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LPL Financial Holdings, Inc. (NASDAQ:LPLA)

Q2 2014 Earnings Conference Call

July 30, 2014, 08:00 AM ET

Executives

Trap Kloman - Head of Investor Relations

Mark Casady - Chairman and Chief Executive Officer

Dan Arnold - Chief Financial Officer

Analysts

Chris Harris - Wells Fargo

Alex Kramm - UBS

Chris Shutler - William Blair

Joel Jeffrey - KBW

Devin Ryan - JMP Securities

Bill Katz - Citi

Alex Blostein - Goldman Sachs

Operator

Good day, ladies and gentlemen, and welcome to the LPL Financial Holdings Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Trap Kloman. Sir, you may begin.

Trap Kloman

Thank you. Good morning and welcome to the LPL Financial second quarter earnings conference call. On the call today is Mark Casady, our Chairman and Chief Executive Officer, who will provide his perspective on our performance. Following his remarks, Dan Arnold, our Chief Financial Officer, will speak to our financial results and capital deployment.

Following the introductory remarks, we'll open the call for questions. We would appreciate if each analyst would ask no more than two questions each. Please note that we have posted a financial supplement on the Events section of the Investor Relations page on lpl.com.

Before turning the call over to Mark, I'd like to note that comments made during this conference call may incorporate certain forward-looking statements. This may include statements concerning such topics as earnings growth targets, operational plans, our ability to raise benefits from the pending business opportunities with Financial Telesis and Global Retirement Partners and our abilities to capitalize on the shift toward fee-based business and the lower expense growth rate as well as other opportunities we foresee. Underpinning these forward-looking statements are certain risks and uncertainties. We refer our listeners to the Safe Harbor disclosures contained in the earnings release and our latest SEC filings to appreciate those factors that may cause results to differ from those contemplated in such forward-looking statements.

In addition, comments during this call will include certain non-GAAP financial measures governed by SEC Regulation G. For a reconciliation of these measures, please refer to our earnings press release.

With that, I'll turn the call over to Mark Casady.

Mark Casady

Thanks, Trap, and thank you everyone for joining our call. Today, I'll provide commentary on our second quarter performance, our success in attracting and retaining advisors and our agreement with Financial Telesis to expand our presence in the retirement plan market. I'll also share insight into the progress of transformation of our compliance and risk management capabilities that's designed to lower our risk profile. In addition, each quarter this year, we're providing color into areas of long-term growth for LPL. And this quarter, I'll share thoughts on the growth trajectory of our advisory platform and the drivers of LPL success in supporting fee-based businesses.

Starting with our financial performance, in the second quarter, adjusted earnings per share of $0.61 was flat year-over-year. Earnings per share benefited from revenue growing 7% to $1.1 billion as well as our repurchase of 6.7 million shares over the past 12 months. We experienced increased spend for the resolution of regulatory issues, which raised our expenses 14% year-over-year, which Dan will speak to further.

Our new advisor headcount over the past four quarters, the firm added 431 net new advisors. This trend builds off of our success in 2013 where we led the marketing capture over 6% of advisors in motion, as recently reported by the industry research firm Meridian-IQ. In the second quarter, we included 114 net new advisors, and in the year-to-date, we have retained 97% of our existing production. We continue to be a leader in the industry in these key metrics, affirming our compelling value proposition to advisors. We attracted a variety of advisor practices this quarter, primarily from the independent and wire house channels and saw a growing number affiliate with our unique hybrid RIA solution. We believe that our pipeline for Q3 is solid, and we see positive conditions for continued success.

In addition to our typical recruiting activity, in the third quarter, we have the opportunity to attract advisors as results of our recent agreement with Financial Telesis and Global Retirement Partners. Financial Telesis is a premier, retirement plan provider in the industry, and its decision to partner with LPL reflects the strength of our capabilities to provide industry leading technology, marketing, and research support to advisors who serve retirement plans. As of the second quarter, our platform supported over $110 billion of retirement planned assets across 40,000 plans.

Advisors from Financial Telesis will begin to join LPL in mid-August and ramp over the remainder of the year. Once fully transitioned, we expect to capture approximately $25 million in commissions on an annual basis. In addition to the value of the retirement plan commission revenue, this transaction creates greater opportunity to provide in-plan advice to plan participants and capture retirement accounts that are transitioned into IRA accounts. We'll provide greater insight next quarter on the overall growth in our retirement plan business and how we're capitalizing on this opportunity.

Turning to our efforts in compliance and risk management, LPL has always been committed to setting a high standard to protect the interest of investors and support the independent advisors who serve them. As a baseline, we dedicate investment and people and technology to help ensure that our compliance and risk management approach is commensurate with our growth and changing regulatory expectations.

In 2013, we began an effort to transform our legal, risk, and compliance teams to improve the efficacy of our risk management and supervision. This resulted in increasing our investment and attracting new leadership. The costs associated with this expansion were anticipated and included in our 2014 expense guidance. Under the direction of David Bergers and Michelle Oroschakoff, we expect this transformation to continue through 2015 as we have identified opportunities to develop more specialized functions and automate more capabilities to improve our risk profile.

