LPL Financial Holdings' Management Presents at Bank of America Merrill Lynch 2013 Smid Cap Conference (Transcript)

| About: LPL Financial (LPLA)

LPL Financial Holdings, Inc. (NASDAQ:LPLA)

Bank of America Merrill Lynch 2013 Smid Cap Conference Call

May 07, 2013, 03:05 pm ET

Executives

Trap Kloman - SVP, Investor Relations

Dan Arnold - CFO

Analysts

[Abrupt Start]

Trap Kloman

But make this as interactive as possible, and we'll definitely be stopping on each page to take any questions you might have, so feel free to jump right in. And with this big a group, we would look forward to having a good discussion on the growth drivers of LPL and the opportunities we see but want to make sure we also level set, so please feel free.

With that, I'll turn it over to our CFO, Dan Arnold.

Dan Arnold

Thank you, Trap and good afternoon everyone. What we thought would be the best approach is to do a flip-turn through the presentation but as Trap said, very much have an interactive session and allow for that Q&A along the way.

If you’ll turn to slide 2 in the presentation and that does a good job of setting context around the high level and overview of our business model. I think the key takeaway on this page is we are very much a mission driven company and it is our belief that dissemination of investment advice is best done in a conflict free independent environment.

And so consequently our mission has been to try to make that type of financial advice available to every American and we do that by creating an industry leading business platform of which financial advisors can lever to ultimately position themselves to offer financial advice in a very objective methodology. And secondarily, to do that across 92% of the potential marketplace and so it's a platform that provides the functionality and capability for them to reach that significant opportunity set.

And so the attributes and appeal of that type of model have led us to what is now a national footprint of where 17,000 advisors access our business platform and business model and in doing so they managed almost 400 billion in assets across a multitude of different types of solutions, so advisory solutions brokerage solutions and insurance solutions.

And ultimately, this has led to industry leading position as we rank as the fourth largest broker-dealer in the country today and in the independent space of which we operate and serve, we are the market leader by two to one to our next competitor. So clearly, we have established a capability that market leadership and a capability side and awareness that comes with that.

What we have also done along the way is demonstrate our ability to grow our share at a faster pace in the rest of the marketplace as we have increased our market share in that independent space or independent channel from roughly 4.5% to over 10% since 2004. So not only are we the industry leader from the scale standpoint, but in that pace of growing share.

(Inaudible) Okay. If you’ll flip to the next page, this does a job of I think hopefully aligning as a mission driven oriented business that is very much focused on dissemination of that independent conflict free advice, then you would expect our model to be designed such that it wouldn’t have the inherent conflicts that might impair that objectivity and so this does a great job, I think of framing and showing you that we don't offer proprietary products that wouldn’t sent us to potentially sell those products versus another one.

We don't offer investment banking of which potentially could be in conflict with the dissemination of the financial advice; we don't trade in our own proprietary account or make markets, and so what we have really try to do is eliminate any potential conflict that may occur within the model. Now what’s that done is actually as you can see from the graph on page three, is created a differentiated model in the marketplace, which is also been instrumental, we believe in attracting new advisors and helping ultimately those advisors attract new end clients. This independent conflict free approach tends to resonate across both those dimensions, both the advisor and then client dimensions.

If you go to the next slide, just began to speak to some of the favorable secular trends that we get to benefit of out in the marketplace and there is two really been described on page four. One is the growing opportunity set just associated with the expansion of addressable retail assets. Now in the presentation, you see $27 trillion asset level that’s actually a 2011 number, I think its closer to $30 trillion if you are looking at 2012 in your number.

And we have seen good and solid trend in terms of the overall addressable assets overtime, but we think that because of the demographics associated with the baby-boomers and the demand for retirement advice and insight that that will be catalyst to continue to expand and trend this asset level up or the opportunity set up. And I think by the end of the decade, we may have this many or 78 million retired American, so clearly a need and clearly an opportunity in terms of advisors to step in to that need in the marketplace.

