LPL FINANCIAL HOLDINGS INC. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes to those consolidated financial statements included in Item 8 of this Form 10-K. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under "Risk Factors" and elsewhere in this Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements. Please also refer to the section under heading "Special Note Regarding Forward-Looking Statements."
Overview
We are the nation's largest independent broker-dealer, a top custodian for registered investment advisors ("RIAs"), and a leading independent consultant to retirement plans. We provide an integrated platform of brokerage and investment advisory services to more than 13,300 independent financial advisors including financial advisors at approximately 700 financial institutions (our "advisors") across the country, enabling them to provide their retail investors (their "clients") with objective, conflict-free financial advice. We also support approximately 4,500 financial advisors who are affiliated and licensed with insurance companies with customized clearing services, advisory platforms and technology solutions. In addition, through our subsidiary companies, we support a diverse client base.Fortigent Holdings Company, Inc. is a leading provider of solutions and consulting services to RIAs, banks and trust companies servicing high-net-worth clients, whileThe Private Trust Company N.A. manages trusts and family assets for high-net-worth clients in all 50 states. Our newest subsidiary,NestWise LLC , supports the recruitment and development of new-to-the-industry financial advisors dedicated to serving mass market clients under the fee-based, independent model. Our singular focus is to provide our advisors with the front-, middle- and back-office support they need to serve the large and growing market for independent investment advice. We believe we are the only company that offers advisors the unique combination of an integrated technology platform, comprehensive self-clearing services and 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 inthe United States based on the information available as of the date this Annual Report on Form 10-K has been issued. Through our advisors, we are also one of the largest distributors of financial products inthe United States . Our scale is a substantial competitive advantage and enables us to more effectively attract and retain advisors. Our unique business model allows us to invest in more resources for our advisors, increasing their revenues and creating a virtuous cycle of growth. We have approximately 2,900 employees with primary offices inBoston , Charlotte andSan 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 the use of our technology, custody, clearing, trust and reporting platforms. We also generate asset-based revenues through our platform of over 8,900 financial products from a broad range of product manufacturers. Under our self-clearing platform, we custody the majority of client assets invested in these financial products, for which we provide 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 interest from margin loans made to our advisors' clients. We track recurring revenue, a characterization of net revenue and a statistical measure, which we define to include our revenues from asset-based fees, advisory fees, trailing commissions, cash sweep programs and certain other fees that are based upon accounts and advisors. Because certain recurring revenues are associated with asset balances, they will fluctuate depending on the market values and current interest rates. These asset balances, specifically related to advisory revenues and asset-based revenues, have a correlation of approximately 60% to the fluctuations of the overall market, as measured by the S&P 500. Accordingly, our 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 dependent upon transaction volumes or other activity-based revenues, 37 -------------------------------------------------------------------------------- which are more difficult to predict, particularly in declining or volatile markets. 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 Year Ended December 31, 2012 % of Total Total Net Sources of Revenue Primary Drivers (millions) Revenue % Recurring Advisor-driven Commission - Transactions revenue with - Brokerage asset $1,821 50% 39% ~85%-90% levels payout ratio Advisory - Advisory asset $1,062 29% 99% levels Asset-Based - Cash balances - Cash Sweep Fees - Interest rates - Sponsorship Fees - Number of accounts $403 11% 100% - Record Keeping - Client asset levels Transaction and - Client activity Attachment Other - Number of clients
revenue - Transactions - Number of advisors
retained by - Client (Investor) - Number of accounts
64% us Accounts - Premium technology - Advisor Seat and subscribers Technology Interest and Other - Margin accounts Revenue - Alternative $53 1% 43% investment transactions Total Net Revenue $3,661 100% 65% Total Recurring Revenue $2,395 65%
• Commission and Advisory Revenues. Commission and advisory revenues both
represent advisor-generated revenue, generally 85-90% of which is paid to advisors. Commission Revenues. We generate two types of commission revenues: front-end sales commissions that occur at the point of sale and trailing commissions. Transaction-based commission revenues primarily represent gross commissions generated by our advisors, primarily from commissions earned on the sale of various financial products such as mutual funds, variable and fixed annuities, alternative investments, general securities, fixed income, insurance, group annuities and options and commodities. The levels of transaction-based commissions 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 earn trailing commission 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 in trail-eligible assets. Advisory Revenues. Advisory revenues represent fees charged on our corporate 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 each calendar quarter. Generally, the advisory revenues collected on our corporate RIA platform range from 0.5% to 3.0% of the underlying assets. 38 -------------------------------------------------------------------------------- In addition, we support independent RIAs who conduct their advisory business through separate entities by establishing their own RIA ("Independent RIAs") pursuant to the Investment Advisers Act of 1940, rather than using our corporate RIA. The assets held under these investment advisory accounts custodied withLPL Financial LLC ("LPL Financial") are included in our advisory and brokerage assets, net new advisory assets and advisory assets under custody metrics. The advisory revenue generated by an Independent RIA is earned by the Independent RIA, and accordingly is not included in our advisory revenue. However, there are administrative fees charged to Independent RIAs including custody and clearing fees, based on the value of assets within these advisory accounts. The administrative fees collected on our Independent RIA platform vary, and can reach a maximum of 0.6% of the underlying assets. Furthermore, we support certain financial advisors at broker-dealers affiliated with insurance companies through our customized advisory platforms and charge fees to these advisors based on the value of assets within these advisory accounts.
• Asset-Based Revenues. Asset-based revenues 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. Our omnibus
and networking revenues represent fees paid to us in exchange for
administrative and record-keeping services that we provide to clients of our
advisors. Omnibus revenues, paid to us by mutual fund manufacturers, are
generally correlated to assets served while networking revenues, paid to us
by mutual fund and annuity product manufacturers, are correlated to the
number of positions we administer.
• Transaction and Other Revenues. Revenues earned from transactions and other
services provided 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 certain 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 and fees to advisors who
subscribe to our reporting services. 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, for which we charge an attendance fee.
• Other Revenue. Other revenue includes marketing re-allowance fees from
certain financial product manufacturers, primarily those who offer
alternative investments, mark-to-market gains or losses on assets held by us
for the advisors' non-qualified deferred compensation plan and our model
portfolios, revenues from our retirement partner program, 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 payout amounts that are earned by and paid out to advisors based on commission and advisory revenues earned on each client's account (collectively, commission and advisory revenues earned are referred to as
gross dealer concessions, or "GDC"); production bonuses earned by advisors
based on the levels of commission and advisory revenues 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 GDC.
We characterize production payout, which includes all production expenses except brokerage, clearing and exchange fees, as either GDC sensitive or non-GDC sensitive. Base payout amounts and production bonuses earned by and paid to advisors are GDC sensitive because they are variable and highly correlated
39 -------------------------------------------------------------------------------- to the level of our commission and advisory revenues in a particular reporting period. Non-GDC sensitive payout 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. Non-GDC sensitive payout is correlated to market movement in addition to the value of our stock. We believe that production payout, viewed in addition to, and not in lieu of, our production expenses, provides useful information to investors regarding our payouts to advisors. The following table is presented as an illustration of how the aforementioned production expenses impact our production payout ratio for the year endedDecember 31, 2012 : Base payout rate 84.16 % Production based bonuses 2.68 % GDC sensitive payout 86.84 % Non-GDC sensitive payout 0.22 % Total Payout Ratio 87.06 %
________________________________
See "Results of Operations" for comparative 2011 and 2010 periods' analyses of production payout ratio.
• 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.
• 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") and our 2009 consolidation of
(collectively referred to herein as the "Affiliated Entities"). 40
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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 years endedDecember 31, 2012 , 2011 and 2010 are as follows: As of and for the Year Ended December 31, 2012 2011 2010 Business Metrics Advisors(1) 13,352 12,847 12,444 Advisory and brokerage assets (in billions)(2) $ 373.3 $ 330.3 $ 315.6 Advisory assets under custody (in billions)(3)(4) $ 122.1 $ 101.6 $ 93.0 Net new advisory assets (in billions)(5) $ 10.9 $ 10.8 $ 8.5 Insured cash account balances (in billions)(4) $ 16.3 $ 14.4 $ 12.2 Money market account balances (in billions)(4) $ 8.4 $
8.0
Financial Metrics Revenue growth from prior year 5.2 % 11.8 % 13.2 % Recurring revenue as a % of net revenue(6) 65.4 % 62.7 % 60.7 % Net income (loss) (in millions) $ 151.9 $ 170.4 $ (56.9 ) Earnings (loss) per share (diluted) $ 1.37 $ 1.50 $ (0.64 ) Non-GAAP Measures: Gross margin (in millions)(7) $ 1,112.3 $ 1,031.0 $ 937.9 Gross margin as a % of net revenue(7) 30.4 % 29.6 % 30.1 % Adjusted EBITDA (in millions) $ 454.5 $ 459.7 $ 413.1 Adjusted EBITDA as a % of net revenue 12.4 % 13.2 % 13.3 % Adjusted EBITDA as a % of gross margin(7) 40.9 % 44.6 % 44.0 % Adjusted Earnings (in millions) $ 225.0 $ 218.6 $ 172.7 Adjusted Earnings per share (diluted) $ 2.03 $
1.95
____________
(1) Advisors are defined as those independent financial advisors and financial
advisors at financial institutions who are licensed to do business with
the Company's broker-dealer subsidiary. During 2012, an institutional
client's parent company consolidated its operations onto the broker-dealer
platform of an affiliate within its organization, which resulted in a loss
of 181 advisors. Excluding the attrition of the institutional client's
advisors, we added 686 net new advisors during the twelve months ended
Financial which resulted, as expected, in the attrition of 146 advisors
during the year ended
integration of the UVEST platform, we added 549 net new advisors during
the twelve months ended
(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. Such
totals do not include the market value of certain other client assets as
of
supported by advisors licensed with LPL Financial,
assets supported by
billion of assets supported by
regarding certain of these assets was not available at
In addition, reported retirement plan assets represent assets that are
custodied with 26 third-party providers of retirement plan administrative
services who provide reporting feeds. We estimate the total assets in
retirement plans served to be between
we receive reporting feeds in the future from providers for whom we do not
currently receive feeds, we intend to include and identify such additional
assets in this metric. During the fourth quarter of 2012, we began
receiving a reporting feed from one such provider, which accounted for
billion of assets reported atSeptember 30, 2012 . (3) In reporting our financial and operating results for the year ended
under custody (formerly known as advisory assets under 41
-------------------------------------------------------------------------------- management). Advisory assets under custody are comprised of advisory assets under management in our corporate RIA platform, and Independent RIA assets in advisory accounts custodied by us. See "Results of Operations" for a tabular presentation of advisory assets under custody. (4) Advisory assets under custody, insured cash account balances and money
market account balances are components of advisory and brokerage assets.
(5) 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.