We have made meaningful progress evolving our capabilities over the past 18 months. We've grown the number of personnel in our legal, risk, and compliance functions by 41% since the beginning of 2013 to 636 employees. We've deployed those resources to support a variety of functions, including the expansion of our home office supervision capabilities to work more closely with small advisor practices on compliance oversight. We've expanded the number of personnel in our centralized supervisory function to over 70 employees to enhance processes and procedures for reviewing the sale of complex products such as variable annuities and real estate investment trusts.

We've also improved our underlying technology and processing capabilities. For example, we've upgraded our e-mail retention review capabilities to enhance our surveillance and are improving our variable annuity and alternative investment order entry systems to speed processing and provide greater controls. Ultimately, we believe the combination of our objective, independent business model, and our efforts to expand the efficacy of our compliance and risk management capabilities will lower our risk profile and create value for advisors and ultimately can be a competitive advantage in the industry.

I'd now like to share perspectives on how LPL is positioned to drive outside growth in our advisory business in the years ahead. I'll discuss how the breadth of our differentiated offering creates value for advisors, how we grow and monetize this business, and conclude with perspectives on the expanding market opportunity. LPL's history of innovation and leadership in the advisory marketplace dates back to 1991. This commitment has led to the evolution of fully integrated platform that provide advisors access to a wide array of choices to meet investor needs. We've developed several turnkey solutions oriented towards advisors who are focused on robust financial planning, offering them access to our research team, and eight leading investment firms who provide asset allocation strategies for investment implementation.

Alternatively, advisors who serve as a portfolio manager can leverage our enhanced trading and rebalancing technology and in-house product research to seamlessly manage their own models. These scalable solutions drive efficiency for the advisor and allow them to spend more time with clients focusing on broader planning and wealth management opportunities. We complement our investment solutions with a variety of services, which we believe are unparalleled in the market in order to drive advisory adoption and fuel asset accumulation.

As a result, we have an advisory consulting team with 34 dedicated personnel who regularly conduct field appointments in advisors' offices and local trading events to help advisors grow their fee-based practices. Our 50 person research team assists with portfolio strategy, product diligence, manager selection, asset allocation, and rebalancing models. We further differentiate our services by offering advisors a choice of affiliation by providing the only integrated RIA custodial platform in the industry.

Before we entered this market in 2008, independent RIAs who wished to maintain their brokerage business had to operate their practices using at least two service providers. This meant two advisor workstations, multiple custodians, and the need to engage third-party service providers to produce consolidated statements and performance reporting. This complexity reduces advisor productivity and increases administrative expense. Through our hybrid solution, LPL is the only provider in the marketplace who has solved for this need with a fully integrated brokerage advisory platform. Our success in accumulating $78 billion in hybrid platform assets in just six years reflects the market's demand for our solution.

The strength and competitiveness of our overall fee-based solution has led to rapid growth. Our platform is appealing to investors, because it provides them with financial planning, professional management and access to a wide variety of investment options and a range of strategists all for a fixed fee. Today, 36% of our assets our fee-based and approximately 70% of our advisors are licensed to conduct advisory business. This momentum creates the conditions for steady growth with net new advisory assets consistently increasing 8% to 11% a year before the benefit of market appreciation. Since 2008, we've outpaced the industry and accumulated advisory assets with 21% annual advisory growth, including market appreciation compared to 18% for the industry.

From a financial standpoint, the trend towards advisory business is valuable, because advisory assets generate margins greater than brokerage assets. In addition, our fee-based business has helped to raise our recurring revenue from 59% in 2008 to approximately 68% today, which has increased the revenue predictability of our business. Looking at industry trends will shape the future, we believe we are uniquely positioned to capitalize on the increasing demand for our fully integrated solution that really projects the fee-based advisory market to nearly double to over $5 trillion by 2016. In this market, it really projects hybrid RIAs will be the fastest growing channel, expanding their market share of assets between 2012 and 2016 by 3.6% to 12.2%. This projected growth compares favorably to the projections for pure RIAs were forecasted to drive market share by only 1.2%. In both cases, this growth is expected to become largely at the expense of the wirehouse channel, which is forecasted to lose nearly 5% of the market.

Building upon this unique value proposition, we are focused on execution to capture market share. We'll win based on the breadth of our affiliation, our array of investment solutions and leading support services that create the flexibility and value advisors seek at a best-in-breed business partner.

With that, I'll turn the call over to our CFO, Dan Arnold, who will review our financial results and outlook in greater detail.

Dan Arnold

Thanks, Mark. This morning I'll discuss four main themes. First I'll address the fundamental drivers behind our revenue growth in the second quarter, including details on advisor production and activity in our cash sweep program. Second I'll provide insight on our expense structure and share our outlook going forward. I'll then discuss our bottomline results and conclude with an update on our capital management activity.

