XFRA:7LI LPL Financial Holdings Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2012
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to
Commission File Number: 001-34963
LPL Investment Holdings Inc.
(Exact name of registrant as specified in its charter)
Delaware
20-3717839
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)

One Beacon Street, Boston, MA 02108
(Address of Principal Executive Offices) (Zip Code)

(617) 423-3644
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes     o No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes     o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
 
 
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes     x No
The number of shares of Common Stock, par value $0.001 per share, outstanding as of April 20, 2012 was 110,429,780.





TABLE OF CONTENTS
Item Number
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 




i




WHERE YOU CAN FIND MORE INFORMATION

We file annual, quarterly and current reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the Securities and Exchange Commission (the "SEC"). You may read and copy any document we file with the SEC at the SEC’s public reference room located at 100 F Street, N.E., Washington, D.C. 20549, U.S.A. Please call the SEC at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public from the SEC’s internet site at http://www.sec.gov.

On our Internet website, http://www.lpl.com, we post the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: our annual reports on Form 10-K, our proxy statements, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act. Hard copies of all such filings are available free of charge by request via email (investor.relations@lpl.com), telephone (617) 897-4574, or mail (LPL Financial Investor Relations at One Beacon Street, 22nd Floor, Boston, MA 02108). The information contained or incorporated on our website is not a part of this Quarterly Report on Form 10-Q.

When we use the terms “LPLIH”, “we”, “us”, “our”, the “firm” and the "Company," we mean LPL Investment Holdings Inc., a Delaware corporation, and its consolidated subsidiaries, taken as a whole, unless the context otherwise indicates.

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of this Quarterly Report on Form 10-Q contain forward-looking statements (regarding future financial position, budgets, business strategy, projected costs, plans, objectives of management for future operations, ability and plans to pay regular dividends and other similar matters) that involve risks and uncertainties. Forward-looking statements can be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts” and similar terms. Forward-looking statements are not guarantees of future performance and our actual results could differ significantly from the results discussed in the forward-looking statements. For example, we may be unable to successfully integrate the systems and operations of Fortigent, LLC and realize the expected synergies from the transaction, and our Board of Directors may not approve the payment of quarterly cash dividends or may authorize quarterly cash dividends of a different amount than previously considered or specified. Other factors include risks and uncertainties associated with changes in general economic and financial market conditions, fluctuations in the value of assets under management, effects of competition in the financial services industry, changes in the number of our financial advisors and institutions and their ability to effectively market financial products and services, the effect of current, pending and future legislation and regulation and regulatory actions. In particular, you should consider the numerous risks outlined in Part I, Item IA— “Risk Factors” in our 2011 Annual Report on Form 10-K filed with the SEC.

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. You should not rely upon forward-looking statements as predictions of future events. Unless required by law, we will not undertake and we specifically disclaim any obligation to release publicly the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of events, whether or not anticipated. In that respect, we wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made.



ii



PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Income
(Unaudited)
(Dollars in thousands, except per share data)

 
 
Three Months Ended
March 31,
 
 
2012
 
2011
REVENUES:
 
 
 
 
Commissions
 
$
463,653

 
$
451,877

Advisory fees
 
250,981

 
244,087

Asset-based fees
 
97,241

 
89,823

Transaction and other fees
 
74,572

 
73,749

Interest income, net of interest expense
 
4,710

 
5,142

Other
 
10,616

 
9,191

Total net revenues
 
901,773

 
873,869

EXPENSES:
 
 
 
 

Commissions and advisory fees
 
617,392

 
594,678

Compensation and benefits
 
89,012

 
84,142

Depreciation and amortization
 
17,175

 
18,165

Promotional
 
16,831

 
19,536

Occupancy and equipment
 
14,497

 
15,525

Professional services
 
13,121

 
10,164

Brokerage, clearing and exchange
 
9,515

 
9,649

Communications and data processing
 
8,899

 
8,682

Regulatory fees and expenses
 
7,546

 
6,572

Restructuring charges
 
1,694

 
537

Other
 
6,672

 
6,489

Total operating expenses
 
802,354

 
774,139

Non-operating interest expense
 
16,032

 
18,172

Loss on extinguishment of debt
 
16,524

 

Total expenses
 
834,910

 
792,311

INCOME BEFORE PROVISION FOR INCOME TAXES
 
66,863

 
81,558

PROVISION FOR INCOME TAXES
 
25,684

 
32,559

NET INCOME
 
$
41,179

 
$
48,999

EARNINGS PER SHARE (Note 12):
 
 
 
 

Basic
 
$
0.38

 
$
0.44

Diluted
 
$
0.37

 
$
0.43

See notes to unaudited condensed consolidated financial statements.

1




LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
(Dollars in thousands)

 
 
Three Months Ended
March 31,
 
 
2012
 
2011
NET INCOME
 
$
41,179

 
$
48,999

Other comprehensive income, net of tax:
 
 
 
 
Unrealized gain on interest rate swaps,
   net of tax expense of $254 and $821, respectively
 
409

 
1,325

Total other comprehensive income, net of tax
 
409

 
1,325

TOTAL COMPREHENSIVE INCOME
 
$
41,588

 
$
50,324


See notes to unaudited condensed consolidated financial statements.


2



LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition
(Unaudited)
(Dollars in thousands, except par value)
 
 
March 31, 2012
 
December 31, 2011
ASSETS
Cash and cash equivalents
 
$
688,818

 
$
720,772

Cash and securities segregated under federal and other regulations
 
340,444

 
382,905

Receivables from:
 
 

 
 

Clients, net of allowance of $672 at March 31, 2012 and $716 at December 31, 2011
 
288,413

 
301,292

Product sponsors, broker-dealers and clearing organizations
 
161,023

 
143,493

Others, net of allowance of $8,608 at March 31, 2012 and $8,833 at December 31, 2011
 
192,926

 
187,408

Securities owned:
 
 

 
 

Trading — at fair value
 
6,688

 
6,290

Held-to-maturity
 
9,152

 
11,167

Securities borrowed
 
11,977

 
7,890

Income taxes receivable
 
90

 

Fixed assets, net of accumulated depreciation and amortization of $312,232 at March 31, 2012 and $305,143 at December 31, 2011
 
92,634

 
91,317

Debt issuance costs, net of accumulated amortization of $1,912 at March 31, 2012 and $19,197 at December 31, 2011
 
24,618

 
18,620

Goodwill
 
1,334,086

 
1,334,086

Intangible assets, net of accumulated amortization of $207,971 at March 31, 2012 and $198,139 at December 31, 2011
 
527,838

 
537,670

Other assets
 
86,768

 
73,416

Total assets
 
$
3,765,475

 
$
3,816,326

LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
Drafts payable
 
$
157,350

 
$
187,575

Payables to clients
 
412,007

 
456,719

Payables to broker-dealers and clearing organizations
 
29,318

 
34,755

Accrued commissions and advisory fees payable
 
105,803

 
109,715

Accounts payable and accrued liabilities
 
132,253

 
161,776

Income taxes payable
 

 
906

Dividends payable
 
220,590

 

Unearned revenue
 
65,551

 
59,537

Securities sold, but not yet purchased — at fair value
 
342

 
161

Senior credit facilities
 
1,350,000

 
1,332,668

Deferred income taxes — net
 
115,718

 
127,766

Total liabilities
 
2,588,932

 
2,471,578

STOCKHOLDERS’ EQUITY:
 
 

 
 

Common stock, $.001 par value; 600,000,000 shares authorized; 114,066,252 shares issued at March 31, 2012 and 110,531,939 shares issued at December 31, 2011
 
114

 
110

Additional paid-in capital
 
1,186,002

 
1,137,723

Treasury stock, at cost — 3,767,525 shares at March 31, 2012 and 2,617,629 shares at December 31, 2011
 
(126,523
)
 
(89,037
)
Accumulated other comprehensive loss
 
(441
)
 
(850
)
Retained earnings
 
117,391

 
296,802

Total stockholders’ equity
 
1,176,543

 
1,344,748

Total liabilities and stockholders’ equity
 
$
3,765,475

 
$
3,816,326

See notes to unaudited condensed consolidated financial statements.

3



LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Stockholders’ Equity
(Unaudited)
(Amounts in thousands)

 
 
 
 
 
Additional
Paid-In
Capital
 
 
 
 
 
Accumulated Other
Comprehensive
Loss
 
Retained
Earnings
 
Total
Stockholders'
Equity
 
Common Stock
 
 
Treasury Stock
 
 
 
 
Shares
 
Amount
 
 
Shares
 
Amount
 
 
 
BALANCE — December 31, 2010
108,715

 
$
109

 
$
1,051,722

 

 
$

 
$
(4,496
)
 
$
126,420

 
$
1,173,755

Net income and other comprehensive income, net of tax expense
 

 
 

 
 

 
 
 
 
 
1,325

 
48,999

 
50,324

Stock option exercises and other
126

 
 
 
1,022

 
 
 
 
 
 
 
 
 
1,022

Excess tax benefits from share-based compensation
 
 
 
 
35,967

 
 
 
 
 
 
 
 
 
35,967

Share-based compensation
 
 
 
 
4,848

 
 
 
 
 
 
 
 
 
4,848

BALANCE — March 31, 2011
108,841

 
$
109

 
$
1,093,559

 

 
$

 
$
(3,171
)
 
$
175,419

 
$
1,265,916

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
BALANCE — December 31, 2011
110,532

 
$
110

 
$
1,137,723

 
2,618

 
$
(89,037
)
 
$
(850
)
 
$
296,802

 
$
1,344,748

Net income and other comprehensive income, net of tax expense
 
 
 
 
 
 
 
 
 
 
409

 
41,179

 
41,588

Issuance of common stock to settle restricted stock units (Note 11)
2,823

 
3

 
(3
)
 
 
 
 
 
 
 
 
 

Treasury stock purchases (Note 11)
 
 
 
 
 
 
1,150

 
(37,486
)
 
 
 
 
 
(37,486
)
Dividends declared on common stock
 
 
 
 
 
 
 
 
 
 
 
 
(220,590
)
 
(220,590
)
Stock option exercises and other
711

 
1

 
4,122

 
 
 
 
 
 
 
 
 
4,123

Excess tax benefits from share-based compensation
 
 
 
 
37,664

 
 
 
 
 
 
 
 
 
37,664

Share-based compensation


 


 
6,496

 


 


 


 


 
6,496

BALANCE — March 31, 2012
114,066

 
$
114

 
$
1,186,002

 
3,768

 
$
(126,523
)
 
$
(441
)
 
$
117,391

 
$
1,176,543

See notes to unaudited condensed consolidated financial statements.