The other key secular trend is this notion or this phenomena of advisors moving from the employee model to an independent model and of course this was started many years ago and we've seen it accelerate post the 2008-2009 market displacement, but this is a trend where we see the appeal of the independent model versus the employee-based model and where LPL as a leader in the independent model and as a net leader in attracting net new advisors over the past two years demonstrates how we are positioned to capitalize on this secular trend. I think Cogent did some great research that shows over the next two years LPL is by far the destination of choice or interest over advisors who will consider to re-affiliate; so we think that that bodes well in terms of positioning in the model to capitalize on this secular trend.

Any questions on that?

Question-and-Answer Session

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, right. So one of the reasons why an advisor would be interested in the independent model versus their employee based model, there's three principal reasons. One is the economic driver and if I earn somewhere around 40% of the revenue that I generate today in an employee based model, in an independent model I’ll typically net somewhere around 65% of the amount of production I produce, so let's call it a 50% increase in pay for producing the same amount of revenue.

The second reason they we would be interested is, they are actually creating their own business, so there's the opportunity to create equity value in that business with some monetization event at some point in the future whether that be selling that practice or even a transition to a family member or what have you.

And the final reason they would do it is because of the autonomy of positioning their practice branding it at around themselves and their local market and not being necessarily forced to follow guidelines around which products to sell and how to sell them that having pure autonomy to try to align their practice with the best interest of their end clients would be the three primary reasons.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, so this is just a subset of them; it wasn’t meant to say that these are all the competitors as much as only room on the page allows us to highlight so many of them and what we try to do is capture a mix of warehouses of regional firms and even other independents. Okay.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, there's no one that has aligned their model in this framework exactly positions us, a great example being take Ameritrade down at the bottom is a great example and Charles Schwab, they both have direct-to-consumer business lines. See our model is to never get in between the end investor and our advisors, so we are very committed to working on behalf of the advisor versus going direct to the consumer.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

It doesn't, other than the stability behind the advisor and so from a branding standpoint they would care much more about who we are to scale versus any certain type of capability set that we would offer down at that direct consumer level.

Unidentified Analyst

But at the consumer level, when they get a statement or what have you, does it even have your name on it or just the local advisor?

Dan Arnold

It does. For regulatory purposes it has to have disclose us as the broker dealer or the registered investment advisor. What it also does though is this, it includes the brand of the local office or practice. So if you turn to page five, those secular trends ultimately, this reinforces how we're positioned to support those secular trends and capitalize on them. So we've done that up to this point as I said before. It's helped us grow as the fourth largest broker dealer in the industry and at the same time we think that market leadership in this independent space and because we think that trend of transition to the independent channel is only in the third or fourth innings of a nine inning game, we've (inaudible) well positioned to continue to capitalize on that in the future. What we've also done is because of the functionality and the capability set we offer, it enables that advisor to meet the needs of some 92% of the investible market place out there as that macro investible asset market place grows, it certainly positions us and our advisors to capitalize on that.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yes, it's the ultra high net work. So that 20 million of investible asset and above, we’ve carved out and simply haven't focused on investment there to ensure that we either can meet those needs of those types of investors at that level or specifically have chosen not to because we don’t believe in the economic opportunities at that level. It's a very customized, personalized model of which it’s a crowded space and we think there is ample opportunity down below that to meet the under serve investors.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

It would typically speaking I think we’ve if you looked at our overall client mix, it would what we would be, what we could call the massive (inaudible) a $100,000 of investible assets up to a 1 million. Over the past five years, we’ve extended that upto the $20 million range through both organic functionality build out as well as acquisitions. So now I suggest to you it's the mass affluent up to what I would call the high network up to $20 million of investible assets. And that doesn’t mean that some of our advisors may not have one or two clients that are above $20 million, but it just means that typically we are not attracting a practice that just focuses in that area, that’s what I mean by that.