In the second quarter, revenue grew 7% year-over-year to $1.1 billion, driven by a combination of newly recruited advisors, the productivity of existing advisors and market appreciation. These factors also lifted asset level 17% year-over-year to a record $465 billion. Underlying this growth were positive trends in two key performance indicators: advisory net new assets and commissions per advisor. The advisors attracted $16.5 billion in net new advisory assets over the past 12 months, including $4.2 billion in the second quarter, which represents 10% annualized growth. This marks the 10th straight quarter that growth in net new advisory assets has exceeded 8%, reflecting our sustained ability to gather advisory assets. Notably, an increasing percentage of assets continue to flow to our hybrid RIA platform, demonstrating the increasing demand for this unique solution.

In the second quarter, we continued to see sustained investor engagement. Overall we achieved moderate commission growth as alternative investment sales returned to near normalized levels. For the quarter, annualized commissions per advisor of $155,000 increased 2% year-over-year and declined 0.5% sequentially. Excluding elevated levels of alternative investment sales, commissions per advisor was flat on a sequential at $152,000. Looking forward, absent a dramatic change in market or economic sentiment, we expect the strength in advisory asset flows to continue in the third quarter. We anticipate a mid single-digit percentage decrease in commissions per advisor on a sequential basis due to seasonality and alternative investment sales remaining at near normalized levels.

The low interest rate environment continued to be a headwind to our growth in revenue, as cash sweep revenue for the quarter declined $6 million year-over-year to $25 million. This was driven by two factors: a 15 basis point reduction in ICA fees due to the pricing compression in bank contracts and a 3 basis point decline in fed funds. Since the majority of ICA contract repricing occurred in the first quarter, we do not anticipate meaningful bank compression in the remainder of the year.

Cash sweep balances declined $900 million sequentially to $22.8 billion for the quarter. The underlying business drivers that contribute to our cash sweep balances remained strong as we continue to generate net positive inflows from new accounts. In the quarter, the additional cash gathered was offset by increasing client investment activity primarily directed to our advisory platforms. Cash sweep assets represent 4.9% of total customer assets, which is below our historical range of approximately 6%. Based on our prior experience, we expect cash sweep asset levels to grow in the latter half of the year as we attract new deposits and account rebalancing activity occurs.

With respect to our ICA pricing in 2015, we affirm our prior guidance of incremental 13 basis point step-down on contract pricing below the 2014 ending rate. We retained the upside from rising rates and will benefit immediately as fed fund rate increases, which could offset the effects of the contract pricing decline. Based on current balances, fed funds rate and bank contract fees, we believe we unlocked approximately $245 million in adjusted EBITDA if we maximize our economics in a rising rate environment.

Looking forward to 2016, contracts which represent 27% of our current deposits are up for renewal. As we have previously shared with you, a portion of these contracts currently are in above market fees. As a result, we anticipate further contract pricing compression, which may be mitigated in part by improving market conditions, potentially leading to rising demand for brokered deposits in the coming quarters. We are maintaining flexibility in our commitments and will provide an update in the third quarter on our progress managing these contracts.

I'd like to now focus on expenses. In the second quarter, core G&A expenses were $171 million, up $9 million sequentially. $7 million of this increase stems from the resolution of regulatory and legal matters. Our strong recruiting results account for the remaining $2 million of the increase due to higher incentive compensation cost for our recruiters and related travel expenses. After growing 12% in each of the past two years, our core G&A growth rate would be on track for 4.5% growth in 2014, excluding the up-weighted cost for regulatory matters. As we factor this incremental regulatory expense, we're raising our full year forecast for 2014 to 7%. The 2.5% or $15 million increase to our guidance can be directly attributed to the cost to manage and resolve regulatory matters.

We expect the regulatory environment we're operating in to persist into 2015. We've seen regulators over the last several years broaden the scope, frequency and depth of their examinations to include greater emphasis on the quality and consistency of the industry's execution of policies and procedures. As a result, the additional $15 million of up-weighted regulatory spend incurred in 2014 will be maintained in our baseline expense for 2015. With these costs added to our run rate for 2014, we expect our 2015 core G&A expense growth to be within our stated target of 4% to 6%.

Turning to promotional items, expenses grew $5 million year-over-year as our Annual Masters Conference moved from the first quarter 2013 to the second quarter of this year. Transition assistance expense increased $1 million year-over-year as the growth in recruited advisors is partially offset by the greater use of forgivable loans. Consistent with past years, we will host our Annual Advisor Training and Education National Conference in the third quarter, which will raise promotional expense by an additional $5 million sequentially. We expect this event to generate approximately $4 million in incremental fee revenue to partially mitigate these additional expenses.

GAAP expenses that are excluded from our adjusted EBITDA results were $20 million this quarter, primarily consisting of $5 million in employee share-based compensation and $9 million in restructuring charges associated with the service value commitment. In addition, there was $4 million related to parallel rent and facilities expenses as we transitioned from our old San Diego facilities to our new office tower. We have fully exited our former facilities, so the parallel cost will not recur.

