Mark Casady – Chairman and CEO
LPL Investment Holdings, Inc. (LPLA) NASDAQ OMX 27th Investor Program Conference Presentation December 7, 2011 4:30 AM ET
Thanks very much. Good morning. Thank you, NASDAQ OMX, and thank you, Morgan Stanley, for having us here today.
Let me speak a little bit to LPL Financial, what it is that we do. Want to stop by our Safe Harbor as we go to a little bit more about the business.
We are in the business of managing the complexity of financial planning practices for over 17,000 professionals. They can own their own business as independent contractors or they can be part of financial institution, a bank, credit union or insurance company. We do that in an unusual way in that we do not manufacture any products. We’re not a life insurance company. We’re not an asset manager. We don’t do any proprietary trading or market-making of securities. So, that allows us to have a very open supermarket of products available to those financial advisers to be able to use with their clients.
Importantly, those products are all quality tested before they’re put into our system. They’re reviewed by our research department and our compliance group to make sure they’ll perform as expected.
What this has led to is market leadership. We’re the number one independent broker-dealer in America and have been for over 16 years. We’re the fourth largest broker-dealer in America as measured by our adviser count. There are roughly 13,000 advisers who are part of our broker-dealer.
We are the market leader in providing, particularly community banks and credit unions, with a white label brokerage service for their clients to be able to use that in financial planning. And we recently have built leading position in servicing defined contribution plans. And there what we’re really doing is servicing the advisers who are consultants to 401(k) plans in America, and that covers over 25,000 plans, 2 million participants, and about $60 billion worth of assets.
As I said, there’s a wide range of clients that we’re serving, and that allows us to have some diversification in terms of how our earnings work over time. I think an instructive one is the Registered Investment Advisers. That’s a market that we entered about three years ago, to essentially be a custodian of assets for RIAs in the US market. We’ve grown to number five in the market, right behind Pershing in that business, and have seen significant growth in new assets coming to us. As of the end of the third quarter, we’re up to $20 billion of assets under custody. So we’re seeing very extensive growth by expanding the platform into new markets and new types of organizations to serve.
At the bottom left-hand side of this chart, you can see the growth of advisers over time. Again, these are those that are affiliated into our broker-dealer, and it’s important to understand that over this period of time, 80% of our growth has been organic. We did a number of acquisitions in 2007, as you can see, is that line jumps up quite a bit that year, which allowed us really to gain scale at an important time in the marketplace, but it is important to understand that most of our growth has been organic.
On the right-hand side, you basically can see where we stand visa vie other competitors in the marketplace who certainly have better brand names than we do. And that the reason we don’t have a consumer brand name is we don’t need it. About 80%, 85% of our advisers use their own name, could be the name of the bank, the credit union, or their individual practice, Cassidy Wealth Management, as an example, and therefore don’t need to have the backing of the LPL brand name at the consumer level. We certainly have grown significantly over the years but we still feel there’s plenty of room to grow within the US market over the next decade.
Now, this slide really gets to why someone joins us, particularly an adviser who’s joining us from an employee model, so, from a wirehouse, the larger brand names known in the US market. And really it’s quite simple, is they’re going to make twice as much money as they did when they were an employee of that firm. That’s certainly a motivating factor.
We know that, on the right-hand side of this chart, they come to us for these four key services that we offer them, the technology and the support. That really helps them build their practice over many, many years.
I think it’s also important to understand that part of the service that we offer is making sure that we have a wonderful firm when it comes to compliance and regulation, certainly a very important part of running a firm like ours. We have a fantastic track record, a very low number of customer complaints. If you’ve measured us by complaints per thousand brokers, we can show you that we would finish last among the top ten broker-dealers in America, which is a good place to finish when it comes to number of complaints. So we have a wonderful way of thinking about compliance as a business tool and compliance as a competitive advantage for our business and for the advisers who affiliate with us.
In the end, what really matters is what do your clients say about you? And you’ll see in the blue box at the bottom of the slide that we have a net promoter score of 61%. I’m sure you’re familiar with MPS, but essentially measures across industries what someone would recommend you or not for the services that you offer. It could be just as true for a PC maker as it can for someone in our business of supporting the financial practice.
And what’s important about a 61 is that would put us at the top ranks of those of the US markets supporting investment advisers. So, these are our customers, the advisers, telling us that they’re very satisfied and would recommend us to other firms. Very important mark for us in terms of satisfaction. It’s part of the ways that I know that the business is in good shape, by looking at our net promoter score every year.
