LPL Financial Holdings Inc (LPLA) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the LPL Financial Holdings third-quarter earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Mr. Chris Koegel, Senior Vice President and Head of Investor Relations. You may begin.

Thank you, Vicki. Good afternoon and welcome to the LPL Financial third-quarter 2016 earnings conference call. On the call today are Mark Casady, our Chairman and CEO, and Matt Audette, our CFO. Mark and Matt will offer introductory remarks, and then we will open the call for questions. We ask that each analyst limit their questions to one question and one follow-up.

Please note that we have posted our earnings release on the Events & Presentations section of the Investor Relations page on lpl.com.

Before turning the call over to Mark, I would like to note the comments made during this conference call may include certain forward-looking statements concerning such topics as our future revenue, expenses, and other financial and operating results; improvements in our risk management and compliance capabilities; the regulatory environment and its expected impact on us; industry growth and trends; our business strategies and plans; as well as other opportunities we foresee. Underpinning these forward-looking statements are certain risks and uncertainties. We refer our listeners to the Safe Harbor disclosures contained in the earnings release and our latest SEC filings to appreciate those factors that may cause actual, financial or operating results or the timing of matters to differ from those contemplated in such forward-looking statements.

In addition, comments during this call will include certain non-GAAP financial measures governed by SEC Regulation G. For a reconciliation and discussion of these measures, please refer to our earnings press release.

With that, I will turn the call over to Mark.

Thank you, Chris, and thanks to everyone joining our call today. We are pleased to have generated strong results again in the third quarter. Over the last three quarters, we have felt momentum building. Our long-term investments and multi-year efforts to improve service, technology, and risk management are coming to fruition for our business and our advisors, while our businesses become more efficient at the same time.

Our employees leading our DOL efforts have developed thoughtful plans and innovative solutions, and we believe these have positioned LPL and our advisors to respond to this regulatory change from a position of strength. Advisor sentiment is improving as they experience the benefits of our strategy and investments, and we are seeing increased demand from prospective advisors and institutions.

We're also excited about the additional growth opportunities that the changing regulatory environment is enabling. I will expand on these points on today's call, but we are feeling good about our progress.

Let me first summarize our third-quarter business and financial results. Our total brokerage and advisory assets exceeded a half a trillion dollars at the end of Q3, a significant milestone that demonstrates the success of our advisors and the strength of our model. Our net new advisory assets increased at an 8% annualized rate in the third quarter, supported by continued strong recruiting. Excluding an institutional client that was acquired by another bank that operates its own broker-dealer, net new advisory assets would have grown at a 10% annualized rate. We would have had 88 net new advisors. This follows second-quarter results including net new advisory assets grown at a 6% annualized rate and 100 net new advisors.

Q4 is also off to a good start, so we are pleased with our recruiting progress. Our third-quarter business results, combined with disciplined expense management and effective tax planning, contributed $0.58 of earnings per share, which Matt will cover in greater depth.

I will now expand on what we are seeing in the business, starting with advisor sentiment. In August, we hosted our annual national advisor conference, Focus, and we had over 6000 people in attendance. Advisor feedback at Focus was the best it has been in years. We heard that advisors have felt significant improvements in the speed and quality of our service.

Additionally, advisors were enthusiastic about our new digital advice solution, Guided Wealth Portfolios. They are similarly eager to use new modules in our ClientWorks platform. ClientWorks helps advisors to better automate their operations, in turn helping them spend more time serving investors and growing their businesses. About 80% of advisors and their staff now have access to client works, and we expect that the remaining users will have access by the end of Q1 2017.

Overall, the atmosphere at Focus was one of great energy and willingness to apply new solutions that will help advisors grow their businesses.

At the same time, our advisors are mindful of coming regulatory changes, and they value our industry leadership on this front. We are committed to preserving choice for investors by continuing to offer brokerage solutions for retirement accounts. And, as you recall from prior quarters, we have already done many things to innovate and adapt to regulatory changes. We began to standardize commissions for variable annuities and alternative investments in early Q2. We will soon be rolling out our mutual fund only brokerage account, which has generated significant advisor interest. We introduced our FDIC insured deposit cash account that had more than $4 billion of money market balances convert to the program. Our centrally managed platform enhancements help advisors to serve investors more efficiently.

Beyond those enhancements, we have made further progress over the past quarter, and I will discuss three areas today. First, we are working with sponsors to standardize our brokerage mutual fund commissions. Much like the updates we made in Q2 on variable annuities and alternative investments, standardizing brokerage mutual fund commissions will reduce potential conflict for advisors. Second, in late November, we will be adding more no transaction fee funds to our corporate advisory platform. For those funds, investors will benefit from lower costs made possible by additional sponsor revenue. Those lower investor costs should also help participating sponsors by making them more price competitive versus other mutual funds as well as ETFs. And, third, we are working to make it easy for advisors to take advantage of all these enhancements. For example, this past quarter, we launched our new [Win and Grow] program, which provides advisors with weekly digital outreach, planning tools, customizable content, training webinars, and consulting support. This program helps guided advisors to win competitively and grow their businesses through taking advantage of industry changes and our platform offerings. Thus far, more than 5000 advisors have registered as they embrace change in a way that benefits their clients and businesses.

It is important to note that the same progress which has created opportunity for our existing advisors is also a catalyst for growth with prospective advisors and institutions. Across our industry, we expect more assets to be in motion as a result of changes in the regulatory environment and wirehouse compensation. Advisors and institutions have taken notice of the enhancements we are making, and we are getting more opportunities in our pipeline. For individual advisors and practices, we offer stability, leadership and a platform for growth. The coming regulatory changes are an even stronger catalyst among banks, many of whom are exploring no longer operating a broker dealer rather than have to adapt to new regulations. These are some of the examples of how the DOL rule could create opportunities for us. While it is always difficult to predict the timing of recruiting, we like our current pipeline. As we look forward to 2017, while we have much work ahead to comply with the new regulation, we feel good about our business outlook. The improvements we are seeing in advisor sentiment, and our recruiting pipeline are encouraging, and we are focused on taking advantage of our industry leadership and DOL preparation to gain market share.