Alright. Have you turn to the next page, page six, this shows you the evolution of our strategy since the year 2000 and there three distinct phases I think which you can carve it into the first from 2000 to 2008 just before the market dislocation. Our focus was building scale and we did that through both organic and acquisition, and at the end of day, it was meant to create the scale. So we have the stability to manage through different market cycle and different challenges in the business to ensure that we have the right economic of which to ensure that we could provide a competitive solution to the market place both at the end investor level and to the advisor level.

Post the market dislocation in 2008- 2009 we moved to a phase which was more about expanding our capabilities to attract a more diverse set of advisors. So instead of just traditional independent we now attracted the advisors who were affiliated with financial institutions, we attracted those that actually wanted to operate their own RIA and custody their assets on our platform as well as use our broker dealer. We acquired a firm who had specialized capability set in the retirement services space specifically in the qualified [plant] place that positioned us as a market leader to consult on 401K and 403B, and so at the end of that period of time which you now have there is a much more diverse advisor base and the ability to attract advisors across really any different segment that an advisor maybe looking to affiliate with an independent firm; and the diversity of advisors gives us a much broader region to the end investors out in the market place, and so during that period of time we saw some up waiting in investments that helped us expand this capability set.

But now that our footprints in place moving into the third phase of strategy in 2013 going forward its really now we turn to focus on investing in our strengths really core model near that 13,000 advisors out there that are accessing the model, and we feel like there is a great opportunity to continue to unlock additional value in our core model to do really three things to help advisors better serve their clients, to help them operate their practices more efficiently and finally to help them more rapidly grow their practices; and at the end of the day this alliance with the key core drivers of our business which is helping create a more fueling solution to attract more advisors, helping those advisors ultimately to gather more assets and generate more revenue inside their practices and finally driving inside our own model its efficacy and efficiency of operation and so opportunity set is big now with that number of advisors plugged into their model and will continue to unlock value and help them expand their capabilities.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah in terms of acquisition of new advisors here recruiting of new advisors.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, sorry so in those cases back in that phase we were very much focused on roll up of other broker dealers who may have been smaller in stature or outsourced at clearing, so their financial performance was very different than ours in terms of margin creation. So you had a lot of expense synergy as well as revenue synergy by integrating those on to our self clearing platform, as well as could expand the functionality that those advisors had. So you tend to have a very high retention of advisors in those transactions and typically they were accretive in the fiscal year.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

You would tend to look at the overall financial performance of the firm, so the revenue and what they are able to ultimately pull down from a margin standpoint and value it off of cash flow.

Unidentified Analyst

I think you are correct to understand that there would a earn-out performance to mitigate that investment for advisor breakage.

Dan Arnold

Yeah no so they are not employees they are all independent contractors so they are not employees of ours and so what we would do is ultimately sign a contract with each individual advisor or a practice of advisors or a group of advisors, yeah. Any other questions on that. So if you turn to page seven those strategies ultimately propel these fundamental drivers and this is what I spoke of on the last page. This is again some of the key growth levers and contributors to our overall financial performance. Up top shows you how we've continued to expand our advisor base since 2000 and again I think as our strategy going forward positions us well to capitalize on the secular trends as well as continue to unlock value on our model to increase the pace at which we grow our advisors.

The second chart there speaks to overall performance at the advisor practice, and if we can continue to help those advisors grow their practice operate more efficiently than they can reallocate that time, effort and energy to continuing to focus on the growth of the practice which creates a more appealing outcome for them and clearly we benefit from that overall aggregate growth and then finally you will see we continue to work on and leverage the benefits of scale, introducing new technology and automation that drives efficiency under our overall effort and then a specific initiatives as part of this new phase of our strategy, its called the service value commitment and that has two objectives, one is to drive overall efficiency into our model by what I will call unlocking efficiencies associated with non-core activities, back office functionality, administrative functionality.

