when you look at investor engagements and when you even look at some of the uncertainty around government and regulatory policy. And so we intended to focus in a couple of different areas with respect to that investment and largely to expand the scope in market reach of our model and again that’s across two key areas; that would be across our advisors ability to service and support more potential clients out in the marketplace and then adding to the versatility of our model or the broader appeal to a diversified set of advisors that are potentially looking to potentially re-affiliate with a new partner.
So if you take the end investor dimension, first off, what we have done over the last couple of years through the acquisition of Fortigent to the organic build out of NestWise, we’ve really positioned our advisors now to successfully compete potentially 92% of the assets that are out in the marketplace which is up from 2009 of only 66%, so thus expanding their opportunities set for providing them the functionality they need to successfully compete at both that high network part of the marketplace, the affluent part of the marketplace and then at the other end of the market down and what I would call more of the maps and middle market segments.
At the same time, we’ve looked at the trends associated with the advisor trends and we certainly see the popularity and growth in the RIA market. So back in late 2008 we built out a hybrid RIA solution and this is a unique solution in the marketplace because its an integrated brokerage and RIA platform and that's what it allowed to do is the advisement that potentially was leaving the warehouse and would be affiliating and focusing on RIA.
This allowed them not to leave those brokered assets behind but bring their entire book-of-business and their entire client base and integrate it inside one platform and thus positioned us to participate in that fast growing RIA segment of the marketplace with a unique offering.
The second thing that we've done along the way is we acquired a retirement services capability which gave us the immediate market leadership role in both the scale and size of assets within our retirement services program but also the functionality and capability set to attract more assets and more advisors that specialize in retirement services.
Now because of the long-term trend and opportunity in the retirement space what we also did is added the organic investment behind that acquisition of both developing an implant advice capability which expands the revenue opportunity associated with these advisors focused on retirement services and we also have now developed the rollover capability which now allows as participants move out of those plans into an individual account, the revenue opportunity associated with our advisors to do that in an efficient and effective way and position them to maintain those assets on a go forward basis.
So again, this has given us a diversity and a capability that's unique in the marketplace that has also been very helpful in attracting advisors. So if you look at these two segments of our business, they will represent as much as 30% of our recruiting class or new advisors in 2013. So, very meaningful ways of which to broaden the versatility of our model to make it more attractive to a broader set of advisors.
Now, if you look at those investments over time and look at our strategy over the past 12 to 13 years, you’ll see something that very much aligns with what I was describing. So up until 2008, it was a period of focusing on expanding and growing scale to amass if you will the critical mass necessary to efficiently effectively and competitively operate our model.
And then, we turn to expanding the market reach and scope of the model and that's what I just described across both the end investor opportunity set as well as the advisors. And so, now that we have our footprint in place and we've reached the outer targets of our desired scope and we've amassed that scale, there's the great opportunity now to turn inwardly and focus on our core model and our core platform and continue to strengthen it offer the benefit of the support of the almost 18,000 advisors that now leverage and use our model today.
So, if you think about what that means going forward, I would frame it in really three ways. What we will do is continue to add technology and automation and align that with business intelligence to help our advisors create more capability to grow their practices.
We will continue to deliver technology automation as well as new outsourcing capabilities and services that will allow advisors to lower their operating costs associated with their practices and potentially reallocate the time they spend on back office work, which is as much as 30% of their overall time spent and reallocate that to focusing on servicing their clients and growing their practice.
And then finally, it would be focused on simplifying that interface with our advisors, making it more intuitive, more personalize so that they are able to optimally leverage the capability set at LPL and align them in a personalized and customized way with the needs of their unique practice.
And we think together these things will continue to drive the key fundamental growth drivers of our model. So at the top part of this slide is really focused on growth, and again I think our key characteristics of organic growth are growing things towards sales, which you guys pointed out is probably the best opportunity to continue to drive value inside the model.
It's also to continue to extend the successful trajectory of the addition of new advisors and the positive impact of ramping up of and maturing of those new advisors to our model. And then finally, adding new services that we can charge additional fees for. So that creates three different levers of which to drive that growth.
At the same time, we always are focused on that operational efficiency and if you think about the operational efficiency in terms of the incremental growth, creating additional margin expansion as a function of scale. If you also think about it from the standpoint of the absorption of the up waiting of the investments that we've made in 2011 and 2012 and then you overlay that with the service value commitment which is an initiative within our overall strategy that we announced with fourth quarter earnings which is really focused on accelerating the driving of efficiency within our overall mode and I will drill down on service value commitment and give you some framework for that.