In a Morgan Stanley survey done last year, Morgan Stanley surveyed the registered adviser market which as I mentioned is a newer market for us, and in that process of measuring the net promoter score, we came at number one across all custodians in the industry with a very high net promoter score there.
In the lower half of the slide is the satisfaction that the clients of our advisers have with their experience with them. And you can see here, in the J.D. Powers survey, our advisers came at number two in investment adviser satisfaction, very high score, and for many years has been a very high score of that satisfaction of end-clients. So, we feel very good about the relationship we have with clients and the relationship they have with their individual financial planning customers.
This slide goes into a bit more detail of why we’re different than others in the US market. Some of these are public company. Some of these are divisions of larger public organizations or privately-held partnerships, as in the case of Jones. And this really goes across the spectrum of what we don’t do, by checking the box screen, showing that we don’t have proprietary products and we’re not manufacturing anything, as I mentioned before.
We’re not in the investment banking business. We don’t make markets and securities. In fact, most of our sales are made up of packaged goods, mutual funds, annuities and life insurance, are the lion’s share, 85% of our volume in any given year. That’s why, unlike the custodians, we don’t talk about darts and other trading activity because it’s not really a driver of profitability or growth of any significance to us.
We don’t directly serve the consumer. We’re always working through someone else in that relationship. So, there we’re a trusted partner of the adviser in serving their market. And we also serve independent financial advisers, and you can see most of these competitors all have employees who are in this structure together, which surely changes the economics quite significantly both for the adviser but also for the firm.
If you think about it, we’re outsourcing agents. We get paid a fee for the services that we offer. And the dynamic of paying for their office rents and the staff are really done by the advisers themselves, so we don’t have to worry about what real estate looks like, what the right location is for an office in Des Moines, Iowa, that’s really done by the local adviser, it’s their risk in doing so.
And finally, the last one is fully open architecture, which really means that we have lots of products for advisers to choose from as they practice their business. In fact, we have more funds that are available with no transaction charge in our RIA business than Schwabb does, who’s the market leader in that business. And as I mentioned before, over 8,500 products in total for us to be able to serve those clients.
This gets into a bit more of the operating model for the business. You can see a few things about this. We’ll start with the upper left-hand side. Very high retention. Most broker-dealers lose about 10% to 11% of revenues per year. We retain about 96%, so, lose about 4% of revenues per year. So that’s significantly better. So that tells us the high net promoter score is real, because people, when they choose to be with us, choose to stay, which is important for us maintaining our margins and maintaining our growth pattern.
It’s also important to understand that we don’t have any clients who are more than 3% of our revenues. So they have really very little concentration in the market. As you may know, many broker-dealers have sort of an 80/20 rule. Twenty percent of their adviser headcount controls 80% of their revenues, and that’s not the case at LPL, it’s widely diversified across those 17,000 advisers that we have relationships with.
Our expenses are highly variable, which allows us in times of market turbulence, as we may have noticed we’ve been in of late, to really control our expenses because we’re able to really pull back rather quickly on variable costs that are there. Now, one of the quite unique business model designs that we have is that, as production goes up, we tend to pay more, so it tends to incent the adviser to grow their practice while times are good. And when times are more difficult, as they are at the moment, their business will tend to slip back a little bit, and then we actually pay them less.
So, it gives us a way to accelerate growth in good times and be protected, our gross margin level, in more difficult times when their revenues may be slipping. So, they get the benefit of the upside but we get the benefit of the downside, which is why we have a highly resilient profit model, and why in a year like 2009 we can have a 12% drop in revenues but in fact a 2% growth in profit. This is one of the main reasons why that’s the case.
Our margin, as stated, is just over 13%. That’s total production expenses against revenues, or, excuse me, against profits. But if you were to go to the gross margin level, which will put us on the same playing field and the same accounting method, that you would see that the custodian models in the US market, the discount brokers, there we would have over a 40% profit margin as a firm. So, you have to take into account this sort of unusual nature of broker-dealer accounting and that the advisers’ revenues are on our books and that we pay them out as a production expense, and so the gross margin in essence are really our revenues.
The other important point is we generate about $125 million to $150 million of free cash flow, so that’s after we make investments in infrastructure from space to IT, which run anywhere from $50 million to $75 million a year, [which are often] a significant part of our earnings in cash. We have over $400 million of free cash on the balance sheet as a result of saving cash over many years, and the results of going public a year ago and some tax breaks that come with that, that I can certainly explain if there’s questions.
