LPL Financial Holdings Remains A Compelling Long-Term Buy

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About: LPL Financial Holdings Inc. (LPLA)
by: Joseph Allan Sinay
Summary

LPL Financial Holdings is a provider of front-, middle-, and back-office services via an integrated self-clearing technology platform to over 8,500 independent financial advisors.

The company has generated a seven-year average ROIC, ROTCE, and ROE of 9%, 27%, and 27%, respectively, through its competitive advantages arising from customer captivity and scale.

Continued growth in advisory assets and centrally-managed assets will raise yield on AUC regardless of the market environment (of which adverse events are operationally hedged).

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LPL Financial Holdings, Inc. (LPLA) is a provider of front-, middle-, and back-office services via an integrated self-clearing technology platform to over 8,500 independent financial advisors (FAs) representing over $628 billion in assets under custody (AUC). I recommend LPLA as a strong buy: over the next five years, I expect LPLA to deliver a price appreciation of 89% under my base case scenario and 236% under my bull case scenario. Management initiatives to increase AUC, shift usage to advisory assets and centrally managed platforms, and maximize operating leverage are expected to drive higher sustainable earnings to shareholders. On the other hand, I expect the downside risk to be capped at 33% under adverse market conditions which I will discuss further.

Most of the information I will be using will be available at the investor relations page of LPLA. LPLA promptly uploads all the investor presentations, earnings transcripts, and Securities and Exchange Commission (SEC) filings on their investor relations website.

Investment Thesis

LPLA is has compounded significant value over the past decade: I calculate 2010-17 average return on invested capital, return on tangible capital employed, and return on beginning shareholders' equity to be 9.21%, 26.64%, and 27.33%, respectively. Said returns were largely due to competitive advantages arising from customer captivity and scale.

According to LPLA's May 2019 Investor Day Presentation, its 14% market share in the $8 trillion independent financial advisory industry is the largest among its peers. Hence, LPLA is able to extract more value from its AUC by negotiating more favorable terms with product manufacturers (e.g., product sponsorship on the LPLA platform) and financial intermediaries (e.g., better cash sweep deals with banks and money market funds). Furthermore, LPLA is able to spread its fixed cost investments in technology and compliance over a wider base of financial advisers, allowing LPLA to attract and retain advisers vis-à-vis wire houses and regional players.

Buying opportunity exists as LPLA expands into the traditional employee model worth $11 trillion in AUC by developing an independent employee business model.

We believe that LPLA management has the ability to successfully expand in this market given its track record. Recall that in 2015, LPLA entered the pure Registered Investor Advisor (RIA) market and was able to gain 8% market share by the end of 2018.

In addition to the employee market, the implementation of a fiduciary standard on a state-by-state basis is another driver for an increase in AUC. Contrary to market expectations, I believe that the shift toward a fiduciary standard will be a net positive for LPLA: The conversion of brokerage assets (~0.52% revenue to AUC) into advisory assets (~0.98% revenue to AUC) effectively double LPLA's margins on AUC. On the cost side, LPLA has already invested in the infrastructure to be compliant with fiduciary regulations, and the company stands ready to convert said brokerage assets into advisory assets (as it has been doing over the past few quarters).

Management is a solid capital allocator. Capital expenditures, amounting to ~25% of operating cash flows, are geared toward capability investments to attract net new assets. Of the free cash flow generated by LPLA, 20% has been deployed toward management acquisitions (which have been accretive to earnings and have been made at reasonable prices e.g., 6-8x EBITDA compared to average LPLA valuation of 12x EBITDA), 60% to buybacks (which have reduced shares outstanding by 14% in the past five years), and 20% to dividends. The company continues to return capital to shareholders, announcing a $1 billion buyback program for 2019-20, potentially reducing total shares outstanding by another 15%.

The rest of the write-up provides more details on the valuation, key risks, consensus expectations, industry structure, and impact of regulations.

Valuation

Our multiples-based scenario analysis suggests that LPLA remains undervalued and offers an attractive risk/reward ratio.

Key Metrics

FY18

Bear '23

Base '23

Bull '23

Total AUC $ Mn

628,000

628,000

728,024

840,406

AUC CAGR%

0.00%

3.00%

6.00%

Gross Profit

1,948.00

1,794.68

2,622.28

3,447.27

Gross Profit on AUC%

0.3102%

0.2858%

0.3602%

0.4102%

OPEX

1,230.00

1,230.00

1,569.83

1,569.83

OPEX CAGR%

0.00%

5.00%

5.00%

Effective Tax Rate%

25.00%

25.00%

25.00%

Net Income

439.55

423.51

789.34

1,408.08

Diluted EPS

4.85

5.64

10.51

18.74

Diluted EPS CAGR%

3.05%

16.72%

31.04%

LTM PE

15.00

10.00

15.00

15.00

Target Price

83.65

56.37

157.60

281.15

Upside%

-33%

89%

236%

IRR%

-8%

14%

27%

Source: LPLA 2018 10-K, Author

Key Risks

A sharp downturn in financial market conditions. LPLA's product mix has a ~60% correlation to movements in the S&P 500: each 100pt decline will likely reduce the company's gross profit by $20M. Furthermore, if the economy weakens and the Federal Reserve cuts the Fed funds rate, the yield on LPLA cash sweep will decline - aggravating the earnings decline from a weakness in equity markets.

However, LPLA has several tools to manage this risk (as it did in the 2008 financial crisis), including the shift in product promotions towards low-risk products (e.g., fixed annuities), drastically reducing operating expenses (e.g., broker assistance, IT infrastructure spend, etc.), and extending duration on the cash sweep placements. More importantly, LPLA has a strong balance sheet (2.15x net leverage ratio and an untapped $500 million revolving credit facility) and minimal regulatory capital requirements, enabling it to survive a sharp and/or prolonged market downturn.