4



LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Dollars in thousands)

 
 
Three Months Ended
March 31,
 
 
2012
 
2011
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
 
Net income
 
$
41,179

 
$
48,999

Adjustments to reconcile net income to net cash (used in) provided by operating activities:
 
 
 
 
Noncash items:
 
 
 
 
Depreciation and amortization
 
17,175

 
18,165

Amortization of debt issuance costs
 
1,228

 
1,273

Share-based compensation
 
6,496

 
4,848

Excess tax benefits related to share-based compensation
 
(37,664
)
 
(35,967
)
Provision for bad debts
 
126

 
321

Deferred income tax provision
 
(12,302
)
 
(5,509
)
Loss on extinguishment of debt
 
16,524

 

Lease abandonment
 
26

 
414

Loan forgiveness
 
375

 
371

Other
 
(82
)
 
(125
)
Changes in operating assets and liabilities:
 
 
 
 
Cash and securities segregated under federal and other regulations
 
42,461

 
93,908

Receivables from clients
 
12,922

 
(24,827
)
Receivables from product sponsors, broker-dealers and clearing organizations
 
(17,530
)
 
27,908

Receivables from others
 
(6,062
)
 
(14,477
)
Securities owned
 
(28
)
 
41

Securities borrowed
 
(4,087
)
 
(3,408
)
Other assets
 
(14,125
)
 
(1,145
)
Drafts payable
 
(30,225
)
 
(16,978
)
Payables to clients
 
(44,712
)
 
34,277

Payables to broker-dealers and clearing organizations
 
(5,437
)
 
23,533

Accrued commissions and advisory fees payable
 
(3,912
)
 
(18,003
)
Accounts payable and accrued liabilities
 
(33,276
)
 
(31,288
)
Income taxes receivable/payable
 
36,668

 
82,592

Unearned revenue
 
6,014

 
6,810

Securities sold, but not yet purchased
 
181

 
(2,276
)
Net cash (used in) provided by operating activities
 
$
(28,067
)
 
$
189,457



5



LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows - (Continued)
(Unaudited)
(Dollars in thousands)
 
 
Three Months Ended
March 31,
 
 
2012
 
2011
CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
 
Capital expenditures
 
$
(4,270
)
 
$
(3,292
)
Purchase of securities classified as held-to-maturity
 

 
(2,767
)
Proceeds from maturity of securities classified as held-to-maturity
 
2,000

 
650

Deposits of restricted cash
 

 
(500
)
Release of restricted cash
 
500

 
17,006

Acquisitions
 

 
(16,674
)
Net cash used in investing activities
 
(1,770
)
 
(5,577
)
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
 
Repayment of senior credit facilities
 
(1,332,668
)
 
(43,493
)
Proceeds from senior credit facilities
 
1,330,681

 

Payment of debt issuance costs
 
(4,431
)
 

Repurchase of common stock
 
(37,486
)
 

Excess tax benefits related to share-based compensation
 
37,664

 
35,967

Proceeds from stock options and warrants exercised
 
4,123

 
1,022

Net cash used in financing activities
 
(2,117
)
 
(6,504
)
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
 
(31,954
)
 
177,376

CASH AND CASH EQUIVALENTS — Beginning of period
 
720,772

 
419,208

CASH AND CASH EQUIVALENTS — End of period
 
$
688,818

 
$
596,584

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
 
 
 
 
Interest paid
 
$
15,973

 
$
18,178

Income taxes paid
 
$
815

 
$
479

NONCASH DISCLOSURES:
 
 
 
 
Capital expenditures purchased through short-term credit
 
$
4,390

 
$
3,515

Increase in unrealized gain on interest rate swaps, net of tax expense
 
$
409

 
$
1,325

Dividends declared but not yet paid
 
$
220,590

 
$

Discount on proceeds from senior credit facilities recorded as debt issuance costs
 
$
19,319

 
$

See notes to unaudited condensed consolidated financial statements.


6


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)



1.    Organization and Description of the Company

LPL Investment Holdings Inc. (“LPLIH”), a Delaware holding corporation, together with its consolidated subsidiaries (collectively, the “Company”) provides an integrated platform of brokerage and investment advisory services to independent financial advisors and financial advisors at financial institutions (collectively “advisors”) in the United States of America. Through its custody and clearing platform the Company provides access to diversified financial products and services enabling its advisors to offer independent financial advice and brokerage services, using both proprietary and third-party technology, to retail investors (their “clients”).

2.    Summary of Significant Accounting Policies
Basis of Presentation Quarterly Reporting — The unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. These adjustments are of a normal recurring nature. The Company’s results for any interim period are not necessarily indicative of results for a full year or any other interim period. Certain reclassifications were made to previously reported amounts in the unaudited condensed consolidated financial statements and notes thereto to make them consistent with the current period presentation.
The unaudited condensed consolidated financial statements do not include all information and notes necessary for a complete presentation of financial position, results of income, comprehensive income and cash flows in conformity with generally accepted accounting principles in the United States of America (“GAAP”). Accordingly, these financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the related notes for the year ended December 31, 2011, contained in the Company’s Annual Report on Form 10-K as filed with the SEC. The Company has evaluated subsequent events up to and including the date these unaudited condensed consolidated financial statements were issued.

Consolidation — These unaudited condensed consolidated financial statements include the accounts of LPLIH and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which the Company exercises significant influence but does not exercise control and is not the primary beneficiary are accounted for using the equity method.

Comprehensive Income — In accordance with Accounting Standards Update No. 2011-05, Comprehensive Income — Presentation of Comprehensive Income, adopted in the first quarter of 2012, the Company presents its unaudited condensed consolidated statements of comprehensive income separately and immediately following its unaudited condensed consolidated statements of income. The Company’s comprehensive income is composed of net income and the effective portion of the unrealized gains on financial derivatives in cash flow hedge relationships, net of related tax effects.
Use of Estimates — The preparation of the unaudited condensed consolidated financial statements in conformity with GAAP requires the Company to make estimates and judgments that affect the reported amounts of assets and liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. On an on-going basis, the Company evaluates estimates, including those related to revenue and related expense recognition, asset impairment, valuation of accounts receivable, valuation of financial derivatives, contingencies and litigation, valuation and recognition of share-based payments, dividends and income taxes. These accounting policies are stated in the notes to the audited consolidated financial statements for the year ended December 31, 2011, contained in the Annual Report on Form 10-K as filed with the SEC. These estimates are based on the information that is currently available and on various other assumptions that the Company believes to be reasonable under the circumstances. Actual results could vary from these estimates under different assumptions or conditions and the differences may be material to the unaudited condensed consolidated financial statements.
Reportable Segment — The Company’s internal reporting is organized into three service channels; Independent Advisor Services, Institution Services and Custom Clearing Services, which are designed to enhance the services provided to its advisors and financial institutions. These service channels qualify as individual operating segments, but are aggregated and viewed as one single reportable segment due to their similar economic

7


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


characteristics, products and services, production and distribution process, regulatory environment and quantitative thresholds.

Fair Value of Financial Instruments — The Company’s financial assets and liabilities are carried at fair value or at amounts that, because of their short-term nature, approximate current fair value, with the exception of its indebtedness. The Company carries its indebtedness at amortized cost. The Company measures the implied fair value of its debt instruments using trading levels obtained from a third-party service provider. Accordingly, the debt instruments qualify as Level 2 fair value measurements. See Note 4 for additional detail regarding the Company’s fair value measurements. As of March 31, 2012, the carrying amount and fair value of the Company’s indebtedness was approximately $1,350.0 million and $1,333.6 million, respectively. As of December 31, 2011, the carrying amount and fair value was approximately $1,332.7 million and $1,328.2 million, respectively.

Recently Issued Accounting Pronouncements — There were no recently issued accounting pronouncements or changes in accounting pronouncements as compared to the recent accounting pronouncements described in the Company’s 2011 Annual Report on Form 10-K, that are of significance, or potential significance to the Company.

3.    Restructuring

Consolidation of UVEST Financial Services Group, Inc.
On March 14, 2011, the Company committed to a corporate restructuring plan to consolidate the operations of UVEST Financial Services Group, Inc. ("UVEST") with LPL Financial LLC ("LPL Financial"). The restructuring plan was effected to enhance the Company’s service offering, while also generating efficiencies. In connection with the consolidation, certain registered representatives associated with UVEST moved to LPL Financial through a transfer of their licenses. The Company completed the transfers in December 2011. Following the transfer of registered representatives and client accounts to LPL Financial, all registered representatives and client accounts are associated with LPL Financial and all of the Company’s securities business is done through a single broker-dealer. In addition, UVEST expects to terminate its clearing relationship with a third-party clearing firm and plans to file a broker-dealer withdrawal request with the Financial Industry Regulatory Authority ("FINRA") in 2012.
The Company estimates total expenditures associated with the initiative to be approximately $31.6 million over the course of the restructuring plan. These expenditures are comprised of advisor retention and related benefits, contract penalties, technology costs, non-cash charges for the impairment of intangible assets resulting from advisor attrition and other expenses principally relating to the conversion and transfer of registered representatives and client accounts from UVEST to LPL Financial.
The following table summarizes the balance of accrued expenses and the changes in the accrued amounts as of and for the three months ended March 31, 2012 (in thousands):
 
Accrued
Balance at
December 31,
2011

 
Costs
Incurred
 
Payments
 
Non-cash
 
Accrued Balance at March 31, 2012
 
Cumulative Costs Incurred to Date
 
Total
Expected
Restructuring
Costs(1)
Conversion and transfer costs
$
1,076

 
$
1,207

 
$
(2,216
)
 
$

 
$
67

 
$
10,385

 
$
14,690

Contract penalties
8,832

 

 
(8,270
)
 

 
562

 
8,642

 
8,642

Advisor retention and related benefits
250

 
241

 
(13
)
 
(228
)
 
250

 
1,030

 
5,513

Asset impairments

 

 

 

 

 
2,776

 
2,776

Total
$
10,158

 
$
1,448

 
$
(10,499
)
 
$
(228
)
 
$
879

 
$
22,833

 
$
31,621

________________________________
(1)
At March 31, 2012, total expected restructuring costs exclude approximately $12.0 million of internally developed software related to the corporate restructuring initiative that is being capitalized over a useful life ranging from three to five years, with expense being recorded as depreciation and amortization within the unaudited condensed consolidated statements of income. As of March 31, 2012, approximately $12.7 million has been spent on development activities of which approximately $10.3 million has been capitalized, with the

8


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


remainder included in costs incurred. The Company anticipates capitalizing an additional $1.7 million of internally developed software in the remainder of 2012.