But it is meant to be an overlay or an accelerator of the natural benefits of scale and the absorption of the up waiting of investment. So with respect to the service value commitment, it is a strategic initiative within that overall strategic scope that I described, it is about improving and enhancing our core model. First and foremost, it's focused on improving the service experience associated with our advisors, it is intended to simplify their operating environment as well as ours and then ultimately it is meant to challenge us to focus on our core differentiators and invest in those core differentiators that drive the most value while finding a better, faster and cheaper way to outsource some of those transaction more administrative oriented task.
So what we did was made the decision after evaluating our opportunity set to outsource many of our back office non-customer facing functionality and what we have identify is areas like finance, like human capital, like back office operational, new account setup is an example, things that or an opportunity to leverage a global outsource provider who can help us do this in a better, faster and cheaper manner and at the same time then ultimately drive operating efficiency into our environment and allow us to maximize our focus and investment on those key differentiators in our model.
So from an economic standpoint, you will see that we have an overall estimated restructuring charge of $70 million to $75 million which will occur over the three-year period of time from fourth quarter ‘12 through ‘13 and ‘14 and which will ultimately produce as much as $30 million to $35 million of annualized operational segments.
And so if you look at some the ultimate effects of the strategy across different operating environments, you will see that the model continues to perform regardless of the market conditions returning and continuing to provide and generate growth both at the top line and at the EBITDA level.
And I think its most interesting if you look from 2010 forward in a top operating conditions all right, a lack of investment engagement, low interest rate environment, we have continue the trend of revenue growth, I think the model on the right also shows you the up waiting in investment that’s occurred in ‘11 and ‘12 to create those seeds of continued growth by expanding our footprint in the marketplace and positions us well to continue that march back towards both EBITDA growth and margin expansion on a go forward basis.
From the cash flow standpoint and the capital management standpoint, we are in a business that is a good consistent generator of free cash flow, it’s a cash flow right model that gives us the ability to balance investment strategically in the business to drive future growth as well as it has been balancing that against the return of capital to shareholders and so this gives you a view of 2007 through 2012 free cash flow creation.
And if you use 2012 as a proxy for thinking about this, I frame the way that we think about free cash flow generation in this way, using $250 million in 2012, I would frame it as an approximately a third of that cash or capital would be used to manage our obligations associated with quarterly dividends as well as repaying debt, a third of that would be used for strategic investments. So typically CapEx spend, so think about our strategy in delivering new technology inside our core model as a great example of the use of that capital and then finally that would leave about a third for discretionary purposes. So a great example of that would be repurchases or share buybacks and obviously in the second half of 2012, we saw a great opportunity of the price being discounted below its intrinsic growth and prospects and ultimately we are opportunistic in buying back some of those shares in a significant way in the second half of the year. So again that's how I would think about using our free cash flow as a means of both returning capital as well as strategically investing in the business.
A few comments about the quarter itself and how things are shaping up. We came out of fourth quarter and in our earnings shared with you the growing momentum in the business as we saw investors reengaging, and just as importantly advisors reengaging. As they saw clarity beginning to emerge associated with tax policy as an example, they were able to develop a longer term point of view on the appropriate advice for their clients, clients have begun to put back on or have a bigger appetite for that risk on trade and you see this reengagement occurring that we have seen sustained both through January and February.
I think some of our question coming into to this year was, was it just a phenomena around tax planning and that the reengagement and the activity would somewhat fizzle out after January, but we've seen it sustain itself through February which gives us encouraging multiple data points that we do have a more sustained investor reengagement in the business. So that's certainly an encouraging sign and we see that in terms of improvement and enhancement in sales commissions per day, per advisor as well as the trading level that's occurring underneath that.
We also see a continued strong pipeline in our business development or recruiting of new advisors. In the first quarter there's always the ramping up effect associated with recruiting or adding new advisors. So it’s not a linear type of pattern of adding new advisors. So where the first quarter won't be as robust as the fourth quarter if you look at the aggregate over the full year, our pipeline remains strong and we feel great that of sustaining the recruiting results that we have in the past couple of years.
Finally if you look at operating expenses, we try to provide more guidance and more clarity relative to the overall operating environment of our model and we gave some guidance at the end of fourth quarter relative to the sequential growth of what we call our core expenses of $5 million and we are sticking to that guidance and on the next slide it gives you a little bit better perspective around the dialogue associated with our G&A.