(6) Recurring revenue, a characterization of net revenue and a statistical
measure, is derived from sources such as advisory revenues, asset-based
revenues, trailing commission revenues, revenues related to our cash sweep
programs, interest earned on margin accounts and technology and service
revenues, and is not meant as a substitute for net revenues. (7) Gross margin is calculated as net revenues less production expenses. Production expenses consist of the following expense categories from our consolidated statements of operations: (i) commission and advisory 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 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, officers and non-employee
directors 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. Adjusted
42 --------------------------------------------------------------------------------
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 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 (loss) to Adjusted EBITDA, a non-GAAP measure, for the years endedDecember 31, 2012 , 2011 and 2010 (in thousands): For the Year Ended December 31, 2012 2011 2010 Net income (loss) $ 151,918 $ 170,382 $ (56,862 ) Interest expense 54,826 68,764 90,407 Income tax expense (benefit) 98,673 112,303 (31,987 ) Amortization of purchased intangible assets and software(1) 39,542 38,981 43,658 Depreciation and amortization of all other fixed assets 32,254 33,760 42,379 EBITDA 377,213 424,190 87,595 EBITDA Adjustments: Employee share-based compensation expense(2) 17,544 14,978 10,429 Acquisition and integration related expenses(3) 20,474 (3,815 ) 12,569 Restructuring and conversion costs(4) 6,146 22,052 22,835 Debt amendment and extinguishment costs(5) 16,652 - 38,633 Equity issuance and related offering costs(6) 4,486 2,062 240,902 Other(7) 11,967 253 150 Total EBITDA Adjustments 77,269 35,530 325,518 Adjusted EBITDA $ 454,482 $ 459,720 $ 413,113 ____________
(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 for equity awards granted to
employees, officers and directors. Such awards are measured based on the
grant-date fair value and share-based compensation is recognized over the
requisite service period of the individual grants, which generally equals
the vesting period. (3) Represents acquisition and integration costs resulting from various
acquisitions, including changes in the estimated fair value of future
payments, or contingent consideration, required to be made to former
shareholders of certain acquired entities. During the year ended
against earnings due to a net increase in the estimated fair value of
contingent consideration. As previously disclosed, we have been involved
in a legal dispute with a third-party indemnitor under a purchase and sale
agreement with respect to the indemnitor's refusal to make 43
-------------------------------------------------------------------------------- indemnity payments that we believed were required under the purchase and sale agreement. Included in the year endedDecember 31, 2010 , is$11.4 million of expenditures related to the legal dispute with the third-party indemnitor that has been classified within general and administrative expenses and included in the presentation of Adjusted EBITDA, a non-GAAP measure. We settled our legal dispute with the third-party indemnitor in the fourth quarter of 2011. Accordingly in 2011, we received a$10.5 million cash settlement,$9.8 million of which has been excluded from the presentation of Adjusted EBITDA, a non-GAAP measure. See Note 14 - Commitments and Contingencies, within the notes to consolidated financial statements for additional information. (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 December 31,
2012, approximately 89% and 98%, respectively, of costs related to these
two initiatives have been recognized. The remaining costs largely consist
of the amortization of transition payments that have been made in
connection with these two conversions for the retention of advisors and
financial institutions that are expected to be recognized into earnings by
December 2014 . (5) For the year endedDecember 31, 2012 , represents expenses incurred resulting from the early extinguishment and repayment of amounts
outstanding under the prior senior secured credit facilities, including
the write-off of
have no future economic benefit, as well as various other charges incurred
in connection with the establishment of the new senior secured credit
facilities. For the year ended
amendment costs incurred in 2010 for amending and restating our senior
secured credit agreement to establish a new term loan tranche and to extend the maturity of an existing tranche on our senior credit facilities.
(6) Represents equity issuance and offering costs incurred in the years ended
offering in the second quarter of 2012, the closing of a secondary
offering in the second quarter of 2011 and our initial public offering
("IPO") in the fourth quarter of 2010, respectively. In addition, results
for the year ended
the late deposit of withholding taxes related to the exercise of certain
non-qualified stock options in connection with our 2010 IPO. See Note 14 -
Commitments and Contingencies, within the notes to consolidated financial
statements for additional information. (7) Results for the year endedDecember 31, 2012 include approximately$7.0 million for consulting services and technology development aimed at enhancing the Company's performance in support of its advisors while operating at a lower cost. In addition, results for the year ended
certain fixed assets related to internally developed software that were determined to have no estimated fair value. Remaining costs include certain excise and other taxes.
Adjusted Earnings and Adjusted Earnings per share
Adjusted Earnings represents net income before: (a) employee 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 amendment and 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.
In reporting our financial and operating results for the years ended
Adjusted Earnings per share represents Adjusted Earnings divided by weighted average outstanding shares 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.
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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, officers and non-employee
directors 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. 45
-------------------------------------------------------------------------------- The following table sets forth a reconciliation of net income (loss) to non-GAAP measures Adjusted Earnings and Adjusted Earnings per share for the years endedDecember 31, 2012 , 2011 and 2010 (in thousands, except per share data): For the Year Ended December 31, 2012 2011 2010 (unaudited) Net income (loss) $ 151,918 $ 170,382 $ (56,862 ) After-Tax: EBITDA Adjustments(1) Employee share-based compensation expense(2) 13,161 11,472
8,400
Acquisition and integration related expenses(3) 11,106 (2,354 ) 7,638 Restructuring and conversion costs
3,792 13,606
13,877
Debt amendment and extinguishment costs 10,274 -
23,477
Equity issuance and related offering costs(4) 4,262 1,272149,568 Other 7,384 156 91 Total EBITDA Adjustments 49,979 24,152 203,051 Amortization of purchased intangible assets and software(1) 24,397 24,051
26,531
Acquisition related benefit for a net operating loss carry-forward(5) (1,265 ) - - Adjusted Earnings $ 225,029 $ 218,585 $ 172,720 Adjusted Earnings per share(6) $ 2.03 $ 1.95 $ 1.71 Weighted average shares outstanding - diluted(7) 111,060 112,119
100,933
____________
(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 the periods presented.
(2) Represents the after-tax expense of non-qualified stock options for which
we receive a tax deduction upon exercise, restricted stock awards for
which we receive a tax deduction upon vesting, and the full expense impact
of incentive stock options granted to employees that have vested and
qualify for preferential tax treatment and conversely, for which we do not
receive a tax deduction. Share-based compensation for vesting of incentive
stock options was$6.1 million ,$5.8 million and$5.3 million , respectively, for the years endedDecember 31, 2012 , 2011 and 2010. (3) Represents the after-tax expense of acquisition and related costs for
which we receive a tax deduction. In addition, the results for the twelve
months ended
relating to the fair value of contingent consideration for the stock acquisition ofConcord , that is not deductible for tax purposes and that we do not consider to be indicative of our core performance. (4) Represents after-tax equity issuance and offering costs incurred in the years endedDecember 31, 2012 , 2011 and 2010, related to the closing of a secondary offering in the second quarter of 2012, the closing of a
secondary offering in the second quarter of 2011 and the full expense
impact of
2010 for which we do not receive a tax deduction, respectively. In addition, results for the year endedDecember 31, 2012 include a$3.9 million charge in other expenses in the consolidated statements of operations for the late deposit of withholding taxes related to the exercise of certain non-qualified stock options in connection with our 2010 IPO, that is not deductible for tax purposes. See Note 14 -
Commitments and Contingencies, within the notes to consolidated financial
statements for additional information.
(5) Represents the expected tax benefit available to us from the accumulated
net operating losses ofConcord that arose prior to our acquisition; such benefits were recorded in the third quarter of 2012. 46
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(6) 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 (loss) per share on a fully diluted basis
as calculated in accordance with GAAP to Adjusted Earnings per share: For the Year Ended December 31, 2012 2011 2010 (unaudited) Earnings (loss) per share - diluted $ 1.37 $
1.50 $ (0.64 ) Adjustment to include dilutive shares, not included in GAAP earnings (loss) per share
- - 0.08 Adjustment for allocation of undistributed earnings to stock units - 0.02 - After-Tax: EBITDA Adjustments per share 0.45
0.22 2.01 Amortization of purchased intangible assets and software per share
0.22 0.21 0.26 Acquisition related benefit for a net operating loss carry-forward per share (0.01 ) - - Adjusted Earnings per share $ 2.03 $ 1.95 $ 1.71 (7) Included within the weighted average share count for the year endedDecember 31, 2012 , is approximately 850,000 shares resulting from the distribution pursuant to the 2008 Nonqualified Deferred Compensation Plan inFebruary 2012 that were not included in the weighted average share
count for the year ended
Equity, within the notes to consolidated financial statements for
additional information.
The following table reflects pro-forma Adjusted Earnings per share, a non-GAAP measure, and growth in pro-forma Adjusted Earnings per share, assuming weighted average shares outstanding on a fully diluted basis as ofDecember 31, 2012 were also outstanding as ofDecember 31, 2011 (in thousands, except per share data): For the Year Ended December 31, % Change 2012 2011 2010 '12 vs. '11 '11 vs. '10 (unaudited) Adjusted Earnings $ 225,029 $ 218,585 $ 172,720 Weighted average shares outstanding - diluted as of December 31, 2012 111,060 111,060 111,060 Pro-forma Adjusted Earnings per share $ 2.03 $ 1.97 $ 1.56 3.0 % 26.3 %
Acquisitions, Integrations and Divestitures
From time to time we undertake acquisitions and/or divestitures based on opportunities in the competitive landscape. These activities are part of our overall growth strategy, but can distort comparability when reviewing revenue and expense trends for periods presented. The following describes significant acquisition and divestiture activities that have impacted our 2010, 2011 and 2012 results.
Consolidation of the Affiliated Entities
OnSeptember 1, 2009 , we consolidated the operations of the Affiliated Entities with those of LPL Financial. The consolidation involved the transfer of securities licenses of certain registered representatives associated with the Affiliated Entities and their client accounts. Following the consolidation, the registered representatives and client accounts that were transferred are associated with LPL Financial. The consolidation of the Affiliated Entities was effected to enhance service offerings to our advisors while also generating efficiencies. While our acquisition of the Affiliated Entities has contributed to the overall growth of our base of advisors and related revenue and market position, the consolidation into LPL Financial resulted in restructuring costs in the form of personnel costs, system costs and professional fees, as well as restructuring charges including severance and one-time termination benefits, lease and contract termination fees, asset impairments and transfer and conversion costs. See Note 4 - Restructuring, within the notes to consolidated financial statements for additional information. 47 --------------------------------------------------------------------------------
Acquisition of
OnFebruary 9, 2011 , we acquired certain assets ofNational Retirement Partners, Inc. ("NRP"). As part of the acquisition, 206 advisors previously registered with NRP transferred their securities and advisory licenses and registrations to LPL Financial. We may be required to pay future consideration to former shareholders of NRP that is contingent upon the achievement of certain revenue-based milestones in the third year following the acquisition. We estimated the fair value of the remaining contingent consideration at the close of the transaction and we re-measure contingent consideration at fair value at each interim reporting period with changes recognized in earnings. There is no maximum amount of contingent consideration; however, based on our current estimate, we expect to make a cash payment of an amount between$20.0 million and $30.0 million in the first quarter of 2014.
Consolidation of
OnMarch 14, 2011 , we committed to a corporate restructuring plan to enhance our service offering, while generating operating efficiencies. The restructuring plan included the consolidation of the operations of our subsidiary, UVEST, with those of LPL Financial. In connection with the consolidation of UVEST, certain registered representatives formerly associated with UVEST moved to LPL Financial through a transfer of their licenses. The transfers began inJuly 2011 and were completed inDecember 2011 . Following the transfer, all registered representatives and client accounts that transferred are now associated with LPL Financial. UVEST has withdrawn its registration with theFinancial Industry Regulatory Authority ("FINRA") effectiveJuly 16, 2012 , and is no longer subject to net capital filing requirements.
Based on current estimates, we expect to improve pre-tax profitability by approximately
Acquisition of
OnJune 22, 2011 , we acquired all of the outstanding common stock ofConcord .Concord provides open architecture investment management solutions for trust departments of financial institutions. As ofDecember 31, 2012 ,$0.5 million remained in an escrow account to be paid to former shareholders ofConcord in accordance with the terms of the stock purchase agreement. We may be required to pay future consideration that is contingent upon the achievement of certain gross margin-based milestones for the year endingDecember 31, 2013 . We estimated the fair value of the contingent consideration at the close of the transaction and re-measure contingent consideration at fair value at each interim reporting period with changes recognized in earnings. The maximum amount of contingent consideration is$15.0 million ; however, based on our current estimate, we expect any payment to range between$0.0 million and $12.0 million in 2014. Acquisition ofFortigent Holdings Company, Inc. OnApril 23, 2012 , we acquired all of the outstanding common stock ofFortigent Holdings Company, Inc. and its wholly owned subsidiariesFortigent, LLC , a registered investment advisory firm,Fortigent Reporting Company, LLC andFortigent Strategies Company, LLC (together, "Fortigent").Fortigent is a leading provider of solutions and consulting services to RIAs, banks and trust companies servicing high-net-worth clients. This strategic acquisition further enhances our capabilities and offers an extension of our existing services for wealth management advisors. Total purchase price consideration at the closing of the transaction was$38.8 million . As ofDecember 31, 2012 ,$8.1 million remained in an escrow account to be paid to former shareholders of <org value="ACORN:2726895135" idsrc="xmltag.org">Fortigent in accordance with the terms of the stock purchase agreement. Acquisition ofVeritat Advisors, Inc. OnJuly 10, 2012 , we acquired all of the outstanding common stock ofVeritat Advisors, Inc. ("Veritat"). Veritat was a registered investment advisory firm that developed and utilized a proprietary online financial planning platform designed to support advisors who serve the mass market. This strategic acquisition will enhance our technological capabilities and increase the flexibility of our service offering in light of our recently announced initiative to serve mass market clients through the formation ofNestWise LLC . 48 -------------------------------------------------------------------------------- At the closing of the transaction we paid$4.9 million , net of cash acquired. We may be required to pay future consideration to the former Veritat shareholders that is contingent upon the achievement of certain financial targets and retention of key employees. The maximum aggregate amount of contingent payments is$20.9 million to be paid over the following measurement dates:December 31, 2013 ,June 30, 2015 ,June 30, 2017 andDecember 31, 2017 (together, the "Performance Measurement Dates"), if such financial targets are fully achieved and key employees are retained. Based on our current estimate, we expect to make cash payments in an aggregate amount between$5.0 million and $18.0 million at the Performance Measurement Dates.
