Description

Investment Thesis: I advocate a long position in the common stock of LPL Financial Holdings Inc. (“LPLA” or the “Company”), as it is undervalued by the market with an intrinsic value of ~$240.0, representing upside of approximately 20%.

Description: LPLA is a leading independent broker-dealer (“BD”) and provider of comprehensive solutions to financial advisors. LPLA is the largest independent broker-dealer in the United States and the third largest financial advisory firm by advisor headcount. The Boston-based company was formed in 1989 through the merger of Linsco and Private Ledger, and went public in November 2010.

Investment Thesis

• Market dynamics favor a business like LPLA that is an independent provider of retail financial services and advice
  • Overall household investable assets should show strong growth over next decade – baby boomers, wealth accumulation, more advisory, 401K rollovers into IRA.  Mass affluent segment is no exception
  • Increasing desire for financial planning and general investing advice wrapped around brokerage business
  • Push for independence of distribution from manufacturing, from regulatory, client perception and from performance perspective
  • Distribution has grown in negotiating strength relative to the manufacturers over last several years and will likely continue
  • Channel to clients is extremely valuable – should be able to sell a variety of ancillary products where LPLA significantly is underpenetrated; mortgages, insurance, trust products in particular
  • Regulatory scrutiny has raised the bar on competition
• Unique business with a strong competitive position in the generally mediocre world of IBD
  • Strong relative market share – three times next largest IBD
  • Scale allows for significant economic advantage – particularly in back office cost (self-clearing and proprietary software platforms for brokers), recruiting awareness/presence, and in terms of manufacturer mindshare
• Weak competitors
  • IBD distribution margins have typically been thin and firms have been highly dependent on the power of brokers to bring in assets (relationship business with clients), which has meant very high payouts to brokers.  Plethora of sub-scale players has meant fundamental lack of cost/infrastructure leverage and inability to differentiate for most.  With added regulatory costs and diminished ability to extract value from manufacturers via directed brokerage, model becomes more challenging for most IBD’s
  • Wirehouses have made money although largely on brand, scale and pushing proprietary products
• Good business model
  • Strong customer value proposition
    • To end customers – independent contractor model with no proprietary investment products.  Attractive to brokers and attractive to ultimate clients
    • To brokers – 100% focused on brokers – can be a payout but still make money because of scale feeds cost efficiency and the creation of numerous ancillary, non-shared revenue streams
• Compelling unit economics

• Low fixed costs base
  • • >70% of costs vary directly with revenues
    • Relying on brand only in advisor market, not in ultimate client market leads to more efficient marketing
• Only issue here is underlying risk of the independent broker model

• Good momentum – recruiting momentum gives built in ramp as new recruits mature.  Has substantially increased commitment to advisory business.  Increasingly important to manufactures
• Strong management team – very sound operational and strategic management who have been with the company a long time and have made good improvements over the last decade
• Multiple prongs to growth – fundamental investment judgment is on quality of business and competitive position.  From a returns standpoint, clearly there is a bet on growth but that growth can come from a number of different sources (market, same store, new recruits etc.)

Catalysts

• Value acts as its own catalyst
• Rising interest rates

What does LPLA do?

• Independent broker-dealers (“IBD”) compete with wirehouses, insurance agents, captive independents (ING, AIG), banks, discount brokers and other truly independent broker dealers for retail investment assets
  • Offer financial advisory assistance and commissioned financial products (equities, fixed income, life insurance, mortgages, etc.)
  • Really a relationship business where assets move with reps
  • Not a high net worth business (72% of LPLA’s business is from clients with less than $50,000 of assets invested with them)
• LPLA is the number one independent broker dealer
  • Over 17,000 brokers/financial advisors working as independent contractors, not employees
  • Serve advisors who want to operate their own business
  • Offer back-office, product packaging/distribution, compliance, trade execution, research, technology infrastructure, etc.
  • No proprietary products and completely open architecture
  • Essentially a franchisor – take ~10-15% commissions/fees
  • Unique opportunity to be a packager, not a manufacturer, and create additional revenue opportunities as a franchisor
• LPLA’s real customer is the agents/reps
  • Compete with other IBD’s and captive independents for advisors based upon quality of service and technology, breadth of support and payouts
  • Agent price competition ad churn do not appear to be a big issue (switching costs exist)
  • Major competitors for independent mode: are AMEX Financial Advisors, AIG, ING Advisor Network, Raymond James, in addition to captive models like Edward Jones
• Well run business
  • Management is very impressive and been with the business a long time
  • Very metric-focused and advisor-focused
  • 7,124 employees
• Good industry tailwinds
  • Baby boomers coming into over $11 trillion of wealth seeking advice
  • Regulatory scrutiny of integrated manufacturing and distribution
  • Trends toward more profitable fee-based products