So, as we look at it, we have a lot of cash to use for acquisitions. We’ve already done a couple of share buybacks. Up to about $90 million of shares have been repurchased since we’ve been public. So we have a wonderful position of a strong balance sheet.
On the right-hand side, the thing I would put out is the recurring revenue nature of the business. Over 60% of our revenues recur every year, which makes us a bit more like an asset manager or other companies that are able to therefore predictably think about their revenues for the coming year.
In this chart, a few things that we want to get to is to really show you that over a very long time period we can take top line growth of 15% and turn it into bottom line growth at 19%. So we are clearly getting margin improvements year in and year out. We’ll talk about that a bit more in a moment.
And I’d point out, 2001 and 2009, during this string of years, you can see those are the two rough years. I think we all remember them, at least most of us in this audience. And you can see the company, while it didn’t raise profits much in those years, did raise profits. So we now have an 11-year track record of being able to increase profits really through thick and thin and through certainly two of the worst market periods I know I’ve ever had in a nearly 30-year career.
So we feel very good about our resiliency in a variety of models. And it comes with that design that I was mentioning before of whether the advisers have the upside and protecting us on the downside, in addition to a few other features.
Now, ultimately, we’re driving towards a profit growth on the EPS level of about 20% per year. If you look at the major drivers here, you’ll note two that are not there. Importantly, they’re interest rates going up, someday perhaps they’ll go up, and secondly, our acquisitions. We view those as really outside of our operating control. So, as rates go up, we would expect earnings to go significantly higher than the 20% that we’re targeting as a management team, and certainly those are outside our control.
The second part, acquisitions, we’ve done a couple since we’ve been public, relatively small ones. But acquisitions we would view as again contributing above that 20% level.
So, let’s just take the five that are here and spend a few minutes on what they mean and how we think about them. The first one are same-store sales. In a period where there’s GDP growth in America and they’re relatively benign to even decent market performance, which certainly described the first half of 2011, you can see significant growth rates in same-store sales. Through the third quarter of this year, our same-store sales growth were low double-digits, so at 11%, 12% per year in same-store sales growth, which allows us to really create quite a significant profitability because that marginal growth does not take a lot of extra expense for us to manage.
Secondly, of course, we’re adding new stores. Advisers join us, and the way that they join us and the way that they rebuild their practice after joining has a long history of data, over a decade’s worth of data that shows us that a producer will recover their business over a three-year period in a very programmed way. Only market extremes like 2009 alter that course of essentially ramping.
So let me just give you an example because that’s sometimes a difficult concept. If there’s a million-dollar producer that joins us in the first year, they’ll do about $500,000 of production, and that’s because on average they’re joining us at half the year. So if you think about it, it’s really just a calendaring issue. Then they basically build up the business as they go along at a certain rate, and then they’ll travel beyond the million dollars by the time they get beyond year three. So that’s the ramp that’s mentioned here in terms of new and maturing advisers. Once they’re in year four, they go into the same-store sales category.
So if you think about it, in same-store sales you have relatively high predictability, a lot of recurring revenue, about 60%, but on top of that you add the last three years’ worth of classes, the current year in the previous two, you have a lot of predictability of revenues. About 80% of our revenues are known, sitting here in 2011 for 2012, as an example.
New capability -- or sorry, one thing on new stores. We have said as part of the public offering that we would add about 400 net new advisers per year, is how we suggested analysts model it. We have done through the third quarter over 500 net new per year so far, which is our more historic growth rate in that area, and we were the market leader last year in America coming in at number two behind Merrill Lynch in terms of net new advisers added to the system.
New capabilities refers to new things that we can do for an adviser. You think about our work is really managing their desktop and their business day in and day out. The more we can do to automate and integrate that work that they’re doing, the more we can create profitability. A simple example is customer relationship management systems, CRMs. It’s something that we feed data to a lot of different systems that advisers want to use.
We went into a deal about 18 months ago with Salesforce.com. We’re able to get them to discount their price to the adviser who pays for that software and then Salesforce shares 50% of the revenues with us. Salesforce wholesales it, Salesforce does all the data conversions, we essentially get half of the revenues, which turn to a significant amount of profits since we don’t have many expenses against them. And there’s literally two or three things per year that we can do across the 17,000 advisers to add more capabilities and increase revenues.