So here what we try to do is focus on what our really core operating expenses are. So we've taken out things like depreciation and amortization, advisor payout and the cost associated with recruiting as an example. So these are more of your stable consistent operating results associated with managing the day to day business, and you can see from this graph that we continue to maintain our guidance around 6% to 7% growth year-on-year in this core expenses. Now, that’s down from about 10% to 11% from 2011 to 2012, which again was a function of the upwaiting of the investment that we made to expand our market reach and scope of our model.
And I think what's important to think about that overall 6% to 7% as an average throughout the year. So what you will see in the first part of the year is that number is larger on a quarterly basis, more in the high single digit level as we continue to absorb some of that upwaiting in investment and spend in 2012; and by the second half of the year, that will be fully absorbed and you will see more quarterly growth year-on-year and your expenses in the more 4% to 5% range, which we think is a much more normal level for the business given the prospects of revenue growth this year. That gives you a little bit of a framework and a bit more transparency around how we think about expenses going forward.
So in summary, the model from an opportunity standpoint is certainly we have a leader in the space that we operate in, who continues to expand its share of the market. We’ve got the favorable market trends and structural trends that are occurring both at the end investor level as well as at the advisor level. The fundamental growth drivers are in place and continue to perform across markets and the momentum behind those growth drivers have certainly picked up over the past quarter, and then finally you have that strong generator of free cash flow that can be deployed well back to shareholders because of the capital light nature of our overall balance sheet.
And with that should we move to Q&A or you want to need to take some from the crowd or what?
Sure. I will start up the Q&A. Dan you mentioned possibly in the third or fourth inning of the ship towards independence, from the perspective of the finance advisor, what is really driving them to the LPL model?
If you think about it from a macro standpoint, it's appealing if an advisor can and look at their overall environment and by going to the independent model, double the compensation they make for the same of production, create their own business that they can create long term equity; and ultimately have the autonomy to run and drive their own practice. So that is the starting point that creates a very appealing option relative to an employee base affiliation, and again I think like any other disruptive model it occurs over a long period of time, where it typically starts with the smaller customers within any industry and it expands and grows up to your larger customers overtime as people have kept with that methodology, it's proven the work in drive out the expectations and attributes they expect associate with it.
So that’s why we think again you will see this continued trend, there is still a lot of assets and a lot of advisors in employee based models, but we are seeing larger and larger advisors, explore and ultimately transition to the independent model. So that’s why we say we are in the third or fourth ending and we are beginning to get into a whole new set of advisors that have explored, but not moved now they are beginning to make that transition.
You also mentioned that the pipeline looks strong, going into 2013, what are some sort of the trends you are seeing around they are grouping for the breakaway phase in pricing and so forth?
Yeah, so there is couple of areas there, if you look at our recruiting in ’12, roughly 70% to 75% of the source of those recruits came from other independents or from the wire houses. We see those opportunities continuing in ’13; a lot of the success coming from other independents is a function of the market place creating constraints in terms of financial performance for some of those other independent and which make it hard for them to continue doing invest in their model and thus their advisors began to explore a better solution or opportunity set.
So we see that opportunity continuing and we also see this continued trend out from the wire houses as truly noted in their research as much as 7% of the assets and I think the wires have roughly 43% of the assets today. So over the next couple of years you will see that trend down to 35% and we see most of that either going to the [RAA] market place where the independent market place, of which we are participant in both. So we like our positioning relative to that trend as well.
So for in January and February we’ve seen a rerisking into equity. Your model is more of a distributor than a manufacturer. How does the rerisking to equities impact your financials either short term or longer term?
Yeah, whether it’s the mix of assets is not overly important, I think it’s certainly a bigger driver above our overall profitability would be the use of advisory versus brokerage and that our advisory platform tends to have higher margins then our brokerage platform. And we do see continued trend towards the utilization of advisory as a sustained trend of our advisors and brokerage and that remains regardless of market conditions or appetite for risk of the end investor. I think as it relates so in more on an indirect way as end clients are willing to take more risk and have an appetite to take more risk, I think it just has a general positive impact on the overall flow of assets into this part of the marketplace which we obviously indirectly benefit from that.
Okay, maybe we could open up to (inaudible), any questions? Okay, I'll just continue until anyone has a question. Dan you touched upon free cash flow and I think you ticked off a couple of areas, is there any preference, the one you can tell me I mean you pretty evenly allocated them, is there any preference?