One of the ways that we would do that would be to outsource some of that work to a global provider and so you benefit from the benefits of that labor arbitrage that come with that. But at the same time in doing that and driving that efficiency you also improve and enhance the overall service performance to your advisors as an example you are able to outsource certain things that are don eat scale or done through more automation or efficiency or done around the clock where we only would work from at certain confine times around the Eastern Time zone as an example in the U.S. And so it creates a great opportunity for us to evolve our operating model and drive efficiencies in to our model and through this effort, we expect to drive as much as $30 million to $35 million in additional savings in 2015. So it's a multi-year effort of which that annualized savings would first occur in 2015.

Turn to the next slide, this does a good job of showing the resiliency of our financial performance over the years and that it shows the continued revenue and earnings growth across a multitude of different market cycles and I think one of the things that distinguishes us is that 13% (inaudible) annual growth rate in revenue since 2000 certainly leveraging the scale underneath that. It's able to drive 17% annual growth in EBITDA which over that period of time we've seen margins expand 380 basis points or average somewhere around 30 basis points a year.

And I think if you look at 2008-2009, that market dislocation you see a very resilient model that held up well from a revenue standpoint on a relative basis because of the diversity of our advisor base, but you also see it over in our EBITDA where the variable cost structure nature of our business enables us to pivot very quickly and adjust our operating model to the opportunity set that exist and pull out as much as $100 million of operating cost given the displacement that occurred in the marketplace and thus still produce a trajectory, a positive trajectory on earnings.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, a lot of that has to do with the headwinds in the marketplace due to the interest environment and secondly just in the investor disengagement, which had a big lag on advisor productivity. In fact, I think Q1 of this year, you actually saw that begin to turn and our top line revenue is poised to benefit greatly from new market levels, higher market levels as well as investor reengagement returning and advisor productivity lifting very positively over the -- sequentially over the last couple of quarters.

And to a point now where we would expect improved top line revenue just given the current market levels and advisor productivity, we would expect improved top line performance through the balance of 2013, (inaudible) comps in 2012 are easy. So, that good positive growth versus the comps in ‘12 created an attractive 2013 framework for our revenue.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yes, I think it paid in two ways, depending on what type of business they conduct. If it's advisory business, its asset under management reoccurring advisory fee that’s usually build on a quarterly basis, typically a 100 basis points to 110 basis points and somewhere in that range directionally. And then the other way is that they open up a brokerage account and helped investing a mutual fund or annuity that will generate brokerage commission. That typically is a one-time commission somewhere in the 4% range that generally will have a trail commission on it or recurring commission of about 25 basis points.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, for the most part our advisors offer a mix and that is one of the unique opportunities of our platform is it actually offers the advisor the ability on one integrated platform to conduct their advisory business and their brokerage business. So in many cases that can be a competitive differentiator to many of the competitive set and that they have a harder time doing that or they will only offer custodian capabilities for just advisory assets.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Our revenues.

Unidentified Analyst

Yeah.

Dan Arnold

No, they are both.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, so if you go to page, it’s in the appendix on page 13, it does a good job of outlining our revenue mix, so take a couple of minutes but I will explain it and it will be helpful to you. So the pie chart on top of the page is the gross revenue, all right. And if you look at that, you can see the 50% of our revenue is generated from commissions. Again that is the sale of an annuity, a mutual fund; it is also the trail commissions that come as a part of that, of those products that I mentioned earlier.

The red section of that pie represents the advisory fees that are charge to end clients for advisory accounts. And that blue and that red pie we will typically pay out somewhere on our average around 87% of the revenue to the advisor for those to sources of revenue, okay. So we keep our 13% in that.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Ultimately, the advisor has the ability when discussing the opportunities within an end client and presenting that choice and different options and alternatives. They can help the end client make the best determination for whatever their needs are.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

That's right or somewhere in between, yeah.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

No, the investor disengagement had more to do with the lack of conviction and uncertainty, sorry the lack of conviction around where to place their investments because of the uncertainty and tax policy or the fiscal cliff and that was causing people to sit on the sidelines and wait for clarity and that was the real catalyst point where we saw investors reengage and once there was more clarity on what tax policy would be, you can take a more informed approach about how you would give guidance and ultimately allocate those assets.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Well, you saw a couple of places you see that, one is you saw that in the run up of cash balances in the last couple of months of the year. And so you saw as much as 15% increase in those cash balances over the last two months of the year. You saw that redeployed in January. What we've seen though is continued investor engagement and continued new assets being gathered either through the form of existing clients adding to their positions or advisors adding new clients.