4.    Fair Value Measurements

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. Inputs used to measure fair value are prioritized within a three-level fair value hierarchy. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

Level 1 — Quoted prices in active markets for identical assets or liabilities.

Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.

There have been no transfers of assets or liabilities between fair value measurement classifications during the three months ended March 31, 2012.

The Company’s fair value measurements are evaluated within the fair value hierarchy, based on the nature of inputs used to determine the fair value at the measurement date. At March 31, 2012, the Company had the following financial assets and liabilities that are measured at fair value on a recurring basis:

Cash Equivalents — The Company’s cash equivalents include money market funds, which are short term in nature with readily determinable values derived from active markets.

Securities Segregated Under Federal and Other Regulations— The Company’s segregated accounts contain U.S. treasury securities that are short term in nature with readily determinable values derived from quoted prices in active markets.

Securities Owned and Securities Sold, But Not Yet Purchased — The Company’s trading securities consist of house account model portfolios for the purpose of benchmarking the performance of its fee based advisory platforms and temporary positions resulting from the processing of client transactions. Examples of these securities include money market funds, U.S. treasuries, mutual funds, certificates of deposit, traded equity securities and debt securities.

The Company uses prices obtained from independent third-party pricing services to measure the fair value of its trading securities. Prices received from the pricing services are validated using various methods including comparison to prices received from additional pricing services, comparison to available quoted market prices and review of other relevant market data including implied yields of major categories of securities. In general, these quoted prices are derived from active markets for identical assets or liabilities. When quoted prices in active markets for identical assets and liabilities are not available, the quoted prices are based on similar assets and liabilities or inputs other than the quoted prices that are observable, either directly or indirectly. For certificates of deposit and treasury securities, the Company utilizes market-based inputs including observable market interest rates that correspond to the remaining maturities or the next interest reset dates. At March 31, 2012, the Company did not adjust prices received from the independent third-party pricing services.

Other Assets — The Company’s other assets include deferred compensation plan assets that are invested in money market funds and mutual funds which are actively traded and valued based on quoted market prices in active markets.

9


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


Accounts Payable and Accrued Liabilities — The Company’s accounts payable and accrued liabilities include an interest rate swap, and contingent consideration from its 2011 acquisitions of National Retirement Partners, Inc. and Concord Wealth Management.
The Company’s interest rate swap is not traded on a market exchange; therefore, the fair value is determined using models which include assumptions about the London Interbank Offered Rate (“LIBOR”) yield curve at interim reporting dates as well as counterparty credit risk and the Company’s own non-performance risk. Accordingly, the Company has classified the interest rate swap as a Level 2 measurement within the fair value hierarchy. Contingent consideration is measured by discounting, to present value, the contingent payments expected to be made based on the Company’s estimates of certain financial targets expected to result from the acquisitions. The Company has determined that contingent consideration qualifies as a Level 3 fair value measurement.

The following table summarizes the Company’s financial assets and financial liabilities measured at fair value on a recurring basis at March 31, 2012 (in thousands):
 
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Fair Value
Measurements
At March 31, 2012:
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Cash equivalents
$
499,128

 
$

 
$

 
$
499,128

Securities owned — trading:
 
 
 
 
 
 
 
Money market funds
490

 

 

 
490

Mutual funds
5,087

 

 

 
5,087

Equity securities
52

 

 

 
52

Debt securities

 
159

 

 
159

U.S. treasury obligations
900

 

 

 
900

Total securities owned — trading
6,529

 
159

 

 
6,688

Other assets
26,874

 

 

 
26,874

Total assets at fair value
$
532,531

 
$
159

 
$

 
$
532,690

Liabilities
 
 
 
 
 
 
 
Securities sold, but not yet purchased:
 
 
 
 
 
 
 
Equity securities
$
221

 
$

 
$

 
$
221

Debt securities

 
81

 

 
81

Certificates of deposit

 
40

 

 
40

Total securities sold, but not yet purchased
221

 
121

 

 
342

Accounts payable and accrued liabilities

 
714

 
16,593

 
17,307

Total liabilities at fair value
$
221

 
$
835

 
$
16,593

 
$
17,649


10


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


Changes in Level 3 Recurring Fair Value Measurements
Set forth below is a reconciliation of contingent consideration classified as accounts payable and accrued liabilities on the unaudited condensed consolidated statements of financial condition and measured at fair value on a recurring basis using significant unobservable inputs (Level 3). Contingent consideration is measured by discounting, to present value, the contingent payments expected to be made based on the Company’s estimates of certain financial targets expected to result from the acquisitions.
Three Months Ended March 31, 2012 (in thousands):
 
Fair value at December 31, 2011
$
16,104

Total unrealized losses included in earnings(1)
489

Fair value at March 31, 2012
$
16,593

________________________________
(1) Represents the accretion of contingent consideration as the Company approaches the future expected payment.

The following table summarizes the Company’s financial assets and financial liabilities measured at fair value on a recurring basis at December 31, 2011 (in thousands):
 
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Fair Value
Measurements
At December 31, 2011:
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Cash equivalents
$
575,243

 
$

 
$

 
$
575,243

Securities owned — trading:
 

 
 

 
 

 
 

Money market funds
262

 

 

 
262

Mutual funds
4,966

 

 

 
4,966

Equity securities
47

 

 

 
47

Debt securities

 
115

 

 
115

Certificates of deposit
900

 

 

 
900

Total securities owned — trading
6,175

 
115

 

 
6,290

Other assets
21,400

 

 

 
21,400

Total assets at fair value
$
602,818

 
$
115

 
$

 
$
602,933

Liabilities
 
 
 
 
 
 
 
Securities sold, but not yet purchased:
 
 
 
 
 
 
 
Equity securities
$
134

 
$

 
$

 
$
134

Debt securities

 
2

 

 
2

Certificates of deposit

 
25

 

 
25

Total securities sold, but not yet purchased
134

 
27

 

 
161

Accounts payable and accrued liabilities

 
1,377

 
16,104

 
17,481

Total liabilities at fair value
$
134

 
$
1,404

 
$
16,104

 
$
17,642


5.    Held-to-Maturity Securities

The Company holds certain investments in securities including U.S. government notes. The Company has both the intent and the ability to hold these investments to maturity and classifies them as such. Interest income is accrued as earned. Premiums and discounts are amortized using a method that approximates the effective yield method over the term of the security and are recorded as an adjustment to the investment yield. The Company measures the fair value of its securities held-to-maturity using quoted prices in active markets. Accordingly, the securities held-to-maturity qualify as Level 1 fair value measurements.

11


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)



The amortized cost, gross unrealized gains and fair value of securities held-to-maturity were as follows (in thousands):
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Fair Value
At March 31, 2012:
 
 
 
 
 
U.S. government notes
$
9,152

 
$
11

 
$
9,163

 
 
 
 
 
 
At December 31, 2011:
 
 
 
 
 
U.S. government notes
$
11,167

 
$
27

 
$
11,194


At March 31, 2012, the held-to-maturity securities were scheduled to mature as follows (in thousands):
 
Within 1 Year
 
1-3 Years
 
Total
U.S. government notes — at amortized cost
$
6,113


$
3,039

 
$
9,152

U.S. government notes — at fair value
$
6,126

 
$
3,037

 
$
9,163


6.    Intangible Assets
 
The components of intangible assets as of March 31, 2012 and December 31, 2011 are as follows (dollars in thousands):
 
Weighted
 Average Life 
Remaining
(in years)
 
Gross
 Carrying 
Value
 
 Accumulated 
Amortization
 
Net
 Carrying 
Value
At March 31, 2012:
 
 
 
 
 
 
 
Definite-lived intangible assets:
 
 
 
 
 
 
 
Advisor and financial institution relationships
13.5
 
$
450,164

 
$
(138,793
)
 
$
311,371

Product sponsor relationships
13.8
 
230,916

 
(66,840
)
 
164,076

Client relationships
12.7
 
14,910

 
(2,338
)
 
12,572

Total definite-lived intangible assets
 
 
$
695,990

 
$
(207,971
)
 
$
488,019

Indefinite-lived intangible assets:
 
 
 
 
 
 
 
Trademark and trade name
 
 
 
 
 
 
39,819

Total intangible assets
 
 
 
 
 
 
$
527,838

 
 
 
 
 
 
 
 
At December 31, 2011:
 
 
 
 
 
 
 
Definite-lived intangible assets:
 
 
 
 
 
 
 
Advisor and financial institution relationships
13.7
 
$
450,164

 
$
(132,503
)
 
$
317,661

Product sponsor relationships
14.0
 
230,916

 
(63,710
)
 
167,206

Client relationships
12.9
 
14,910

 
(1,926
)
 
12,984

Total definite-lived intangible assets
 
 
$
695,990

 
$
(198,139
)
 
$
497,851

Indefinite-lived intangible assets:
 
 
 
 
 
 
 
Trademark and trade name
 
 
 
 
 
 
39,819

Total intangible assets
 
 
 
 
 
 
$
537,670



12


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


Total amortization expense of intangible assets was $9.8 million and $9.5 million for the three months ended March 31, 2012 and 2011, respectively. Amortization expense for each of the fiscal years ended December 31, 2012 through 2016 and thereafter is estimated as follows (in thousands):
2012 - remainder
$
29,218

2013
38,268

2014
37,991

2015
37,111

2016
37,004

Thereafter
308,427

Total
$
488,019


7.    Income Taxes
The Company’s effective income tax rate differs from the federal corporate tax rate of 35.0%, primarily as a result of state taxes, settlement contingencies and expenses that are not deductible for tax purposes. These items resulted in effective tax rates of 38.4% and 39.9% for the three months ended March 31, 2012 and 2011, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

8.    Indebtedness

Senior Secured Credit Facilities — On March 29, 2012, the Company entered into a Credit Agreement (the “Credit Agreement”) with its wholly owned subsidiary, LPL Holdings, Inc., the other Credit Parties signatory thereto, the Several Lenders signatory thereto, and Bank of America, N.A. as Administrative Agent, Collateral Agent, Letter of Credit Issuer, and Swingline Lender. The Credit Agreement refinances and replaces the Company’s Third Amended and Restated Credit Agreement, dated as of May 24, 2010 (the "Original Credit Agreement").