Business Economics

• Customer and broker demographics

• Targeting the midrange / upper mid-range brokers
  • Lower than wirehouses or niche IBD’s typically target.  Those places are moving upstream aggressively
  • On par generally with Raymond James, Edward Jones, etc.
  • Higher than most other independents
  • LPLA has a unique ability to make positive contribution on even small contributors
• Through brokers, targeting the mass affluent with $50,000 - $1.0 million of investible assets
  • 15% of business is in CA, balance spread reasonably around country though generally underpenetrated in South and Midwest
• Business model is predicated on scale and ability to generate ancillary (non-shared) revenue streams

Profit building blocks:

• Core commissions and advisory fees – characterized by high payouts to brokers.  Need scale to cover back office, compliance, G&A, fixed costs, etc.  generally slim margins for people but once at critical mass it does have high marginal profitability though smaller dollars
• Non-shared advisory fees – for advisory assets there are a number of fees that come to LPLA that are not shared with the advisor via the payout mat
• Money Market Funds / MMDA fees – fees and spreads earned from customer cash balances where they generate fee from Scudder sweep vehicle to a money market depository account which is more like a banking/spread product where LPLA can get better economics by farming deposits out to participating banks at a wholesale negotiated price
• Manufacturer payment – sponsorships on mutual funds and variable annuities
• Platform fees – LPLA earns a packaging fee on some products sitting between manufacturers and distribution layer essentially.  Small but growing quickly
• Margin lending – small piece of the business

Competitive Landscape

• LPLA has an excellent position due to its “one-stop shop” capability, low-cost position and significant scale, leading market share, conflict-free platform and sticky customer base
  • LPLA is the dominant player for small, newly independent brokers with both fee and commission based business and is uniquely positioned to provide a very attractive way for newly independent advisors to reduce the complexity of running their business
  • Many wirehouse or bank advisors who break away intend to slowly transition from commission-based brokerage business to advisory fee-based business, which is more stable and often more profitable
  • Approximately 75% of LPLA's advisors have both types of accounts: a brokerage, B/D-affiliated account for commission-based assets and an advisory, RIA account for fee-based assets. Using both types of accounts significantly increases the regulatory and reporting complexities for an advisor operating his own business
  • The advisor must operate under two different regulatory regimes (FINRA and the SEC) and must comply with two different standards of responsibility (fiduciary and suitability). The advisor must also integrate data from multiple entities for reporting purposes. LPLA provides a "one-stop shop" for advisors by providing both RIA and BD affiliations, as well as the compliance, clearing and reporting services for both
• LPLA enjoys a low-cost competitive advantage due to its significant scale advantage in the small independent advisor niche.  LPLA is the largest independent BD and has invested over $500 million in technology systems over the last 10 years (continuing to do so), enabling LPLA to serve smaller advisors at a much lower cost than competitors and to do so very profitably
  • LPLA also has the ability to self-clear (other custodians typically outsource clearing to a firm such as Pershing), which eliminates a significant cost. It is unlikely that a smaller firm would develop the capability to self-clear since it is costly to do and requires massive scale  
  • Additionally, as the largest independent BD (by advisors and assets), LPLA is able to negotiate favorable pricing with a number of product manufacturers (e.g. Vanguard, Franklin, Fidelity etc)
• LPLA offers a conflict-free platform, which many advisors find quite attractive and use as a selling point with prospective new clients  
  • Unlike other custodians (e.g. Fidelity) or wirehouses (e.g. Merrill Lynch) which are also product manufacturers, LPLA is solely a distributor.  This avoids the conflict of interest that in-house advisors face when they are incentivized to sell proprietary products (because in-house products are structured to generate larger commissions for the parent company). Many advisors find this quite attractive and can use this independence as a selling point to new clients
  • LPLA has also built a team to provide investment recommendations and managed products to its advisors, which many advisors find useful. Approximately 60% of LPLA's advisors use LPLA's managed investment products or investment recommendations
• LPLA's business is very sticky  
  • Advisors almost never leave voluntarily because of the paperwork involved in re-authorizing a client with a new custodian.  It is a significant administrative hassle for both the advisor and the client
  • LPLA's advisor retention rate is approximately 96%, which includes involuntary advisor departures as well as retirements
• LPLA has built a strong competitive position with an excellent service offering and significant scale that allows the company to earn a 40%+ adjusted EBITDA margin serving small advisors that many other custodians do not even want (i.e. Schwab and Fidelity) and that wirehouses do not care too much to keep.  This speaks to the power of LPLA's low cost business model: this is a very good business with high margins and low capital intensity