Yeah, we've seen certainly the value of share repurchases as I especially in where our stock was discounted back in the second half of the year is a great opportunity to maximize that value to the shareholder and return that capital in an efficient way that creates the ongoing value associated with the lift in earnings per share and the benefit of the future growth of the stock for the shareholders.
With that said, we are always trying to balance that against the impact share repurchases would have on the overall growth in the marketplace which is why you see issues, a diversified approach in returning capital and using that quarterly dividend as a way to also distribute capital and I think most of you probably saw we raised our dividend for beginning in Q1 of ’13 and again with that confidence of that expanding growth in the business and earnings creation it ultimately allows us to continue to increase that form of return of capital to shareholders.
So I think, if we look at in a very balanced way and trying to meet the needs of the diverse base of our investors by returning capital in the most efficient manner and in a way that I think balances out the aspects of the positive and potentially challenging aspects of share repurchases and dividend.
Okay, and switching gears a little bit, I think during the fourth quarter call you gave some additional thoughts around interest rates and possibly when the yield compression might come to an end I believe you indicated 2015, is there anything you can do to move that out or how are you looking at it at present?
Yeah, so our sensitivity to interest rates really moves down to our cash deposits and more specifically the FDIC insured cash program that we offer that we call ICA. And back in 2009 when the world was in a place of uncertainty, we began to ensure that the capacity for our ICA program was there with our banks and because the banks had a desire and an appetite for deposits began to make longer term commitments on a minimum amount of deposits that we would keep that those banks very attractive to banks because it gave them the certainty and predictability of those deposits and thus they were willing to pay our market premium if you will said (inaudible) plus to lock down that commitment and what we did with the latter that in maturities across multiple years.
And so in late 2011 early 2012, we began to renegotiate some of those maturities and you see the impact of those renegotiations as you got a very different environment. Now you’ve got banks that are flushed with deposits and much less demand for overall deposits and thus the premium they are willing to pay has been reduced relatively to that 2009, 2010 timeframe, and so our renegotiations and repositioning of those contracts can be smooth overtime as we reprice those. They don’t have to be episodic in nature where they just flip from one day to the next and we tend to take that approach to smooth out that impact.
We’ve also in those renegotiations made sure that we maintain full upside of [debt] funds repricing, because the predominant driver of our yield in those account is really the Fed funds rate and in a world where we get back to Fed funds rate of 200 basis points, the premium that has been paid on those positives becomes irrelevant at that point because we're capped out in terms of the amount of revenue that we participate in at about a 180 basis points, and that’s just to ensure that we have the right balance of the yield that’s going to the end client versus ultimately what we keep. So I think that’s how we're trying to manage that as in repricing these is smoothing those out over time and the pricing changing over time.
Great, any final questions from the audience?
So, Wells Fargo started out the conference today and they talked a bit about how they are looking at their clients on a more of a holistic basis across product, and so recognizing that advisors are moving towards remodel to be independent, just two related questions on how the wire houses are responding to you and then how client preferences, the need the advisors who are servicing them might be changing, looking for maybe more a simpler, more holistic approach.
Yeah, so let me take the second one first, the end client trends. I think we continue to see through both industry trend as well as research that reinforcement that the end client is looking for that conflict free relationship in orientation and the transparency associated with it and certainly a more holistic financial planning orientation where you are focused on achieving my life goals and dreams and your ability as an advisor to provide me the advice and strategies necessary to help me achieve that.
So we certainly see that trend continuing and we think that that certainly is aligned with how the LTL advisors in their local markets with a very personalized local positioning of themselves to their client based certainly lines up well. We tend to provide them the functionality and the capability set in order for them to provide that holistic approach, and solution orientation to their clients and so with their positioning in the market place and with the suite of tools and resource is available to them, again we think they are well positioned to capitalize on that ongoing trend.
Relative to the trend in terms of the advisors desire and appetite to explore the independent model and the continued interest in this independent model and how competitors may respond; that’s a bit harder for us to say I think we continue to look at our model and look how we continue to add capability, functionality, versatility in our model all for the purpose of we feel like if we can create better growth drivers for an advisors once they affiliate with us to operate their model that are lower cost and better economics for them that at the end of the day that will drive the success of our recruiting into the future, and we will stand up well against whatever competitive response that may occur.
And thank you with that, I think we are out of time.
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