Good day, ladies and gentlemen, and welcome to the LPL Financial Holdings Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator instructions) As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Trap Kloman. Sir, you may begin.

Thank you. Good morning and welcome to the LPL Financial second quarter earnings conference call. On the call today is Mark Casady, our Chairman and Chief Executive Officer, who will provide his perspective on our performance. Following his remarks, Dan Arnold, our Chief Financial Officer, will speak to our financial results and capital deployment. Following the introductory remarks, we'll open the call for questions. We would appreciate if each analyst would ask no more than two questions each. Please note that we have posted a financial supplement on the Events section of the Investor Relations page on lpl.com. Before turning the call over to Mark, I'd like to note that comments made during this conference call may incorporate certain forward-looking statements. This may include statements concerning such topics as earnings growth targets, operational plans, our ability to raise benefits from the pending business opportunities with Financial Telesis and Global Retirement Partners and our abilities to capitalize on the shift toward fee-based business and the lower expense growth rate 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 results 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 of these measures, please refer to our earnings press release. With that, I'll turn the call over to Mark Casady.

Thanks, Trap, and thank you everyone for joining our call. Today, I'll provide commentary on our second quarter performance, our success in attracting and retaining advisors and our agreement with Financial Telesis to expand our presence in the retirement plan market. I'll also share insight into the progress of transformation of our compliance and risk management capabilities that's designed to lower our risk profile. In addition, each quarter this year, we're providing color into areas of long-term growth for LPL. And this quarter, I'll share thoughts on the growth trajectory of our advisory platform and the drivers of LPL success in supporting fee-based businesses. Starting with our financial performance, in the second quarter, adjusted earnings per share of $0.61 was flat year-over-year. Earnings per share benefited from revenue growing 7% to $1.1 billion as well as our repurchase of 6.7 million shares over the past 12 months. We experienced increased spend for the resolution of regulatory issues, which raised our expenses 14% year-over-year, which Dan will speak to further. Our new advisor headcount over the past four quarters, the firm added 431 net new advisors. This trend builds off of our success in 2013 where we led the marketing capture over 6% of advisors in motion, as recently reported by the industry research firm Meridian-IQ. In the second quarter, we included 114 net new advisors, and in the year-to-date, we have retained 97% of our existing production. We continue to be a leader in the industry in these key metrics, affirming our compelling value proposition to advisors. We attracted a variety of advisor practices this quarter, primarily from the independent and wire house channels and saw a growing number affiliate with our unique hybrid RIA solution. We believe that our pipeline for Q3 is solid, and we see positive conditions…

Thanks, Mark. This morning I'll discuss four main themes. First I'll address the fundamental drivers behind our revenue growth in the second quarter, including details on advisor production and activity in our cash sweep program. Second I'll provide insight on our expense structure and share our outlook going forward. I'll then discuss our bottomline results and conclude with an update on our capital management activity. In the second quarter, revenue grew 7% year-over-year to $1.1 billion, driven by a combination of newly recruited advisors, the productivity of existing advisors and market appreciation. These factors also lifted asset level 17% year-over-year to a record $465 billion. Underlying this growth were positive trends in two key performance indicators: advisory net new assets and commissions per advisor. The advisors attracted $16.5 billion in net new advisory assets over the past 12 months, including $4.2 billion in the second quarter, which represents 10% annualized growth. This marks the 10th straight quarter that growth in net new advisory assets has exceeded 8%, reflecting our sustained ability to gather advisory assets. Notably, an increasing percentage of assets continue to flow to our hybrid RIA platform, demonstrating the increasing demand for this unique solution. In the second quarter, we continued to see sustained investor engagement. Overall we achieved moderate commission growth as alternative investment sales returned to near normalized levels. For the quarter, annualized commissions per advisor of $155,000 increased 2% year-over-year and declined 0.5% sequentially. Excluding elevated levels of alternative investment sales, commissions per advisor was flat on a sequential at $152,000. Looking forward, absent a dramatic change in market or economic sentiment, we expect the strength in advisory asset flows to continue in the third quarter. We anticipate a mid single-digit percentage decrease in commissions per advisor on a sequential basis due to seasonality and…

(Operator Instructions) Our first question comes from the line of Chris Harris of Wells Fargo.