On a financial basis, we believe we have already felt the impact of much of the change we are seeing in brokerage commissions, and we continue to expect that the gross profit impact will be manageable going forward.

Let me take a few minutes to share our thinking. Our industry continues to experience long-term secular trends, including the movement from brokerage assets to advisory assets and among brokerage from sales commissions to trailing commission.

The same is true for our business. Most of our gross profit is recurring from advisory assets that are already managed to a fiduciary standard, and most of our brokerage commissions come from recurring trailing revenues that are grandfathered under the DOL rule.

Additionally, networking fees and marketing dollars from sponsors are permitted under the DOL rule. So while we believe that the DOL rule could lower sales commissions, we also believe we have already seen the majority of the impact. Starting with alternative investments, sales commissions are already down more than 90% from three years ago. So any further decline would not be material.

As for brokerage mutual funds, we plan to move to a standardized commission, and we do not anticipate that this will cause a meaningful change in our sales commission rate going forward.

Finally, for brokerage variable annuities, sales commissions are down about 40% over the past three years, consistent with the low interest rate environment. As I mentioned, we moved to a single share class and eliminated L shares in early Q2. So our third-quarter results look a lot like what we expect to see going forward.

In Q3, variable annuity sales commissions contributed about $25 million of annualized gross profit or less than 2% of our total annualized gross profit of $1.4 billion. We expect any further decline in variable annuity sales commissions would be manageable.

Let's now turn to the potential gross profit opportunities due to the changing regulatory environment. We anticipate continued business shifts from brokerage to advisory accounts where appropriate for investors, and that trend could accelerate. And, as a reminder, advisory accounts receive a higher level of service and are more profitable to us than brokerage.

We also think that our new mutual fund only brokerage account will increase assets on our platform and generate additional sponsor revenues. And we believe changes to our centrally managed platforms and offering additional no transaction fee mutual funds will attract more assets to the most profitable parts of our advisory platform.

It is too early to tell precisely how these gross profit factors will all play out; however, we believe we have already experienced much of the potential impact and that any further impact would be manageable.

Now turning to expenses, we like the progress we have made this year to be more productive and efficient, and we are on track to deliver low core G&A growth in 2016. Going forward, we are committed to investing for growth to support our advisors and business progress. At the same time, we plan to continue our trajectory of low core G&A growth in 2017, including DOL implementation costs. We believe this balance will help us keep growing our business while generating operating leverage.

In closing, we had another good quarter, and we like our business outlook. We are focused on strong execution to create long-term shareholder value.

I will now turn the call over to Matt.

Thank you, Mark, and I am glad to speak with everyone on today's call. Before we get into the details of the quarter, it is good to look at our results in context of our long-term objectives. And, as a reminder, we want to grow assets organically and benefit from market growth, grow gross profit faster than our assets and be disciplined on expenses to drive greater operating leverage and EBITDA growth.

We also want to maintain a strong balance sheet while staying dynamic in our capital allocation to grow earnings per share. And if we look at our results, we improved on those measures, so we feel we are making progress.

Now let's get into our Q3 results. We had another good financial quarter, driven by solid fundamentals, disciplined expense management, and effective tax planning. As we expected, these results were partially offset by a seasonally higher payout rate and greater core G&A and conference expenses. As a result, we had $0.58 of earnings per share in Q3.

Let's now discuss our brokerage and advisory assets, which were $502 billion, up $14 billion or 3% sequentially. Net new advisory assets were $4.1 billion and an 8% annualized growth rate. This was up from $2.8 billion or a 6% annualized growth rate in the prior quarter. These Q3 results include the impact of an institutional client that was acquired by another bank that operates its own broker-dealer. Excluding this impact, brokerage and advisory assets would have totaled $505 billion and net new advisory assets would have been $4.7 billion in the quarter or a 10% annualized growth rate.

As for gross profit, it was $347 million in Q3, up $2 million or 1% from the prior quarter. This was driven by increased conference fee revenue from Focus and account termination fees from the institutional client that was acquired. This is mostly offset by a seasonally higher advisor production bonus.

Turning to commissions, there were $432 million, down $14 million or 3% sequentially. Sales commissions were down partly due to Q3 seasonality and partly due to lower market volatility in Q3 than in the prior quarter.

That said, trailing commissions, which made up 55% of commissions in Q3, grew with rising asset balances, enhanced by the favorable secular trend from sales-based to trail-based commissions.

As for advisory fees, there were $322 million, down $1 million or less than 1% from Q2. Recall that in Q2, we had a unique $11 million benefit, and that did not recur in Q3. Excluding that item, advisory fees grew by 3% sequentially. Advisory fees are mostly billed off the prior quarter's asset balances, and at the end of Q2, balances increased along with the S&P 500, which drove advisory fee growth.

Our strong Q3 net new advisory assets also drove part of the increase.

Turning to payout rate, it was 87.2% in Q3, up from 86% in Q2 for two primary reasons. Advisor production bonus increased seasonally as expected, and non-GDC sensitive payout also increased as rising equity markets increased the value of advisor deferred compensation, though there was an offsetting increase in other income.

Next, let's talk about asset-based fees, which include sponsor and cash sweep revenues. Sponsor revenues were $98 million, up $1 million from Q2 as average billable assets were up slightly.

As for cash sweep revenues, they were $41 million, relatively flat to Q2. Starting with balances, investor engagement was fairly consistent through Q3. So balances remained at approximately $29 billion or about 6% of brokerage and advisory assets.

At the same time, more than $4 billion of balances converted from money market accounts to our new FDIC insured DCA accounts. So the mix of balances is somewhat different.

As for third-quarter yields, our ICA yield was 62 basis points, down 1 basis point sequentially. An ICA anchor bank contract which completed at the end of Q2 benefited our ICA yield in Q2 but not in Q3. This impact was mostly offset by Fed funds and LIBOR rates that increased sequentially.