Significant adviser fee compression as part of a broader push to lower retail investment costs. Fees for manufactured products (e.g., mutual funds, ETFs, etc.) have significantly declined. Fortunately for LPLA, the brunt of the fee compression has been in the largely commoditized brokerage business (0.75% revenues per AUC in 2008 to 0.52% in 2017), whereas the fees in the advisory business has been relatively intact. Nonetheless, the emergence of low-cost or hybrid alternatives (e.g., robo-advisors) may continue to pressure the industry pricing structure, leading to lower fees even on the advisory business. In response, LPLA remains at the forefront of improving advisory productivity, investing in technology-enabled solutions to mitigate or offset pricing threats.

Consensus Estimates

My estimate is in line with consensus for 2019, but exceeds consensus estimates for 2020. The difference is primarily driven by my expectations of higher adviser recruitment in 2019, which in turn will drive higher revenues and earnings for 2020.

Metrics $ '000

Consensus

Own Estimate

%

2019 Revenues

5,456,000

5,555,443

2%

2019 EBITDA

1,010,000

966,929

-4%

2019 Operating Profit

832,333

822,149

-1%

2020 Revenues

5,827,000

6,128,630

5%

2020 EBITDA

1,074,000

1,126,527

5%

2020 Operating Profit

889,667

984,807

11%

2021 Revenues

5,845,000

6,548,652

12%

2021 EBITDA

1,112,000

1,173,444

6%

2021 Operating Profit

833,000

1,034,718

24%

Source: Bloomberg, Author

Industry Structure

The core market for the independent broker-dealer channel amounting to ~$2.3 trillion in investable assets is very fragmented. As of the end of 2018, LPLA claimed that it had 13% market share while the next top 4 competitors Raymond James Financial, Inc. (RJF), Ameriprise Financial, Inc. (AMP), Cetera Financial Group, and American International Group, Inc. (AIG) claim 43%. The remaining 44% of the market is divided among over 900 independent broker-dealers. These players are predominantly sub-scale and below the $200 million in AUC necessary to economically invest in the technological and compliance capabilities to meet regulatory and competitive requirements.

Discussion of Valuation Assumptions

Key Assumptions

Bear '23

Base '23

Bull '23

AUC CAGR%

0.00%

3.00%

6.00%

Gross Profit on AUC%

0.2858%

0.3602%

0.4102%

OPEX CAGR%

0.00%

5.00%

5.00%

Effective Tax Rate%

25.00%

25.00%

25.00%

Source: Author

Bear case scenario: I assumed a recession in 2019, triggering a decline in the S&P by 40% and a cut in the fed policy rate to 0.00-0.25%, in line with the 2008 experience. As a result, AUC falls by 24% in 2019 and yields on cash sweep declines by 75%. In response, LPLA engages in cost cutting measures and rationalizes broker payouts. In the subsequent years, I forecast the S&P to grow 10% p.a. until 2023, bringing AUC to pre-recession levels (with some net new assets from defensive assets such as bonds and annuities). In sum, the bear scenario assumes a recession in 2019, resulting in a five-year forecast of flat AUC growth, a decline in margins (i.e., lower cash sweep yield and fee compression), and cost cutting on operating expenses.

Base case scenario: I assumed that AUC will grow at 3%, representing half the organic growth rate of its underlying markets (e.g., independent broker dealer, RIA, institutional, and hybrid). I did not assume any AUC uplift or decline from changes in market value of AUC. However, I assumed that brokerage assets will continue to convert at a rate of 1 percentage point per year, with each percentage point increasing gross profit on AUC by 0.01 bp. In turn, the company will have to continue moderately investing in marketing and compliance, resulting in operating expense growth of 5% p.a. In sum, the base case scenario assumes a conservative organic growth rate in AUC, improving margins due to the shift from brokerage to advisory, and modest reinvestment in marketing and compliance over the next five years.

Bull case scenario: I assumed that AUC will grow at 6%, representing the organic growth rate of its underlying markets. As with the base case scenario, I did not assume any change in AUC from changes in market value. I assumed a more aggressive shift from brokerage to advisory assets, converting at a rate of 2 percentage points per year, raising gross profit on AUC by 0.10bps over the next five years. In order to support the AUC growth, I maintained a 5% CAGR on operating expenses, primarily for marketing and compliance purposes. In sum, the bull case scenario assumes a fair organic growth rate in AUC, improving margins due to an aggressive shift from brokerage to advisory, and modest reinvestment in marketing and compliance over the next five years.

History and implications of Fiduciary Standard Regulations

The Department of Labor's (DOL) Fiduciary rule was initially proposed in April 2016 in response to a call from President Obama in February 2015 to have financial advisers put client interests above self-interest. The implementation of the rule would have required financial advisers to disclose in dollar terms all fees and commissions for retirement plans and retirement planning advice to clients whose accounts are part of a defined-contribution plan, a defined-benefit plan, or an Individual Retirement Account (IRA). Consequently, the rule faced significant opposition from market players: market players argued that the implementation of the rule would lead to significant losses for the commission business in lost fees and commissions, amounting to $2.4 billion per year.

Said challenges to the rule eventually led to the U.S. Fifth Circuit Court of Appeals in May 2018 to vacate the DOL, citing the rule to be "unreasonable" and "an arbitrary and capricious exercise of administrative power." In turn, the SEC has now taken the lead in developing a new standard, potentially a less aggressive one. On the other hand, some states (e.g., Maryland, Nevada, New Jersey) have proposed their own version of a fiduciary standard. As a result, financial advisers face a significant amount of regulatory uncertainty.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.