So first question on the expenses. You guys gave a lot of good color there. But just wondering if you could expand on that a little bit more. I know just kind of as recently as June, you thought that 5.5% growth for this year was still kind of okay. And so just wondering exactly what happened since that timeframe to move it up to 7%. And then related to that for next year, kind of curious if you could expand on how you're comfortable on hitting that 4% to 6%, because it sounds like a lot of these expenses are going to be kind of recurring. And based on, Mark, what you were saying, some of the risk management build-out is still going to be in effect going into 2015.

If you look at this year's expenses outside of the up-weight in regulatory spend, we are tracking to the 4.5% targeted growth in expenses year-on-year. And if you look at the ramp throughout the year in core G&A, it's very different than last year's ramp where we increased spend over the year by about 18%. It's much flatter this year, so that sets up a different dynamic going into next year relative to meeting that 4% to 6% range. And the shift in guidance from 5.5% back in the quarter to 7% now, it is based on a couple of things. It's regulatory related in terms of the resolution of these matters and it's just -- there was a bit of an increased scope in some of the matters we were working on this quarter as we closed the quarter. And I think, we've got good line of sight on the rest of the year in these matters and hence the increase from the 4.5% at the beginning of the year up to the 7% now for guidance for full year.

Just a couple of things. One is that we do see an ability to really manage forward expenses by being clear about the source of these expense increases, which we view is not permanent to the cost structure of the business because of the investments we're making, particularly in risk management and compliance oversight. That should give us a return that lets us run an organization in which those surprises are not there, and that's the philosophical thing of what we're trying to do, Chris, as an expense matter.

And then my one follow-up would be related to new advisors’ recruiting effort. I mean it sounds like from your comments that things are tracking nicely there, and we've heard kind of constructive things from others as well that are targeting the independent channel. Wondering if that might potentially lead to a little bit better margin for you guys, and what I'm getting at is if all of a sudden there's a lot of demand to get into the independent channel as some of these retention packages are rolling off, might you guys be able to have a little bit of pricing power in bringing in new advisors to your platform?

Well, we certainly see an uptick in activity. So advisors in motion are what we want to be able to capture a large part of the share. We have captured the market leading share. So we obviously have a great history of knowing what to do when advisors are in motion. Just to remind you, our costs for transition systems are among the lowest. They really are the lowest among the top broker/dealers in the country, already. And so that already demonstrates the pricing power we have in moving advisors to our platform. I think it's generally correct that when we see more movement than normal, generally what we find is that the transition of systems doesn't need to be more robust, and in fact it could be less robust. We know that also what we're selling is isn’t transition assistance , it's the value proposition that we have, and an advisor's practice will be more profitable moving on to the LPL platform whether it's a hybrid RIA or in the more conventional business because of the investments we've made in technology and services and capabilities that lets that advisor have a less costly footprint locally. PWC did a study few years ago and that was roughly 18% more profitable, and that's the value we're selling when we're doing recruiting. So, we think that affirming a few things, one is the increase in interest in movement. Two is our ability to capture that. We feel as good as ever about our ability to do that and generally agree that that should come at a cost that is pretty close to where you've seen it most recently.

Our next question comes from the line of Alex Kramm of UBS.

The production expense, to talk about that, why that non-GDC related one was lower than usual and then maybe give us some color of what the outlook is there or that might be ramping over the course of the year?

The GDC related portion of payout is based on two things: your base payout rate, which consistently runs around the 84% range; and then your production bonus. If you look at it on the trailing 12-month basis, it typically runs in the 2.7% range. The non-GDC related piece, we typically see range somewhere in the 20 basis point to 40 basis point range, and that's driven off of two things. One, it's the deferred comp plan for advisors, which is mark-to-market at the end of each quarter and is based on typically a good proxy for that is the movement in the S&P 500 as an example. And then you also have the second thing that drives that non-GDC relation portion is the stock plan that we have, the equity base plan that we have for our advisors. And that is driven off of the LPLA trading price, of which again is mark-to-market at the end of each quarter. And so this quarter, you saw it down relative to the prior two quarters, because actually LPL A was off about $3 over the quarter in second quarter. And you saw a bigger move up in fourth quarter and first quarter, so that helps you at least understand why that sequential change over those three quarters.

