LPL Financial Holdings, Inc. - Managing The Incoming Yield Compression

Summary

• The market is expecting the Fed to cut rates, cutting into spreads earned by financial institutions.
• LPL Financial Holdings, Inc. has anticipated this and has the means to mitigate the earnings impact.
• However, impact to valuations can still be meaningful: investors should be prepared.

On June 19 the Federal Open Market Committee (OTCPK:FOMC) kept the Fed funds rate steady and announced a pivot towards a more dovish stance. You can find more details about that particular Fed meeting in this article. Consequently we expect the financial services firms (e.g., banks, insurance companies, asset managers, etc.) to face yield compression as the spread between low-cost funding sources (i.e., deposits) and interest-earning assets (e.g., loans, investment securities, etc.) narrows. LPL Financial Holdings, Inc. (NASDAQ:NASDAQ:LPLA), a company we actively cover, is impacted by this event. In this article we hope to give investors a better idea of how meaningful the impact could be and how that would affect the valuations for LPLA.

An expectation of rate cuts

According to the CME FedWatch Tool (seen in the chart below), the market probabilities for the July FOMC meeting are 68% for a 25 bps cut and 32% for a 50 bps cut. No room for keeping rates steady and definitely no expectations of a rate hike.

Source: CME FedWatch tool

These probabilities were in sharp contrast to those prior to the June FOMC meeting which displayed a 16% chance of keeping rates steady for July. Furthermore, the Financial reporting industry has jumped on this issue and published articles such as this which solidifies the notion of an impending rate cut in July. As a result it becomes very difficult for the Fed to fight the market on this issue and may be forced to let monetary policy take the path already laid out by the traders.

So given the inevitability of rate cuts - what does that mean for LPLA?

Fed funds rate matters for cash sweep

As described by LPLA in its 1Q19 10Q filing:

Cash sweep fees are generated based on advisors’ clients’ cash sweep accounts. Uninvested cash balances are swept into either insured cash accounts at various banks or third-party money market funds for which the Company receives fees for administration and recordkeeping, which are based on account type and the invested balances. These fees are paid and recognized over time.

Mathematically there are three factors driving earnings from cash sweep: the average cash balances in client accounts, the fees paid to clients for those cash balances, and the yield earned by LPLA on those cash balances lent out to third party banks and other financial institutions. Changes in the Fed funds rate initially affect the yield earned on those cash balances and subsequently impact the fees paid to clients (given enough movement on the rates). Essentially the higher the fed funds rate the higher the earnings from cash sweep.

$10-20 million decline in earnings for each 25 bps cut

As seen in LPLA’s 2019 investor day presentation, the annualized impact of each 25 bps cut is expected to be between $10-20 million on a standalone basis.

Soure: LPLA 2019 investor day presentation

Note that the $10-20 million has already accounted for the duration adjustment and the fixed rate adjustment. Recall that over the past two quarters LPLA management has been increasing the fixed portion of the cash sweep and has been extending the duration of the portfolio. Here is Chief Financial Officer (CFO) Matt Audette explaining the shift during the investor day presentation:

You look from an interest rate sensitivity standpoint, if you bridge from our 10% fixed position, when interest rates moved up or down, most of the dialogue now is when they move down, it would have reduced our earnings by $30 million to $40 million. Move to where we were at the end of the last quarter, 40%, that sensitivity came down to 10 to 20. Now if we get to the midpoint of that range, we're basically neutral to short-term movements and interest rates. Now over the long term, right, we're going to eventually move to wherever that 3-or 4-year point on the curve, but again, for the short-term and near-term volatility, it will largely be gone, right? Again, allowing us to focus on our clients.

We applaud management for thinking ahead and positioning the portfolio in anticipation of a potential turn in the Fed’s stance (as very few market participants would have anticipated a dovish Fed before February or March 2019). Unfortunately, it takes time to renegotiate cash sweep contracts and there are no major contract pricing renewals up in 2019. Hence, management is not able to reposition a larger portion of the cash sweep rate to fixed despite the change in market conditions.