As for our money market yield, it was 42 basis points, up 5 basis points from Q2. We converted lower yielding money market balances to DCA, and the remaining balances had higher yields.

Finally, our DCA yield was 36 basis points. Looking forward to Q4, changes in our cash sweep yields will mostly be a function of interest rates, as well as our management of the cash sweep portfolio. As for our money market yields, we discussed last quarter that we expected money market reform to cause some balances to shift to lower yielding government funds, and we did have $1.6 billion of balances shift at the end of Q2. We expect this will slightly lower our average money market yields, but given the shift happened at the end of the quarter, we expect to see that impact in Q4.

Turning now to transaction and fee revenues. They were $108 million, up $7 million or 6% sequentially. The main drivers of the increase were a $7 million sequential increase in conference revenues from Focus and $5 million of account termination fees from the institutional client that was acquired. Offsetting these increases were lower transaction volumes consistent with lower volatility in Q3, as well as lower revenue from fees that are more seasonal in nature such as IRA maintenance fees.

One final point on the impact to assets and gross profit from the institutional client that was acquired. As is the nature of the institutional side of our business, mergers and acquisitions can lead to banks changing their broker-dealer affiliation to that of the new owner. We expect some degree of this over time and saw that happen in Q3. We had approximately $3 billion of brokerage and advisory assets depart in Q3, and we anticipate an additional $3 billion of brokerage assets will depart in Q4 or later as those assets transition.

We also anticipate this institutional client departure will decrease gross profit by approximately 1% on a run rate basis, starting in Q4.

That said, I will reiterate Mark's point that our institutional pipeline feels ready to generate significant levels of business going forward. Let's now move on to expenses, starting with core G&A.

In Q3, core G&A expense was $175 million, up $7 million from Q2. We continued to keep most costs flat while also investing more in technology and DOL rule implementation.

Additionally, where possible, we want to keep our costs variable and controllable as opposed to increasing our fixed costs. So we paid our nonexecutive employees a nonrecurring bonus instead of providing an annual merit increase, and executives did not receive such a bonus or a merit increase.

Now, thinking about core G&A for the full year, we remain pleased with our progress. We started with expectations for core G&A of $715 million to $730 million, which would have been a growth rate well below the prior year's. Given our progress through the first half, we lowered that outlook twice, and today we are comfortable lowering our outlook yet again to $700 million to $705 million. We know that this implies a sequential increase in core G&A in Q4, but we anticipate greater investments in technology and DOL rule implementation, as well as seasonal costs like customer statements.

We also have costs related to opening and relocating to our Carolinas campus in Q4.

Now, as we move into 2017, we are approaching expenses with the same philosophy as we did in 2016. We first want to make the investments that drive growth, and that is largely technology spend to help improve advisor experience, as well as increase automated automation to drive productivity and efficiency.

Then, we have DOL implementation expenses, and we will also have ongoing DOL compliance expenses as the rule takes effect in April. We are doing all of this with a focus on productivity and efficiency. Taking this altogether, we are targeting 2017 core G&A of $710 million to $725 million. This would translate to growth well below our historical rate, which we believe would position us to create operating leverage.

All right. Let's now turn back to Q3 results and cover promotional expenses. They were $43 million, up $8 million sequentially, primarily due to increased conference expenses from Focus. As we think about Q4 promotional expenses, we won't have a major conference, so we expect conference expenses will decline by approximately $10 million sequentially.

As for transition assistance, it does vary based on our level of recruiting success, and we have had strong results in the last two quarters. But Q4 tends to be one of the strongest recruiting quarters of the year and is off to a good start. So transition assistance may increase, but we would like that outcome.

Moving to regulatory related expenses, our Q3 total was $4 million, down $1 million sequentially due to slightly less activity than in the prior quarter.

Looking forward, these expenses remain quite difficult to predict, especially on a quarterly basis. But we continue to expect full-year 2016 expenses to be meaningfully below prior-year levels.

Let me quickly touch on real estate expenses. Our teams have already started moving into our new Carolinas campus. We anticipate our total expenses will likely increase by about $3 million per quarter, starting in Q4. This will primarily show up as increased interest and depreciation expenses from having built out the building.

We also anticipate some nonrecurring core G&A expenses related to relocation that will mostly be in Q4.

Let's now move to some good progress we have made on our tax rate. One of our primary areas of investment has been our technology. And there are certain tax benefits you can receive on technology spend, but there is a lot of work involved to both document and confirm you qualify. We put significant efforts into documenting and assessing our technology spend, and that work came together in Q3, allowing us to file for these benefits all the way back to 2012. That historical benefit from 2012 through Q2 of 2016 totaled $0.12 of earnings per share.

Going forward, we also expect our tax work could generate a small benefit that could lower our rate by about one half of one percentage point per year, though it could be more or less depending on the year.

Now on to capital management, starting with our leverage ratio. In Q3, our credit agreement net leverage ratio was 3.6 times, down 0.1 times from the prior quarter. If we factored in additional cash on our balance sheet, our leverage ratio would have been 3.1 times.

As for our target leverage ratio, we have been paused in share repurchases for much of the year while holding our target at 4 times. We believe this made sense, given the volatile market we have seen and while we were assessing our capital allocation plans.

Going forward, we want to be in a place where our leverage ratio is at a level where we can deploy capital beyond that with confidence. And there is no escaping the fact that the environment is now different than when we set our target at 4 times a year ago.

After much thought and analysis, we are now lowering our target leverage ratio to a range of 3.25 to 3.50 times. We think this lower level is the right balance of financial strength and flexibility to deploy capital. We are not moving there today, but we will focus on getting there over the next few quarters through earnings growth, debt repayment or a combination of both.

Turning to capital deployment, we still have more than $500 million of cash on the balance sheet, and we have lots of things we are looking at. Our recruiting pipeline is building, especially with large bank prospects where the assets and transition assistance would be larger. We're also planning to invest even more in technology next year, and we could repay some debt to reach our new target leverage ratio.