And then maybe a bigger picture question. I think you addressed a lot of this in your prepared remark and then in the question that you already answered before. But I just want to ask from a broader perspective, if you look at the results this quarter and you think about the environment out there with equity markets up 22% year-over-year, your revenue growth trailing that by decent amounts, 7% or so, but still growing pretty nicely. But then EBITDA being down and obviously in terms of EPS flattish, I mean obviously you have a lot of stuff going on and a lot of the expense growth. But when I look at that from a big picture perspective, it doesn't create a great picture in this great environment. And now obviously the environment can change again. So I'm just wondering as you think about the next few years and maybe the environment changing for the worst, how do you feel about creating any sort of operating leverage on the positive side or being really hurt?

Just to be clear, we are not happy with these results. We should be getting leverage in gearing into the P&L in a way you don't see the second quarter. So just affirming what I hear a little bit of your voice, the frustration, I could only affirm for you it's the same here. What causes not to get the leverage that we should be getting in the P&L sort of up and down the P&L is essentially cost that we did not foresee or we would have talked about our expense profile differently and a regulatory environment that is much more difficult than we anticipated. We own that and that's our problem. What I do feel strongly about is our ability to control our expenses going forward and our ability to understand the dynamics of the underlying cost. The other thing I can point to give you proof points of that, because at this point, I'm sure what you'd like to see is proof of it, not our words of it, is if you take out the cost that Dan outlined in the discussion part of our call related to regulatory expenses, our run rate has come down dramatically from where it was. That's the way the performance should be running. It's the result of removing cost on our ongoing basis, it's procurement work. It's all the things that we should be doing. So the fundamentals of the business are looking as good as I've seen them in my 12 years here. The issue that we run into is that we've needed to invest heavily in risk management and compliance resources and we're a bit behind the curve. As a result of being behind the curve in that, we're getting the regulators appropriately, making sure that we understand that we should have been ahead of the curve. And therefore they're finding fines traveling through the P&L. Our goal is to get those fines to go away, not because they go away, but because we do a great job in risk management and compliance work. And so that's how we know we can then get the P&L to operate the way that's traditionally operated in all cycles of the market, Alex, which will let us be able to control the levers of cost whether the markets start to go down and sales slow or whether they are robust. And therefore I'd have to increase expenses as a run rate matter when we see volumes increase.

So if you think about the second half of the year, if you were to create a similar type revenue growth characteristic in the 7.5% range and you look at the expenses in the second half of the year, roughly maintaining flat where they were in the first half of the year, then you're going to end up with low single-digit expense growth year-on-year and you're going to then start to see what we would expect how the model would operate where you get 7.5% revenue growth and you're getting low single-digit expense growth. You're going to start to see that margin expansion come back.

Our next question comes from the line of Chris Shutler of William Blair.

On the regulatory expense issue and the upweighted expenses, to the extent that you guys can disclose the issue, what have the issues been? And then what specifically are you doing to mitigate those issues?

Let's start with what they are. So basically we have, as you know, a variety of regulators. So you've seen some of the releases related to fines for matters for securities such as non-traded REITs or variable annuities. We also of course regulated in all 50 states. We've had a number of matters with the states, Massachusetts being the one, as I said here in Boston, that's easiest to point out. We've also had matters with the state of Illinois and a variety of states related to REIT matters. So what we're doing to make sure that we are making sure that investors are protected, which is our primary goal here. Number two, making sure advisors are fully compliant and doing the right thing by clients, which we generally see that they are. These are for the most part home office retrokeeping and processing matters that we've needed to shore up. So let's just rattle off some of the things that we're doing. We've created a centralized review team. That's 70 people that I mentioned in my remarks that are looking at all activities in those areas for products that are just more complex either because the nature of how they're built or the nature of how they're processed. Remember, alternative investments are still a manual paper process, which means it's hard to automate that work. The second thing I'd say is we're spending money and working in partnership with the industry to create a solution for processing non-traded REITs just as we helped created a solution for variable annuities, which helped the process quite a bit. We also are making sure that we're doing a great deal more in terms of training of our own employees, the supervisors who oversee them, the supervisors in local offices and advisors as…

I remember going back probably nine months or a year ago, you guys were talking about how Robert Moore was spearheading some efforts to segment your advisor base a little bit more to try to increase productivity and provide different types for each group. Was just hoping to get an update on those efforts.