Management

• Management is smart, driven and likely to grow per share value over many years.  The team is led by CEO Dan Arnold, and the team has proven to be excellent operators even in changing and tumultuous market conditions
  • This management team structured the cash sweep programs with the anchor banks during the depth of the crisis and extracted favorable terms on 5-7 year contracts when the banks were in dire need of capital
  • By structuring the payout grid so that EBITDA is product-agnostic, LPLA's cash flow is fairly steady and the business is able to handle a reasonable degree of financial leverage
  • Management also has smartly dealt with potential new products that could have potentially adversely impacted cash flow
  • Management found a way to offer ETFs without seeing any decline in cash flow by offering asset allocation wrap products and also introduced an independent RIA platform to stem departures by its highest producing advisors
  • Management has created a wide moat for the business by making smart investments in technology and gaining scale in order to become the low-cost leader in their niche

CEO:  Dan Arnold is the CEO of LPLA.  He is responsible for formulating financial policy, leading the capital management efforts, and ensuring the effectiveness of the organization's financial functions.  Before assuming this role in 2012, he was managing director, head of strategy, with responsibility for developing long-term strategic plans and assessing the trends prevalent in the industry.  He has also served as divisional president of the Institution Services business.  He joined LPLA in January 2007 following the acquisition of UVEST.  Prior to LPLA, he worked at UVEST for 13 years, serving most recently as president and chief operating officer.

It is important to note that, over the last 10 years, LPLA management has focused on driving and managing the company's rapid growth, both organically and through acquisitions.  LPLA recently began to focus on squeezing inefficiencies out of the business model.  During the financial crisis, management reduced general and administrative costs by over $100 million through a 10% headcount reduction, integrating an acquisition and other productivity initiatives.  LPLA’s increased focus on expenses should provide an opportunity to improve the company's already high level of profitability.

Interest Rate Sensitivity

• LPLA earns fees on its advisors' clients' cash in money market funds as well as on client cash that is swept into insured cash accounts (ICAs) 
  • LPLA structured a program to sweep client cash into insured accounts at partnering banks.  Funds in ICA accounts are allocated into several accounts at different banks in order to remain below FDIC limits
  • The cash is treated by the bank like a deposit for regulatory purposes. The 15 banks which participate in the program pay a fee to have the funds swept onto their balance sheet. The banks can invest the cash into longer duration assets on which they earn a spread.  LPLA has 4 "anchor" banks with agreements that pay LPLA the Fed Funds + 90-120bps and agreements with approximately 10 other banks that pay Fed Funds + 60bps 
  • LPLA structured these agreements during the heart of financial crisis when the banks were eager for capital.  If LPLA renewed non-anchor bank contracts today, they would likely feel some compression from the Fed Funds + 60bps fee  

• LPLA's management did an excellent job structuring these long-term agreements, which have provided a nice benefit to the company in today's low yield environment  
  • Given current market interest rates on deposit accounts, LPLA is able to capture the majority of the fee it earns on client cash balances (85bps), while passing on a competitive rate to its clients
  • The agreements with the 4 anchor banks cover approximately 80% of insured cash assets. The agreements do not begin to roll off for another 4 years
  • The capital provided to the banks by LPLA's agreement is actually more attractive to banks than regular deposits because a portion of the swept cash carries lighter reserve requirements 
  • Cash currently represents 5-6% of total client assets, which is a normal amount.  This percentage is down significantly from 10-12% during the financial crisis 
  • Given already normal levels, it seems unlikely that cash levels will further decrease materially, even in a bull-market environment (if client cash levels decreased materially, LPLA's earnings would be negatively impacted)

• The anchor bank agreements are structured with a sliding scale, so that the margin that LPLA earns over Fed Funds will compress as interest rates rise 
  • As a result, LPLA is less sensitive to interest rate movements than Schwab or other banks especially as Fed Funds increases beyond 2.75%  (As Fed Funds rises above 2.75%, any additional interest is paid to the client)
  • A smaller portion of LPLA's client cash is placed in money market funds (MMF) which earn LPLA 15bps today.  As Fed Funds increases above 1.25%, LPLA will earn approximately 55bps on its money market assets instead of the 15bps which it is earning today