Turning to our bottomline results, we generated $128 million in adjusted EBITDA in the second quarter, down 2% year-over-year, driven by declining cash sweep revenue, the timing of our conference and the increase in regulatory expense. These factors also served to lower our margins by 1% to 11.7% year-over-year. Despite the decline in adjusted EBITDA, second quarter adjusted earnings per share of $0.61 remained flat year-over-year primarily due to our repurchase of 6.7 million shares over the past 12 months.

I'll now turn to our capital management activity. In the second quarter, we continued to leverage our capital light model to opportunistically repurchase shares conducting $25 million of buybacks in the quarter. As of quarter end, we retained authorization to repurchase up to $93 million in shares, which we will deploy to opportunistically buy back shares in the market. In addition, during the second quarter, $23 million was allocated to capital expenditures, and we maintained our dividend, distributing $24 million to shareholders.

With that, Mark and I look forward to answering your questions. Operator, please open up the call.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Chris Harris of Wells Fargo.

Chris Harris - Wells Fargo

So first question on the expenses. You guys gave a lot of good color there. But just wondering if you could expand on that a little bit more. I know just kind of as recently as June, you thought that 5.5% growth for this year was still kind of okay. And so just wondering exactly what happened since that timeframe to move it up to 7%. And then related to that for next year, kind of curious if you could expand on how you're comfortable on hitting that 4% to 6%, because it sounds like a lot of these expenses are going to be kind of recurring. And based on, Mark, what you were saying, some of the risk management build-out is still going to be in effect going into 2015.

Dan Arnold

If you look at this year's expenses outside of the up-weight in regulatory spend, we are tracking to the 4.5% targeted growth in expenses year-on-year. And if you look at the ramp throughout the year in core G&A, it's very different than last year's ramp where we increased spend over the year by about 18%. It's much flatter this year, so that sets up a different dynamic going into next year relative to meeting that 4% to 6% range.

And the shift in guidance from 5.5% back in the quarter to 7% now, it is based on a couple of things. It's regulatory related in terms of the resolution of these matters and it's just -- there was a bit of an increased scope in some of the matters we were working on this quarter as we closed the quarter. And I think, we've got good line of sight on the rest of the year in these matters and hence the increase from the 4.5% at the beginning of the year up to the 7% now for guidance for full year.

Mark Casady

Just a couple of things. One is that we do see an ability to really manage forward expenses by being clear about the source of these expense increases, which we view is not permanent to the cost structure of the business because of the investments we're making, particularly in risk management and compliance oversight. That should give us a return that lets us run an organization in which those surprises are not there, and that's the philosophical thing of what we're trying to do, Chris, as an expense matter.

Chris Harris - Wells Fargo

And then my one follow-up would be related to new advisors’ recruiting effort. I mean it sounds like from your comments that things are tracking nicely there, and we've heard kind of constructive things from others as well that are targeting the independent channel. Wondering if that might potentially lead to a little bit better margin for you guys, and what I'm getting at is if all of a sudden there's a lot of demand to get into the independent channel as some of these retention packages are rolling off, might you guys be able to have a little bit of pricing power in bringing in new advisors to your platform?

Mark Casady

Well, we certainly see an uptick in activity. So advisors in motion are what we want to be able to capture a large part of the share. We have captured the market leading share. So we obviously have a great history of knowing what to do when advisors are in motion. Just to remind you, our costs for transition systems are among the lowest. They really are the lowest among the top broker/dealers in the country, already. And so that already demonstrates the pricing power we have in moving advisors to our platform. I think it's generally correct that when we see more movement than normal, generally what we find is that the transition of systems doesn't need to be more robust, and in fact it could be less robust.

We know that also what we're selling is isn’t transition assistance , it's the value proposition that we have, and an advisor's practice will be more profitable moving on to the LPL platform whether it's a hybrid RIA or in the more conventional business because of the investments we've made in technology and services and capabilities that lets that advisor have a less costly footprint locally. PWC did a study few years ago and that was roughly 18% more profitable, and that's the value we're selling when we're doing recruiting.

So, we think that affirming a few things, one is the increase in interest in movement. Two is our ability to capture that. We feel as good as ever about our ability to do that and generally agree that that should come at a cost that is pretty close to where you've seen it most recently.

Operator

Our next question comes from the line of Alex Kramm of UBS.

Alex Kramm - UBS

The production expense, to talk about that, why that non-GDC related one was lower than usual and then maybe give us some color of what the outlook is there or that might be ramping over the course of the year?

Dan Arnold

The GDC related portion of payout is based on two things: your base payout rate, which consistently runs around the 84% range; and then your production bonus. If you look at it on the trailing 12-month basis, it typically runs in the 2.7% range. The non-GDC related piece, we typically see range somewhere in the 20 basis point to 40 basis point range, and that's driven off of two things. One, it's the deferred comp plan for advisors, which is mark-to-market at the end of each quarter and is based on typically a good proxy for that is the movement in the S&P 500 as an example. And then you also have the second thing that drives that non-GDC relation portion is the stock plan that we have, the equity base plan that we have for our advisors. And that is driven off of the LPLA trading price, of which again is mark-to-market at the end of each quarter.