Finally, we believe the returns we could generate in buying back shares could be quite compelling. So we are being deliberate and methodical about choosing where to deploy our capital as we believe we have many options that could create significant shareholder value.

Looking ahead to Q4, I want to remind everyone that we anticipate our earnings per share will decline on a sequential basis. This is primarily due to the $0.16 of unique Q3 items, our tax planning benefits and account termination fees from the institutional client departure.

Additionally, the seasonality of our business, as well as some planned Q4 spending, is likely to lower our earnings per share. These are all items I have summarized on the call today, so I won't cover them today again. I just wanted to make sure everyone remembers the nature of our business when considering how our Q4 results may play out.

In closing, we are pleased with our continued solid business and financial results. Advisor sentiment is improving, and recruiting has picked up. We believe our new business solutions will benefit our advisors and our financials, and we are staying disciplined on expenses. And we are focused on building on the results from the past three quarters as we work to create long-term shareholder value.

As a final topic for our call today, we know there have been some speculative stories in the news about us, and we understand that you are naturally interested in them. Let me just reiterate two things.

First, we do not comment on rumors and speculation. Second, and perhaps most important, we are focused on creating long-term value for our shareholders. That is what we do each and every day, and will continue to be our focus in the future.

So, before we turn to questions, I want to note we won't comment beyond that. With that, operator, please open the call for questions.

(Operator Instructions) Devon Ryan, JMP Securities.

Maybe just coming back, I know you spoke a little bit about this, but the sales-based portion of commissions, softer, and you have seen kind of a levelized move on the variable annuity side or the annuity side. I guess a couple ones. One, is it fair that we shouldn't expect much average compression as you do the same on the mutual funds aside? And then, just trying to think through with respect to fixed index annuities, it looked like that was a little bit softer. So I'm just curious if that was tied to some uncertainty ahead of the DOL rule.

Let's take the last question first. We did have an increase in fixed annuities about a year ago, so you are just seeing more of a return to the normal levels there. So nothing particularly unusual about that. I think it is probably a little bit related to the interest rate environment where the world seems to anticipate an increase in Fed funds rate, and this is relatively sensitive interest rate money. And so I think that explains that as a return to normalization.

On the mutual fund commission question, important to understand that what we are doing is standardizing the commission charge across all mutual fund families. No matter which fund family you choose, the commission would be the same. And based on what we see in the marketplace, our discussions thus far with mutual fund sponsors and our belief about what is fair compensation that we won't see much substantial change to the average commissions we have today that make their way through the P&L. So not much change really anticipated there.

Okay. Great. And then, with respect to expenses, appreciate the updated guidance there. I'm just curious, when thinking about the messaging here because you have brought it down a couple of times, is that just conservatism? As the year has kind of going on, you have gotten a better picture, or have you actually found more areas where there are savings than maybe you realized as the years progress? I'm just trying to think about -- because when you look at next year and where starting point is already 1%, I think, at the midpoint, just trying to think about how you are thinking about messaging now given that you have had a couple of cuts here.

Sure. I think we are in the ballpark of your latter point, not the former. I think when we lay out our expectations, I think we lay out goals that I think are stretched goals for us to go execute upon, and I think the team overall has just gotten better and better at being executed on productivity and efficiency. And within that, I think getting better and better at allocating our resources to where they are needed most. So I think it is just been a great team effort on getting the productivity and efficiency that we need.

Now, when we look to 2017, I think the things to keep in mind are both our planned increases in technology. So just emphasizing what I said in the prepared remarks, we are focused first and foremost on doing the spending that we think we need to drive growth, and technology is a great example of that. So we are focused on increasing technology next year. We have to continue to implement DOL, not only from an implementation expense standpoint, we are going to have the ongoing expenses as well.

So I think there are some fair reasons that even if you kept all other expenses flat, you will likely have an increase next year. So hopefully, that is a bit of helpful color, but I think the foundation of everything that has happened throughout this year is I think the group is just getting better and better at productivity and efficiency.

Christian Bolu, Credit Suisse.

Mark, you sound more bullish on the recruitment pipeline than I have heard you in awhile. Curious if you could provide a bit more color on what is driving this optimism? And then, any status on what kind of channels you are getting share from and the type and size of an advisor that is likely to come onto the platform.

And then, also, if you -- if it is possible, if you could comment at this point to the 400 net new advisor target that you targeted a couple of years ago.

Yes. So I think we are doing a few things, Christian, is we are seeing a significant increase in volume of inquiries. And so, therefore, we call it the pipeline, right, of those who are likely to consider us to move and who seem likely to move. And that is really what we're seeing is we are seeing a significant increase in that activity, which leads to better recruiting results. So we would certainly feel comfortable with net 400 that we have used historically as a goal and, therefore, the business.

I think some things that are a little bit different are the institutions. So we specifically mentioned those in the prepared remarks, that we are seeing banking institutions really asking themselves the question, should we retain our brokerage structure in the sense of owning our own broker-dealer. We want to stay in the wealth management business, but we can outsource that broker-dealer activity to LPL, and then we really at the bank focus on the advisors and serving our clients. It is something that one of our clients did a couple of years ago where they basically turned over their broker-dealer, shut down their RIA, and now use ours, and it has been a significant improvement for them in terms of growth and in terms of retention of their advisors. And now we are just seeing larger programs come to talk to us about that as well. So we are seeing more opportunities to potentially move that business, and that business moves very nicely because it is basically all moved at once. There isn't sort of the rebuilding that has to occur within an independent practice, and these are larger bank programs than we typically have seen as an organization.

And then, the third area I would point to is the continued movement from weak platforms in the independent space to our platform, which is the strongest and, of course, the market leader. We have been working hard for over a year on the DOL issues, and I think the work shows that, and the work is starting to pay off in terms of showing our existing advisors how we can help them, how we can drive down costs for investors, and how we can help potential advisors come and grow their businesses with us. And that, I know, is resonating based on the prospective advisors I have been talking to as part of this process.