Pursuant to the Credit Agreement, the Company established a Term Loan A of $735.0 million maturing on March 29, 2017 (the "Term Loan A"), a Term Loan B of $615.0 million maturing on March 29, 2019 (the "Term Loan B") and a revolving credit facility with borrowing capacity of $250.0 million maturing on March 29, 2017 (the "Revolving Credit Facility"). In connection with the Credit Agreement, the Company incurred $23.7 million in costs that are capitalized as debt issuance costs in the unaudited condensed consolidated statements of financial condition.

The Revolving Credit Facility was undrawn at closing. The Revolving Credit Facility is currently used to support the issuance of a $10.0 million irrevocable letter of credit for the Company's subsidiary, the Private Trust Company N.A. ("PTC"), and a $20.7 million irrevocable letter of credit for the construction of the Company's future new San Diego office building.

Quarterly repayments of the principal for Term Loan A are to be made totaling 5.0% per year for years one and two, and 10.0% per year for years three, four, and five, with the remaining principal due upon maturity. Quarterly repayments of the principal for Term Loan B will total 1.0% per year with the remaining principal due upon maturity. Any outstanding principal under the Revolving Credit Facility will be due upon maturity.

The applicable margin for borrowings with respect to the (a) Term Loan A is currently 1.50% for base rate borrowings and 2.50% for LIBOR borrowings; and (b) Term Loan B is currently 2.00% for base rate borrowings and 3.00% for LIBOR borrowings. The LIBOR Rate with respect to the Term Loan B shall in no event be less than 1.00%. The applicable margin for borrowings under the Revolving Credit Facility is currently 1.50% for base rate borrowings and 2.50% for LIBOR borrowings with a commitment fee of 0.50%. Except for the letters of credit described above, there were no outstanding balances on the Revolving Credit Facility at March 31, 2012.

Borrowings under the Credit Agreement bear interest at a base rate equal to either one, two, three, six, nine or twelve-month LIBOR (the "Eurodollar Rate") plus the applicable margin, or an alternative base rate (“ABR”) plus the applicable margin. The ABR is equal to the greatest of (a) the prime rate in effect on such day, (b) the effective

13


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


federal funds rate in effect on such day plus 0.50%, (c) the Eurodollar Rate plus 1.00% and (d) solely in the case of Term Loan B, 2.00%. The Credit Agreement subjects the Company to certain financial and non-financial covenants. As of March 31, 2012, the Company was in compliance with such covenants. The Company may voluntarily repay outstanding loans under its Credit Agreement at any time without premium or penalty, other than customary breakage costs with respect to LIBOR loans.

On March 29, 2012, the Company used proceeds from borrowings under the Credit Agreement to repay all outstanding principal borrowings under the Original Credit Agreement. Accordingly, in the first quarter of 2012, the Company accelerated the recognition of $16.5 million of debt issuance costs related to borrowings under the Original Credit Agreement, which has been recorded as loss on extinguishment of debt within the unaudited condensed consolidated statements of income. Prior to the repayment, the Original Credit Agreement consisted of three term loan tranches: a $302.5 million term loan facility with a maturity of June 18, 2013 (the "2013 Term Loans"), a $476.9 million term loan facility with a maturity of June 25, 2015 (the "2015 Term Loans") and a $553.2 million term loan facility with a maturity of June 28, 2017 (the "2017 Term Loans"). The Original Credit Agreement also subjected the Company to certain financial and non-financial covenants. As of December 31, 2011 and prior to repayment, the Company was in compliance with all such covenants.

The Original Credit Agreement included a revolving credit facility of $163.5 million, which had a maturity date of June 28, 2013, with a commitment fee of 0.75%. Borrowings were priced at LIBOR + 3.50%. Such facility had no outstanding balance at December 31, 2011 and has been replaced by the Revolving Credit Facility.

The applicable margin for borrowings under the Original Credit Agreement with respect to the (a) 2013 Term Loans was 0.75% for base rate borrowings and 1.75% for LIBOR borrowings, (b) 2015 Term Loans was 1.75% for base rate borrowings and 2.75% for LIBOR borrowings, and (c) 2017 Term Loans was 2.75% for base rate borrowings and 3.75% for LIBOR borrowings. The LIBOR Rate with respect to the 2015 Term Loans and the 2017 Term Loans had a floor of 1.50%.

Bank Loans Payable — The Company maintains three uncommitted lines of credit. Two of the lines have an unspecified limit, and are primarily dependent on the Company’s ability to provide sufficient collateral. The other line has a $150.0 million limit and allows for both collateralized and uncollateralized borrowings. Certain lines were utilized in 2012 and 2011; however, there were no balances outstanding at March 31, 2012 or December 31, 2011.

The Company’s outstanding borrowings were as follows (dollars in thousands):
 
 
 
March 31, 2012
 
 
December 31, 2011
 
 
 
 
Maturity
 
 
Balance
 
Interest
Rate    
 
 
 
Balance
 
Interest
Rate    
 
Senior secured term loans:
 
 
 
 
 
 
 
 
 
 
 
Hedged with an interest rate swap(1)
3/29/2017
 
$
65,000

 
2.97
%
(2)
 
$
65,000

 
2.33
%
(5)
Unhedged:
 
 
 
 
 
 
 
 
 
 
 
2013 Term Loans
6/28/2013
 

 

 
 
237,489

 
2.05
%
(6)
2015 Term Loans
6/25/2015
 

 

 
 
476,935

 
4.25
%
(7)
2017 Term Loans
6/28/2017
 

 

 
 
553,244

 
5.25
%
(8)
Term Loan A
3/29/2017
 
670,000

 
2.74
%
(3)
 

 
 
 
Term Loan B
3/29/2019
 
615,000

 
4.00
%
(4)
 

 
 
 
Total borrowings
 
 
1,350,000

 
 
 
 
1,332,668

 
 
 
Less current borrowings
(maturities within 12 months)
 
 
42,900

 
 
 
 
13,971

 
 
 
Long-term borrowings — net of current portion
 
 
$
1,307,100

 
 
 
 
$
1,318,697

 
 
 
____________
(1)
The original maturity of the hedged portion of the senior secured term loan was June 28, 2013 prior to the refinancing entered into on March 29, 2012.

14


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


(2)
As of March 31, 2012, the variable interest rate for the hedged portion of Term Loan A is based on the three-month LIBOR of 0.47%, plus the applicable interest rate margin of 2.50%.
(3)
As of March 31, 2012, the variable interest rate for the unhedged portion of Term Loan A is based on the one-month LIBOR of 0.24%, plus the applicable interest rate margin of 2.50%.
(4)
As of March 31, 2012, the variable interest rate for the unhedged portion of Term Loan B is based on the greater of the one-month LIBOR of 0.24% or 1.00%, plus the applicable interest rate margin of 3.00%.
(5)
As of December 31, 2011, the variable interest rate for the hedged portion of the 2013 Term Loans is based on the three-month LIBOR of 0.58%, plus the applicable interest rate margin of 1.75%.
(6)
As of December 31, 2011, the variable interest rate for the unhedged portion of the 2013 Term Loans is based on the one-month LIBOR of 0.30%, plus the applicable interest rate margin of 1.75%.
(7)
As of December 31, 2011, the variable interest rate for the unhedged portion of the 2015 Term Loans is based on the greater of the one-month LIBOR of 0.30% or 1.50%, plus the applicable interest rate margin of 2.75%.
(8)
As of December 31, 2011, the variable interest rate for the unhedged portion of the 2017 Term Loans is based on the greater of the one-month LIBOR of 0.30% or 1.50%, plus the applicable interest rate margin of 3.75%.

The combined average balance outstanding in the revolving and uncommitted line of credit facilities was approximately $132,000 and $6,000 for the three months ended March 31, 2012 and 2011, respectively. The weighted-average interest rate was 1.25% and 1.50% for the three months ended March 31, 2012, and 2011, respectively.

The minimum calendar year payments and maturities of the senior secured borrowings as of March 31, 2012 are as follows (in thousands):
2012 — remainder
$
32,175

2013
42,900

2014
70,463

2015
79,650

2016
79,650

Thereafter
1,045,162

Total
$
1,350,000


9.    Interest Rate Swap

An interest rate swap is a financial derivative instrument whereby two parties enter into a contractual agreement to exchange payments based on underlying interest rates. The Company uses an interest rate swap to hedge the variability on a portion of its floating rate senior secured term loan. The Company is required to pay the counterparty to the agreement fixed interest payments on a notional balance and in turn, receives variable interest payments on that notional balance. Payments are settled quarterly on a net basis.

At March 31, 2012, the Company has an interest rate swap with a notional balance of $65.0 million and a fair value of $0.7 million that carries a fixed pay rate of 4.85% and has a variable receive rate of 0.47%, with a maturity date of June 30, 2012. The effective rate from December 31, 2011 through March 30, 2012 was 0.58%, and the rate resets on the last day of the period. 

The interest rate swap agreement qualifies for hedge accounting and has been designated as a cash flow hedge against specific payments due on the Company’s Term Loan A. As of March 31, 2012, the Company assessed the interest rate swap agreement as being highly effective and expects it to continue to be highly effective. Accordingly, the changes in fair value of the interest rate swap have been recorded in other comprehensive income, with the fair value included as a liability on the Company’s unaudited condensed consolidated statements of financial condition. The Company has recorded net unrealized gains of $0.7 million and $2.1 million for the three months ended March 31, 2012 and 2011, respectively, to accumulated other

15



comprehensive loss related to the change in the fair value of its interest rate swap agreement. The Company has reclassified $0.7 million and $2.4 million to interest expense from accumulated other comprehensive loss for the three months ended March 31, 2012 and 2011, respectively. Based on current interest rate assumptions and assuming no additional interest rate swap agreements are entered into, the Company expects to reclassify $0.7 million, or $0.4 million after tax, from other comprehensive loss as additional interest expense over the remaining life of the interest rate swap.