Next is market. We’re a balance portfolio, about 50% in fixed income, 50% in equities, over $300 billion of assets. So we’re going to go up hopefully into the right over a longer period of time as essentially a market bet, and not a huge dependency for the business but an important one.
And then finally, scalability, we have processes, Lean Six Sigma and so forth, that allows us to really go in and look at processes where we’ll move through the third quarter of this year over 50 positions of our 2,750 employees, where we looked in our process, changed it, made it more efficient, and we’re able to eliminate work and therefore reduce costs.
The other part is our IT spend. We’re quite good at technology development, and many of those are productivity tools for advisers or for our employees. And that allows us to grow margins in that 30 to 50 basis-point range per year on average. It’s never a perfect formula but you’ll see it sometimes go up quite significantly more than that, depending on the year and the investments that we’d make.
So, those are the five key drivers for the business that are really under management’s control with perhaps the exception of market that’s there on this page.
And then finally, the “what have you done for me lately” category. This really talks about what happened with the company post its IPO, which again was about a year ago. And if you can look at it, we, again, predict that we would have 20% EPS growth. We assumed 5% market growth for using the S&P500 as the example in the US market. And we thought we’d have flat interest rates.
As you can see in the middle of the page, we actually delivered 33% profit growth. Now, some of that was due to advantages of refinancing debt at relatively low rates a couple of years ago, but most of it came from operating activities. So, we exceeded beyond our 20% predicted rate. And while it may not look like a lot of numbers, 19 going down to 8 basis points, I can tell you that is a very painful drop in money market fund levels, and our bank deposit program where that comes right out of profits and right out of spreads that we have on roughly $24 billion of assets for our customers. So, we really face a significant headwind as all broker-dealers have in America for low interest rate environments that we’re in, and not a great market environment when it comes to of course the S&P500.
So, against those headwinds, we’re still able to produce very, very good earnings growth. I think it’s important to understand that as you think about the company and our ability to deliver results over time.
And then we often get the question of what will happen in different market scenarios, the last part that we’ll touch on before opening for questions. As you can see, we certainly have applauded the market movement in the last few days, because that tends to turn right into gross margin and into profits for the company. Of course, there’s no expenses against market movement, just as there’s no savings when markets go down.
Secondly, as you can see the impact to us if Fed funds rates were to move, so you can see the kind of movement that we’ve had of roughly 11 basis points has caused us nearly $20 million of EBITDA over this year past year. Someday we’ll hope that those numbers start to reverse and go back up, and we’ll see the benefit of that.
So, as we think about it, what we try to do is really control our G&A costs as much as possible, use the variable nature of the income statement our relationship with our advisers to make sure that it really works from the standpoint of delivering results for shareholders.
So, I want to stop there and see if you have any questions.
Hi. Thinking about some of the trends amongst your clients’ clients, is there any difference in profitability to you whether they invest more in actively-managed funds versus ETFs where they’re more focused on -- in fixed income investments rather than equity investments, the longer-term trends of retail investors in the US, is there any change in that mix for you visa vie profitability?
Yes. So the way that we’ve built it, similar to the way that we talked about, our gross margin and our ways of thinking about the way that we control for their growth in and of itself, our grid, the way we pay out, takes into account the relative profitability of each of those product categories. So, you could take something like a fixed annuity, which you can imagine was quite a significant product to be sold in 2009 in America, we sold billions of fixed annuities, particularly through our banking channel. We then dropped probably 70% of that volume within two years, really had no impact to our gross margin activity. It would have changed the top line quite a bit, but that really again mainly goes 90% to the adviser. So, for our business, a change in product mix really doesn’t have much effect, and that’s important, and it’s really designed in the way that we pay out on those products.
Secondly, there’s certainly major trends, we would absolutely agree with the statement that long-term consumers are going to pay less for financial advice five years from now than they pay today, just like they’re paying less today than they paid five years ago, which is why we think it’s important for us to invest heavily in productivity and in things like Lean, to make sure that we’re continuing to get scale and continuing to really grow our efficiency and really to pass that along to advisers.
So, over the last five years in particular at the company, before we went public, we changed prices at a number of areas. We cut ticket charges. We’re also able to pay higher production bonuses in an attempt to both drive our competitors a little bit batty, and also as an attempt to make sure that our advisers were best equipped for those change in prices. So, as a result, we’ve seen nice growth come by giving them that competitive advantage.