So I think that is a number of things coming together that have been part of our plan for pivoting this regulatory opportunity into a growth opportunity for the business for us in a meaningful way. So we are trying to signal more optimism in the growth of the pipeline and more optimism about our ability to win larger share if it is profitable.

Thank you. That's very helpful. And then, just a quick one on M&A as you as an acquirer were. Just remind us your appetite here to do deals or to acquire struggling BDs? And then, if you would be willing to break the leverage target if an attractive opportunity comes.

Well, all things in life at M&A are built on price. And so, look, we are always looking for opportunities in which we can make sure that we make shareholders a good return on the capital that is used, and we would look to maximize our capital structure to do that, which certainly could improve include leverage and possibly we have a significant amount of cash as well. So we feel very well prepared for any M&A opportunities that come our way, and we do feel like the market is getting into better alignment related to pricing, generally speaking. And I will say, although we don't think so much in recruiting, we are seeing some interest in much smaller dependent broker-dealers about just shutting down and moving on to become what is sometimes called an OSJ or an office with an LPL. We have had some of that happen in this year's recruiting. We see more of that, and we do see what I would describe as small-scale M&A potentially coming up as well. So I don't want to overpromise here, but I do think we are starting to see, again, some forces align as smaller brokerage firms just recognize there is a lot to invest in. The cost of investing in DOL is about the same for all of us, and in our case, it is spread over a significant business. In other cases, it is over a fairly small business. So that is what will lead to M&A, in our view.

Steven Chubak, Nomura.

Mark, had a question relating to one of your earlier remarks on the better economics for advisory, and clearly you guys have made really good progress converting a lot of clients from brokerage to higher fee advisory, which is clearly net accretive. But one of your large wirehouse competitors, which is eliminating commission-based activities and retirement accounts, indicated that they may consider rebating some of those incremental fees ahead of the DOL. I didn't know if you anticipated making any changes of that sort to potentially rebate fees for those clients that you are looking to convert, given that that does technically fall under the BIC.

Yes. Their answer to that is a very specialized answer, which it relates to commissionable activity that would have occurred within the last two years in an account. When you move it into advisory, you can't have just charged a commission two months ago or a year ago and then move them into an advisory product and charge the same. This happens all the time in conversions, so we don't see that as an issue for us at all, and it is unique to their decision to not support investors in the way they want to be supported. We are here to stand for investor choice and to help support our advisors to serve the investor needs that are there, and we think that is the right decision for investors, we think that is the right decision for our shareholders, we think that is the right decision to support our clients, the advisors. So we are approaching this from a very different perspective than those who are choosing to leave or abandon this part of what investors have as a need.

Thanks, Mark. And then, switching gears for a moment and probably a better question for Matt on the leverage strategy is we are still getting a lot of inbound from folks on some of the changes to your guidance. I think it might be helpful if you could articulate what has really fundamentally changed over the last 12 months since you made that initial decision to lever up to 4 times. As I think about the backdrop, the final DOL proposal which came out was a bit better than feared, which you noted, not only on multiple conference calls, but even in an 8-K. Rates are higher and ICA yields are better than your guidance, and markets are, in fact, higher. And yet the actions that you have taken, at least on the leverage side, would suggest the complete opposite. And I was hoping that you could speak to really what has changed over the last 12 months to drive this difference or adjustment to your leverage levels and targets?

Yes. Sure, Steven. So, I think a few things. When you go back to a little over a year ago and sitting on the target 4 times and bridge to where we are today, I mean I think the big thing that has been different is just simply the level of volatility in the market. A couple of examples, the volatility in January and February, I don't think is anything anybody would have anticipated. The vast majority of folks I don't think anticipated Brexit at the end of June. And the volatility associated with that and its impact on our earnings and, therefore, the impact on our leverage ratio is, I think, just higher than you would have thought sitting back in Q4 2015. So just that volatility has been much bigger.

I think, in addition to that, the market's acceptance of risk has really changed than where it was back in Q4. So you put those two things together and the main driver -- the primary driver we have is making sure, as I said in the prepared remarks, that our leverage ratio is at a level we can deploy capital with confidence.

So we want to make sure that we are at that level. When you look at our target of 4 times, which, again, we are sitting at 3.6 today, so we are not talking about much more below where we are right now. But being a half to three-quarters of a turn below that target gives us the ability to absorb a lot more volatility and still deploy capital whether it be in share repurchase or recruiting or M&A to drive value for shareholders. So hopefully, that gives you a fair bit of color, but really what has changed is the level of volatility that we saw and the market's acceptance of leverage on the balance sheet.

Bill Katz, Citigroup.

Just staying on the DOL thing for a moment, sort of reading through even the more recent FAQs that came out, I still have a two-part question here. Just want to talk a little bit about how you are thinking about the payout and whether there is any risk to that?

And then, as I think about the implications of the DOL, could you talk a little bit about what you are seeing at the FA level around the economics for the wrap fee business?

I'm not sure I understand the last part of your question, Bill.

Just wondering if there is any downward pressure on wrap fees that the broker or the financial advisor are charging their clients within the focus on reducing costs?

No. We are not seeing that at all, and I think the numbers bear that out, and it makes sense. In a case of a wrap fee, Bill, they are doing a financial plan. There's regular meetings with the investors. There's a lot of services that go with that fee, and those services are obviously valued by investors, and that is why we see continued strength in that number and don't anticipate that changing.

Obviously, advisors always need to make sure that they are providing good value to investors, and that is what results in their clients giving them more assets or them wanting prospective investors as well.

So let's go back to your DOL question. The FAQs obviously just came out, so we are doing the normal meet and review and kind of reading every line and crossing every T and dotting every I. But I think our preliminary view was this felt good to us in terms of the decisions we have made thus far and doesn't do anything other than affirm the direction that we are heading. So I feel very good about that.