And so this quarter, you saw it down relative to the prior two quarters, because actually LPL A was off about $3 over the quarter in second quarter. And you saw a bigger move up in fourth quarter and first quarter, so that helps you at least understand why that sequential change over those three quarters.

Alex Kramm - UBS

And then maybe a bigger picture question. I think you addressed a lot of this in your prepared remark and then in the question that you already answered before. But I just want to ask from a broader perspective, if you look at the results this quarter and you think about the environment out there with equity markets up 22% year-over-year, your revenue growth trailing that by decent amounts, 7% or so, but still growing pretty nicely. But then EBITDA being down and obviously in terms of EPS flattish, I mean obviously you have a lot of stuff going on and a lot of the expense growth. But when I look at that from a big picture perspective, it doesn't create a great picture in this great environment. And now obviously the environment can change again. So I'm just wondering as you think about the next few years and maybe the environment changing for the worst, how do you feel about creating any sort of operating leverage on the positive side or being really hurt?

Mark Casady

Just to be clear, we are not happy with these results. We should be getting leverage in gearing into the P&L in a way you don't see the second quarter. So just affirming what I hear a little bit of your voice, the frustration, I could only affirm for you it's the same here. What causes not to get the leverage that we should be getting in the P&L sort of up and down the P&L is essentially cost that we did not foresee or we would have talked about our expense profile differently and a regulatory environment that is much more difficult than we anticipated. We own that and that's our problem.

What I do feel strongly about is our ability to control our expenses going forward and our ability to understand the dynamics of the underlying cost. The other thing I can point to give you proof points of that, because at this point, I'm sure what you'd like to see is proof of it, not our words of it, is if you take out the cost that Dan outlined in the discussion part of our call related to regulatory expenses, our run rate has come down dramatically from where it was. That's the way the performance should be running. It's the result of removing cost on our ongoing basis, it's procurement work. It's all the things that we should be doing. So the fundamentals of the business are looking as good as I've seen them in my 12 years here.

The issue that we run into is that we've needed to invest heavily in risk management and compliance resources and we're a bit behind the curve. As a result of being behind the curve in that, we're getting the regulators appropriately, making sure that we understand that we should have been ahead of the curve. And therefore they're finding fines traveling through the P&L. Our goal is to get those fines to go away, not because they go away, but because we do a great job in risk management and compliance work. And so that's how we know we can then get the P&L to operate the way that's traditionally operated in all cycles of the market, Alex, which will let us be able to control the levers of cost whether the markets start to go down and sales slow or whether they are robust. And therefore I'd have to increase expenses as a run rate matter when we see volumes increase.

Dan Arnold

So if you think about the second half of the year, if you were to create a similar type revenue growth characteristic in the 7.5% range and you look at the expenses in the second half of the year, roughly maintaining flat where they were in the first half of the year, then you're going to end up with low single-digit expense growth year-on-year and you're going to then start to see what we would expect how the model would operate where you get 7.5% revenue growth and you're getting low single-digit expense growth. You're going to start to see that margin expansion come back.

Operator

Our next question comes from the line of Chris Shutler of William Blair.

Chris Shutler - William Blair

On the regulatory expense issue and the upweighted expenses, to the extent that you guys can disclose the issue, what have the issues been? And then what specifically are you doing to mitigate those issues?

Mark Casady

Let's start with what they are. So basically we have, as you know, a variety of regulators. So you've seen some of the releases related to fines for matters for securities such as non-traded REITs or variable annuities. We also of course regulated in all 50 states. We've had a number of matters with the states, Massachusetts being the one, as I said here in Boston, that's easiest to point out. We've also had matters with the state of Illinois and a variety of states related to REIT matters. So what we're doing to make sure that we are making sure that investors are protected, which is our primary goal here. Number two, making sure advisors are fully compliant and doing the right thing by clients, which we generally see that they are. These are for the most part home office retrokeeping and processing matters that we've needed to shore up.

So let's just rattle off some of the things that we're doing. We've created a centralized review team. That's 70 people that I mentioned in my remarks that are looking at all activities in those areas for products that are just more complex either because the nature of how they're built or the nature of how they're processed. Remember, alternative investments are still a manual paper process, which means it's hard to automate that work.

The second thing I'd say is we're spending money and working in partnership with the industry to create a solution for processing non-traded REITs just as we helped created a solution for variable annuities, which helped the process quite a bit. We also are making sure that we're doing a great deal more in terms of training of our own employees, the supervisors who oversee them, the supervisors in local offices and advisors as well either on product complexity, different areas of the rules that we oversee and so forth. And then we're also making sure that we have plenty of disclosure and good processes for making sure investors understand what it is they're buying and how they're buying it.