Economic Overview and Impact of Financial Market Events
In 2012, valuations inthe United States equity markets generally improved with the S&P 500 closing the year at 1,426, up 13.4% from its closing level onDecember 31, 2011 . Notwithstanding the general upward trend of the equity markets, 2012 had periods of weakness, such as the period fromMay 1st to June 1st , when the S&P 500 declined by 9.1%. The overall equity market levels improved despite lingering economic concerns about US and global growth rates, a persistent high unemployment level, and sovereign debt concerns in certain countries in theEuropean Union . These continuing concerns have led to lack of retail investor engagement throughout the year, as illustrated by relatively soft trading volumes in the equity markets and consistent outflows from equity mutual funds. In response to the economic concerns, central banks including the Federal Reserve have continued to maintain interest rates at historically low levels. The average Federal Funds effective rate was 0.14% in 2012, a slight increase from the average of 0.10% in 2011. The prolonged low interest rate environment pressured our revenues from our cash sweep programs. The low interest rate environment continued to impact investor demand for fixed income securities and fix annuities. In its September meeting, theBoard of Governors of theFederal Reserve System announced that it expected to support low short-term interest rates into 2015. Beginning in the second half of 2012, investors generally became more cautious asUnited States elections approached and as investors became more focused on the uncertainty over the direction of fiscal and tax policies inthe United States , as a number of tax provisions were slated to expire onDecember 31, 2012 , and other tax provisions were scheduled to begin onJanuary 1, 2013 . A number of these uncertain tax topics included the rates of taxation applicable to dividends and capital gains. The impending increase in the 2013 tax rates was referred to as the "fiscal cliff". As the end of the year approached, we generally saw investor activity slow in light of the continued uncertainty of fiscal policy. In November and December, we saw a substantial increase in the balances held by clients in our cash sweep products, which increased by 13.3% fromOctober 31, 2012 toDecember 31, 2012 . We also saw substantial increases in cash held in client accounts (shown as payables to clients in our consolidated statement of financial condition), which increased from$388.0 million atOctober 31, 2012 to$749.5 million atDecember 31, 2012 . We believe these trends arose as our advisors' clients realized capital gains and companies and mutual funds increased dividend payout rates before tax rates were expected to increase. We also believe clients increased the cash component of their asset allocations awaiting resolution of the fiscal cliff. Despite the economic challenges faced during 2012, our business continued to grow, largely based on the addition of net new advisors and the offering of new products and services, as we reported record levels of both commission and advisory revenues. With a partial resolution in earlyJanuary 2013 of some of the issues that gave rise to the fiscal cliff concerns, we remain cautiously optimistic and will continue to attempt to manage the impact of financial markets on our earnings. 49 --------------------------------------------------------------------------------
Results of Operations
The following discussion presents an analysis of our results of operations for the years endedDecember 31, 2012 , 2011 and 2010. Where appropriate, we have identified specific events and changes that affect comparability or trends, and where possible and practical, have quantified the impact of such items. Year Ended December 31, Percentage Change 2012 2011 2010 '12 vs. '11 '11 vs. '10 (In thousands) Revenues Commission $ 1,820,517 $ 1,754,435 $ 1,620,811 3.8 % 8.2 % Advisory 1,062,490 1,027,473 860,227 3.4 % 19.4 % Asset-based 403,067 359,724 317,505 12.0 % 13.3 % Transaction and other 321,558 292,207 274,148 10.0 % 6.6 % Other 53,456 45,536 40,795 17.4 % 11.6 % Net revenues 3,661,088 3,479,375 3,113,486 5.2 % 11.8 % Expenses Production 2,548,837 2,448,424 2,397,535 4.1 % 2.1 % Compensation and benefits 362,705 322,126 308,656 12.6 % 4.4 % General and administrative 350,212 263,228 267,799 33.0 % (1.7 )% Depreciation and amortization 71,796 72,741 86,037 (1.3 )% (15.5 )% Restructuring charges 5,597 21,407 13,922 (73.9 )% 53.8 % Total operating expenses 3,339,147 3,127,926 3,073,949 6.8 % 1.8 % Non-operating interest expense 54,826 68,764 90,407 (20.3 )% (23.9 )% Loss on extinguishment of debt 16,524 - 37,979 * * Total expenses 3,410,497 3,196,690 3,202,335 6.7 % (0.2 )% Income (loss) before provision for (benefit from) income taxes 250,591 282,685 (88,849 ) (11.4 )% * Provision for (benefit from) income taxes 98,673 112,303 (31,987 ) (12.1 )% * Net income (loss) $ 151,918 $ 170,382 $ (56,862 ) (10.8 )% * ____________ * Not Meaningful 50
--------------------------------------------------------------------------------
Revenues
Commission Revenues The following table sets forth our commission revenue, by product category included in our consolidated statements of operations for the periods indicated (dollars in thousands): Year Ended December 31, 2012 % Total 2011 % Total 2010 % Total Variable annuities $ 764,502 41.9 % $ 731,770 41.7 % $ 636,128 39.3 % Mutual funds 498,239 27.3 % 472,466 26.9 % 457,947 28.2 % Alternative investments 142,996 7.9 % 113,589 6.5 % 97,606 6.0 % Equities 99,380 5.5 % 97,882 5.6 % 93,961 5.8 % Fixed annuities 98,976 5.4 % 136,020 7.8 % 138,753 8.6 % Fixed income 83,235 4.6 % 84,568 4.8 % 85,250 5.2 % Insurance 81,124 4.5 % 70,060 4.0 % 72,297 4.5 % Group variable annuities(1) 50,891 2.8 % 45,579 2.6 % 36,241 2.2 % Other 1,174 0.1 % 2,501 0.1 % 2,628 0.2 % Total commission revenue $ 1,820,517 100.0 % $ 1,754,435 100.0 % $ 1,620,811 100.0 % ____________________
(1) In 2012, we began to present group variable annuities as a separate
component of commission revenues. Previously, group variable annuities had
been presented within variable annuities. Accordingly, amounts have been reclassified for the years endedDecember 31, 2011 and 2010 to make them consistent with the current period presentation. Commission revenues increased by$66.1 million , or 3.8%, for 2012 compared with 2011. The 4.5% growth in revenues from variable annuities is based on an increase in trail-based commissions partially offset by a decrease in sales-based commissions. The combination of low interest rates and market uncertainty impacted sales commissions for variable annuities due to its impact on product design, which lowered demand for these products. In addition, insurers have lowered the amount of risk they are willing to retain on variable annuity products by reducing certain insurance benefits, thereby making the products less attractive to investors. Group variable annuities increased due to growth in our retirement business. Mutual fund commission revenues increased for the year endedDecember 31, 2012 compared to the year endedDecember 31, 2011 as a result of increases in both sales-based commissions and in trail-based commissions due to improving market conditions and growth of the underlying assets. The increase in alternative investments is reflective of investor preferences for diversification and opportunities to earn return outside of the traditional equity and fixed income markets. Income producing alternative strategies continue to grow in popularity as the needs of investors shift toward diversification. Insurance commission revenues increased on improved universal life and whole life sales, which was partially offset by a decrease in term life sales. The continued low interest rate environment, which has reduced investor demand for fixed annuities and fixed income securities, is reflected in the decline in commission revenues for these two products. Commission revenues increased by$133.6 million , or 8.2%, for 2011 compared to 2010. In 2011, the product mix reflects the volatility of the financial markets in the latter half of the year as retail investors sought protection from downside risk while maintaining their upside potential with investment products such as variable annuities with minimum guarantee options. Mutual fund commission revenues were bolstered by increasing levels of trail-based commissions due to strong growth of the underlying assets. The increase in alternative investments is reflective of more product availability and investor preferences for diversification. Insurance commissions declined as term life insurance experienced reduced sales. 51 -------------------------------------------------------------------------------- Advisory Revenues The following table summarizes the activity within our advisory assets under custody for the periods endedDecember 31, 2012 , 2011 and 2010 (in billions): 2012 2011 2010
Beginning balance at
10.9 10.8 8.5 Market impact and other 9.6 (2.2 ) 7.3
Ending balance at
Net new advisory assets for the years endedDecember 31, 2012 , 2011 and 2010 have a limited impact on advisory fee revenue for those respective periods. Rather, net new advisory assets are a primary driver of future advisory fee revenue. Net new advisory assets were$10.9 billion for the year endedDecember 31, 2012 as a result of strong new business development coupled with the continued shift by our existing advisors toward more advisory business. Advisory fee revenue increased by$35.0 million , or 3.4%, in 2012 compared to 2011. Advisory revenue for a particular quarter is predominately driven by the prior quarter-end advisory assets under custody. The growth in advisory fee revenue is due to both net new advisory assets in prior periods and higher levels of the S&P 500 on the applicable billing dates in 2012 compared to 2011. The average of the S&P 500 on the close of the four prior quarter-end dates,September 30, 2012 June 30, 2012,March 31, 2012 andDecember 31, 2011 , was 1,367, which is an 8.6% increase over the average of 1,259 for the prior year corresponding dates. The continued shift of advisors to the Independent RIA platform and a re-pricing in one of our significant agreements have caused the rate of revenue growth to lag behind the rate of advisory asset growth. Advisory revenues increased by$167.2 million , or 19.4%, for 2011 compared to 2010. The increase was the effect of an improving market, which resulted in an increase in the value of clients assets in advisory programs combined with net new advisory assets. The growth in advisory fee revenue is due to both higher levels of the S&P 500 on the applicable billing dates in 2011 compared to 2010 and net new advisory assets in prior periods. The average of the S&P 500 on the close of the four prior quarter-end dates,September 30, 2011 ,June 30, 2011 ,March 31, 2011 andDecember 31, 2010 , was 1,259, which is a 13.0% increase over the average of 1,114 for the prior year corresponding dates. Net new asset flows in 2011 were$10.8 billion , a$2.3 billion increase over 2010 as a result of strong new business development and a shift by our existing advisors towards more advisory business. The following table summarizes the makeup within our advisory assets under custody for the periods endedDecember 31, 2012 , 2011 and 2010 (in billions): As of December 31, Percentage Change 2012 2011 2010 '12 vs. '11 '11 vs. '10 Advisory assets under management $ 100.7 $ 90.3 $ 86.7 11.5 % 4.2 % Independent RIA assets in advisory accounts custodied by LPL Financial 21.4 11.3 6.3 89.4 % 79.4 %
Total advisory assets under custody
20.2 % 9.2 %
Growth of the Independent RIA assets in advisory accounts custodied by LPL Financial has outpaced the growth in advisory assets under management. This growth is consistent with the industry trend as more advisors shift their business toward the Independent RIA model.