Valuation

• • LPL currently trades at a 15x normalized P/E, which is a discount to intrinsic value.
    • Current pricing does not reflect the company's low-risk, scalable business that has the healthy industry tailwind of advisors going independent 
    • The company's strong competitive position and its ability to take share and likely robust industry growth, LPLA will grow Revenue, EBITDA, and EPS by 13%, 19%, and 26% annually, respectively through 2024
      • The growth rates assume 4.0% annual market growth and modest increases in interest rates
      • An investment in LPLA is an excellent risk/reward with a likely 3 year compounded annual return in the low-to-mid twenties with low risk of permanent capital loss
  • Advisor Growth – LPLA will continue to add advisors at a strong pace
  • IBD channel gaining share of advisors
    • Superior economic proposition versus employee-based model
    • Wirehouses – moving upscale and tainted by captive products
    • Captive Insurance - tainted by captive product, narrow product capability
• Market share growth
  • Over indexing in gross adds for industry for relative to share
  • Lower churn particularly among their mid to high level producers
  • Independent – mostly sub-scale
  • LPLA is a better mouse trap
    • Strong RMS in independent channel means in winners circle from recruiting standpoint and disproportionate share of “looks” from brokers looking to move
    • Satisfaction data is very strong and consistent
    • LPLA is well positioned with awareness very high and impressions almost uniformly highly favorable
    • Does not pay upfront for brokers and still gets results
• Biggest competitors – boutique independent niche players (Commonwealth and NFP), RIA’s (powered by Schwab, Fidelity), Wirehouses (to the extent LPLA competes for upper-tier advisors)
• Same store growth – LPLA advisors will continue to grow their book
  • Strong market tailwind (mass affluent trends plus retirement wave)
  • Historical regression data suggests a 4.0% CAGR excluding market impact
  • Underlying commission and advisory yield pricing levels fairly stable
• Mix shift towards Advisory business feeds business profitability
• MMDA – cash sweep program to a brokered deposits model bumps profitability

Risks

Regulatory Environment

• Operates in a highly regulated industry where the broker has a special, quasi-fiduciary responsibility to clients and the firm, notwithstanding the independent contractor model, has a strong oversight responsibility and liability for all of the actions of its brokers.  In the last few years, the number of regulatory actions, sweeps, fines have increased substantially.  Like in other industries, regulators have acted through enforcement rather than rule-making/policy-making and have sometimes found fault/liability etc. today from practices that were industry standard in the past. 

Key issues here:

• General risks/challenges of running a large, disparate, independent contractor broker force
• High level of variable annuity sales
• Payments from mutual fund and variable annuity manufacturers

• Broker fines, sanctions, and disciplinary actions over the last several years are fairly light

• Some ambient level of cost/risk here will be unavoidable but way to mitigate is factor in ~$20M in fines/year
• Variable Annuities (“VA”) – LPLA is a large seller of VA’s, the number 3 independent and number 5 overall.  Significant contribution to revenue and volumes.  Even more important to advisors than to LPLA in terms of contribution.  Product has been under public and regulatory scrutiny for a long time for believe that VA’s are costly and inefficient products that are often oversold or wrongly sold.  Question on VA’s is whether there is any historical liability based on how VA’s have been sold and whether there is a risk that VA’s will be structurally curtailed in the future.
  • Historical liability – to assert historical liability, fundamentally saying that VA’s were unsuitably sold in the past with special concern for the VA’s sold into retirement accounts which account for roughly half LPLA’s VA sales.  The risk would manifest itself in mass class action lawsuits and/or regulatory actions/settlements
  • The SEC and NASD have been concerned about VA’s for over a decade and have looked at them closely several times.  LPLA has always been responsive with the regulators and there aren’t any systematic or meaningful concerns here.  Issue is suitability and churn, not sales into retirement accounts.  There is the risk of historical liabilities/malpractice here but this is a key issue for a long time and management has dealt with it in best possible way
  • There were some lawsuits against a certified manufacturer who had a program aggressively pushing VA churn but no class actions against distributors
  • Compliance and supervision is a big risk here but LPLA has invested heavily in systems to manage any issues here
  • There are structural constraints because of branch network and non-performing manager to be supervised

Market exposure

• A material drawdown in the equity markets would have a negative impact on LPLA by reducing assets and inhibiting advisor recruitment
  • Continuation of the breakaway broker trend - the breakaway broker trend could fail to return to pre-crisis levels though the advantages of breaking off have not been dampened
  • Market conditions have improved and the retention packages paid to advisors are beginning to roll off.  New advisor growth has recently improved in 2022.
  • Decline in the commission rates - commissions on investment products have declined over time, and may continue to decline in the future. Since 1990, mutual fund commission rates have decreased by approximately 50%.  Over the last 5 years, LPLA's commission as a % of AUM has decreased slightly.  It is important to note that LPLA's robust historical growth has happened in the midst of this market decline in commission rates

Competition

• Schwab and Fidelity could potentially begin to target smaller advisors and/or begin to focus on commission-based and dually-registered advisors, neither of which they have done historically.  While LPLA’s existing customers are sticky, competition could slow growth

Conclusion

A long position in LPLA is a compelling investment on a risk-adjusted basis.  LPLA's strong management team, solid business, good competitive position in an attractive, growing industry coupled with current trading levels are the basis of this investment thesis.

Catalyst

• Value acts as its own catalyst
• Rising interest rates