And so as we look across the totality of what we're trying to do, we're trying to move a lot of activities at once. That's why you're seeing just the sheer increase in number of people across legal, our compliance group as well as audit. I think the good news in that is that once you've got the right people in place and you've got good technology in place, which we're about halfway through at this stage, then actions start to create an environment in which those exceptions are more unusual than they are today and it's the exceptions and the documentation of them that's leading to this higher level of settlements with the regulators. And so it's not an excuse. Again, we should have come into this part of the cycle stronger than we did. But we want to make sure shareholders understand that we're going to invest in this. It's a smart investment for us to make and it's the right thing to do as it relates to the industry and the investors who are trying to save for their retirement and their financial future.

Chris Shutler - William Blair

I remember going back probably nine months or a year ago, you guys were talking about how Robert Moore was spearheading some efforts to segment your advisor base a little bit more to try to increase productivity and provide different types for each group. Was just hoping to get an update on those efforts.

Mark Casady

We are making good progress on segmentation. And understanding the dynamics of what different groups of advisors need to be, so how does that show up? It shows up for example in our upcoming national conference where advisors who might be smaller in production, but have good growth trajectory will be brought to the conference as part of our training and development of them to help them with their business. That'll be the simplest example I can give you. More complex should be some of the pricing works that we're doing around how to make that simpler for advisors and thinking about the practices that are in effects. And then also thinking about how we deal with transition advisors into the company and what type of practice they have or sort of pre-segmentation, if you will, and how best to help them with that activity.

That's also combined with our data management or big data is the common term in the world. We're doing some really fascinating work like Dan just spoke about, because it's not segmentation per se, but it's the same idea, how do we make sure that we're creating better outcomes in terms of growth and profits for the company through being smarter about and put more personalized to the advisors that we serve and their investors and also sponsors in the case of big data.

Dan Arnold

In this period of leveraging big data and turning it into business intelligence, we look at the opportunity set across our entire ecosystem. So you start with the product sponsors as an example and how can we create efficiency and efficacy in their efforts to position products and ideas and solutions to our advisors in a more effective way that will drive productivity of our advisors and reduce their overall cost of distribution. And to the extent we're successful at doing that, that's obviously a real value we're creating in their overall models, which helps improve our overall economics in those product sponsor relationships. So that's one body of work around business intelligence.

The second one that I think ties back to your question around segmentation, it allows us to leverage that insight and information to be able to better support our advisors and their growth opportunities whether that's gathering new clients or new assets with their existing clients and how do we help them better understand where that opportunity set is within their practice and then provide them the solutions in an efficient way, so they are very on target and on point in leveraging where their opportunity is with the right solution, again all in the spirit of helping them grow their practices. So those are two applications, if you will, across the ecosystem, where we would leverage business intelligence to drive value.

Operator

Our next question comes from the line of Joel Jeffrey of KBW.

Joel Jeffrey - KBW

Just a question on the non-traded REITs, I appreciate the color you gave on the performance this quarter and sort of expectations for the third quarter. If I recall, in the last conference call, you guys had talked a little bit about the potential for increased liquidity events happening in the back half of the year. Are you now thinking that this could occur in the fourth quarter or is this just not likely to occur at all?

Dan Arnold

So again, these are, as we've said along, a little tough to predict, because I think some of the product manufacturers will state they have a plan and then ultimately there's a variety of different reasons why they may shift that plan. And so I think what we do know is there's a couple of larger non-traded REIT sponsors who have suggested that they are contemplating a liquidity event. And when those occur, obviously the repositioning of those assets back into a non-traded REIT all to achieve the same yield characteristics as they had before the liquidity event, you see some upweight in commissions that occur.

And so the second half of the year, we had anticipated a bigger opportunity set associated with that. I think there's still some potential for activity from a liquidity standpoint. But as we look out and look forward, we don't see the big variance, if you will, than you saw in the second half of last year. In fact, if you look at the inflated level of AI, which was about $40 million inside the quarters, the second half of last year, at most it would represent about 25% of that inflated amount in the second half of the year.

Joel Jeffrey - KBW

In the Financial Telesis deal, talking about potentially $20 million to $25 million in annual incremental revenue?

Mark Casady

Yes.

Joel Jeffrey - KBW

And are there any costs associated with that? What was the bottomline impact for those revenues?

Dan Arnold

You want to think about this just like we're recruiting a new client. So the cost that we're inheriting inside Financial Telesis will be maintained in the new practice that is created Global Retirement Partners. And so the only incremental expenses that we get are the normal traditional growth expenses relative to that $20 million to $25 million of incremental revenue coming onboard.

And because this retirement business is not typically custodied here, it has a slightly different revenue trajectory and ultimately margin associated with it in the short run. I think the opportunity set is that now we see a larger practice that can effectively leverage two things: our roll-over program that we've created and our in-planned advice capabilities in this retirement space. And that's a way to more effectively and holistically leverage those capabilities. You'll see the margins drive off from that business and the economics improve.