Asset-Based Revenues Asset-based revenues increased by$43.3 million , or 12.0%, to$403.1 million for 2012 compared with 2011. Revenues from product sponsors and for record-keeping services, which are largely based on the underlying asset values, increased due to the impact of the higher average market indices on the value of those underlying assets and net new sales of eligible assets. The average S&P 500 index for 2012 was 1,379, an increase of 8.8% over the 2011 average. In addition, revenues from our cash sweep programs increased by$11.4 million , or 9.0%, to$138.1 million for year endedDecember 31, 2012 from$126.7 million for the year endedDecember 31, 2011 . This was driven by an increase in the assets in our cash sweep programs, which averaged$22.3 billion and$20.9 billion for 2012 and 2011, respectively, as investors and advisors were wary of the volatility in the financial markets and the impending fiscal cliff at the end of 2012. 52 -------------------------------------------------------------------------------- Asset-based revenues increased by$42.2 million , or 13.3%, to$359.7 million for 2011 compared with 2010. Revenues for record-keeping services and from product sponsors, which are largely based on the underlying asset values, increased due to the impact of the higher average market indices on the value of those underlying assets and net new sales of eligible assets. The average S&P 500 index for 2011 was 1,268, an increase of 11.2% over the 2010 average. In addition, revenues from our cash sweep programs increased by$7.0 million , or 5.8%, to$126.7 million for year endedDecember 31, 2011 from$119.7 million for the year endedDecember 31, 2010 . This was driven by an increase in the assets in our cash sweep programs, which averaged$20.9 billion and$18.5 billion for 2011 and 2010, respectively, as investors and advisors were wary of the volatility in the financial markets. Transaction and Other Revenues Transaction and other revenues increased by$29.4 million , or 10.0%, for 2012 compared with 2011. Transaction and other revenues increased in 2012 due to fee revenues of$10.5 million from the acquiredFortigent business. Transaction revenues also increased due to a 3.6% increase in the average number of advisors for the year endedDecember 31, 2012 compared to 2011, increases in revenues earned from those advisors and institutions who converted to the LPL Financial platform from UVEST during 2011 and increases due to repricing of certain services. Lower trade volumes in certain advisory accounts reduced transaction revenues, which partially offset these increases. Transaction and other revenues increased by$18.1 million , or 6.6%, for 2011 compared with 2010. Transactional revenues increased by$7.9 million due to increased transaction volumes in investment activities, including advisory products, general securities and fixed income products. The average number of advisors increased 5.0% in 2011 compared to 2010, which led to the increase in other revenues, specifically advisor based, technology and conference revenues. Other Revenue Other revenue increased$7.9 million , or 17.4%, to$53.5 million for 2012 compared to 2011. The primary contributor to this increase in 2012 was alternative investment marketing allowance fees received from product sponsors, which increased by$5.7 million compared to the same period in 2011, largely based on increased sales of alternative investments. An additional contributor to the increase was growth in retirement sponsorship programs of$2.2 million , as a result of growth based on our synergies with NRP. Other revenue increased$4.7 million , or 11.6%, to$45.5 million for 2011 compared to 2010. The primary contributor to this increase in 2011 is growth in retirement sponsorship programs of$1.9 million , an effect of our acquisition of NRP. Also in 2011, direct investment marketing allowances received from product sponsor programs increased by$1.7 million compared to the same period in 2010, largely based on increased sales of alternative investments. 53 --------------------------------------------------------------------------------
Expenses
Production Expenses The following table shows our production payout ratio and our adjusted payout ratio, a non-GAAP measure, for the years endedDecember 31, 2012 , 2011 and 2010: Year ended December 31, Change 2012 2011 2010 '12 vs. '11 '11 vs. '10 Base payout rate 84.16 % 84.15 % 83.86 % 0.01 % 0.29 % Production based bonuses 2.68 % 2.37 % 2.19 % 0.31 % 0.18 % GDC sensitive payout 86.84 % 86.52 % 86.05 % 0.32 % 0.47 % Non-GDC sensitive payout(1) 0.22 % 0.12 % 9.19 % 0.10 % (9.07 )% Total Payout Ratio 87.06 % 86.64 % 95.24 % 0.42 % (8.60 )% IPO related share-based compensation charge(1) - - (8.95 )% - 8.95 % Adjusted Payout Ratio 87.06 % 86.64 % 86.29 % 0.42 % 0.35 % __________________________
(1) Upon closing of our IPO in the fourth quarter of 2010, the restriction on
approximately 7.4 million shares of common stock issued to advisors under
the Fifth Amended and Restated 2000 Stock Bonus Plan was released.
Accordingly, we recorded a share-based compensation charge of
in 2010, representing the offering price of$30.00 per share multiplied by 7.4 million shares. This charge has been shown separately for 2010 for consistency and comparability to other periods presented. Production expenses increased by$100.4 million , or 4.1%, for 2012 compared with 2011. This increase is correlated with our commission and advisory revenues, which increased by 3.6% during the same period. Our GDC sensitive production payout was 86.84% for the year endedDecember 31, 2012 , compared to 86.52% for 2011. The increase in our payout ratio was driven by the increase in our production based bonuses, which reflect our advisors' trend of attaining higher payout tiers earlier in the year and graduating to larger advisor practices. The 0.10% increase in non-GDC sensitive payout is primarily attributable to mark-to-market gains for the advisor non-qualified deferred compensation plan for the year endedDecember 31, 2012 . Production expenses increased by$50.9 million , or 2.1%, for 2011 compared with 2010. Excluding a$222.0 million share-based compensation charge which was recorded in 2010 related to our IPO, production expenses increased$272.9 million or 12.5% for 2011 compared to 2010. This increase is correlated with our commission and advisory revenues, which increased by 12.1% during the same period. Our production payout was 86.64% for 2011, compared to an adjusted production payout, a non-GAAP measure, of 86.29% for 2010 which excludes the$222.0 million share-based compensation charge resulting from our IPO. The increase in payout ratios is driven by a change in the product mix of our commission revenues as well as our production based bonus incentive structures, which increase throughout the year as our advisors achieve higher production levels. As a result of greater advisor activity, more advisors reached higher payout tiers than in the prior year. Compensation and Benefits Expense Compensation and benefits increased by$40.6 million , or 12.6%, for 2012 compared with 2011. This was primarily based on the fact that our average number of full-time employees increased 6.6% from 2,687 in 2011 to 2,865 in 2012, due to our acquisitions ofFortigent andConcord , and due to increases in staffing to support higher levels of advisor and client activities. Compensation and benefits increased by$13.5 million , or 4.4%, for 2011 compared with 2010. The increase was driven by increases in staffing to support higher levels of advisor and client activities. Our average number of full-time employees increased 6.8% from 2,517 in 2010 to 2,687 in 2011, partially due to our acquisitions of NRP andConcord . Underlying this increase is a 5.7% increase in wages offset by flat employee benefits and other compensation year over year. In addition, employee related share-based compensation increased$4.5 million for the year endedDecember 31, 2011 compared to the prior year, primarily due to equity grants issued inDecember 2010 . 54 -------------------------------------------------------------------------------- General and Administrative Expenses General and administrative expenses increased by$87.0 million , or 33.0%, to$350.2 million for 2012 compared with 2011. The primary drivers behind the increase were increases of$24.2 million for business development and promotional expenses and$19.7 million of expenses related to our acquisitions ofFortigent andConcord . Another primary driver was an increase of$20.7 million for professional fees, which was partially due to$10.5 million of indemnification payment collections in 2011 associated with the resolution of a legal dispute with a third-party indemnitor. Refer to the Litigation section in Note 14 - Commitments and Contingencies, within the notes to consolidated financial statements for additional information regarding this matter. Additional contributors to the increase were a$10.1 million charge due to a change in the fair value of our contingent consideration obligations and a$3.9 million charge for the late deposit of withholding taxes related to the exercise of certain non-qualified stock options in connection with the 2010 IPO. General and administrative expenses decreased by$4.6 million , or 1.7%, to$263.2 million for 2011 compared with 2010. The decrease is primarily due to$10.5 million of indemnification payment collections associated with the resolution of a legal dispute with a third-party indemnitor. Refer to the Litigation section in Note 14 - Commitments and Contingencies, within the notes to consolidated financial statements for additional information regarding this matter. Advisor growth of 549 net new advisors excluding attrition related to UVEST in 2011, fueled a 20.1% increase in business development and other promotional expenses. Further, we had a$3.8 million increase in expenditures on non-depreciable equipment, licensing fees and other costs year over year. Depreciation and Amortization Expense For the year endedDecember 31, 2012 , depreciation and amortization decreased by$0.9 million , or 1.3% compared to the prior year period. This decrease is primarily due to a reduction in depreciation incurred in 2012, attributed to assets that became fully depreciated in 2011. For the year endedDecember 31, 2011 , depreciation and amortization decreased by$13.3 million , or 15.5% compared to the prior year. This decrease is primarily attributed to a$27.9 million reduction in depreciation incurred in 2011, attributed to assets that became fully depreciated in 2010 and 2011. This was partially offset by an increase of$7.5 million of depreciation on assets placed in service during 2010 and 2011, and depreciation of$2.7 million on assets for our acquisitions of NRP and CCP.
Restructuring Charges
Restructuring charges represent expenses incurred as a result of our 2011 consolidation of UVEST and our 2009 consolidation of the Affiliated Entities. Restructuring charges were$5.6 million in 2012. These charges relate primarily to technology costs and other expenditures incurred for the conversion and transfer of advisors and their client accounts from UVEST to LPL Financial. Refer to Note 4 - Restructuring, within the notes to consolidated financial statements for additional information. Restructuring charges were$21.4 million in 2011. These charges relate primarily to technology costs and other expenditures incurred for the conversion and transfer of advisors and their client accounts from UVEST to LPL Financial. Additionally, impairment charges of$2.8 million related to advisor intangible assets are included for the year endedDecember 31, 2011 .
Interest Expense
Interest expense represents non-operating interest expense for our senior secured credit facilities. Interest expense decreased$13.9 million , or 20.3%, for 2012 compared with 2011. The reduction in interest expense for 2012 is due to a lowered interest rate on our debt as a result of its refinancing inMarch 2012 and the maturity of an interest rate swap agreement with a notional value of$65.0 million onJune 30, 2012 , which resulted in a combined decrease of$13.7 million to interest expense for the year endedDecember 31, 2012 . Interest expense decreased$21.6 million , or 23.9%, for 2011 compared with 2010. The reduction in interest expense for 2011 is primarily attributed to our debt refinancing in the second quarter of 2010, which included the redemption of our senior unsecured subordinated notes, resulting in a lower cost of borrowing and$8.7 million of 55 -------------------------------------------------------------------------------- savings in 2011 compared to 2010. Interest rate swap agreements with notional values of$190.0 million and$145.0 million matured onJune 30, 2010 and 2011, respectively, reducing our comparative interest expense by$7.2 million for the year endedDecember 31, 2011 compared to 2010. Additionally, we repaid$40.0 million of term loans under our senior secured credit facilities using net proceeds received in our IPO, as well as cash on hand, which resulted in interest savings of$1.5 million in 2011. Loss on Extinguishment of Debt Loss on extinguishment of debt was$16.5 million for the year endedDecember 31, 2012 . InMarch 2012 , we refinanced and replaced our credit agreement primarily to extend the maturities on our borrowings and wrote off$16.5 million of unamortized debt issuance costs related to the previous credit agreement. For the year endedDecember 31, 2010 , loss on extinguishment of debt was$38.0 million which represents debt amendment costs incurred in 2010 for amending and restating our credit agreement to establish a new term loan tranche and to extend the maturity of an existing tranche on our senior credit facilities, and debt extinguishment costs to redeem our subordinated notes, as well as certain professional fees incurred. Provision for Income Taxes For the year endedDecember 31, 2012 , we recorded income tax expense of$98.7 million , compared with an income tax expense of$112.3 million in 2011. Our effective income tax rate was 39.4% and 39.7% for 2012 and 2011, respectively. For the year endedDecember 31, 2011 , we recorded income tax expense of$112.3 million , compared with an income tax benefit of$32.0 million recorded in 2010. The 2010 tax benefit was a result of the net loss due to charges incurred related to our IPO. Our effective income tax rate was 39.7% and 36.0% for 2011 and 2010, respectively.