10.    Commitments and Contingencies

Leases — The Company leases certain office space and equipment under various operating leases. These leases are generally subject to scheduled base rent and maintenance cost increases, which are recognized on a straight-line basis over the period of the leases.

Service Contracts — The Company is party to certain long-term contracts for systems and services that enable back office trade processing and clearing for its product and service offerings. One agreement, for clearing services, contains no minimum annual purchase commitment, but the agreement provides for certain penalties should the Company fail to maintain a certain threshold of client accounts.

Future minimum payments under leases, lease commitments and other noncancellable contractual obligations with remaining terms greater than one year as of March 31, 2012, are as follows (in thousands):
2012 - remainder
$
20,273

2013
24,234

2014
24,591

2015
25,530

2016
25,507

Thereafter
261,607

Total(1)
$
381,742

____________
(1)
Minimum payments have not been reduced by minimum sublease rental income of $5.7 million due in the future under noncancellable subleases.

Included in the schedule of future minimum payments above is a fifteen year lease commitment that was executed in December 2011 for the Company's future San Diego office building with a lease commencement date of May 1, 2014. Future minimum payments for this lease commitment are $9.6 million, $14.8 million, $15.4 million and $236.8 million for the years 2014, 2015, 2016 and thereafter, respectively.

Total rental expense for all operating leases was approximately $4.3 million and $4.2 million for the three months ended March 31, 2012, and 2011, respectively.

Guarantees — The Company occasionally enters into certain types of contracts that contingently require it to indemnify certain parties against third-party claims. The terms of these obligations vary and, because a maximum obligation is not explicitly stated, the Company has determined that it is not possible to make an estimate of the amount that it could be obligated to pay under such contracts.

Certain of the Company’s subsidiaries provide guarantees to securities clearing houses and exchanges under their standard membership agreements, which require a member to guarantee the performance of other members. Under these agreements, if a member becomes unable to satisfy its obligations to the clearing houses and exchanges, all other members would be required to meet any shortfall. The Company’s liability under these arrangements is not quantifiable and may exceed the cash and securities it has posted as collateral. However, the potential requirement for the Company to make payments under these agreements is remote. Accordingly, no liability has been recognized for these transactions.

Loan Commitments — From time to time, the Company makes loans to its advisors, primarily to newly signed advisors to assist in the transition process. Due to timing differences, the Company may make commitments to issue such loans prior to actually funding them. These commitments are generally contingent upon certain events

16


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


occurring, including but not limited to the advisor joining the Company, and may be forgivable. The Company had no significant unfunded commitments at March 31, 2012.

Litigation — The Company has been named as a defendant in various legal actions, substantially all of which are arbitrations. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases in which claimants seek substantial or indeterminate damages, the Company cannot predict with certainty what the eventual loss or range of loss related to such matters will be. The Company recognizes a legal liability when it believes it is probable a liability has occurred and the amount can be reasonably estimated. If some amount within a range of loss appears at the time to be a better estimate than any other amount within the range, the Company accrues that amount. When no amount within the range is a better estimate than any other amount, however, the Company accrues the minimum amount in the range.

The Company records legal reserves and related insurance recoveries for significant or unusual cases on a gross basis.

The Company is subject to and maintains insurance coverage for claims and lawsuits in the ordinary course of business, such as customer complaints or disclosures about risks with securities purchased, as well as various arbitrations and other litigation matters. With respect to these matters, the estimated losses on the majority of pending matters are less than the applicable deductibles of the insurance policies, and matters with estimated losses in excess of the applicable deductibles are not, in the aggregate, material.

Defense costs are expensed as incurred and classified as professional services within the unaudited condensed consolidated statements of income. When there is indemnification or insurance, the Company may engage in defense of settlement and subsequently seek reimbursement for such matters. In connection with various acquisitions, and pursuant to the purchase and sale agreements, the Company has received third-party indemnification for certain legal proceedings and claims. Some of these matters have been defended and paid directly by the indemnifying party.

The Company believes, based on the information available at this time, after consultation with counsel, consideration of insurance, if any, and indemnifications provided by the third-party indemnitors, that the outcomes will not have a material adverse impact on the unaudited condensed consolidated statements of financial condition, income, comprehensive income or cash flows.

Other Commitments — As of March 31, 2012, the Company had received collateral primarily in connection with client margin loans with a market value of approximately $327.5 million, which it can sell or repledge. Of this amount, approximately $37.5 million has been pledged or sold as of March 31, 2012; $20.7 million was pledged with client-owned securities to the Options Clearing Corporation ("OCC") as collateral to secure client obligations related to options positions, and $16.8 million was loaned to the National Securities Clearing Corporation ("NSCC") through participation in its Stock Borrow Program. Additionally, approximately $140.6 million are held at banks in connection with unutilized secured margin lines of credit; these securities may be used as collateral for loans from these banks. The remainder of $149.4 million has not been re-pledged or sold, and as of March 31, 2012 there are no restrictions that materially limit the Company's ability to re-pledge or sell the client collateral of $290.0 million.

As of December 31, 2011, the Company had received collateral primarily in connection with client margin loans with a market value of approximately $350.2 million, which it can sell or repledge. Of this amount, approximately $32.7 million has been pledged or sold as of December 31, 2011; $18.4 million was pledged with client-owned securities to the OCC as collateral to secure client obligations related to options positions, and $14.3 million was loaned to the NSCC through participation in its Stock Borrow Program. Additionally, approximately $145.0 million are held at banks in connection with unutilized secured margin lines of credit; these securities may be used as collateral for loans from these banks. The remainder of $172.5 million had not been re-pledged or sold, and as of December 31, 2011 there are no restrictions that materially limited the Company's ability to re-pledge or sell the client collateral of $317.5 million.
    
Trading securities on the unaudited condensed consolidated statements of financial condition includes $0.9 million and $0.9 million pledged to clearing organizations at March 31, 2012 and December 31, 2011, respectively.


17


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


LPL Financial provides brokerage, clearing and custody services on a fully disclosed basis; offers its investment advisory programs and platforms; and provides technology and additional processing and related services to the advisors of the broker-dealer subsidiary of a large global insurance company and their clients under a multi-year agreement. Termination fees may be payable by a terminating or breaching party depending on the specific cause of termination.

11.    Stockholders' Equity

Share-Based Compensation

Certain employees, advisors, officers and directors participate in various stock option plans. In addition, certain financial institutions participate in a warrant plan. Stock options and warrants generally vest in equal increments over a three- to five-year period and expire on the 10th anniversary following the date of grant.

The Company recognizes share-based compensation expense related to employee stock option awards based on the grant date fair value over the requisite service period of the award, which generally equals the vesting period. The Company recognized $4.2 million and $3.8 million of share-based compensation related to the vesting of employee stock option awards during the three months ended March 31, 2012 and 2011, respectively, which is included in compensation and benefits on the unaudited condensed consolidated statements of income. As of March 31, 2012, total unrecognized compensation cost related to non-vested share-based compensation arrangements granted was $48.6 million, which is expected to be recognized over a weighted-average period of 3.79 years.

The Company recognizes share-based compensation expense for stock options and warrants awarded to its advisors and financial institutions based on the fair value of the awards at each interim reporting period. The Company recognized $2.3 million and $1.0 million of share-based compensation during the three months ended March 31, 2012 and 2011, respectively, related to the vesting of stock options and warrants awarded to its advisors and financial institutions, which is classified within commissions and advisory fees on the unaudited condensed consolidated statements of income. As of March 31, 2012, total unrecognized compensation cost related to non-vested share-based compensation arrangements granted was $19.6 million for advisors and financial institutions, which is expected to be recognized over a weighted-average period of 3.87 years.

2008 Nonqualified Deferred Compensation Plan

On November 19, 2008, the Company established an unfunded, unsecured deferred compensation plan to permit employees and former employees who held non-qualified stock options issued under the 2005 Stock Option Plan for Incentive Stock Options and 2005 Stock Option Plan for Non-qualified Stock Options that were to expire in 2009 and 2010, to receive stock units under the 2008 Nonqualified Deferred Compensation Plan ("Deferred Compensation Plan"). On February 22, 2012, the Company distributed 1,673,556 shares, net of shares withheld to satisfy withholding tax requirements, pursuant to the terms of the Deferred Compensation Plan. Distributions to participants were made in the form of whole shares of common stock equal to the number of stock units allocated to the participant's account, with fractional shares paid out in cash. Participants authorized the Company to withhold shares from their distribution of common stock to satisfy their withholding tax obligations. Accordingly on February 22, 2012, the Company repurchased 1,149,896 shares and paid $37.5 million of cash consideration related to tax withholdings. The repurchase of shares was executed under the share repurchase program approved by the Board of Directors on August 16, 2011.

Special Dividend

On March 30, 2012, the Company's Board of Directors approved a special dividend of $2.00 per share to common stockholders. The dividend will be paid on May 25, 2012 to stockholders of record as of May 15, 2012. As of March 31, 2012, the Company has recorded a liability of $220.6 million as dividends payable in the unaudited condensed consolidated statements of financial position based on the number of shares of common stock outstanding on that date. Stock options and warrants exercised after March 31, 2012 increase share count; therefore, the actual dividend payment is dependent on the number of stock options and warrants that are exercised before May 15, 2012.


18


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)



12.    Earnings Per Share
Prior to February 22, 2012, the Company was required to calculate earnings per share using the two-class method by allocating a portion of its earnings to employees who held stock units containing non-forfeitable rights to dividends or dividend equivalents under its Deferred Compensation Plan. Basic earnings per share was computed by dividing income less earnings attributable to employees that held stock units under the Deferred Compensation Plan by the basic weighted average number of shares outstanding. Diluted earnings per share was computed in a manner similar to basic earnings per share, except the weighted average number of shares outstanding is increased to include the dilutive effect of outstanding stock options, warrants and other stock-based awards. After the distribution of shares on February 22, 2012 to satisfy the Deferred Compensation Plan, the two-class method was no longer applicable.