Operator

Our next question comes from the line of Devin Ryan of JMP Securities.

Devin Ryan - JMP Securities

Just wanted to get an update on acquisition opportunities and really your appetite there, specifically around independent broker roll-ups. Is the opportunity any better today? I know that you guys haven't done one in a while. Is the timing better for any reason whether it be better pricing or something else that can just lead to more inorganic activity expanding headcount?

Mark Casady

We look at what's available in the marketplace. Our general assessment is that the prices of today and at the quality of what's on offer are not the right transactions for us. As simple as that. I don't see that outlook changing in the foreseeable future for us. And so that lets us put capital work in a different way. We obviously have been buying our own shares, which we see as a bargain. And therefore what we have is ability to make sure you get a good return on that cash by being able to buy back our own shares and use that free cash flow to effectively return to our shareholders. We have about a third of our free cash flow that we use to pay dividends. And that's given us a nice yield on the stock, which certainly has been helpful as we look at the different buyers of it and so forth.

And so at this point, we like no better investment than our own and are happy with that. We'll continue to look for inorganic possibilities, but don't see anything on the horizon that looks pretty good.

Dan Arnold

Of course, we like the organic growth that comes from recruiting as well. And so we continue always to assess that balance around maximizing the opportunity set with the right balance in the cost to acquire that business. And so it's something that we're constantly working on and assessing within an organization who is very adept at capitalizing on their recruiting opportunities and has 60-plus people that's been full time focused on trying to make sure that the marketplace is aware of the capability sets of our model and ultimately and successfully bringing in those new advisors. And as you've heard us talk about before, we generate some of the best returns that we can offer that investment.

Devin Ryan - JMP Securities

We've been in recent months that there's been a bit of increase in demand from third-party banks for cash and that is driving actually little better pricing power on cash balances. And so I just wanted to get a sense if that's the case, that doesn't sound like the yield guidance for next year has changed at all and my guess is that there's timing around which programs roll off and what they're on. But do you expect any upward pressure there based on what's happening in the competitive market right now?

Dan Arnold

We're beginning to see certainly characteristics of improved pricing power for the reasons that you said. There's certainly the lending environment and has enhanced. There's a growing demand for deposits. We're also seeing some capacity in banks for these types of deposits. And so that creates a greater demand for them to attract new deposits and even some of the clarity that comes with Basil III and LCR rates relative to these deposits are all three things that we believe and are beginning to see signs that pricing power changing a bit. Too early to tell you exactly what that is. We've maintained our flexibility to continue to let those market dynamics evolve a bit before we ultimately make commitments or lend on how to reposition the portfolio in the future.

Mark Casady

Yeah, that's certainly helping the portfolio from a maturity standpoint is to try take advantage of that, Devin. Hopefully see demand rise a bit more as the economy improves and as liquidity obviously comes out of the market as the feds slows its QE programs. So we like the idea of shortening up a little bit as much as you can in this current portfolio.

Devin Ryan - JMP Securities

Are you still examining the industrial bank charter or will that be determined as that might be the best course, especially if there's any shift in possibilities from other cash programs?

Mark Casady

We're certainly still investigating to understand what the possibilities are. But obviously what we're trying to do is we know that placing deposits into the banking system in the way we're doing, it says once in a while if a banking system works well for us, works well for shareholders. So that is our preferred. There's no capital involved with it. Let's just continue to be a capital light model, which is the preference, which is why I'm saying whether there's optionality or does it help us, for example, in some way in the future as we think about what an ILC might look like.

Operator

Our next question comes from Ken Worthington of JPMorgan.

Unidentified Analyst

It's (inaudible) for Ken Worthington. Yields in ICA were up 4 basis points this quarter, more than fed funds increased on average for the quarter. Balances are also down a little. Can you talk about the dynamics that drove the yields higher?

Mark Casady

The reduction in some of the lower-priced balances create a slight sequential tick up in that yield.

Operator

Our next question comes from the line of Bill Katz of Citi.

Bill Katz - Citi

Just going back to the regulatory backdrop, how much of your incremental spend is idiosyncratic to catching up to pace of growth versus industry dynamic?

Mark Casady

100% of it is unique to us in the sense that it's our particular journey in terms of what's happening. So 100% of it's related to fines for us for activities that have occurred. That's the difference what our expense run rate would be to what it actually is. Certainly across the board, what we're seeing in the industry is heightened regulatory review in all financial services industries, not just broker/dealers. But those are individual items to our firm that relate to our practices in and of itself, but we've seen actions by the regulators to our competitors in the space that are similar to what was happening here. And so it's a different dynamic in terms of how they make their way into the world.

Bill Katz - Citi

Dan, just sort of requalify what you mentioned in terms of where the non-traded REITs are in terms of the contribution to commissions or production. I guess the broader question is, is there any behavioral change you're making with your FAs to reduce the regulatory risk on that side of the equation as long as a result with that if any kind of lasting impact on production levels?