Liquidity and Capital Resources
Senior management establishes our liquidity and capital policies. These policies include senior management's review of short- and long-term cash flow forecasts, review of monthly capital expenditures and daily monitoring of liquidity for our subsidiaries. Decisions on the allocation of capital are based upon, among other things, projected profitability and cash flow, risks of the business, regulatory capital requirements and future liquidity needs for strategic activities. OurTreasury Department assists in evaluating, monitoring and controlling the business activities that impact our financial condition, liquidity and capital structure and maintains relationships with various lenders. The objectives of these policies are to support executive business strategies while ensuring ongoing and sufficient liquidity. A summary of changes in cash flow data is provided as follows: For the Year Ended December 31, 2012 2011 2010 (In thousands) Net cash flows provided by (used in): Operating activities $ 254,268 $ 442,378 $ (22,914 ) Investing activities (91,669 ) (65,558 ) (39,192 ) Financing activities (417,110 ) (75,256 ) 102,720 Net (decrease) increase in cash and cash equivalents (254,511 ) 301,564 40,614 Cash and cash equivalents - beginning of year 720,772 419,208 378,594 Cash and cash equivalents - end of year $ 466,261 $
720,772
Cash requirements and liquidity needs are primarily funded through our cash flow from operations and our capacity for additional borrowing. Net cash provided by (used in) operating activities includes net income adjusted for non-cash expenses such as depreciation and amortization, restructuring charges, share-based compensation, amortization of debt issuance costs, deferred income tax provision and changes in operating assets and liabilities. Operating assets and liabilities include balances related to settlement and funding of client transactions, receivables from product sponsors and accrued commission and advisory expenses due to our advisors. Operating assets and liabilities that arise from the settlement and funding of transactions by our advisors' clients are the principal cause of changes to our net cash from operating activities and can fluctuate significantly from day to day and period to period depending on overall 56 -------------------------------------------------------------------------------- trends and client behaviors. Net cash provided by operating activities for 2012 and 2011 was$254.3 million and$442.4 million , respectively, compared to net cash used in operating activities in 2010 of$22.9 million . The change between 2012 and 2011 is primarily due to a decrease of$155.4 million in income taxes receivable as the results for 2011 include the collection of$202.5 million of tax receivables that arose primarily from tax benefits related to our IPO inNovember 2010 . Due to substantial client activity at the end of 2012, our cash flows from operating activities fluctuated significantly, which is reflected by a use of$194.5 million for cash and securities segregated under federal and other regulations and a provision of$292.8 million in payables to clients. Our 2012 operating activities also include net income of$151.9 million and a collection of$47.2 million in tax receivables offset by$53.3 million of excess tax benefits related to share-based compensation. Cash flows from operating activities increased in 2011 when compared to 2010 primarily due to an increase of$227.2 million in net income from the loss position in 2010. Net cash provided by operating activities in 2011 also increased due to the collection of$202.5 million of tax receivables, which was offset by$57.6 million of excess tax benefits resulting from share-based compensation that primarily occurred inMay 2011 at the expiration of the IPO lock-up. Net cash used in investing activities for 2012, 2011 and 2010, totaled$91.7 million ,$65.6 million and$39.2 million , respectively. Net cash used in 2012 increased in comparison to 2011 due to an increase of$18.4 million in capital expenditures in addition to reduction in restricted cash releases of$14.7 million . Net cash used in 2012 primarily consists of$43.7 million for the acquisitions ofFortigent and Veritat and$54.8 million in capital expenditures partially offset by$7.6 million of restricted cash releases. The increase in net cash used in investing activities for 2011 as compared to 2010 primarily consisted of$42.0 million used in 2011 for the acquisitions of NRP andConcord . Net cash used in 2011 also included$36.3 million in capital expenditures partially offset by$22.2 million of restricted cash releases. Net cash used in financing activities for 2012 and 2011 was$417.1 million and$75.3 million , respectively. Net cash provided by financing activities for 2010 was$102.7 million . Cash flows used in financing activities in 2012 increased in comparison to 2011 as a result of a$110.1 million increase in repurchases of outstanding common stock and$248.8 million of cash dividends paid in 2012. Cash flows used in financing activities in 2012 also include$1.4 billion of repayments on our senior secured credit facilities offset by$1.3 billion of proceeds from our senior secured credit facilities, as well as$53.3 million in cash generated from excess tax benefits arising from share-based compensation. Net cash used in financing activities in 2011 increased in comparison to a provision of cash flows from financing activities in 2010 as a result of$89.0 million of cash used to repurchase outstanding common stock in 2011, a$41.4 million increase in cash used to repay senior credit facilities, a$35.9 million decrease in cash from excess tax benefits arising from share-based compensation and a decrease of$41.8 million for the issuance of common stock. We believe that based on current levels of operations and anticipated growth, cash flow from operations, together with other available sources of funds, which include three uncommitted lines of credit available, will be adequate to satisfy our working capital needs, the payment of all of our obligations and the funding of anticipated capital expenditures for the foreseeable future. In addition, we have certain capital requirements due to our registered broker-dealer and have met all capital adequacy requirements for our registered broker dealer and expect this to also continue for the foreseeable future. We regularly evaluate our existing indebtedness, including refinancing thereof, based on a number of factors, including our capital requirements, future prospects, contractual restrictions, the availability of refinancing on attractive terms and general market conditions. Share Repurchases The Board of Directors has approved several share repurchase programs pursuant to which we may repurchase issued and outstanding shares of our common stock. Purchases may be effected in open market or privately negotiated transactions, including transactions with our affiliates, with the timing of purchases and the amount of stock purchased generally determined at our discretion within the constraints of our credit agreement and general operating needs. 57 -------------------------------------------------------------------------------- For the years endedDecember 31, 2012 and 2011, the Company had the following activity under its approved share repurchase plans (in millions, except share and per share data): 2012 2011 Amount Remaining at Weighted Average Weighted Average Approval Authorized December 31, Shares Price Paid Per Total Shares Price Paid Per Date Repurchase Amount 2012 Purchased Share Cost(1) Purchased Share Total Cost
May 25, 2011 $ 80.0 $ - - $ - $ - 2,297,723 $ 34.84 $ 80.0 August 16, 2011 $ 70.0 $ - 1,891,072 $ 32.27 $ 61.0 319,906 $ 28.11 $ 9.0 May 25, 2012 $ 75.0 $ - 2,611,022 $ 28.74 $ 75.1 - $ - $ - September 27, 2012 $ 150.0 $ 86.9 2,309,558 $ 27.34 $ 63.1 - $ - $ - $ 86.9 6,811,652 $ 29.25 $ 199.2 2,617,629 $ 34.01 $ 89.0 ___________________
(1) Included in the total cost of shares purchased is a commission fee of
per share.
Issuance Under 2008 Nonqualified Deferred Compensation Plan OnFebruary 22, 2012 , we distributed 1,673,556 shares, net of shares withheld to satisfy withholding tax requirements of the participants, pursuant to the terms of our 2008 Nonqualified 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 (fractional shares were paid out in cash). Participants authorized us to withhold shares from their distribution of common stock to satisfy their withholding tax obligations. OnFebruary 22, 2012 we repurchased 1,149,896 shares and made the related withholding tax payment of approximately$37.5 million . See "Item 5 - Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities ". In calculating earnings per share and diluted earnings per share using the two-class method, we were required to allocate a portion of our earnings to employees that held stock units that contained non-forfeitable rights to dividends or dividend equivalents under our 2008 Nonqualified Deferred Compensation Plan. After the distribution of shares under the 2008 Nonqualified Deferred Compensation Plan, the two-class method is no longer applicable. This distribution of shares did not have a material impact on earnings per share or diluted earnings per share. However, the distribution increased the weighted average share count for the year endedDecember 31, 2012 by approximately 850,000 shares. Dividends InApril 2012 , we announced that our Board of Directors had approved a one-time special dividend of$2.00 per share, which was paid inMay 2012 . InJuly 2012 , we announced an initial quarterly cash dividend of$0.12 per share. The payment of any dividends permitted under our credit facilities are subject to approval by our Board of Directors, including both timing and amount. Cash dividends per share of common stock and total cash dividends paid during each quarter for the year endedDecember 31, 2012 were as follows (in millions, except per share data): Dividend per Share Total Cash Dividend Second quarter $ 2.00 $ 222.6 Third quarter $ 0.12 $ 13.2 Fourth quarter $ 0.12 $ 13.0 OnFebruary 05, 2013 , the Board of Directors declared a cash dividend of$0.135 per share on our outstanding common stock to be paid onMarch 4, 2013 to all stockholders of record onFebruary 18, 2013 . Regulatory OnJuly 20, 2012 , theInternal Revenue Service ("IRS") issued a Notice of Proposed Adjustment (the "Notice") asserting we are subject to a penalty with respect to an alleged untimely deposit of withholding taxes related to the exercise of certain non-qualified stock options in connection with our IPO in 2010. We have been engaged in discussions with theIRS regarding the Notice. As a result of these discussions, we believe the outcome will not be material to our financial position and we have recorded an estimate of the probable loss in the results of operations 58 -------------------------------------------------------------------------------- for the year endedDecember 31, 2012 . Service Value Commitment OnFebruary 5, 2013 , we committed to an expansion of our Service Value Commitment, an ongoing effort to position us for sustainable long-term growth by improving the service experience of our financial advisors and delivering efficiencies in our operating model. With the assistance ofAccenture LLP , we have assessed opportunities to enhance the quality, speed and cost of processes that support our clients by outsourcing certain functions to firms that specialize in such processes. In addition, with the assistance ofBain & Company , we have assessed our information technology delivery, governance, organization and strategy. As a result, acting pursuant to a delegation of authority by our Board of Directors, we committed to undertake a course of action (the "Program") to reposition our labor force and invest in technology, human capital, marketing and other key areas to enable future growth. The Program is expected to be completed in 2015. We expect total charges in connection with the Program to be approximately$70 million to $75 million . Pre-tax charges of$11 million were incurred in the second half of 2012, which consisted of$7 million of cash expenditures and$4 million for an asset impairment charge for certain fixed assets related to internally developed software that were determined to have no estimated fair value. These 2012 expenses are not considered restructuring charges under GAAP, but are excluded in reporting certain non-GAAP measures, including Adjusted EBITDA, Adjusted Earnings and Adjusted Earnings per share. We estimate that we will incur pre-tax restructuring charges of approximately$60 million to $65 million in connection with the Program, including approximately$24 million to $26 million in outsourcing and other related costs, approximately$21 million to $23 million in technology transformation costs, approximately$13 million to $14 million in employee severance obligations and other related costs and approximately$1 million in non-cash impairment charges. We expect to incur approximately$58 million to $63 million of future cash expenditures in connection with the Program. Operating Capital Requirements Our primary requirement for working capital relates to funds we loan to our advisors' clients for trading conducted on margin and funds we are required to maintain at clearing organizations to support these clients' trading activities. We have several sources of funds to enable us to meet increased working capital requirements related to increased client margin activities and balances. These sources include cash and cash equivalents on hand, cash and securities segregated under federal and other regulations, and proceeds from re-pledging or selling client securities in margin accounts. When a client purchases securities on margin or uses securities as collateral to borrow from us on margin, we are permitted, pursuant to the applicable securities industry regulations, to re-pledge or sell securities, which collateralize those margin accounts. As ofDecember 31, 2012 , we had received collateral in connection primarily with client margin loans with a fair value of approximately$375.8 million , which can be re-pledged or sold. Of this amount, approximately$22.2 million has been pledged to theOptions Clearing Corporation as collateral to secure certain client obligations related to options positions, and approximately$19.3 million was loaned to theNational Securities Clearing Corporation through participation in the Stock Borrow Program. Additionally, approximately$40.3 million are held at banks in connection with uncommited lines of credit, which were unutilized atDecember 31, 2012 ; these securities may be used as collateral for loans from these banks. The remainder of$294.0 million has not been re-pledged or sold. There are no restrictions that materially limit our ability to re-pledge or sell the remaining$334.3 million of client collateral. Our other working capital needs are primarily related to regulatory capital requirements at our broker-dealer and bank trust subsidiaries and software development, which we have satisfied in the past from internally generated cash flows. Notwithstanding the self-funding nature of our operations, we may sometimes be required to fund timing differences arising from the delayed receipt of client funds associated with the settlement of client transactions in securities markets. These timing differences are funded either with internally generated cash flow or, if needed, with funds drawn on our uncommitted lines of credit at our broker-dealer subsidiary LPL Financial, and/or under our revolving credit facility. Our registered broker-dealer, LPL Financial, is subject to theSEC's Uniform Net Capital Rule, which requires the maintenance of minimum net capital. LPL Financial computes net capital requirements under the alternative 59 -------------------------------------------------------------------------------- method, which requires firms to maintain minimum net capital, as defined, equal to the greater of$250,000 or 2.0% of aggregate debit balances arising from client transactions. LPL Financial is also subject to theNational Futures Association's ("NFA") financial requirements and is required to maintain net capital that is in excess of or equal to the greatest of its minimum financial requirements. Currently the highest NFA requirement is the minimum net capital calculated pursuant to theSEC's Uniform Net Capital Rule. In addition to the minimum net capital requirements, theSEC and FINRA have established "early warning" capital requirements for broker-dealers that when exceeded, limit certain activities of the broker-dealer. Early warning requirements provide advance warning that a firm's net capital is dropping toward its minimum requirement, allowing time for initiation of corrective action. For LPL Financial, an early warning level is reached if its ratio of aggregate customer debit balances falls below 5.0% of net capital. AtDecember 31, 2012 , LPL Financial's net capital was$58.5 million and its early warning requirement was$18.6 million . LPL Financial typically maintains net capital in excess of the early warning level to maintain its ability to grow its business, demonstrate the stability of its operations and provide a safeguard in the event of sustained levels of market volatility, as experienced by the securities industry in 2008. AtDecember 31, 2012 , LPL Financial's excess net capital was$51.1 million . LPL Financial's ability to pay dividends greater than 10% of its excess net capital during any 35 day rolling period requires approval from FINRA. In addition, payment of dividends is restricted if LPL Financial's net capital would be less than 5.0% of aggregate customer debit balances. Prior toJuly 16, 2012 , UVEST was also a registered broker-dealer and computed net capital requirements under the aggregate indebtedness method, which requires firms to maintain minimum net capital, as defined, of not less than 6.67% of aggregate indebtedness. In connection with the consolidation of UVEST with LPL Financial, UVEST's registration with FINRA was withdrawn effectiveJuly 16, 2012 and is no longer subject to net capital filing requirements. Our subsidiary, PTC, is subject to various regulatory capital requirements. Failure by any of our subsidiaries to meet their respective minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. Liquidity Assessment Our ability to meet our debt service obligations and reduce our total debt will depend upon our future performance, which, in turn, will be subject to general economic, financial, business, competitive, legislative, regulatory and other conditions, many of which are beyond our control. In addition, our operating results, cash flow and capital resources may not be sufficient for repayment of our indebtedness in the future. Some risks that could materially adversely affect our ability to meet our debt service obligations include, but are not limited to, general economic conditions and economic activity in the financial markets. The performance of our business is correlated with the economy and financial markets, and a slowdown in the economy or financial markets could adversely affect our business, results of operations, cash flows or financial condition. If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay investments, seek additional capital or restructure or refinance our indebtedness. These measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of sufficient cash flows and capital resources, we could face substantial liquidity constraints and might be required to dispose of material assets or operations to meet our debt service and other obligations. However, our senior secured credit agreement will restrict our ability to dispose of assets and the use of proceeds from any such dispositions. We may not be able to consummate those dispositions, and even if we could consummate such dispositions, to obtain the proceeds that we could realize from them and, in any event, the proceeds may not be adequate to meet any debt service obligations then due.