We are making good progress on segmentation. And understanding the dynamics of what different groups of advisors need to be, so how does that show up? It shows up for example in our upcoming national conference where advisors who might be smaller in production, but have good growth trajectory will be brought to the conference as part of our training and development of them to help them with their business. That'll be the simplest example I can give you. More complex should be some of the pricing works that we're doing around how to make that simpler for advisors and thinking about the practices that are in effects. And then also thinking about how we deal with transition advisors into the company and what type of practice they have or sort of pre-segmentation, if you will, and how best to help them with that activity. That's also combined with our data management or big data is the common term in the world. We're doing some really fascinating work like Dan just spoke about, because it's not segmentation per se, but it's the same idea, how do we make sure that we're creating better outcomes in terms of growth and profits for the company through being smarter about and put more personalized to the advisors that we serve and their investors and also sponsors in the case of big data.

In this period of leveraging big data and turning it into business intelligence, we look at the opportunity set across our entire ecosystem. So you start with the product sponsors as an example and how can we create efficiency and efficacy in their efforts to position products and ideas and solutions to our advisors in a more effective way that will drive productivity of our advisors and reduce their overall cost of distribution. And to the extent we're successful at doing that, that's obviously a real value we're creating in their overall models, which helps improve our overall economics in those product sponsor relationships. So that's one body of work around business intelligence. The second one that I think ties back to your question around segmentation, it allows us to leverage that insight and information to be able to better support our advisors and their growth opportunities whether that's gathering new clients or new assets with their existing clients and how do we help them better understand where that opportunity set is within their practice and then provide them the solutions in an efficient way, so they are very on target and on point in leveraging where their opportunity is with the right solution, again all in the spirit of helping them grow their practices. So those are two applications, if you will, across the ecosystem, where we would leverage business intelligence to drive value.

Our next question comes from the line of Joel Jeffrey of KBW.

Just a question on the non-traded REITs, I appreciate the color you gave on the performance this quarter and sort of expectations for the third quarter. If I recall, in the last conference call, you guys had talked a little bit about the potential for increased liquidity events happening in the back half of the year. Are you now thinking that this could occur in the fourth quarter or is this just not likely to occur at all?

So again, these are, as we've said along, a little tough to predict, because I think some of the product manufacturers will state they have a plan and then ultimately there's a variety of different reasons why they may shift that plan. And so I think what we do know is there's a couple of larger non-traded REIT sponsors who have suggested that they are contemplating a liquidity event. And when those occur, obviously the repositioning of those assets back into a non-traded REIT all to achieve the same yield characteristics as they had before the liquidity event, you see some upweight in commissions that occur. And so the second half of the year, we had anticipated a bigger opportunity set associated with that. I think there's still some potential for activity from a liquidity standpoint. But as we look out and look forward, we don't see the big variance, if you will, than you saw in the second half of last year. In fact, if you look at the inflated level of AI, which was about $40 million inside the quarters, the second half of last year, at most it would represent about 25% of that inflated amount in the second half of the year.

In the Financial Telesis deal, talking about potentially $20 million to $25 million in annual incremental revenue?

Yes.

And are there any costs associated with that? What was the bottomline impact for those revenues?

You want to think about this just like we're recruiting a new client. So the cost that we're inheriting inside Financial Telesis will be maintained in the new practice that is created Global Retirement Partners. And so the only incremental expenses that we get are the normal traditional growth expenses relative to that $20 million to $25 million of incremental revenue coming onboard. And because this retirement business is not typically custodied here, it has a slightly different revenue trajectory and ultimately margin associated with it in the short run. I think the opportunity set is that now we see a larger practice that can effectively leverage two things: our roll-over program that we've created and our in-planned advice capabilities in this retirement space. And that's a way to more effectively and holistically leverage those capabilities. You'll see the margins drive off from that business and the economics improve.