A reconciliation of the income used to compute basic and diluted earnings per share for the three months ended March 31, 2012 and 2011 is as follows:
 
 
For the Three
Months Ended
March 31,
 
 
2012
 
2011
 
 
(In thousands)
Basic earnings per share:
 
 

 
 

Net income, as reported
 
$
41,179

 
$
48,999

Allocation of undistributed earnings to stock units
 

 
(630
)
Net income, for computing basic earnings per share
 
$
41,179

 
$
48,369

Diluted earnings per share:
 
 

 
 

Net income, as reported
 
$
41,179

 
$
48,999

Allocation of undistributed earnings to stock units
 

 
(606
)
Net income, for computing diluted earnings per share
 
$
41,179

 
$
48,393


A reconciliation of the weighted average number of shares outstanding used to compute basic and diluted earnings per share for the three months ended March 31, 2012 and 2011 is as follows:
 
 
For the Three
Months Ended
March 31,
 
 
2012
 
2011
 
 
(In thousands)
Basic weighted average number of shares outstanding
 
108,956

 
108,807

Dilutive common share equivalents
 
3,573

 
4,389

Diluted weighted average number of shares outstanding(1)
 
112,529

 
113,196

________________________________
(1)
Included within the weighted average share count for the three months ended March 31, 2012, is approximately 850,000 shares resulting from the distribution pursuant to the Deferred Compensation Plan (see Note 11).

Basic and diluted earnings per share for the three months ended March 31, 2012 and 2011 are as follows:
 
 
 
For the Three
Months Ended
March 31,
 
 
2012
 
2011
Basic earnings per share
 
$
0.38

 
$
0.44

Diluted earnings per share
 
$
0.37

 
$
0.43



19


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


The computation of diluted earnings per share excluded stock options and warrants to purchase 3,545,280 shares and 3,149,811 shares for the three months ended March 31, 2012 and 2011 because the effect would have been anti-dilutive, respectively.

13.    Related Party Transactions

One of the Company’s majority stockholders owns a minority interest in Artisan Partners Limited Partnership (“Artisan”), which pays fees in exchange for product distribution and record-keeping services. During the three months ended March 31, 2012 and 2011, the Company earned $0.8 million and $0.7 million, respectively, in fees from Artisan. Additionally, as of March 31, 2012 and December 31, 2011, Artisan owed the Company $0.8 million and $0.7 million, respectively, which is included in receivables from product sponsors, broker-dealers and clearing organizations on the unaudited condensed consolidated statements of financial condition.

One of the Company’s majority stockholders owns a minority interest in XOJET, Inc. (“XOJET”), which provides chartered aircraft services. The Company paid $1.0 million to XOJET during the three months ended March 31, 2011.

Certain entities affiliated with SunGard Data Systems Inc. (“SunGard”), a company majority-owned by one of the Company’s majority stockholders, provide data center recovery services. The Company paid $0.1 million to SunGard during the three months ended March 31, 2011.

Aplifi, Inc. ("Aplifi"), a privately held technology company in which the Company holds an equity interest, provides software licensing for annuity order entry and compliance. The Company paid $0.4 million and $0.7 million to Aplifi for such services during the three months ended March 31, 2012 and 2011, respectively.

An immediate family member of one of the Company’s executive officers, is an executive officer of CresaPartners LLC (“CresaPartners”). CresaPartners provides the Company and its subsidiaries real estate advisory, transaction and project management services. The Company paid $0.1 million to CresaPartners during the three months ended March 31, 2012.

14.    Net Capital and Regulatory Requirements
The Company’s registered broker-dealers are subject to the SEC’s Uniform Net Capital Rule (Rule 15c3-1 under the Exchange Act), which requires the maintenance of minimum net capital, as defined. Net capital is calculated for each broker-dealer subsidiary individually. Excess net capital of one broker-dealer subsidiary may not be used to offset a net capital deficiency of another broker-dealer subsidiary. Net capital and the related net capital requirement may fluctuate on a daily basis.

Net capital and net capital requirements for the Company’s broker-dealer subsidiaries as of March 31, 2012 are presented in the following table (in thousands):
 
Net
Capital
 
Minimum
Net Capital
Required
 
Excess Net
Capital
LPL Financial LLC
$
108,392

 
$
6,069

 
$
102,323

UVEST Financial Services Group, Inc.
$
20,098

 
$
339

 
$
19,759


LPL Financial is a clearing broker-dealer and UVEST is an introducing broker-dealer. In connection with the Company's 2011 initiative to consolidate UVEST with LPL Financial, UVEST plans to file a broker-dealer withdrawal request with FINRA in 2012 upon transfer of all clients accounts and to maintain sufficient capital to carry out any remaining activities during the interim.
PTC is also subject to various regulatory capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s unaudited condensed consolidated financial statements.
As of March 31, 2012 and December 31, 2011, the Company’s registered broker-dealers and PTC have met

20


LPL INVESTMENT HOLDINGS INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements (Unaudited)


all capital adequacy requirements to which they are subject.
The Company operates in a highly regulated industry. Applicable laws and regulations restrict permissible activities and investments. These policies require compliance with various financial and customer-related regulations. The consequences of noncompliance can include substantial monetary and non-monetary sanctions. In addition, the Company is also subject to comprehensive examinations and supervision by various governmental and self-regulatory agencies. These regulatory agencies generally have broad discretion to prescribe greater limitations on the operations of a regulated entity for the protection of investors or public interest. Furthermore, where the agencies determine that such operations are unsafe or unsound, fail to comply with applicable law, or are otherwise inconsistent with the laws and regulations or with the supervisory policies, greater restrictions may be imposed.

15.    Financial Instruments with Off-Balance-Sheet Credit Risk and Concentrations of Credit Risk
LPL Financial’s client securities activities are transacted on either a cash or margin basis. In margin transactions, LPL Financial extends credit to the advisor's client, subject to various regulatory and internal margin requirements, collateralized by cash and securities in the client’s account. As clients write options contracts or sell securities short, LPL Financial may incur losses if the clients do not fulfill their obligations and the collateral in the clients’ accounts is not sufficient to fully cover losses that clients may incur from these strategies. To control this risk, LPL Financial monitors margin levels daily and clients are required to deposit additional collateral, or reduce positions, when necessary.
LPL Financial is obligated to settle transactions with brokers and other financial institutions even if its advisor's clients fail to meet their obligation to LPL Financial. Clients are required to complete their transactions on the settlement date, generally three business days after the trade date. If clients do not fulfill their contractual obligations, LPL Financial may incur losses. In addition, the Company occasionally enters into certain types of contracts to fulfill its sale of when, as, and if issued securities. When, as, and if issued securities have been authorized but are contingent upon the actual issuance of the security. LPL Financial has established procedures to reduce this risk by generally requiring that clients deposit cash and/or securities into their account prior to placing an order.
LPL Financial may at times hold equity securities on both a long and short basis that are recorded on the unaudited condensed consolidated statements of financial condition at market value. While long inventory positions represent LPL Financial’s ownership of securities, short inventory positions represent obligations of LPL Financial to deliver specified securities at a contracted price, which may differ from market prices prevailing at the time of completion of the transaction. Accordingly, both long and short inventory positions may result in losses or gains to LPL Financial as market values of securities fluctuate. To mitigate the risk of losses, long and short positions are marked-to-market daily and are continuously monitored by LPL Financial.
UVEST is engaged in buying and selling securities and other financial instruments for clients of advisors. Such transactions are introduced and cleared through a third-party clearing firm on a fully disclosed basis. While introducing broker-dealers generally have less risk than clearing firms, their clearing agreements expose them to credit risk in the event that their clients don’t fulfill contractual obligations with the clearing broker-dealer.

16.    Subsequent Events
On January 3, 2012, the Company announced its intent to acquire Fortigent Holdings Company, Inc. and its wholly owned subsidiaries Fortigent, LLC, Fortigent Reporting Company, LLC, and Fortigent Strategies Company, LLC (together, "Fortigent"). On April 23, 2012, the transaction closed. Total purchase price consideration at the closing of the transaction was $39.5 million, including $9.9 million of cash that the Company placed into escrow subject to adjustment pursuant to the terms of the stock purchase agreement. Fortigent is a leading provider of high net worth solutions and consulting services to RIAs, banks, and trust companies. This strategic acquisition will further enhance the Company's capabilities and offer an extension of the Company's existing services for wealth management advisors. 



******

21



Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We provide an integrated platform of brokerage and investment advisory services to over 12,900 independent financial advisors and financial advisors at financial institutions (our "advisors") across the country, enabling them to successfully service their retail investors with objective, conflict-free financial advice. In addition, we support approximately 4,400 financial advisors who are affiliated and licensed with insurance companies with customized clearing, advisory platforms and technology solutions. Our singular focus is to support our advisors with the front-, middle- and back-office support they need to serve the large and growing market for independent investment advice, particularly in the mass affluent market. We believe we are the only company that offers advisors the unique combination of an integrated technology platform, comprehensive self-clearing services and full open-architecture access to leading financial products, all delivered in an environment unencumbered by conflicts from product manufacturing, underwriting or market making.
For over 20 years we have served the independent advisor market. We currently support the largest independent advisor base and we believe we have the fourth largest overall advisor base in the United States based on the information available as of the date this Quarterly Report on Form 10-Q has been issued. Through our advisors, we are also one of the largest distributors of financial products in the United States. Our scale is a substantial competitive advantage and enables us to more effectively attract and retain advisors. Our unique model allows us to invest more resources in our advisors, increasing their revenues and creating a virtuous cycle of growth. We currently have approximately 2,700 employees with headquarters in Boston, Charlotte and San Diego.

Our Sources of Revenue

Our revenues are derived primarily from fees and commissions from products and advisory services offered by our advisors to their clients, a substantial portion of which we pay out to our advisors, as well as fees we receive from our advisors for use of our technology, custody and clearing platforms. We also generate asset-based fees through the distribution of financial products for a broad range of product manufacturers. Under our self-clearing platform, we custody the majority of client assets invested in these financial products, which includes providing statements, transaction processing and ongoing account management. In return for these services, mutual funds, insurance companies, banks and other financial product manufacturers pay us fees based on asset levels or number of accounts managed. We also earn fees for margin lending to our advisors’ clients.

We track recurring revenue, a characterization of net revenue and statistical measure, which we define to include our revenues from asset-based fees, advisory fees, trailing commissions, cash sweep programs and certain transaction and other fees that are based upon accounts and advisors. Because recurring revenue is associated with asset balances, it will fluctuate depending on the market value of the asset balances and current interest rates. Accordingly, recurring revenue can be negatively impacted by adverse external market conditions. However, recurring revenue is meaningful to us despite these fluctuations because it is not based on transaction volumes or other activity-based fees, which are more difficult to predict, particularly in declining or volatile markets.