Indebtedness
OnMarch 29, 2012 , we entered into a Credit Agreement (the "Credit Agreement") withLPL Holdings, Inc. , the other Credit Parties signatory thereto, the Several Lenders signatory thereto, andBank of America, N.A . as Administrative Agent, Collateral Agent, Letter of Credit Issuer, and Swingline Lender. The Credit Agreement refinanced and replaced our Third Amended and Restated Credit Agreement, dated as ofMay 24, 2010 (the "Original Credit Agreement"). Pursuant to the Credit Agreement, we established a Term Loan A tranche of$735.0 million maturing atMarch 29, 2017 (the "Term Loan A") and a Term Loan B tranche of$615.0 million maturing at 60 --------------------------------------------------------------------------------March 29, 2019 (the "Term Loan B"). In connection with the Credit Agreement, we capitalized certain debt issuance costs totaling$23.7 million . Additionally, we accelerated the recognition of$16.5 million debt issuance costs related to borrowings under the Original Credit Agreement in the year endedDecember 31, 2012 . As ofDecember 31, 2012 , we estimated interest savings of approximately$10.9 million through the first twelve months of operations following execution of the Credit Agreement. The Credit Agreement also refinanced and replaced our then existing revolving credit facility, increasing our capacity from$163.5 million to $250.0 million ("Revolving Credit Facility"). The Revolving Credit Facility will mature onMarch 29, 2017 . There were no outstanding borrowings on the Revolving Credit Facility atDecember 31, 2012 . As ofDecember 31, 2012 , the Revolving Credit Facility was being used to support the issuance of$21.3 million of irrevocable letters of credit for the construction of our futureSan Diego office building and other items. In addition, we maintain three uncommitted lines of credit. Two of the lines have unspecified limits, and are primarily dependent on our ability to provide sufficient collateral. The other line has a$150.0 million limit and allows for both collateralized and uncollateralized borrowings. The lines were utilized in 2012 and 2011; however, there were no balances outstanding atDecember 31, 2012 or 2011. We also were party to an interest rate swap agreement, in a notional amount of$65.0 million , to mitigate interest rate risk by hedging the variability of a portion of our floating-rate senior secured term loan. This agreement expired onJune 30, 2012 . Interest Rate and Fees Borrowings under the Credit Agreement bear interest at a base rate equal to the one, two, three, six, nine or twelve-month LIBOR (the "Eurodollar Rate") plus our applicable margin, or an alternative base rate ("ABR") plus our applicable margin. The ABR is equal to the greatest of (a) the prime rate in effect on such day, (b) the effective 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 the Term Loan B, 2.00%. The applicable margin for borrowings (a) with respect to the Term Loan A is currently 1.50% for base rate borrowings and 2.50% for LIBOR borrowings, and (b) with respect to the Term Loan B is currently 2.00% for base rate borrowings and 3.00% for LIBOR borrowings, and (c) with respect to the Revolving Credit Facility is currently 1.50% for base rate borrowings and 2.50% for LIBOR borrowings. The applicable margin on our term loans and Revolving Credit Facility could change depending on our total leverage ratio. The LIBOR rate with respect to Term Loan B shall in no event be less than 1.00%. In addition to paying interest on outstanding principal under the Credit Agreement, we are required to pay a commitment fee to the lenders under the Revolving Credit Facility in respect of the unutilized commitments thereunder. The commitment fee rate atDecember 31, 2012 was 0.50% for our Revolving Credit Facility, but is subject to change depending on our leverage ratio. Prior to the closing of the Credit Agreement onMarch 29, 2012 , the commitment fee was 0.75% on our previous revolving credit facility. We must also pay customary letter of credit fees. Prior to the repayment onMarch 29, 2012 , the Original Credit Agreement consisted of three term loan tranches: a$302.5 million term loan facility with a maturity ofJune 18, 2013 (the "2013 Term Loans"), a$476.9 million term loan facility with a maturity ofJune 25, 2015 (the "2015 Term Loans") and a$553.2 million term loan facility with a maturity ofJune 28, 2017 (the "2017 Term Loans"). The applicable margin for borrowings (a) with respect to the 2013 Term Loans was 0.75% for base rate borrowings and 1.75% for LIBOR borrowings, (b) with respect to the 2015 Term Loans was 1.75% for base rate borrowings and 2.75% for LIBOR borrowings and (c) with respect to the 2017 Term Loans was 2.75% for base rate borrowings and 3.75% for LIBOR borrowings. The$163.5 million revolver tranche had an applicable margin of 2.50% for base rate borrowings and 3.50% for LIBOR borrowings. The LIBOR rate with respect to the 2015 Term Loans and the 2017 Term Loans had a floor of 1.50%.
Prepayments
The Credit Agreement (other than the Revolving Credit Facility) requires us to prepay outstanding amounts under our senior secured term loan facility subject to certain exceptions, with: • 50% (percentage will be reduced to 0% if our total leverage ratio is 3.00 to
1.00 or less) of our annual excess cash flow (as defined in the Credit
Agreement) adjusted for, among other things, changes in our net working
capital (as of
• 100% of the net cash proceeds of all nonordinary course asset sales or other dispositions of property 61
-------------------------------------------------------------------------------- (including insurance recoveries), if we do not reinvest or commit to reinvest those proceeds in assets to be used in our business or to make certain other permitted investments within 15 months as long as such reinvestment is completed within 180 days and • 100% of the net cash proceeds of any incurrence of debt, other than proceeds
from debt permitted under the Credit Agreement.
Mandatory prepayments in respect of the incurrence of any debt can be applied by us to scheduled installments of principal of the Term Loan A and Term Loan B in any order at our direction. Any other mandatory prepayments described above will be applied to scheduled installments of principal of the Term Loan A and Term Loan B in direct order. We may voluntarily repay outstanding term loans under the Credit Agreement at any time without premium or penalty, other than customary "breakage" costs with respect to LIBOR loans, and with the exception of certain repricing transactions in respect to the Term Loan B consummated beforeMarch 29, 2013 , which will be subject to a premium of 1.0% of the principal amount of Term Loan B subject to such repricing transaction.
Amortization
Quarterly repayments of the principal for Term Loan A will total 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. Guarantee and Security The loans under the Credit Agreement are secured primarily through pledges of the capital stock in certain of our subsidiaries. Certain Covenants and Events of Default The Credit Agreement contains a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to: • incur additional indebtedness;
• create liens;
• enter into sale and leaseback transactions;
• engage in mergers or consolidations;
• sell or transfer assets;
• pay dividends and distributions or repurchase our capital stock;
• make investments, loans or advances;
• prepay certain subordinated indebtedness;
• engage in certain transactions with affiliates;
• amend material agreements governing certain subordinated indebtedness and
• change our lines of business.