Our next question comes from the line of Devin Ryan of JMP Securities.

Just wanted to get an update on acquisition opportunities and really your appetite there, specifically around independent broker roll-ups. Is the opportunity any better today? I know that you guys haven't done one in a while. Is the timing better for any reason whether it be better pricing or something else that can just lead to more inorganic activity expanding headcount?

We look at what's available in the marketplace. Our general assessment is that the prices of today and at the quality of what's on offer are not the right transactions for us. As simple as that. I don't see that outlook changing in the foreseeable future for us. And so that lets us put capital work in a different way. We obviously have been buying our own shares, which we see as a bargain. And therefore what we have is ability to make sure you get a good return on that cash by being able to buy back our own shares and use that free cash flow to effectively return to our shareholders. We have about a third of our free cash flow that we use to pay dividends. And that's given us a nice yield on the stock, which certainly has been helpful as we look at the different buyers of it and so forth. And so at this point, we like no better investment than our own and are happy with that. We'll continue to look for inorganic possibilities, but don't see anything on the horizon that looks pretty good.

Of course, we like the organic growth that comes from recruiting as well. And so we continue always to assess that balance around maximizing the opportunity set with the right balance in the cost to acquire that business. And so it's something that we're constantly working on and assessing within an organization who is very adept at capitalizing on their recruiting opportunities and has 60-plus people that's been full time focused on trying to make sure that the marketplace is aware of the capability sets of our model and ultimately and successfully bringing in those new advisors. And as you've heard us talk about before, we generate some of the best returns that we can offer that investment.

We've been in recent months that there's been a bit of increase in demand from third-party banks for cash and that is driving actually little better pricing power on cash balances. And so I just wanted to get a sense if that's the case, that doesn't sound like the yield guidance for next year has changed at all and my guess is that there's timing around which programs roll off and what they're on. But do you expect any upward pressure there based on what's happening in the competitive market right now?

We're beginning to see certainly characteristics of improved pricing power for the reasons that you said. There's certainly the lending environment and has enhanced. There's a growing demand for deposits. We're also seeing some capacity in banks for these types of deposits. And so that creates a greater demand for them to attract new deposits and even some of the clarity that comes with Basil III and LCR rates relative to these deposits are all three things that we believe and are beginning to see signs that pricing power changing a bit. Too early to tell you exactly what that is. We've maintained our flexibility to continue to let those market dynamics evolve a bit before we ultimately make commitments or lend on how to reposition the portfolio in the future.

Yeah, that's certainly helping the portfolio from a maturity standpoint is to try take advantage of that, Devin. Hopefully see demand rise a bit more as the economy improves and as liquidity obviously comes out of the market as the feds slows its QE programs. So we like the idea of shortening up a little bit as much as you can in this current portfolio.

Are you still examining the industrial bank charter or will that be determined as that might be the best course, especially if there's any shift in possibilities from other cash programs?

We're certainly still investigating to understand what the possibilities are. But obviously what we're trying to do is we know that placing deposits into the banking system in the way we're doing, it says once in a while if a banking system works well for us, works well for shareholders. So that is our preferred. There's no capital involved with it. Let's just continue to be a capital light model, which is the preference, which is why I'm saying whether there's optionality or does it help us, for example, in some way in the future as we think about what an ILC might look like.

Our next question comes from Ken Worthington of JPMorgan.

It's (inaudible) for Ken Worthington. Yields in ICA were up 4 basis points this quarter, more than fed funds increased on average for the quarter. Balances are also down a little. Can you talk about the dynamics that drove the yields higher?

The reduction in some of the lower-priced balances create a slight sequential tick up in that yield.

Our next question comes from the line of Bill Katz of Citi.

Just going back to the regulatory backdrop, how much of your incremental spend is idiosyncratic to catching up to pace of growth versus industry dynamic?