Unidentified Analyst

So that customers had significant cash in your fund and pull over profit situation for you (inaudible).

Dan Arnold

Some of it was sitting in cash, some of it was a temporary build up that got redeployed and some of it is that we saw assets grow by as much as 10% year-on-year which would be reflective of some of the new money coming in.

Trap Kloman

I think one good distinction to make is on the advisory side, there's still recurring revenue stream that both the advisor and LPL benefits from. And at your point on the commission side that's where you can see on the quarterly basis a little bit more variability that the transaction is not occurring, the revenue is not coming in both royalty, on the advisor.

Unidentified Analyst

And I think your profitability on the transaction is higher than it is on the EBIT. I am just looking your revenues going up to the left, that's your EBITDA just plateaued and so the only explanation of the profitability whatever revenues you captures (inaudible).

Trap Kloman

That's the internal nuance and might be best to take offline and have it (inaudible) on that question, but given the time we have left we want to make sure we get to a few final point.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

That's an average number. Actually the payout is a little higher on brokerage products than it is on advisory products and there are production bonuses that we provide to someone as they grow their practice, but that's an average number, but that's in general the way it looks.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Right.

Unidentified Analyst

So is there a ballpark to pay out on the commission side that we should think about versus sort of the 13% that you are talking about on your 5%, all right that's probably something asked or we get keep.

Dan Arnold

Yeah, no, I think typically speaking we've disclosed that average number.

Unidentified Analyst

Yeah, that's a full cycle average advisory and commissions.

Dan Arnold

Commissions together, yes.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, so on a percentage of revenue; it's only about 3% to 5%. It averages typically somewhere in that range across the full-year cycle. By the way the rest of these revenue stream on this pile on the top, the brown, the green and the orange are revenues that we earned as a custodian, as a broker dealer and they are not shared typically with the advisor. So the examples of these would be fees that we would earn on our cash balances as an example; transaction fee that we may charge or an affiliation charge that maybe a charge to the advisor on a monthly basis. So they are recurring in nature, yet they are not shared with the advisor.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

So, I will share with you in this way. From an interest rate opportunity standpoint, if you take our balances in 2012, our cash balances which are roughly $23 billion which is spread over an FDIC suite program and a money market program; and you applied our maximum rate of revenue which we would get to at a Fed fund rate of 200 basis points. We would add as much as $170 million to EBITDA or 400 basis points in margins. So there is obviously inherently a great deal of opportunity as interest rates move for us.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Now, that would move along the way. Right? It's not that we unlock that as soon as it gets to 200 basis points, but it will move as that fund rates move up along the way.

Unidentified Analyst

I think you said just to play devil’s advocate that guy of as you said $100,000 with you one of your advisors, it's five years from now and you can get pretty decent rate on a CD, get (inaudible) money out and buy a CD by himself or you do it through the advisor?

Dan Arnold

Typically the advisor would manage that overall relationship and some reallocation or repositioning of assets would happen through that advisor and through the guidance and advice of that advisor. Does a [client] have the ability to allocate their assets across multiple advisors or do it their selves, sure they are not locked in to just doing it with that advisor. Yeah, okay. So that’s how we monetized business. The final point I will make on this page 13 is everything to the left of that white dotted line is reoccurring revenue in nature, so its predictable reoccurring revenue that’s typically build on a monthly or quarterly basis. So that’s about 65% of the revenue.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