Our Credit Agreement prohibits us from paying dividends and distributions or repurchasing our capital stock except for limited purposes, including, but not limited to payments in connection with: (i) redemption, repurchase, retirement or other acquisition of our equity interests from present or former officers, managers, consultants, employees and directors upon the death, disability, retirement, or termination of employment of any such person or otherwise in accordance with any stock option or stock appreciate rights plan, any management or employee stock ownership plan, stock subscription plan, employment termination agreement or any employment agreements or stockholders' agreement, in an aggregate amount not to exceed$10.0 million in any fiscal year plus the amount of cash proceeds from certain equity issuances to such persons, and the amount of certain key-man life insurance proceeds, (ii) franchise taxes, general corporate and operating expenses not to exceed$3.0 million in any fiscal year, and fees and expenses related to any unsuccessful equity or debt offering permitted by the Credit Agreement, (iii) tax liabilities to the extent attributable to our business and our subsidiaries and (iv) dividends and other distributions in an aggregate amount not to exceed the sum of (a) the greater of (i)$250,000,000 and (ii) 6.75% of our consolidated total assets, (b) the available amount (as defined in the Credit Agreement) and (c) the available equity amount (as defined in the Credit Agreement). Notwithstanding the foregoing, we may make unlimited dividends and distributions provided that after giving pro forma effect thereto, our total leverage ratio does not 62 -------------------------------------------------------------------------------- exceed 2.0 to 1.0. The share repurchase programs approved inMay 2012 andSeptember 2012 were authorized by the Board of Directors pursuant to item (iv) above. Our special dividend was authorized by the Board of Directors pursuant to a one-time exception to the restriction on dividends. Any future declarations of quarterly cash dividends will be authorized pursuant to item (iv) above. In addition, our financial covenant requirements include a total leverage ratio test and an interest coverage ratio test. Under our total leverage ratio test, we covenant not to allow the ratio of our consolidated total debt (as defined in our Credit Agreement) to an adjusted EBITDA reflecting financial covenants in our Credit Agreement ("Credit Agreement Adjusted EBITDA") to exceed certain prescribed levels set forth in the Credit Agreement. Under our interest coverage ratio test, we covenant not to allow the ratio of our Credit Agreement Adjusted EBITDA to our consolidated interest expense (as defined in our Credit Agreement) to be less than certain prescribed levels set forth in the Credit Agreement. Each of our financial ratios is measured at the end of each fiscal quarter. Our Credit Agreement provides us with a right to cure in the event we fail to comply with our leverage ratio test or our interest coverage test. We must exercise this right to cure within ten days of the delivery of our quarterly certificate calculating the financial ratios for that quarter. If we fail to comply with these covenants and are unable to cure, we could face substantial liquidity problems and could be forced to sell assets, seek additional capital or seek to restructure or refinance our indebtedness. These alternative measures may not be successful or feasible. Our Credit Agreement restricts our ability to sell assets. Even if we could consummate those sales, the proceeds that we realize from them may not be adequate to meet any debt service obligations then due. Furthermore, if an event of default were to occur with respect to our Credit Agreement, our creditors could, among other things, accelerate the maturity of our indebtedness. See "Risk Factors - Our indebtedness could adversely affect our financial health and may limit our ability to use debt to fund future capital needs". As of <chron>December 31, 2012 and 2011 we were in compliance with all of our covenant requirements. Our covenant requirements and actual ratios as ofDecember 31, 2012 and 2011 are as follows: December 31, 2012 2011 Covenant Covenant Financial Ratio Requirement Actual Ratio Requirement Actual Ratio Leverage Test (Maximum) 4.00 2.38 3.00 1.77 Interest Coverage (Minimum) 3.00 9.03 3.00 7.10 63
-------------------------------------------------------------------------------- Set forth below is a reconciliation from EBITDA, Adjusted EBITDA and Credit Agreement Adjusted EBITDA to our net income for the years endingDecember 31, 2012 and 2011 (in thousands): For the Year Ended December 31, 2012 2011 Net income $ 151,918 $ 170,382 Interest expense 54,826 68,764 Income tax expense 98,673 112,303 Amortization of purchased intangible assets and software(1) 39,542 38,981 Depreciation and amortization of all other fixed assets 32,254 33,760 EBITDA 377,213 424,190 EBITDA Adjustments: Employee share-based compensation expense(2) 17,544 14,978 Acquisition and integration related expenses(3) 20,474 (3,815 ) Restructuring and conversion costs(4) 6,146 22,052 Debt extinguishment costs(5) 16,652 - Equity issuance and related offering costs(6) 4,486 2,062 Other(7) 11,967 253 Total EBITDA Adjustments 77,269 35,530 Adjusted EBITDA 454,482 459,720 Advisor and financial institution share-based compensation expense(8) 3,807 - Other(9) 4,190 - Credit Agreement Adjusted EBITDA $
462,479
____________________
(1) Represents amortization of intangible assets and software as a result of
our purchase accounting adjustments from our merger transaction in 2005 and various acquisitions.
(2) Represents share-based compensation expense for equity awards granted to
employees, officers, and directors. Such awards are measured based on the
grant-date fair value and share-based compensation is recognized over the
requisite service period of the individual grants, which generally equals
the vesting period. (3) Represents acquisition and integration costs resulting from various
acquisitions, including changes in the estimated fair value of future
payments, or contingent consideration, required to be made to former
shareholders of certain acquired entities. During the years ended
a charge against earnings due to a net increase in the estimated fair value of contingent consideration and$1.3 million was recognized as a charge against earnings representing the accretion of contingent
consideration as we approached the future expected payment, respectively.
Also included in the year ended
indemnifying party in the fourth quarter of 2011. Of this settlement, $9.8
million has been excluded from the presentation of Adjusted EBITDA, a
non-GAAP measure. See the Litigation section of Note 14 - Commitments and
Contingencies, within the notes to consolidated financial statements for additional information.
(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 December 31,
2012, approximately 89% and 98%, respectively, of costs related to these
two initiatives have been recognized. The remaining costs largely consist
of the amortization of transition payments that have been made in
connection with these two conversions for the retention of advisors and
financial institutions that are expected to be recognized into earnings by
December 2014 . (5) Represents expenses incurred resulting from the early extinguishment and
repayment of amounts outstanding under our Original Credit Agreement,
including the write-off of
issuance costs that have no future economic benefit, as well as various
other charges incurred in connection with the establishment of the new Credit Agreement. (6) Represents equity issuance and offering costs incurred in the years ended
in the second quarter of 2012, and the closing of a secondary 64
-------------------------------------------------------------------------------- offering in the second quarter of 2011. In addition, results for the year endedDecember 31, 2012 include a$3.9 million charge for the late deposit of withholding taxes related to the exercise of certain non-qualified stock options in connection with the 2010 IPO. See Note 14 - Commitments and Contingencies, within the notes to consolidated financial statements for additional information. (7) Results for the year endedDecember 31, 2012 include approximately$7.0 million for consulting services and technology development aimed at enhancing the Company's performance in support of its advisors while operating at a lower cost. In addition, results for the year ended
certain fixed assets related to internally developed software that were determined to have no estimated fair value. Remaining costs include certain excise and other taxes.
(8) Credit Agreement Adjusted EBITDA excludes 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 under the Black-Scholes valuation model, as
defined under the terms of the Credit Agreement. Pro-forma disclosure has
been made for the year ended
of share-based compensation expense from stock options and warrants granted to advisors and financial institutions, as if the terms of the Credit Agreement were in effect as ofJanuary 1, 2011 .
(9) Represents other items that are adjustable in accordance with our Credit
Agreement to arrive at Credit Agreement Adjusted EBITDA including employee
severance costs, employee signing costs, and employee retention or
completion bonuses.
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. Prior to its expiration onJune 30, 2012 , we used an interest rate swap agreement to hedge the variability on our floating interest rate for$65.0 million of our Term Loan A under our Credit Agreement. We were required to pay the counterparty to the agreement fixed interest payments on a notional balance and in turn received variable interest payments on that notional balance. Payments were settled quarterly on a net basis. While our term loan is unhedged as ofDecember 31, 2012 , the risk of variability on our floating interest rate is partially mitigated by the client margin loans, which carry floating interest rates, as well as fees received from the cash sweep programs. AtDecember 31, 2012 , our receivables from our advisors' clients for margin loan activity were approximately$268.4 million , and the balance of deposits in the cash sweep programs was$24.7 billion . Off-Balance Sheet Arrangements We enter into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of our advisors' clients. These arrangements include firm commitments to extend credit. For information on these arrangements, see Note 14 - Commitments and Contingencies and Note 20 - Financial Instruments with Off-Balance-Sheet Credit Risk and Concentrations of Credit Risk, within the notes to consolidated financial statements. 65 -------------------------------------------------------------------------------- Contractual Obligations The following table provides information with respect to our commitments and obligations as ofDecember 31, 2012 : Payments Due by Period Total < 1 Year 1-3 Years 4-5 Years > 5 Years (In thousands) Leases and other obligations(1) $ 390,084 $ 31,137 $ 62,634 $ 51,280 $ 245,033 Senior secured term loan facilities(2) 1,317,825 42,900 150,113 545,175 579,637 Commitment fee on revolving line of credit(3) 4,926 1,159 2,319 1,448 - Variable interest payments(4): Term Loan A 69,761 19,063 33,766 16,932 - Term Loan B 149,825 24,659 48,571 47,639 28,956 Total contractual cash obligations $ 1,932,421 $ 118,918 $ 297,403 $ 662,474 $ 853,626
____________________
(1) Included in the payments due by period is a fifteen year lease commitment
that was executed in
office building with a lease commencement date of
minimum payments for this lease commitment are
million and
Years, respectively. Minimum payments have not been reduced by minimum
sublease rental income of
noncancelable subleases. Note 14 - Commitment and Contingencies, within
our notes to consolidated financial statements provides further detail on
operating lease obligations and obligations under noncancelable service
contracts. (2) Represents principal payments under our Credit Agreement. See Note 12 - Indebtedness, within our notes to consolidated financial statements for further detail.
(3) Represents commitment fees for unused borrowings on our Revolving Credit
Facility. See Note 12 - Indebtedness, within our notes to consolidated
financial statements for further detail.
(4) Our senior secured term loan facilities bear interest at floating rates.
Variable interest payments are shown assuming the applicable LIBOR rates
at
our notes to consolidated financial statements for further detail. Our acquisitions of NRP,Concord and Veritat involve the potential payment of contingent consideration dependent upon the achievement of certain revenue, gross-margin and assets under management milestones. The table above does not reflect any such obligation, as the amounts are uncertain. See Note 3 - Acquisitions and Note 5 - Fair Value Measurements, within our notes to consolidated financial statements for further discussion of the maximum amount of future contingent consideration we could be required to pay in connection with these acquisitions. As ofDecember 31, 2012 , we reflect a liability for unrecognized tax benefits of$19.9 million , which we have included in income taxes receivable in the consolidated statements of financial condition. This amount has been excluded from the contractual obligations table because we are unable to reasonably predict the ultimate amount or timing of future tax payments. Fair Value of Financial Instruments We use fair value measurements to record certain financial assets and liabilities at fair value and to determine fair value disclosures. We use prices obtained from an independent third-party pricing service to measure the fair value of our trading securities. We validate prices received from the pricing service using various methods including, comparison to prices received from additional pricing services, comparison to available market prices and review of other relevant market data including implied yields of major categories of securities. AtDecember 31, 2012 , we did not adjust prices received from the independent third-party pricing service. For certificates of deposit and treasury securities, we utilize market-based inputs including observable market interest rates that correspond to the remaining maturities or next interest reset dates. 66 -------------------------------------------------------------------------------- Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with GAAP, which require management to make estimates, judgments and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We believe that of our critical accounting policies, the following are noteworthy because they require management to make estimates regarding matters that are uncertain and susceptible to change where such change may result in a material adverse impact on our financial position and reported financial results. Revenue Recognition Substantially all of our revenues are based on contractual arrangements. In determining the appropriate recognition of commissions, we review the terms and conditions of the brokerage account agreements between us and our advisors' clients, representative agreements with our advisors, which include payout rates and terms, and selling agreements with product sponsors for packaged investment products such as mutual funds, annuities, insurance and alternative investments. In determining the appropriate recognition of advisory revenues, we review the terms and conditions of the advisory agreements between the advisors' clients and the applicable RIA, representative agreements with its advisors, and agreements with third parties who provide specific investment management or investment strategies. Revenues are recognized in the periods in which the related services are performed provided that persuasive evidence of an arrangement exists, the fee is fixed or determinable and collectability is reasonably assured. Payments received by us in advance of the performance of service are deferred and recognized as revenue when earned. Management considers the nature of our contractual arrangements in determining whether to recognize certain types of revenue on the basis of the gross amount billed or net amount retained after payments are made to providers of certain services related to the product or service offering. The main factors we use to determine whether to record revenue on a gross or net basis are whether: • we are primarily responsible for the service to the advisor and its client;
• we have discretion in establishing fees paid by the client and fees due to
the third party service provider and
• we are involved in the determination of product or service specifications.