We don't see any changes to the grid. What we are doing is standardized commissions both across taxable and tax-free accounts. That is important to understand. So, as we make changes to our business, in terms of commissions for variable annuities or commissions for alternative investments or for mutual funds, that is true for both types of accounts. So we are anticipating the SEC is going to have something somewhat like this. And, if not, it is just a good practice to make this a little bit more simple to understand for consumers and for advisors alike.

We are also seeing that, in the direct business, which, as you recall today, is unique to the independent broker-dealer market. We still allow that today, but coming in April, we will stop allowing that, and that is where our mutual fund direct account comes into play. Zero fees for consumers, and again that will be used both for tax-free and taxable accounts, which is important. So I think that is important to understand that that gives us a quite positive because that brings new assets to the platforms that are not there today.

So, in the end, we know that what was happening in compensation just highlighted by the DOL or the normal day to day life is that the comps have got to really be driven by what is best for investors and the way that investors want to be served. So it is either appropriate that they are in an ongoing fee-for-service account, known as advisory, or it is appropriate they are doing the occasional transaction within brokerage. And, ultimately, if we can come back to that premise -- that principle, if you will, that is what really matters is doing right by investors, and that will serve the business well over time.

Okay. And just my follow-up and thanks for taking my questions this afternoon. A number of asset managers continue to talk about the shifting landscape of what it is going to be like to be a winner, quote-unquote, on distribution platforms going forward.

So I guess a two-part question is, what would that look like on a go forward basis? I am thinking about maybe just the number of players you have on the platform as well as like at the product line level? If you could provide some insight, that would be very helpful.

Yes, I would be happy to, Bill. And I certainly understand and we hear, of course, the same thing. Dan Arnold, our President, and I have just sort of finished a listing tour with a number of the leaders of asset management companies to make sure I understand their perspective. I think let's come to first principles, which is ultimately asset managers have to deliver value to investors. They have got to be able to get good returns for their accounts. So they are active managers. They have got to provide traceable and clear product returns to investors. So that is sort of an obvious principle that is there, but sometimes not so obvious when you look at the results.

Secondly, that the world is going to get more narrow. Meaning there is going to be a smaller set of products that one can support. We have 130 fund families today in brokerage. We are going to have fewer in the new world because we have to standardize commissions, and that won't work for all of the mutual fund companies. And there will be some that, as we curate the shelf and think about it in context of the DOL and just in general making sure we are doing the right job by investors, as you would expect that number to come down. Our mutual fund direct account will have somewhere around 15 mutual fund families in it as opposed to the 130 that are available today. And that, obviously, is a significant narrowing, but the good news is that represents by far almost 100% of the assets. There is just a large concentration as you would expect once you get beyond even the top 10 of mutual fund families.

So we do see the shelf space narrowing. We do see the number of relationships narrowing, and we see that creating a better ecosystem for the investor -- the end client for the advisor, for the money manager, and, of course, for LPL.

Chris Shutler, William Blair.

First, on the expenses, a couple of quick questions there. I just want to confirm the nonrecurring bonus payments. Did that occur in Q3, or is that still to come in Q4?

And, on the -- I guess, stepping back, more broadly, like on the guidance for next year, Matt, you talked about productivity and efficiency. But maybe get a little bit more specific in terms of what areas are being cut to enable you to spend more on technology and DOL?

Sure, Chris. So, on the bonus, that was paid in Q3. So that expense is fully in the third quarter. When we look at 2017 -- and I would focus on productivity and efficiencies, and we don't use the nomenclature cut. I think when you think about where we are investing our dollars, I think technology is a great example. It is not only an investment to drive solutions for advisors. It is in to drive automation. So the more we spend on technology, the more we automate, the more that productivity and efficiency can fall to the bottom line. There is no one large area where those savings are coming from other than everywhere. So that is the voiceover I would provide. It is really just a team effort on thinking through being productive and efficient, knowing every dollar that we save can either go into something that can drive value for our advisors or, ultimately, just be delivered to the bottom line for shareholders.

Okay. And then, switching gears, Mark, at what pace do you expect the assets to move from directly held to the mutual fund only brokerage account, and is there a good potential, do you think, for that pace to be accelerated?

Well, I think we will have to wait and live into it. What is important is that starting in April of next year, you will need to bring all of your assets that today are done on a direct relationship to LPL's platform. You don't necessarily need to move your historic assets, but any new ones would be there, and obviously those should be nice amounts of flows. We are anecdotally hearing from advisors who are saying, well, gee, if I am going to use the new mutual fund account at LPL, I should just move the assets that are out there. It will make it easier for me because I just then will work with one operating platform. It will be easier for my client who now gets multiple statements. And so this is all a good thing. And, oh, by the way, it is free for your client, so that is even better.

So, as we look at it, we think that that will cause some movement of assets, but we've really tried not to predict it because it is awfully hard to tell. And the secret in life, as you know, is to keep creating a sense of improvement and reporting and economics and the like, which allow us to bring more assets in. But we do think it will certainly be beneficial, and it will certainly offset any contingent weakness in commissions and offset the sort of short-term change happens when people go from commissionable business to advisory. Just hard to tell with any certainty what that is.

So that is why we use the word manageable because, as we look at it, it all seems quite manageable given the change that I talked about in the opening remarks that have really already gone through the commission business.

Ken Worthington, JPMorgan.

First, I am trying to get a better understanding of how the transition from brokerage to advisory driven by the new DOL rules kind of impacts the typical account. So, if a hypothetical brokerage account holds only mutual funds and transitions to an advisory account, is it likely that all the funds just kind of simply migrate initially from A shares in a brokerage account to maybe advisor institutional shares on the exact same funds in the new advisory account? Or under the DOL rules, is the advisor really forced to evaluate each of the individual mutual fund holdings, and therefore, the conversion leads to like a completely new set of mutual fund investments? How does that work?

