Increasing Our Fair Value for LPL Financial to $289, as Asset Growth Offsets Eventual Rate Headwind

Director

Michael Wong

LPL Financial provides an advisory and brokerage platform for advisors, broker/dealer services for financial institutions, and resources for practice management. At the end of 2022, advisors on LPL's platform served over $1 trillion of wealth management assets in the United States. LPL aims to offer services to all advisors regardless of business model. For example, advisors can be licensed with LPL Financial, giving LPL responsibility for managing risk and compliance, or they can operate as a hybrid Registered Investment Advisor using LPL Financial for custody, trading, and administrative support. LPL has also launched a new employee model that allows advisors to fully outsource practice management. Apart from independent advisors, LPL provides services to more than 2,500 advisors at banks and credit unions and more than 3,500 advisors licensed with insurance companies.

LPL’s capacity to grow its business relies on both the recruitment of new assets and ongoing retention and monetization of existing assets. Production retention, which measures the percentage of advisor-generated revenue maintained from the previous year, has recently been over 95%. This indicates to us that LPL’s services have a high level of stickiness and that maintaining advisor affiliations is an important aspect of the business. Acquisitions of advisor networks have also been a source of growth, with the 2017 acquisition of NPH for $325 million and the wealth management business of Waddell & Reed in 2021 for $300 million showing that LPL is willing and able to buy growth outright when it makes sense to do so.

Being a wealth management firm, LPL has earnings that are highly exposed to changes in the stock market and interest rates. Gross profit in 2023 could increase over 20%, as the company benefits from continued high interest rates. However, when the U.S. Federal Reserve begins to lower interest rates due to a successful soft landing or to combat a recession, gross profit growth will likely move into a mid- to high-single-digit range.

Business Strategy & Outlook

We give LPL Financial a Narrow Morningstar Economic Moat Rating, because the broker/dealer benefits from strong switching costs, evidenced by high retention of advisors on its platform and the stickiness of investor assets. LPL claims to offer advisors the highest average payout ratios of the five largest broker/dealers, and the company is able to provide resources to advisors that its smaller competitors are often unable to match. Annualized production retention, a measure of recurring advisor revenue, has averaged over 95% over the past 10 quarters, with retention ranging from 93% to over 98% in recent years. 

The percentage of advisors switching to a new broker/dealer has decreased over the past decade, and LPL’s ability to retain advisors is generally better than the industry average. In 2018, 6.5% of advisors changed firms compared with over 10% a decade ago. Though LPL is also affected by this systematic churn, recruitment of new advisors to the LPL platform has offset advisor losses in recent years. People are often reluctant to switch advisors because of their relationships with them, uncertainty about the potential cost/benefit trade-off, and inertia with financial management decision-making. Because of this, LPL benefits from stickiness of both its asset and client base. While there is a high level of competition for top advisor talent, LPL has been willing to invest to remain competitive by improving its technology offerings and services. LPL’s strong market position, best-in-class payout, and advisor resources contribute to its meaningful switching costs, which should allow LPL to generate excess returns to shareholders over the next decade.

When evaluating LPL Financial’s ability to attract and retain assets, it’s important to recognize the differing trends of advisory and brokerage asset growth. Net new organic advisory assets, which represent growth of “all-in” investment management accounts, have consistently grown at annualized rates of 6% to over 10%. Advisory assets have also been steadily growing as a percentage of total client assets, with advisory assets at 52% at the end of 2022 compared with less than 40% before 2016. In contrast, net new brokerage assets have been declining significantly. This decline in organic brokerage asset growth won’t necessarily reduce overall brokerage assets in the long term because of market effects.

We think LPL is well positioned to maintain its advisory base and marginally improve market share. Its ability to retain advisors during the recent separation of Independent Financial Partners provides evidence that associating with LPL is appealing for advisors. IFP was an Office of Supervisory Jurisdiction that announced in March 2018 its intention to build its own broker/dealer business and drop its affiliation with LPL. At the time, IFP had $9.5 billion of assets under management, which accounted for about 3% of LPL’s total AUM. LPL retained a majority of the at-risk assets. Though LPL probably offered heavy incentives for advisors to stay, including better payouts and cash bonuses, these costs can be worth the expense if the advisors remain with LPL for a long time. The discrepancy between the 50% of advisors retained and 70% of total AUM indicates that LPL was able to retain the higher-producing advisors, which suggests that retention efforts have been largely successful. For LPL, the risk of large OSJ exits from the platform is a bigger danger than systematic churn, and the relatively successful IFP retention efforts show that LPL can withstand unforeseen advisor departures with limited damage.

As part of its growth strategy, LPL acquired the advisors associated with National Planning Holdings in 2017. LPL needed to convince NPH’s advisors to move to LPL following the acquisition, since advisors are generally able to select their broker/dealer affiliation at will. The terms of the deal were structured with a purchase price of $325 million, and a contingent payment of up to $123 million based on the number of assets and advisors that move from NPH to LPL. Ultimately, LPL was able to convert about 60% of NPH advisors and fell short of its target of 70%. Though LPL was not required to fork out a contingent payment as part of the deal, we think that LPL likely overpaid for the right to integrate the NPH advisor network and that management overestimated its appeal to NPH advisors. With management indicating that mergers and acquisitions are more likely than not, we think LPL will need to show evidence of better advisor conversion following these types of acquisitions, and we like the option of contingency payment deal structures to reduce uncertainty around conversion efforts.

LPL's acquisition of the wealth management business of Waddell & Reed in 2021 went quite well. Retention of client assets was about 99% compared with the 70% that LPL modeled for the transaction. Estimated run-rate EBITDA was revised to be over $90 million compared with over $50 million when the deal was signed.

We believe LPL has the scale and resources to continue to make gains with advisor recruitment, and LPL should be able to absorb fee pressure to maintain its position as a broker/dealer of choice for advisors over the next five to 10 years. We acknowledge that LPL operates in an industry that faces uncertain regulatory conditions and a shifting business model that increasingly emphasizes acting in investors’ best interest. We think LPL's position as a market leader will not go unchallenged, but it should be able to adjust and adapt to changes. On balance, we think LPL will continue to use its scale and industry position to generate consistent net new advisor recruitment in the coming years, and we think LPL's ability to retain sticky financial assets warrants a narrow economic moat rating because of the benefits received from a high level of switching costs.

Narrow

Economic Moat

LPL Financial Hlds

LPL Financial Holdings, Inc. serves independent financial advisors and financial institutions, providing them with the technology, research, clearing and compliance services, and practice management programs they need to create and grow their practices. It provides objective financial guidance to millions of American families seeking wealth management, retirement planning, financial planning and asset management solutions. The company was founded in 1989 and is headquartered in San Diego, CA.

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