However, we are also cognizant that market sentiment towards a more dovish Fed is usually positive. Hence, we expect the assets under custody (AUC) of LPLA to expand as market value rise. Recall that in a prior article I wrote, I mentioned that 60% of LPLA’s AUC is sensitive to the S&P500 index (SPX). Consequently, we expect that the earnings decline from a lower cash sweep yield will be mitigated by higher AUC. This is very similar to the situation that transpired during 1Q19 as described by LPLA management:

Let's just look at the last 2 quarters, right. Q4, I'm sure everyone remembers well, especially Christmas Eve, S&P went down 400 points in the fourth quarter. So what happened to our cash balances? They went up by nearly $7 billion, right? So you can visually see the economics. They effectively offset. Then what happened in Q1, basically the opposite happened. S&P went back up, went up 300 points, cash sweep went back into the market, down by about $4 billion, in April about $1.5 billion has gone back into the market. So effectively offset, right. So there's natural stability in the model with short-term volatility

Source: LPLA 2019 investor day presentation

So what does this all mean in terms of earnings and valuation?

Impact to valuations

Recall that in my base case scenario as described in this article, I assumed that AUC will grow at 3% per year, gross profit on AUC will grow by 1 basis point ((bp)) per year (as brokerage assets convert to advisory assets), and operating expenses will grow 5% per year (as the company maintains investments in technology and compliance).

Taking into account the lower cash sweep yields in isolation (without any assumed benefit of higher AUC from equity markets) into our base case valuation suggests that gross profit on AUC will decline. As seen in the chart below, an increasing Fed funds rate over time has largely benefited LPLA’s gross profit as a percentage of AUC, increasing it by approximately 6 bps.

Source: LPLA 2019 investor day presentation

We demonstrate the valuation impact of a decline in gross profit per AUC resulting from a decrease cash sweep yields in the table below.

Scenario (decline in gross profit, in bps)	6	3	0
AUC ‘23 (USD million)	728,024	728,024	728,024
Gross profit in AUC (%) ’23	0.3002%	0.3302%	0.3602%
Gross profit (USD million) ‘23	2,185.53	2,403.94	2,622.34
Operating expenses (USD million) ‘23	1,569.83	1,569.83	1,569.83
Effective tax rate ‘23	25%	25%	25%
Net income (USD million) ‘23	461.55	625.58	789.38
Diluted EPS ‘23 (USD per share)	6.15	8.33	10.51
LTM PE (assumed)	15	15	15
Target Price (USD per share) 12/31/22	92.18	124.93	157.65
Upside (%)	14%	55%	95%
Two-year rate of return	7%	24%	40%

Click to enlarge

Source: LPLA 2018 10K, author calculations

Note that the assumptions for AUC, operating expenses, effective tax rate, and number of shares outstanding (accounting for dilution and announced buybacks) remain unchanged from the base case scenario. We used the closing price of $80.69 per share in calculating the upside for 2023 valuations.

As seen in the table above, we continue to expect LPLA to generate positive returns despite the decrease in cash sweep yields. However, the magnitude of said returns are very sensitive to every 1 bp decline in gross profit per AUC. As Matt Audette describes during the 2019 investor day question and answer segment (in response to an analyst question about sustainable margins):

There's no getting around the level of interest rates. When they're low, it's tough on the model. When they're high, it is beneficial to the model, right? I think what we walked through is just removing that near-term sensitivity to that to allow us to focus on spending.

Note that even if LPLA’s gross profit per AUC declines by 3 bps, our expected rate of return is still a decent 24%. In the worst-case scenario that LPLA loses all the margin uplift from prior Fed funds rate increases and gross profit per AUC declines by 6 bps, investors will still enjoy a 7% rate of return. On balance, we continue to like the risk-reward ratio for going long LPLA.

Bottom Line - the easy money is done, but there’s profit left to be made

A dovish Fed makes a decline in the Fed funds rate likely. A decline in the Fed funds rate will negatively impact LPLA’s earnings. The decline in earnings will lower the intrinsic value of LPLA over our investment horizon.

However, the potential decline in earnings can be mitigated via extending duration of the cash sweep rates (which management has done) and via an increase in the market value of assets (which has already happened). Furthermore, we expect management initiatives to expand margins will materialize and further mitigate the earnings impact of a decline in the Fed funds rate. Our scenario analysis suggests that it’s all still upside for LPLA despite the most aggressive decline in cash sweep benefit.

Simply put - no matter what happens on the cash sweep front - we expect management to continue prioritizing organic growth, leveraging the balance sheet, and expanding its competitive advantage in the financial advisory industry. With sufficient margin of safety in the price, we continue to recommend going long on LPLA.

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.