The mechanics of it all. So the first thing we want to come to is a taxable account. If it is taxable, typically, there is gains given the market results we have had over the last seven or eight years. So the client ones are looking to take gains for tax purposes typically doesn't like to. So they are going to map, as you say from an A share to probably an I share, in most cases, an institutional share class as you describe, and that is going into a fiduciary account. So fiduciary account is, by definition, exempt from the DOL's best interest contract standard. But, of course, if it is a rollover account, there are already DOL rules that are in place for many years in advisory today. So it is really a very simple process, and in my experience, most of it is moved over in exactly that way from the same mutual fund company going from an A share to an I share.

And then, essentially, what happens is, you do look for that commissionable situation. So, let's say, it is an investment that was made five years ago. That doesn't give rise to that commission rebate we were describing before, but if it happened to have been something that was six months ago, you would need to do a rebate to deal with that. And, again, that is normal. There is nothing unusual about that and not material in terms of that change.

And then, basically, our new services that you are providing to your client and the client obviously needs to have those and want those as part of that service, and the pricing, of course, is quite different because it is ongoing advice for an ongoing fee. So just lots of discussion to make sure that that is the case.

But the mechanics are actually pretty straightforward, and one of the tools that we built actually allows an advisor in beta right now to move an account over and keep the same account number, which, as you know, as a consumer -- just makes life easier so you can keep your same account number. So we are trying to make this as easy as possible for consumers in terms of changes that they want to have in the way that they are serviced as it relates to either their tax-free account or their taxable account.

Okay. And then, on the -- same question on the retirement side since there is no pent-up gains. Does the mapping still look very similar, or is there a chance, or is it likely or does it always happen that the mapping completely changes because there is nothing restricting the advisor or the end customer from migrating from one set of old investments to something completely new in the new retirement advisory account?

Yes. It is a great question, and again, my experience is that most of the time, even a tax-free account, there is not much change. Because there was a reason why that investment was a good investment for that consumer. As you say, there is not a tax issue here, so you would have more flexibility. But my experience is, if that was a good investment to have fund company A in your account in a brokerage situation, it is still a good investment in your advisor relationship.

Where you might see some change would be if you want to use a different platform. So, if you want to use one of our centrally managed platforms, model wealth portfolios or, let's say, it is a small account and you want to use guided wealth portfolios, which is our Robo solution, so that is the case. And certainly, our experience here is that mutual funds beget mutual funds, that if it is a change, it is typically that there is something about that fund that the advisor doesn't feel as confident about and wants to change to another mutual fund has been our experience. That is why you see a very little encroachment of ETFs on our platform. It is about 2% per year on the advisory side. There is none in brokerage, and it is because basically the advisors understand the value that money managers are providing and are good at making sure that that is a good fit for what the investor is trying to do as well.

Awesome. Thank you very much.

Michael Cyprus, Morgan Stanley.

Was just hoping to get to the guidance a little bit for 2017 on core G&A. Can you just talk a little bit about how you are thinking about the risk of, say, that core G&A in 2017? Are they coming in higher or lower than what you are guiding to? And so if we are on this call a year from now and expenses are either higher or lower than that, what, in your view, would have driven that out?

Michael, it sounds like you want guidance on guidance. I don't think I've heard that question before. (inaudible).

Yes. Carefully, Mark. So, good question. I think we put a lot of time and effort into our guidance. So I think if you are sitting here in hindsight, I don't really have any specifics for you, other than we are always aiming to deliver bottom-line results that are great for our shareholders. So that the range that we put out has two big areas of investment. It is increasing our technology spend and spending what we need to implement and the ongoing expenses associated with DOL. And I think our -- we have got confidence that we will deliver in that range. Predicting where we are a year from now is -- I am not sure. I just feel confident based on what we were able to deliver in 2016 that we will be able to hit the range that we have laid out for 2017.

And let's say the DOL expenses come in a little bit higher than what you are thinking today. What levers do you have within your business, say, to offset that? For example, maybe passing on through higher regulatory compliance costs to FAs? Is there sort of a fee that you could implement at your discretion, and then what sort of flexibility do you have to adjust the advisor payout?

In thinking about expenses overall, I would say a couple of things. One, one of the success factors, I think, in what we have been able to deliver in 2016 and I think helps with respect to your question is not only have we been able to deliver the productivity and efficiency, I think the team has demonstrated ability to pivot when needed. Meaning allocate costs on the things that matter. So, if DOL ends up costing us more, I think I feel confident that we can adjust our priorities and spend what is needed there and delay something else that we would need to delay or just deliver more productivity the bottom line.

Second point I would make is just, again, looking at what we have delivered so far, and I think the team's focus on implementing DOL that started well before I started here a year ago. You just got a lot of internal resources and expertise on implementing this, meaning that the third-party costs that we have had to use to implement DOL sitting here today versus a year ago have come down a bit. So I think the risk of the DOL expenses being materially larger than we think. Of course, it is there, but I just think it is a little bit lower given how much the internal team has been working on this for quite some time.

Yes. The only thing I think I would add and you asked specifically about fees and the like and, while there is always that flexibility to change -- payout rates are to change -- charges we don't really see the need to do that. And, in fact, what we have been trying to do is grow volume growth and asset gathering by helping advisors be competitive and, also, to change these policies related to things like direct business that will be helpful. Whether that accrues to shareholders is it just drives significantly more assets to the platforms that are better fits for investors, that is more of what they need, and also are more profitable for us, and it also allows us to bring on board assets that we today don't get any economics on as well. So we think that is the right strategy and feel very comfortable that is going to give us some lift that we are not experiencing today.

So there is both the combination of expense flexibility that Matt described and what we would describe as being conservative about asset growth related to those policy changes, I think, gives us plenty of confidence about the guidance we are giving you for 2017.

Great. Thanks for taking my questions.

Chris Harris, Wells Fargo.

What are the characteristics of the advisors you are seeing in the pipeline, and I am specifically wondering how productive they are versus your current advisors?

The recruited classes tend to continue to have the characteristic of being more productive or having higher production levels than the average advisor who is here. That is for a number of reasons, one of which is that -- remember that we have a geographic disbursement here. So I sometimes use the small town that I grew up in, Columbus, Indiana, as an example where it is 30,000 people there, and it is a small place, and if somebody makes $200,000 a year in revenue in their practice, they live quite well. And that market, for the most part, we have covered. And so what we are seeing is more the urban centers being the location for recruiting because we are seeing more come from the more traditional employee models, the wirehouses, and we are also, of course, seeing the independent opportunities for us.

