LPL Financial, the behemoth independent broker/dealer, reported disappointing earnings the other day. I thought readers might be interested in what Brad Hintz, an analyst at Bernstein Research, has to say about LPL (Ticker: LPLA), whose shares are down by about 17% over the last 12 months.
I know I am frequently quoting Bernstein, but Hintz once was the CFO of Lehman Brothers and therefore has a keen understanding of broker/dealers and of the financial services industry in general.
Hintz basically calls LPL the only pure-play on the IBD/RIA trend, which has been stealing market share from wirehouses over the last decade. He calls it a “market performer,” but says in a “normal operating environment” has the potential to grow revenue at a double-digit rate. Alas, we are not in a normal operating environment. At a p/e of around 14, LPL is trading just above the S&P’s p/e of 13. This might be a time to begin taking a position in LPLA despite the poor industry outlook; basically individual investors are on a buyer’s strike and their stock market participation appears to have peaked 12 years ago (in 2000). They have been net sellers of stocks ever since 2003-2004. And yet the stock market has been rallying.
Here are excerpts from Hintz’s report:
LPL Financial reported weaker than expected earnings this morning at $0.35 GAAP EPS and $0.49 adjusted EPS vs. our expectations of $0.45 and $0.54, respectively. What happened? Total revenue was lower than expected but that is not a surprise. After all, retail brokerage was slow across the board this quarter and LPLA does not have a material cash-sweep business to soften a downturn like the wire houses or SCHW. Commissions were down sequentially as investors shunned the market. More importantly though, the company's costs ballooned (more details below). As a result, the company reported a 40% adjusted EBITDA margin, the lowest level since Q4'08. Furthermore, management said that investors could expect a similar margin for the next several quarters if growth does not pick up. We revise our 2012 and 2013 adjusted EPS estimates to $2.00 (down 12%) and $2.19 (down 10%) reflecting the poor outlook.
Expenses climb as revenue remains grounded. Production expenses (the payout to LPLA brokers) rose 1% sequentially in the face of shrinking commissions, which were down 4%. A series of new investments, such as Fortigent and NestWise/Veritat, drove expenses higher and lead to rising staff headcount. Thus, compensation grew in a slow environment. Specifically, the firm said that NestWise, its subsidiary that acquired Veritat and aims to grow via the mass market, added $2 million a quarter in expenses and likely will not breakeven until 2014. Meanwhile, Concord, Fortigent and the firm's retirement IRA roll-over program are running at approximately breakeven now. Furthermore, management recognized that the average transition costs for a new advisor has risen, along with the production payout ratio to existing advisors; the firm said it is in the process of revising certain agreements to extract better pricing. Management also announced an ill-defined expense control initiative – no numbers, no range dollar savings and no specific deliverable date. Finally, the tax rate increased to 41% as non-tax deductible expenses remained unchanged sequentially in the face of a revenue decline.
LPLA Management attempted to keep a brave face for the investment community on the conference call. "We continue to expand investment in key strategy areas to fuel future growth" stated the CEO. Management opined that the firm's cash flow numbers remained acceptable – and attempted to focus attention on the published "adjusted" earnings performance. Pointing out that the current environment may be like the 2000 downturn, LPLA noted opined that investing through downturns is a successful strategy since the company can come out of the cycle stronger than it was entering the downturn.
Bottom line on LPL – After the operator announced the earnings conference call was over and the participants should sign off, a voice from LPLA management said "Well done!" to the LPLA team at their headquarters. We beg to disagree... it was not a good quarter. LPLA is a growth company that has just stuttered in its growth trajectory during an admittedly difficult operating environment. It is suffering from the legacy of having been a portfolio company of a private equity firm. Management focuses on cash flow as the key metric for the company and is pursuing growth from M&A rollups and the secular expansion of the independent channel. But LPLA is not a private company anymore and the equity markets will not ignore bottom line earnings of a public company and focus only on future "cash earnings" – and thus the decline in the stock today.
LPLA remains a wager on the growth of the independent investment advisor market. The IIA/RIA market is the most rapidly growing segment of the retail brokerage business in the USA. And driven by this secular trend, LPLA has the scale and the market position to grow at a double digit revenue rate in a normal operating environment. Unfortunately, the retail investor in the USA remains cautious and the entire wealth management business is facing a prolonged slowdown. Market-Perform.