So part of that commissions is trail revenue associated with mutual funds or annuities which is reoccurring in nature. The final point I would like to make that I think is somewhat distinctive of our model is on page 9, which is a good framework of thinking about our cash flow. And one of the distinct characteristics of our model is the consistent cash flow that we create regardless of the growth environment that we are in, and I think the second element of that also the capital like nature of our balance sheet, what gives us great flexibility of which to both reinvest in the business, to support future growth as well as returning value to shareholders in the form of ongoing dividend or share repurchases and if you look back at the second half of last year, you saw it’s very opportunistic in pursuing share purchases as a great way and a great example of trying to drive value to our shareholder. And you see over on the right hand side, how we’ve deployed capital post our IPO late in 2010, and again I reinforce the quarterly dividends that we just started third quarter of last year we just increased them in first quarter of this year and share repurchases being the primary sources or methodologies to distribute that capital going forward, you do see the special dividend being quite large subsequent to the IPO but that was more episodic around the tax benefit from doing the IPO and so that was more of a unique event associated with that public offering, all right, your question is on.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yes, so whether that’s annuity where some people might call an insurance products, other people might call that best product, but we also have a fully capable life insurance agency that supports our advisors. If for example they are conducting in a state plan with our client and you need to integrate both investment management with life insurance to openly create the optimal way of which to transition that wealth to the next generation, so many times that will leverage our interim agency and its capabilities to do that and its been a good growth business unit for us because of the continued trends towards its over archiving comprehensive financial planning approach. So again I might summarize on slide 10, which this is just a review of the many elements of that I just took you through in terms of some of the key investment characteristics of our business.

Just to reinforce you've got the industry leader both in scale and growing share. You've got the attractive secular trends associated with the growing overall opportunity set of investible assets and this trend towards advisors pursuing the independent model. You have good proven track record of performance across a multitude of different market cycles. You have strong cash generation and return of capital. And then finally, there's some fundamental catalyst in the business both in the short run from top line revenue growth and managing of our core expenses as well as some of the long-term opportunities associated with the interest rate that we talked about as well as our service value commitment driving long term savings.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, and that's where we are a bit different from swab and that today swab’s offering would be primarily to as a custodian of their advisory assets, but they don't help an advisor with their brokerage assets. And thus what they would do would be to have an advisor plug into their model as custodian for their advisory assets and then have the brokerages, a friendly broker dealer to try to conduct their brokerage business or have them leave that brokerage business behind wherever they left.

For us we actually will allow an advisor to plug in their own advisory firm and custody their assets with us and use our same integrated platform to conduct their brokerage business so they don't have to leave that brokerage business behind or they can do it in a very efficient manner and that's one of the big differentiators of our hybrid RAA model and we've quickly expanded that model which we built in 2008 and now it has close to $50 billion of assets on it because of that unique capabilities.

Unidentified Analyst

(Question Inaudible)

Dan Arnold

Yeah, I think in the past it has been discontinued headwind in terms of investor disengagement that caused a challenge in terms of advisor productivity. And I think that further we get away from the market dislocation back in 2008-2009 and with now better clarity around regulatory and tax policies, we see some conviction back towards longer-term investing. That's certainly a positive transition.

The other thing that we've seen is just a growing challenge around the regulatory environment clearly depending on strong significantly post ’08-’09. And we are all dealing with managing through those regulatory changes. We think we have the scale and the automation at which to integrate that change and do it efficiently and effectively and actually see it as an opportunity long term to add more value to the advisors practices and differentiate ourselves, but it just takes work to ultimately get to that point.

Trap Kloman

And we have probably time one more question before the next presentation.

Unidentified Analyst

According to (inaudible) the float is only about 50%, is that correct. So who kind of owned the other shares or where are they?

Dan Arnold

Yeah, the float is roughly in the 55% range and the 42% of our stock is owned by the [2P] firms that help us originally transition our capital structure back in 2005. So Hellman & Friedman and TPG together own 42% of the stock. They did a secondary offering about a year ago of which took that ownership down below the 50% mark.

Trap Kloman

Great, thank you everyone today for joining and we look forward to talking obviously if you have additional questions.

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