We just announced a couple of fee changes recently, one where we’re cutting charges for transactions and equities in our advisory business, from $15 down to $9, which again will help with the -- will see a nice increase in volume, which tends to overwhelm the cut in fees. And importantly, we’re able to raise fees on our advisers about $1,000 per adviser for the entire system. So, roughly 13,000 people have seen essentially an inflationary increase that’s come as a result of our examination of our costs and the need to charge a bit more in a number of areas, like affiliation fees, E&O insurance, in areas where we see costs going up.
We have a great relationship with our advisers. They understand that we have to make sure the company is profitable. It’s part of our commitment creed that we work on with our advisers and that they understand that there are some inflationary adjustments that have to come along. Likewise, we see it as part of our businesses to make sure and give them the best economic deal so they can be competitive over time. But again, we will not suffer if we see radical product mix from one to the other.
The last one I’ll touch on, our ETFs scenario, that’s of great importance, almost always in front of active managers I get that question. And certainly we believe that ETFs will include active management as they include passive management today. They’re really just a repricing of the service. They take out an enormous amount of administrative cost and the US market and mutual fund has anywhere from as low as 10 basis points of administrative fees up to about 35 basis points of administrative fees. So, just on that component alone, an ETF is really quite an efficient vehicle.
The advisory fee could be very much the same, whether it’s in on a mutual fund structure or an ETF. So, for the money manager, actually can turn out to be quite cost-effective and good tool. For us, we’ve created ways of managing those ETFs. We can do them without ticket charges to the end-clients or to the adviser, and essentially charge a custody fee to take into account that there’s not other revenue-sharing or transfer agency expenses that we receive from ETFs because they’re not structured to do that.
So we have launched a program that’s been our most successful launch in our history of the advisory program, over $1.5 billion of assets in just over a year, that it’s an all ETF portfolio managed by a variety of strategists. So, we applaud those changes, think they’re smart for the consumer, and do think that we have to -- it’s our job to find ways to make them profitable for our business.
How does your compensation structure ensure that advisers don’t sell products that are most profitable for them as opposed to most suitable for the client? And if there is a mis-selling, are you responsible or is the adviser liable?
Well, let me take the questions in backwards order. We are certainly responsible for the nearly 13,000 advisers who are affiliated with our broker-dealer. So if there’s mis-selling, they’re responsible for the mis-selling as are we as a broker-dealer. And in that regard, that’s why I mentioned the number of customer complaints is very low, because we go through an underwriting process before someone joins us, to make sure that we agree with their business practices.
And then we do an annual review of their practice, every year, which includes pulling their credit reports and going through an extensive review of their files for our compliance reviews that we do on a daily basis in many product areas, and we essentially re-underwrite every adviser every year. So, we feel very comfortable with the risk that’s there and how to manage it. We then have a whole variety of insurance that protects their practice and protects us so that essentially our risk is [deductible] of those insurances over time, and of course, reputation risk that comes with that.
So, we have a fantastic track record of doing that quite well. And again, due compliance is a competitive advantage for the company and have invested in it accordingly.
In terms of their own incentives to sell, there’s, within the advisory platforms, of course those are fee for service, meaning that they charge roughly 115 basis points on the assets that are there, and those assets can be of any shape or size, because there’s essentially a flat fee and it’s a negotiated contract between themselves and the customer which we oversee. That market really does not have much problem with those issues.
Within the brokerage world, you have a structure in which they are paid in the majority based on their production levels, which is an acceptable form of compensation within the US markets. It’s been reviewed by all the major regulators through the early 2000s. And the other part of it is that there’s not much difference between what they’re paid on a mutual fund or a variable annuity these days because price compression that’s occurred over the last decade. So there really is not much difference between the various product types at their level to a level, that they would go after a certain product type.
It’s quite different in Europe. As you know, our model still has a robust commission system which of course is not true in the UK, not true in the continent through regulatory change that’s occurred here. So, we still have a very robust program.
If we look at some of the areas that we know that there’s regulatory review, 12B-1 fees, which are the ongoing fee from a packaged product that are paid to an adviser, we receive part of that, but the adviser receives again about 90% of it. There is a review the SEC is doing; we expect the SEC will make changes there. But again, in our view, it’s just part of the longer-term trend that essentially there will be price compression in the business, which is why we’ve wanted the company to be quite sizable and get the advantages of scale that are so critical when industries go through this particular type of change.
All right. Thanks very much.
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