We have had some public announcements about some large group practices that have moved with significant assets. So that is the other characteristic I would add is just large relatively complex businesses that we have an ability to move quite well. We have specialized teams that do nothing but make those transitions really easy for investors and advisors and feel good about our ability to manage the complexity of a move like that. There is not many who can do that.

And then, finally, it is this institutional mix. It has been a little low on the institutional side, say, over the last couple of years, and that is for a range of reasons, but the main part here is that the larger programs are starting to make some changes in the way they think about the wealth management business to offload their fixed costs and essentially rent that costs from us right at an incremental rate, which is quite good for them and quite good for us overall.

And then, in general, we are seeing a pickup as advisors assess the platform they are on and recognize they are not hearing from their management teams about what the solutions are for DOL and they are moving along. So we really do like the average size of the class, the average production we are seeing, and we like the larger group practices that are moving in the institutions.

Okay. Great. Then one clarifying question on the new leverage target. Do you guys want to get to the new target prior to buying back any stock, or might you consider buying back stock at the same time you are approaching the leverage target?

Yes, Chris, I think the timeline is over the next few quarters. We want to be very deliberate about it. Keeping in mind, we are at 3.6 times today. And if you look at the excess cash we have on our balance sheet, we are effectively at 3.1 times. So I would state very broadly on deployment of capital as I think a more tangible example from a recruiting standpoint, we are deploying capital today.

So I think there is a bunch of different scenarios that could be in parallel. We could wait. I think it is more about deploying that overall cash and where we see the recruiting pipeline, which is one of the many things that we had in front of us to deploy capital, but it really depends on how that plays out.

Okay. Thank you.

Doug Mewhirter, SunTrust Robinson.

I just had one question. Obviously, you're going to be working hard to standardize your mutual fund commissions for the DOL reasons. That was spelled out pretty clearly. And so I am wondering, considering you have a range of commissions right now that you are trying to get it to one number, do you think that that standardization will push the average -- the ending average end up near the higher end of that range, the lower end of that range, or do you think that the result will end up being roughly the same as you are now?

Well, again, we are still trying to make sure and understand what is the art of the possible here, given the FAQs coming from the DOL and given our discussions with various product providers. And that is important to us.

So, as we look at it, what we see today is something that probably won't adjust the average much in terms of the category. It is a big category for us in terms of volume. We have -- we believe that, based on the analysis we have done, that it will be fairly close to what it is today.

Okay. Thanks. That was all my questions.

Alex Kramm, UBS.

Just wanted to come back to recruiting for a second, thanks for all the color you have given so far. But if I look at the FAQs that the DOL has put out, it seems like they are really focused on conflict of interest when it comes to recruiting, and maybe this is something you can expand on a little bit. Like how you think it is going to change the recruiting environment and the packages that people are paying to basically for firms like you to really cover all their behinds, I guess, to make sure there is no conflict of interest, and how, maybe, this could be different for, like, wirehouses versus your channel? So just basically asking like, hey, how do you think the risks are to recruiting paying packages and how this could change recruiting holistically over the longer or medium-term?

Yes. So I think we have certainly continued to evaluate this guidance from the DOL as you expect us to. We don't believe that really the majority of our transition assistance is affected. It is -- ours is typically tied to some activity they are doing. They are setting up a new office. They are buying computer equipment and the like. So we are helping enable them in the business. So that is where we are different than the wirehouses have been.

We do think that, broadly speaking, similar to disclosures that FINRA proposed but didn't actually make their way through, that the wirehouses in general are trying to move away from what I would describe as a high payment mechanism of moving of advisors. And this may very well give them the excuse to do so. That means that we would have fewer competition for the movement of advisors who are looking to make a change in their business. That can only be a good thing from our perspective, and of course, it is a good thing to make sure there is transparency and disclosure related to consumers around why individuals change and the like. So that is our perspective on it, thus far, is that is all good as we look at it.

Okay. Fair enough. I guess, second topic, then, just for a second. I think I have asked this in the past, but you made this comment and you made it today again that the advisory business is a better business or higher margin business for you. Can you just flesh it out a little bit? Because sometimes I worry a little bit that -- and please correct me if I'm wrong -- that you are thinking mostly around the GDC side, and it is really the revenue per asset, which is clearly higher on the asset advisory side. But how about some of these other ancillary items? Can you flesh it out a little bit in terms of what kind of fees you are picking up in a brokerage account that are outside of commissions and what kind of fees you are picking up in an advisory account that are outside of advisory fees and how this could differ and how behavior is a little bit different in inside of driving some of these fees? Thank you very much.

Absolutely. So understand there is a lot of complexity to the way these things are done, but quite simply, it is the total return on assets basically that we are looking at. So it is all those fees together, whether it is sales commissions, whether it is the ongoing advisory piece remembering that we keep only 10%. For those numbers, it is the account charges; it is whatever is there. So we boil it down to an ROA view, which tells us basically that advisory is a more profitable business line for us, which makes sense. There's more services that are being offered, so, therefore, there is more we need to do to help the advisor, the investor, in that case. So that is the broad comment, and Matt, you might want to go.

Yes. Sure. I mean, I think from -- we disclosed the overall -- to Mark's point, ROA at 28 basis points, and I would just say directionally, Alex, from an advisory standpoint, we are above that average, call it, in the low to mid 30s. On the brokerage side, we are below that average in the low to mid 20s. And I think that is just how to think about where all the gross profit shows up that Mark described.

All right. Thanks for clarifying that again.

I am showing no further questions at this time. I would now like to turn the call back over to Mr. Mark Casady, Chairman and CEO, for closing remarks.

Well, thank you, everyone, for joining our call today. We look forward to speaking to you in the next quarter.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.