Dan Arnold

A vast majority of advisors here are doing fantastic job for their investors. When I get to look at all the detail here and if I look at activities in this area, there's a varied situations in which someone is doing something that we'd all agree (inaudible) might be that is by far the far exception. The vast majority of these issues really relate to the way processing occurs and our ability to oversee the process to have certainty of the outcome. Best example would be in a particular state where there's a limit to the amount one can sell, you could imagine how easy it would be to say, gee, that limit comes up to $942 and what I want to do is round it to the nearest dollar and I rounded up and set the rounding down. That actually is a violation of the state's limits. And the matters that we've settled, it'd be fair say 80%-ish rounding errors, maybe 78% that are there. That's not acceptable. So it's still a violation, but it's not bad behavior that's causing that. It's the lack of an automated system that lets us catch that in a way that then prevents the sale from going through. That's what we're building.

So what we've done in the interim is we've added people to look at those transactions, 100% of them, make sure the math works correctly, which is our job. And then if it doesn't work correctly, go back to the advisor and work through a solution. So is having some effect? Yes. Just because it's some newer processes that are being built, but not enough to move the revenue line significantly that's there.

The other important thing to state is if you look at the totality of products that have been put on platform, again, they've really performed quite well. So it's again not a product problem where we're approving a product that turns out not to be a good thing for investors. In fact our processes there are quite good. So this really is the mechanics of how one documents and reviews the sale of alternative investments. Variable annuities have a version of the same thing, because again these are all for the most part paper-based products for settlement. And that's really where the issues arise and overseeing them.

So I'd describe all that as a little bit slower revenues, not necessarily permanent. It actually mirrors what we saw in the mutual fund industry in the early 2000s post the market break when A, B and C shares really dramatically changed. And essentially what happened was A shares became the dominant share class what used to be a much more mixed than that prior to the regulatory actions in the early 2000s, as I recall, 2004, 2003. And what happened then was essentially sort of a similar path, which is the realization that processes that were being reviewed as well as they should across the entire industry not just at LPL, the industry changed the series of its policies just as I see it doing right now in REITs and annuities. And that's led to some temporary slowdowns, but actually created a much stronger outcome for investors, which creates more sales when you achieve what it is they're trying to achieve through the planning and activity you're doing with them.

Operator

Our next question comes from the line of Alex Blostein of Goldman Sachs.

Alex Blostein - Goldman Sachs

I was wondering if you could break down the contribution to commission per se kind of from a fee-based component versus more transactional, because it seems like the transactional piece per se, I guess, was down, not as much as some would have thought. So I would imagine that the trend might continue into the back half of the year, given how good activity was in this second half of 2013? So mayb just parse it out for us a little bit and give us a sense of where the true commission activity rate number could go in the back half of the year versus the second half of '13.

Dan Arnold

Your average productivity across both advisory and brokerage in the second quarter of this year was $251,000, of which $155,000 of that was commission-based and $96,000 of that was advisory-based. So if you look at that on a year-on-year basis, you see that good consistent steady 8%-plus growth in advisory and you see your commissions, as you would expect, being up slightly year-over-year from $155,000 to $152,000. But if you back out the incremental small amount of inflated alternative investment or non-traded REIT activity that we had in the second quarter, then your productivity levels on what I would call your baseline goes back to the $152,000 level. So on a year-on-year basis, it would be flat and pretty flat on a sequential basis from first quarter to the second quarter. So that just gives you the characteristics around how advisory is moving and how brokerage or commissions are moving and how they relate to the total productivity in the quarter. And again, that was $251,000.

If you look at the second half of the year, to the extent that as we said, we see consistent flow of net new assets, so you would think there would be a correlation in productivity related to the advisory piece with those net new assets coming in. And then from commissions related standpoint, I think what we were saying earlier is if you maintain the same amount of alternative investments sort of inflated amount of business, your jumping off point is $155,000. And you've got some seasonality adjustment from second quarter to third quarter that you would adjust for that's typically in low single-digits to mid single-digit range from second quarter to third quarter. So hopefully that helps you at least break it down, I think, from an advisor productivity standpoint.

Alex Blostein - Goldman Sachs

And the second question I had, real quick, is just on the rate sensitivity and it's a trailing minor. But I guess when you look at your table, when you guys disclose the upside, it did come down a little bit to 25 basis point from, I guess, 1,700 to 1,600. Anything in particular driving that, I would imagine. I mean maybe some of that is the balance is being lower, but that probably would carry through the rest of the bucket as well. Is there any reason for that?

Dan Arnold

No, that's the right instinct. It was a combination of two things. One, it actually moved up 2 basis points. And so that's sum of it. And then you don't have as much as upside just because of that and then the balances were down. So that's correct.

Operator

And I'm showing no questions in the queue. At this time, ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.

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Source: LPL Financial Holdings' (LPLA) CEO Mark Casady on Q2 2014 Results - Earnings Call Transcript

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