100% of it is unique to us in the sense that it's our particular journey in terms of what's happening. So 100% of it's related to fines for us for activities that have occurred. That's the difference what our expense run rate would be to what it actually is. Certainly across the board, what we're seeing in the industry is heightened regulatory review in all financial services industries, not just broker/dealers. But those are individual items to our firm that relate to our practices in and of itself, but we've seen actions by the regulators to our competitors in the space that are similar to what was happening here. And so it's a different dynamic in terms of how they make their way into the world.

Dan, just sort of requalify what you mentioned in terms of where the non-traded REITs are in terms of the contribution to commissions or production. I guess the broader question is, is there any behavioral change you're making with your FAs to reduce the regulatory risk on that side of the equation as long as a result with that if any kind of lasting impact on production levels?

A vast majority of advisors here are doing fantastic job for their investors. When I get to look at all the detail here and if I look at activities in this area, there's a varied situations in which someone is doing something that we'd all agree (inaudible) might be that is by far the far exception. The vast majority of these issues really relate to the way processing occurs and our ability to oversee the process to have certainty of the outcome. Best example would be in a particular state where there's a limit to the amount one can sell, you could imagine how easy it would be to say, gee, that limit comes up to $942 and what I want to do is round it to the nearest dollar and I rounded up and set the rounding down. That actually is a violation of the state's limits. And the matters that we've settled, it'd be fair say 80%-ish rounding errors, maybe 78% that are there. That's not acceptable. So it's still a violation, but it's not bad behavior that's causing that. It's the lack of an automated system that lets us catch that in a way that then prevents the sale from going through. That's what we're building. So what we've done in the interim is we've added people to look at those transactions, 100% of them, make sure the math works correctly, which is our job. And then if it doesn't work correctly, go back to the advisor and work through a solution. So is having some effect? Yes. Just because it's some newer processes that are being built, but not enough to move the revenue line significantly that's there. The other important thing to state is if you look at the totality of products that have been…

Our next question comes from the line of Alex Blostein of Goldman Sachs.

I was wondering if you could break down the contribution to commission per se kind of from a fee-based component versus more transactional, because it seems like the transactional piece per se, I guess, was down, not as much as some would have thought. So I would imagine that the trend might continue into the back half of the year, given how good activity was in this second half of 2013? So mayb just parse it out for us a little bit and give us a sense of where the true commission activity rate number could go in the back half of the year versus the second half of '13.

Your average productivity across both advisory and brokerage in the second quarter of this year was $251,000, of which $155,000 of that was commission-based and $96,000 of that was advisory-based. So if you look at that on a year-on-year basis, you see that good consistent steady 8%-plus growth in advisory and you see your commissions, as you would expect, being up slightly year-over-year from $155,000 to $152,000. But if you back out the incremental small amount of inflated alternative investment or non-traded REIT activity that we had in the second quarter, then your productivity levels on what I would call your baseline goes back to the $152,000 level. So on a year-on-year basis, it would be flat and pretty flat on a sequential basis from first quarter to the second quarter. So that just gives you the characteristics around how advisory is moving and how brokerage or commissions are moving and how they relate to the total productivity in the quarter. And again, that was $251,000. If you look at the second half of the year, to the extent that as we said, we see consistent flow of net new assets, so you would think there would be a correlation in productivity related to the advisory piece with those net new assets coming in. And then from commissions related standpoint, I think what we were saying earlier is if you maintain the same amount of alternative investments sort of inflated amount of business, your jumping off point is $155,000. And you've got some seasonality adjustment from second quarter to third quarter that you would adjust for that's typically in low single-digits to mid single-digit range from second quarter to third quarter. So hopefully that helps you at least break it down, I think, from an advisor productivity standpoint.

And the second question I had, real quick, is just on the rate sensitivity and it's a trailing minor. But I guess when you look at your table, when you guys disclose the upside, it did come down a little bit to 25 basis point from, I guess, 1,700 to 1,600. Anything in particular driving that, I would imagine. I mean maybe some of that is the balance is being lower, but that probably would carry through the rest of the bucket as well. Is there any reason for that?

No, that's the right instinct. It was a combination of two things. One, it actually moved up 2 basis points. And so that's sum of it. And then you don't have as much as upside just because of that and then the balances were down. So that's correct.

And I'm showing no questions in the queue. At this time, ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a wonderful day.