22



The table below summarizes the sources of our revenue, the primary drivers of each revenue source and the percentage of each revenue source that represents recurring revenue, a characterization of revenue and a statistical measure:
 
 
 
For the Three Months Ended
March 31, 2012
 
Sources of Revenue
Primary Drivers
Total
(millions)
% of Total Net Revenue
% Recurring
Advisor-driven revenue with ~85%-90% payout ratio
Commissions
- Transactions
- Brokerage asset levels
$464
51%
37%
Advisory Fees
- Advisory asset levels
$251
28%
98%
Attachment revenue
 retained by us
Asset-Based Fees
- Cash Sweep Fees
- Sponsorship Fees
- Record Keeping
- Cash balances
- Interest rates
- Number of accounts
- Client asset levels
$97
11%
100%
Transaction and Other Fees
- Transactions
- Client (Investor) Accounts
- Advisor Seat and Technology
- Client activity
- Number of clients
- Number of advisors
- Number of accounts
- Premium technology subscribers
$75
8%
63%
Interest and Other Revenue
- Margin accounts
- Marketing re-allowance fees
$15
2%
37%
 
Total Net Revenue
$902
100%
63%
 
Total Recurring Revenue
$569
63%
 

Commissions and Advisory Fees.  Transaction-based commissions and advisory fees both represent advisor-generated revenue, generally 85-90% of which is paid to advisors.

Commissions.  Transaction-based commission revenues represent gross commissions generated by our advisors, primarily from commissions earned on the sale of various financial products such as variable and fixed annuities, mutual funds, general securities, fixed income, alternative investments and insurance and can vary from period to period based on the overall economic environment, number of trading days in the reporting period and investment activity of our advisors' clients. We also earn trailing commission type revenues (a commission that is paid over time, such as 12(b)-1 fees) on mutual funds and variable annuities held by clients of our advisors. Trailing commissions are recurring in nature and are earned based on the current market value of investment holdings.

Advisory Fees.  Advisory fee revenues represent fees charged on our corporate Registered Investment Advisor ("RIA") platform to clients of our advisors based on the value of advisory assets. Advisory fees are typically billed to clients quarterly, in advance, and are recognized as revenue ratably during the quarter. The value of the assets in the advisory account on the billing date determines the amount billed, and accordingly, the revenues earned in the following three month period. The majority of our accounts are billed using values as of the last business day of the quarter. In addition, we support independent Registered Investment Advisors ("Independent RIA") who conduct their advisory business through separate entities by establishing their own RIA pursuant to the Investment Advisers Act of 1940, rather than using our corporate registered RIA. The assets held under these investment advisory accounts custodied with LPL Financial LLC (“LPL Financial”) are included in our advisory and brokerage assets and advisory assets under management metrics. The fee-based production generated by the Independent RIA is earned by the advisor, and accordingly not included in our advisory fee revenue. However, there are administrative fees charged to

23



Independent RIAs including custody and clearing and trading fees, based on the value of assets within these advisory accounts. Furthermore, we support certain financial advisors with customized clearing and advisory platforms and charge fees to these advisors based on the value of assets within these advisory accounts.

Asset-Based Fees.  Asset-based fees are comprised of fees from cash sweep programs, our sponsorship programs with financial product manufacturers, and omnibus processing and networking services. Pursuant to contractual arrangements, uninvested cash balances in our advisors’ client accounts are swept into either insured deposit accounts at various banks or third-party money market funds, for which we receive fees, including administrative and record-keeping fees based on account type and the invested balances. In addition, we receive fees from certain financial product manufacturers in connection with sponsorship programs that support our marketing and sales-force education and training efforts. We also earn fees on mutual fund assets for which we provide administrative and record-keeping services. Our networking fees represent fees paid to us by mutual fund and annuity product manufacturers in exchange for administrative and record-keeping services that we provide to clients of our advisors. Networking fees are correlated to the number of positions we administer, not the value of assets under administration.

Transaction and Other Fees.  Revenues earned from transaction and other fees primarily consist of transaction fees and ticket charges, subscription fees, Individual Retirement Account ("IRA") custodian fees, contract and license fees, conference fees and other client account fees. We charge fees to our advisors and their clients for executing transactions in brokerage and fee-based advisory accounts. We earn subscription fees for various services provided to our advisors and on IRA custodial services that we provide for their client accounts. We charge monthly administrative fees to our advisors. We charge fees to financial product manufacturers for participating in our training and marketing conferences. In addition, we host certain advisor conferences that serve as training, sales and marketing events. During the reporting periods that these conferences are held we anticipate higher transaction and other fees resulting from the collection of revenues from sponsors and advisors, in comparison to other periods.

Other Revenue.  Other revenue includes marketing re-allowance fees from certain financial product manufacturers as well as interest income from client margin accounts and cash equivalents, net of operating interest expense, and other items.

Our Operating Expenses

Production Expenses.  Production expenses are comprised of the following: base amounts that are earned by and paid out to advisors based on commissions and advisory fees earned on each client's account (collectively, commissions and advisory fees earned are referred to as gross dealer concessions, or "GDC"); bonuses earned by advisors based on the levels of commissions and advisory fees they produce; the recognition of share-based compensation expense from stock options and warrants granted to advisors and financial institutions based on the fair value of the awards at each interim reporting period; a mark-to-market gain or loss on amounts designated by advisors as deferred commissions in a non-qualified deferred compensation plan at each interim reporting period; and brokerage, clearing and exchange fees. Our production payout ratio is calculated as production expenses excluding brokerage, clearing and exchange fees, divided by commissions and advisory revenues.

We characterize production payout, which includes all production expenses except brokerage, clearing and exchange fees, as either GDC sensitive or non-GDC sensitive. Base amounts and production bonuses earned by and paid to advisors are GDC sensitive because they are variable and highly correlated to the level of our commissions and advisory revenues in a particular reporting period. Non-GDC sensitive production payout is correlated to market movement in addition to the value of our stock. Non-GDC sensitive production includes share-based compensation expense from stock options and warrants granted to advisors and financial institutions based on the fair value of the awards at each interim reporting period, and mark-to-market gains or losses on amounts designated by advisors as deferred commissions in a non-qualified deferred compensation plan.

    

24



The following table shows our production payout ratio for the three months ended March 31, 2012:
Base payout rate
84.25
%
Production based bonuses
1.57
%
GDC sensitive payout
85.82
%
Non-GDC sensitive payout
0.57
%
Total Payout Ratio
86.39
%

Compensation and Benefits Expense.  Compensation and benefits expense includes salaries and wages and related employee benefits and taxes for our employees (including share-based compensation), as well as compensation for temporary employees and consultants.

General and Administrative Expenses.  General and administrative expenses include promotional fees, occupancy and equipment, communications and data processing, regulatory fees, travel and entertainment, professional services and other expenses. We host certain advisor conferences that serve as training, sales and marketing events. During the reporting periods that these conferences are held, we anticipate higher general and administrative expenses in comparison to other periods.

Depreciation and Amortization Expense.  Depreciation and amortization expense represents the benefits received for using long-lived assets. Those assets represent significant intangible assets established through our acquisitions, as well as fixed assets which include internally developed software, hardware, leasehold improvements and other equipment.

Restructuring Charges.  Restructuring charges represent expenses incurred as a result of our 2011 consolidation of UVEST Financial Services Group, Inc. ("UVEST") and our 2009 consolidation of Mutual Service Corporation (“MSC”), Associated Financial Group, Inc. (“AFG”), Associated Securities Corp. (“Associated”), Associated Planners Investment Advisory, Inc. (“APIA”) and Waterstone Financial Group, Inc. (“WFG”) (MSC, AFG, Associated, APIA and WFG, are collectively referred to herein as the “Affiliated Entities”).


25



How We Evaluate Our Business

We focus on several business and key financial metrics in evaluating the success of our business relationships and our resulting financial position and operating performance. Our key metrics as of and for the three months ended March 31, 2012 and 2011 are as follows:
 
 
As of and for the Three Months Ended March 31,
 
2012
 
2011
 
 
 
 
Business Metrics
 
 
 
Advisors(1)
12,962

 
12,554

Advisory and brokerage assets (in billions)(2)
$
354.1

 
$
330.1

Advisory assets under management (in billions)(3)
$
110.8

 
$
99.7

Net new advisory assets (in billions)(4)
$
2.5

 
$
3.7

Insured cash account balances (in billions)(3)
$
13.9

 
$
12.3

Money market account balances (in billions)(3)
$
7.7

 
$
6.9

 
 
 
 
Financial Metrics
 
 
 
Revenue growth from prior period
3.2
%
 
17.5
%
Recurring revenue as a % of net revenue(5)
63.0
%
 
60.2
%
Net income (in millions)
$
41.2

 
$
49.0

Earnings per share (diluted)
$
0.37

 
$
0.43

Non-GAAP Measures:
 
 
 
Gross margin (in millions)(6)
$
274.9

 
$
269.5

Gross margin as a % of net revenue(6)
30.5
%
 
30.8
%
Adjusted EBITDA (in millions)
$
125.0

 
$
124.3

Adjusted EBITDA as a % of net revenue
13.9
%
 
14.2
%
Adjusted EBITDA as a % of gross margin(6)
45.5
%
 
46.1
%
Adjusted Earnings (in millions)
$
63.2

 
$
59.4

Adjusted Earnings per share (diluted)
$
0.56

 
$
0.52

____________
(1)
Advisors are defined as those investment professionals who are licensed to do business with our broker-dealer subsidiaries. In 2011, we consolidated the operations of UVEST with LPL Financial which resulted, as expected, in attrition of 146 advisors in 2011. Excluding attrition from the integration of the UVEST platform, we added 554 net new advisors during the twelve months ended March 31, 2012, continuing to build relationships with advisors from all channels across the financial services industry.
(2)
Advisory and brokerage assets are comprised of assets that are custodied, networked and non-networked and reflect market movement in addition to new assets, inclusive of new business development and net of attrition.
(3)
Advisory assets under management, insured cash account balances and money market account balances are components of advisory and brokerage assets. Such totals do not include the market value of client assets held in retirement plans administered by us and trust assets supported by Concord Capital Partners.
(4)
Represents net new advisory assets consisting of funds from new accounts and additional funds deposited into existing advisory accounts that are custodied in our fee-based advisory platforms.
(5)
Recurring revenue, a characterization of net revenue and a statistical measure, is derived from sources such as advisory fees, asset-based fees, trailing commission fees, fees related to our cash sweep programs, interest earned on margin accounts and technology and service fees, and is not meant as a substitute for net revenues.
(6)
Gross margin is calculated as net revenues less production expenses. Production expenses consist of the following expense categories from our unaudited condensed consolidated statements of income: (i) commissions and advisory fees and (ii) brokerage, clearing and exchange. All other expense categories, including depreciation and amortization, are considered general and administrative in nature. Because our gross margin amounts do not include any depreciation and amortization expense, we consider our gross

26



margin amounts to be non-GAAP measures that may not be comparable to those of others in our industry.