When client fees include a portion of charges that are paid to another party and we are primarily responsible for providing the service to the client, we recognize revenue on a gross basis in an amount equal to the fee paid by the client. The cost of revenues recognized by us is the amount due to the other party and is recorded as production expense. In instances in which another party is primarily responsible for providing the service to the client, we only recognize the net amount retained by us. The portion of the fees that are collected from the client by us and remitted to the other party are considered pass through amounts and accordingly are not a component of revenues or cost of revenues. Commission revenue represents gross commissions generated by our advisors for their clients' purchases and sales of securities, and various other financial products such as mutual funds, variable and fixed annuities, alternative investments, fixed income, insurance, group annuities, and option and commodity transactions. We generate two types of commission revenues: front-end sales commissions that occur at the point of sale, as well as trailing commissions for which we provide ongoing support, awareness, and education to clients of our advisors. We recognize front-end sales commissions as revenue on a trade-date basis, which is when our performance obligations in generating the commissions have been substantially completed. We earn commissions on a significant volume of transactions that are placed by our advisors directly with product sponsors, particularly with regard to mutual fund, 529 plan, and fixed and variable annuity and insurance products. As a result, management must estimate a portion of its commission revenues earned from clients for purchases and sales of these products for each accounting period for which the proceeds have not yet been received. These estimates are based on the amount of commissions earned from transactions relating to these products in prior periods. Commission revenue includes mutual fund, 529 plan and fixed and variable product trailing fees which are recurring in nature. These trailing fees are earned by us, based on a percentage of the current market value of clients' investment holdings in trail-eligible assets, and recognized over the period during which services are performed. Because trail commission revenues are generally paid in arrears, management estimates the majority of 67 -------------------------------------------------------------------------------- trail commission revenues earned during each period. These estimates are based on a number of factors including market levels and the amount of trail commission revenues received in prior periods. The amount of such accruals are shown as commissions receivable from product sponsors and others, and are classified within receivables from product sponsors, broker-dealers and clearing organizations in the consolidated statements of financial condition. A substantial portion of our commission revenue is ultimately paid to our advisors. We record an estimate for commissions payable based upon payout ratios for each product for which we have accrued commission revenue. Such amounts are recorded by us as production expense. We record fees charged to clients as advisory fee revenue in advisory accounts where LPL Financial orIndependent Advisers Group Corporation ("IAG") is the RIA. A substantial portion of these advisory fees are paid to the related advisor; such payments are recorded as production expense. Certain advisors 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 RIA. These stand-alone RIAs ("Independent RIA") engage us for clearing, regulatory and custody services, as well as access to our investment advisory platforms. The advisory revenue generated by these Independent RIAs is earned by the advisors, and accordingly not included in our advisory fee revenue. We charge administrative fees based on the value of assets within these advisory accounts, and classify such fees as advisory revenues and transaction and other revenues. Legal Reserves We record reserves for legal proceedings in accounts payable and accrued liabilities in our consolidated statements of financial condition. The determination of these reserve amounts requires significant judgment on the part of management. We consider many factors including, but not limited to, the amount of the claim, the amount of the loss in the client's account, the basis and validity of the claim, the possibility of wrongdoing on the part of an advisor, likely insurance coverage, previous results in similar cases, legal precedents and case law. Each legal proceeding is reviewed with counsel in each accounting period and the reserve is adjusted as deemed appropriate by management. Any change in the reserve amount is recorded as professional services in our consolidated statements of operations. Valuation of Goodwill and Other Intangibles We test intangible assets determined to have indefinite useful lives, including trademarks, trade names and goodwill, for impairment annually, or more frequently if events or circumstances indicate that assets might be impaired. We perform annual impairment reviews as of the first day of the fourth quarter (October 1 ). We use a variety of methodologies in conducting impairment assessments of indefinite-lived intangible assets, including, but not limited to, discounted cash flow models, which are based on the assumptions we believe hypothetical marketplace participants would use. Impairment exists when the carrying amount of goodwill exceeds its implied fair value, resulting in an impairment charge for the excess. For indefinite-lived intangible assets, other than goodwill, if the carrying amount exceeds the fair value, an impairment charge is recognized in an amount equal to that excess. When facts and circumstances indicate that the carrying value of definite-lived intangible assets may not be recoverable, we assess the recoverability of the carrying value by preparing estimates of future cash flows. We recognize an impairment loss if the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount. The impairment loss recognized is the amount by which the carrying amount exceeds the fair value. We use a variety of methodologies to determine the fair value of these assets, including discounted cash flow models, which are consistent with the assumptions we believe hypothetical marketplace participants would use. We perform a goodwill assessment using a more-likely-than-not approach to determine whether there is a greater than 50 percent chance that the fair value of the reporting unit is less than its carrying values. If, after performing the qualitative assessment, management determines there is a less than a 50 percent chance that the fair value of a reporting unit is less than its carrying amount, then performing the two-step test is unnecessary. If we determine the two-step test is necessary, the first step is to compare the fair value of a reporting unit to its carrying value, including goodwill. We typically use income approach methodology to determine the fair value of a reporting unit, which includes the discounted cash flow method and the market approach methodology that includes the use of market multiples. The assumptions used in these models are consistent with those we believe hypothetical marketplace participants would use. If the fair value of the reporting unit is less than its carrying value, 68 -------------------------------------------------------------------------------- the second step of the impairment test must be performed in order to determine the amount of impairment loss, if any. The second step compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit's goodwill exceeds its implied fair value, an impairment charge is recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. As part of our qualitative assessment, we considered macroeconomic conditions such as general deterioration in economic conditions, limitations on accessing capital, debt rating changes and other developments in equity and credit markets. We evaluated industry and market considerations for any deterioration in the environment in which we operate, the increased competitive environment, a decline in market-dependent multiples or metrics (considered in both absolute terms and relative to peers), any change in the market for products or services and regulatory and political developments. We assessed our overall financial performance, cost factors that would have a negative effect on earnings and prior quantitative assessments. Income Taxes We estimate income tax expense based on the various jurisdictions where we conduct business. We must then assess the likelihood that the deferred tax assets will be realized. A valuation allowance is established to the extent that it is more-likely-than-not that such deferred tax assets will not be realized. When we establish a valuation allowance or modify the existing allowance in a certain reporting period, we generally record a corresponding increase or decrease to the provision for income taxes in the consolidated statements of operations. We make significant judgments in determining the provision for income taxes, the deferred tax assets and liabilities and any valuation allowances recorded against the deferred tax asset. Changes in the estimate of these taxes occur periodically due to changes in the tax rates, changes in the business operations, implementation of tax planning strategies, resolution with taxing authorities of issues where we have previously taken certain tax positions and newly enacted statutory, judicial and regulatory guidance. These changes, when they occur, affect accrued taxes and can be material to our operating results for any particular reporting period. Additionally, we account for uncertain tax positions in accordance with GAAP. The application of income tax law is inherently complex. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements.
Share-Based Compensation
Certain employees, advisors, institutions, executive officers and non-employee directors participate in various long-term incentive plans, which provide for granting stock options, warrants, restricted stock awards and restricted stock units. Stock options and warrants generally vest in equal increments over a three- to five-year period and expire on the tenth anniversary following the date of grant. Restricted stock awards, and restricted stock units granted in 2012, generally cliff vest after a two-year period. We recognize share-based payments awarded to employees, officers and directors as compensation and benefits expense, based on the grant-date fair value over the requisite service period of the individual grants, which generally equals the vesting period. We account for share-based payments awarded to our advisors and financial institutions as commissions and advisory expense based on the fair value of the award at each interim reporting period. If the value of our common stock increases over a given period, this accounting treatment results in additional commissions and advisory expense. As there are no observable market prices for identical or similar instruments, we estimate the fair value of stock options and warrants using a Black-Scholes valuation model. We must make assumptions regarding the number of share-based awards that will be forfeited. The forfeiture assumption is ultimately adjusted to the actual forfeiture rate. Therefore, changes in the forfeiture assumptions do not impact the total amount of expense ultimately recognized over the vesting period. Rather, different forfeiture assumptions would only impact the timing of expense recognition over the vesting period. The risk-free interest rates are based on the implied yield available on U.S. Treasury constant maturities in effect at the time of the grant with remaining terms equivalent to the respective expected terms of the stock options and warrants. Stock options and warrants granted during the three months endedMarch 31, 2012 and in periods prior were granted before the declaration of our special dividend and announcement of our intention, subject in each instance to board approval, to pay regular quarterly dividends. Therefore, those stock options and warrants 69 -------------------------------------------------------------------------------- had an expected dividend yield of zero. For any stock options or warrants granted after theMarch 30, 2012 announcement regarding regular quarterly dividends, the dividend yield is based on an expected dividend per share per year as a percentage of our stock price on the valuation date. We estimate the expected term for our stock options awarded to employees, officers and directors using the simplified method in accordance with Staff Accounting Bulletin 110, Certain Assumptions Used in Valuation Methods, because we do not have sufficient relevant historical information to develop reasonable expectations about future exercise patterns. We estimate the expected term for stock options and warrants awarded to our advisors using the contractual term. Beginning in the first quarter of 2012, we base our assumptions about stock-price volatility not only on the stock-price volatility of comparable companies, but also on the historical trading data for the period of time there was a public market for our stock and the implied volatility to buy and sell our stock. We will continue to use peer group volatility information until our historical volatility is sufficient to measure expected volatility for future grants. In the future, as we gain historical data for volatility of our stock and the actual term over which stock options and warrants are held, expected volatility and the expected term may change, which could substantially change the grant-date fair value of future awards of stock options and warrants and, ultimately, compensation expense recorded on future grants. We recognized$15.9 million ,$14.7 million and$10.3 million of share-based compensation related to the vesting of employee, officer and director stock option awards during the years endedDecember 31, 2012 , 2011 and 2010 respectively. These amounts may not be representative of future share-based compensation expense since the estimated fair value of stock options is amortized over the requisite service period using the straight-line method and additional options may be granted in future years. The following table presents the weighted-average assumptions used in calculating the fair value of our employee stock options with the Black-Scholes valuation model that have been granted during the years endedDecember 31, 2012 , 2011 and 2010: 2012 2011 2010 Expected life (in years) 6.49 6.50 6.50 Expected stock price volatility 45.73 % 48.82 % 49.22 % Expected dividend yield 0.29 % - % - % Fair value of options $ 14.43 $ 15.99 $ 17.42 Risk-free interest rate 1.34 % 2.20 % 2.70 % We recognized$3.8 million ,$3.3 million and$4.7 million of share-based compensation related to the vesting of stock options and warrants awarded to our advisors and financial institutions, during the years endedDecember 31, 2012 , 2011 and 2010, respectively. These amounts may not be representative of future share-based compensation expense since additional options may be granted in future years, our stock price is subject to market fluctuations and the estimated fair value of stock options is amortized over the requisite service period using the straight-line method. The fair value of each stock option or warrant awarded to advisors and financial institutions is estimated on the date of the grant and revalued at each interim reporting period using the Black-Scholes valuation model with the following weighted-average assumptions used as ofDecember 31, 2012 , 2011 and 2010: 2012 2011 2010 Expected life (in years) 7.61 8.30 8.23 Expected stock price volatility 43.97 % 48.24 % 48.77 % Expected dividend yield 1.70 % - % - % Fair value of options $ 11.46 $ 17.74 $ 24.91 Risk-free interest rate 1.28 % 1.67 % 2.96 % We have assumed an annualized forfeiture rate for our stock options and warrants based on a combined review of industry and turnover data, as well as an analytical review performed of historical pre-vesting forfeitures occurring over the previous year. We record additional expense if the actual forfeiture rate is lower than estimated and record a recovery of prior expense if the actual forfeiture is higher than estimated. 70 --------------------------------------------------------------------------------
Acquisitions
When we acquire companies, we recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred and the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions as a part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the acquisition date, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statements of operations. Accounting for business combinations requires our management to make significant estimates and assumptions, especially at the acquisition date with respect to intangible assets, liabilities assumed, and pre-acquisition contingencies. Although we believe the assumptions and estimates we have made in the past have been reasonable and appropriate, they are based in part on historical experience, market data and information obtained from the management of the acquired companies and are inherently uncertain. Examples of critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: (i) future expected cash flows from client relationships, advisor relationships and product sponsor relationships; (ii) estimates to develop or use software; and (iii) discount rates. If we determine that a pre-acquisition contingency is probable in nature and estimable as of the acquisition date, we record our best estimate for such a contingency as a part of the preliminary purchase price allocation. We continue to gather information for and evaluate our pre-acquisition contingencies throughout the measurement period and if we make changes to the amounts recorded or if we identify additional pre-acquisition contingencies during the measurement period, such amounts will be included in the purchase price allocation during the measurement period and, subsequently, in our results of operations. Recent Accounting Pronouncements Refer to Note 2 - Summary of Significant Accounting Policies, within the notes to consolidated financial statements for a discussion of recent accounting standards and pronouncements.
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ALLIED WORLD ASSURANCE CO HOLDINGS, AG – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.
PUBLIC STORAGE – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations
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