Adjusted EBITDA

Adjusted EBITDA is defined as EBITDA (net income plus interest expense, income tax expense, depreciation and amortization), further adjusted to exclude certain non-cash charges and other adjustments set forth below. We present Adjusted EBITDA because we consider it an important measure of our performance. Adjusted EBITDA is a useful financial metric in assessing our operating performance from period to period by excluding certain items that we believe are not representative of our core business, such as certain material non-cash items and other adjustments.

We believe that Adjusted EBITDA, viewed in addition to, and not in lieu of, our reported GAAP results, provides useful information to investors regarding our performance and overall results of operations for the following reasons:

because non-cash equity grants made to employees at a certain price and point in time do not necessarily reflect how our business is performing at any particular time, share-based compensation expense is not a key measure of our operating performance and

because costs associated with acquisitions and the resulting integrations, debt refinancing, restructuring and conversions and equity issuance and related offering costs can vary from period to period and transaction to transaction, expenses associated with these activities are not considered a key measure of our operating performance.

We use Adjusted EBITDA:

as a measure of operating performance;

for planning purposes, including the preparation of budgets and forecasts;

to allocate resources to enhance the financial performance of our business;

to evaluate the effectiveness of our business strategies;

in communications with our board of directors concerning our financial performance and

as a factor in determining employee and executive bonuses.

Adjusted EBITDA is a non-GAAP measure and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. The term Adjusted EBITDA is not defined under GAAP, and Adjusted EBITDA is not a measure of net income, operating income or any other performance measure derived in accordance with GAAP.

Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are:

Adjusted EBITDA does not reflect all cash expenditures, future requirements for capital expenditures or contractual commitments;

Adjusted EBITDA does not reflect changes in, or cash requirements for, working capital needs; 

Adjusted EBITDA does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our debt and

Adjusted EBITDA can differ significantly from company to company depending on long-term strategic decisions regarding capital structure, the tax jurisdictions in which companies operate and capital investments, limiting its usefulness as a comparative measure.

Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in our

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business. We compensate for these limitations by relying primarily on the GAAP results and using Adjusted EBITDA as supplemental information.

Set forth below is a reconciliation from our net income to Adjusted EBITDA, a non-GAAP measure, for the three months ended March 31, 2012 and 2011 (in thousands):
 
For the Three Months Ended March 31,
 
2012
 
2011
Net income
$
41,179

 
$
48,999

Interest expense
16,032

 
18,172

Income tax expense
25,684

 
32,559

Amortization of purchased intangible assets and software(1)
9,832

 
9,537

Depreciation and amortization of all other fixed assets
7,343

 
8,628

EBITDA
100,070

 
117,895

EBITDA Adjustments:
 
 
 
Employee share-based compensation expense(2)
4,160

 
3,860

Acquisition and integration related expenses(3)
1,858

 
1,416

Restructuring and conversion costs(4)
2,010

 
835

Debt extinguishment costs(5)
16,543

 

Equity issuance and related offering costs

 
292

Other(6)
314

 
33

Total EBITDA Adjustments
24,885

 
6,436

Adjusted EBITDA
$
124,955

 
$
124,331

____________
(1)
Represents amortization of intangible assets and software as a result of our purchase accounting adjustments from our merger transaction in 2005 and our various acquisitions.
(2)
Represents share-based compensation expense related to stock options awarded to employees and non-executive directors based on the grant date fair value under the Black-Scholes valuation model.
(3)
Represents acquisition and integration costs resulting from various acquisitions.
(4)
Represents organizational restructuring charges and conversion and other related costs incurred resulting from the 2011 consolidation of UVEST and the 2009 consolidation of the Affiliated Entities. As of March 31, 2012, approximately 72% and 97%, respectively, of costs related to these two initiatives have been recognized. The remaining costs largely consist of transition payments made in connection with these two conversions for the retention of advisors and institutions, and conversion and transfer costs that are expected to be recognized into earnings by December 2014.
(5)
Represents expenses incurred in March 2012 resulting from the early extinguishment and repayment of amounts outstanding under the Company's Third Amended and Restated Credit Agreement, including the write-off of $16.5 million of unamortized debt issuance costs that have no future economic benefit, as well as various other charges incurred in connection with the repayment under the prior senior secured credit facilities and the establishment of the new senior secured credit facilities.
(6)
Represents excise and other taxes.

Adjusted Earnings and Adjusted Earnings per share

Adjusted Earnings represents net income before: (a) share-based compensation expense, (b) amortization of intangible assets and software, a component of depreciation and amortization resulting from our merger transaction in 2005 and our various acquisitions, (c) acquisition and integration related expenses, (d) restructuring and conversion costs, (e) debt extinguishment costs, (f) equity issuance and related offering costs and (g) other. Reconciling items are tax effected using the income tax rates in effect for the applicable period, adjusted for any potentially non-deductible amounts.

Adjusted Earnings per share represents Adjusted Earnings divided by weighted average outstanding shares

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on a fully diluted basis.

We prepared Adjusted Earnings and Adjusted Earnings per share to eliminate the effects of items that we do not consider indicative of our core operating performance.

We believe that Adjusted Earnings and Adjusted Earnings per share, viewed in addition to, and not in lieu of, our reported GAAP results provide useful information to investors regarding our performance and overall results of operations for the following reasons:

because non-cash equity grants made to employees at a certain price and point in time do not necessarily reflect how our business is performing, share-based compensation expense is not a key measure of our operating performance;

because costs associated with acquisitions and related integrations, debt refinancing, restructuring and conversions, and equity issuance and related offering costs can vary from period to period and transaction to transaction, expenses associated with these activities are not considered a key measure of our operating performance and

because amortization expenses can vary substantially from company to company and from period to period depending upon each company’s financing and accounting methods, the fair value and average expected life of acquired intangible assets and the method by which assets were acquired, the amortization of intangible assets obtained in acquisitions are not considered a key measure in comparing our operating performance.
Since 2010, we have used Adjusted Earnings for internal management reporting and evaluation purposes. We also believe Adjusted Earnings and Adjusted Earnings per share are useful to investors in evaluating our operating performance because securities analysts use them as supplemental measures to evaluate the overall performance of companies, and our investor and analyst presentations include Adjusted Earnings and Adjusted Earnings per share.
Adjusted Earnings and Adjusted Earnings per share are not measures of our financial performance under GAAP and should not be considered as an alternative to net income or earnings per share or any other performance measure derived in accordance with GAAP, or as an alternative to cash flows from operating activities as a measure of our profitability or liquidity.

We understand that, although Adjusted Earnings and Adjusted Earnings per share are frequently used by securities analysts and others in their evaluation of companies, they have limitations as analytical tools, and you should not consider Adjusted Earnings and Adjusted Earnings per share in isolation, or as substitutes for an analysis of our results as reported under GAAP. In particular you should consider:

Adjusted Earnings and Adjusted Earnings per share do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments;

Adjusted Earnings and Adjusted Earnings per share do not reflect changes in, or cash requirements for, our working capital needs and

Other companies in our industry may calculate Adjusted Earnings and Adjusted Earnings per share differently than we do, limiting their usefulness as comparative measures.

Management compensates for the inherent limitations associated with using Adjusted Earnings and Adjusted Earnings per share through disclosure of such limitations, presentation of our financial statements in accordance with GAAP and reconciliation of Adjusted Earnings to the most directly comparable GAAP measure, net income.
    

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The following table sets forth a reconciliation of net income to non-GAAP measures Adjusted Earnings and Adjusted Earnings per share for the three months ended March 31, 2012 and 2011 (in thousands, except per share data):
 
For the Three Months Ended March 31,
 
2012
 
2011
 
(unaudited)
Net income
$
41,179

 
$
48,999

After-Tax:
 
 
 
EBITDA Adjustments(1)
 
 
 
Employee share-based compensation expense(2)
3,167

 
2,901

Acquisition and integration related expenses
1,146

 
874

Restructuring and conversion costs
1,240

 
515

Debt extinguishment costs
10,207

 

Equity issuance and related offering costs

 
180

Other
194

 
20

Total EBITDA Adjustments
15,954

 
4,490

Amortization of purchased intangible assets and software(1)
6,066

 
5,884

Adjusted Earnings
$
63,199

 
$
59,373

Adjusted Earnings per share(3)
$
0.56

 
$
0.52

Weighted average shares outstanding — diluted(4)
112,529

 
113,196

____________
(1)
EBITDA Adjustments and amortization of purchased intangible assets and software have been tax effected using a federal rate of 35.0% and the applicable effective state rate which was 3.30%, net of the federal tax benefit, for both periods presented.
(2)
Represents the after-tax expense of non-qualified stock options in which we receive a tax deduction upon exercise, and the full expense impact of incentive stock options granted to employees that have vested and qualify for preferential tax treatment and conversely, we do not receive a tax deduction. Share-based compensation for vesting of incentive stock options was $1.6 million and $1.4 million, respectively, for the three months ended March 31, 2012 and 2011.
(3)
Represents Adjusted Earnings, a non-GAAP measure, divided by weighted average number of shares outstanding on a fully diluted basis. Set forth is a reconciliation of earnings per share on a fully diluted basis as calculated in accordance with GAAP to Adjusted Earnings per share:
 
For the Three Months Ended March 31,
 
2012
 
2011
 
(unaudited)
Earnings per share — diluted
$
0.37

 
$
0.43

After-Tax:
 
 
 
EBITDA Adjustments per share
0.14

 
0.04

Amortization of purchased intangible assets and software per share
0.05