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LPL FINANCIAL HOLDINGS INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) 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 13,900 independent financial advisors, including financial advisors at more than 700 financial institutions (our "advisors") across the country, enabling them to provide their retail investors ("clients") with objective financial advice through a lower conflict model. We also support approximately 4,400 financial advisors who are affiliated and licensed with insurance companies that use our customized clearing, advisory platforms, and technology solutions. Fortigent Holdings Company, Inc. and its subsidiaries ("Fortigent") provide solutions and consulting services to RIAs, banks, and trust companies serving high-net-worth clients, while The Private Trust Company, N.A. ("PTC") manages trusts and family assets. 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 in the United States based on the information available as of the date this Quarterly Report on Form 10-Q has been issued. Through our advisors, we are also one of the largest distributors of financial products in the United States. Our scale is a substantial competitive advantage and enables us to more effectively attract and retain advisors. Our unique business model allows us to invest in more resources for our advisors, increasing their revenues and creating a virtuous cycle of growth. We have 3,397 employees, with primary offices in Boston, Charlotte, and San Diego. Our Sources of Revenue Our revenues are derived primarily from fees and commissions from products and advisory services offered by our advisors to their clients, a substantial portion of which we pay out to our advisors, as well as fees we receive from our advisors for the use of our technology, custody, clearing, trust, and reporting platforms. We also generate asset-based revenues through our platform of over 11,000 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 and asset-based revenues, have a correlation of approximately 60% to the fluctuations of the overall market, as measured by the S&P 500 index. 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, which are more difficult to predict, particularly in declining or volatile markets. 22 -------------------------------------------------------------------------------- The table below summarizes the sources of our revenue, the primary drivers of each revenue source, and the percentage of each revenue source that represents recurring revenue: Nine Months Ended September 30, 2014 % of Total Total Net Sources of Revenue Primary Drivers (millions) Revenue % Recurring Advisor-driven Commission - Transactions revenue with - Brokerage asset $1,590 49% 44% ~85%-90% levels payout ratio Advisory - Advisory asset $998 31% 99% levels Asset-Based - Cash balances - Cash Sweep Fees - Interest rates - Sponsorship Fees - Client asset $354 11% 97% - Record Keeping levels - Number of accounts Transaction and Fee - Client activity Attachment - Transactions - Number of clients revenue - Client (Investor) - Number of advisors retained by Accounts - Number of accounts $276 8% 64% us - Advisor Seat and - Number of premium Technology technology subscribers Other - Margin account balances - Alternative $51 1% 34% investment transactions Total Net Revenue $3,269 100% 68% Total Recurring Revenue $2,228 68% 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: transaction-based sales commissions and trailing commissions. Transaction-based sales commission revenues, which occur whenever clients trade securities or purchase various types of investment products, primarily represent gross commissions generated by our advisors. The levels of transaction-based sales commission revenues 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) primarily on mutual funds and variable annuities held by clients of our advisors. Trailing commission revenues are recurring in nature and are earned based on the market value of investment holdings in trail-eligible assets. Advisory Revenues. Advisory revenues primarily represent fees charged on our corporate RIA platform provided through LPL Financial LLC ("LPL Financial") 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 an 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. Advisory revenues collected on our corporate RIA platform generally average 1.1% of the underlying assets, and can range anywhere from 0.5% to 3.0%. 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 through LPL Financial. The assets held under these investment advisory accounts custodied with 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 23 -------------------------------------------------------------------------------- revenue. However, we charge administrative fees to Independent RIAs for clearing and custody of these assets 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 recordkeeping fees based on account type and the invested balances. 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 processing 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 processing revenues are paid to us by mutual fund product sponsors and are based on the value of custodied assets in advisory accounts and the number of brokerage accounts in which the related mutual fund positions are held. Networking revenues on brokerage assets are correlated to the number of positions we administer and are paid to us by mutual fund and annuity product manufacturers. Transaction and Fee Revenues. Revenues earned from transactions and fees primarily consist of transaction fees and ticket charges, subscription fees, Individual Retirement Account ("IRA") custodian fees, contract and license fees, conference fees, and other client account fees. We charge fees to our advisors and their clients for executing 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 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 a fee for attendance. Other Revenues. Other revenues include marketing allowances received from certain financial product manufacturers, primarily those who offer alternative investments, such as non-traded real estate investment trusts and business development companies, 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 Partners program, 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 by LPL Financial 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 equity awards granted to advisors and financial institutions based on the fair value of the awards at each 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 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 components of production payout, which consists of 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 characterized as GDC sensitive because they are variable and highly correlated to the level of our commission and advisory revenues in a particular reporting period. Payout characterized as non-GDC sensitive includes share-based compensation expense from equity awards granted to advisors and financial institutions based on the fair value of the awards at each 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 24 -------------------------------------------------------------------------------- either to market movement or to the value of our stock. We believe that discussion of production payout, viewed in addition to, and not in lieu of, our production expenses, provides useful information to investors regarding our payouts to advisors. 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, occupancy and equipment, professional services, communications and data processing, regulatory fees, and other expenses. General and administrative expenses also include expenses for our hosting of 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 consist of 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 primarily represent expenses incurred as a result of our expansion of our Service Value Commitment announced in 2013 (see Note 3. Restructuring, within the notes to unaudited condensed consolidated financial statements). Other Expenses. Other expenses represent charges incurred arising from the shutdown of our subsidiary NestWise, which ceased operations in the third quarter of 2013 (the "NestWise Closure"). The assets and liabilities acquired through the 2012 acquisition of Veritat Advisors Inc. ("Veritat") were held at NestWise as a result of a merger of Veritat into NestWise. In connection with the NestWise Closure, we determined that a majority of the assets held at NestWise, consisting primarily of goodwill and fixed assets, had no future economic benefit. Accordingly, the carrying values of goodwill and fixed assets were derecognized during the third quarter of 2013. Additionally, we revised our estimate of the potential payment obligation to the former shareholders of Veritat, which resulted in a $7.8 million decrease in the estimated fair value of the contingent consideration obligation during the third quarter of 2013. 25 -------------------------------------------------------------------------------- How We Evaluate Our Business We focus on several business and key financial metrics in evaluating the success of our business relationships and our resulting financial position and operating performance. Our business and key financial metrics are as follows: September 30, 2014 2013 % Change Business Metrics Advisors 13,910 13,563 2.6 % Advisory and brokerage assets (in billions)(1) $ 464.8 $ 414.7 12.1 % Advisory assets under custody (in billions)(2)(3) $ 169.5 $ 141.1 20.1 % Net new advisory assets (in billions)(4) $ 13.5 $ 10.7 26.2 % Insured cash account balances (in billions)(3) $ 16.9 $ 17.3 (2.3 )% Money market account balances (in billions)(3) $ 7.1 $ 8.2 (13.4 )% Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Financial Metrics Revenue growth from prior period 3.4 % 16.1 % 7.3 % 12.1 % Recurring revenue as a % of net revenue(5) 70.2 % 64.0 % 68.1 % 65.0 % Net income (in millions) $ 33.3 $ 37.6 $ 129.5 $ 137.4 Earnings per share (diluted) $ 0.33 $ 0.36 $ 1.26 $ 1.29 Non-GAAP Measures: Gross margin (in millions)(6) $ 331.1 $ 317.0 $ 990.6 $ 927.9 Gross margin as a % of net revenue(6) 30.4 % 30.1 % 30.3 % 30.5 % Adjusted EBITDA (in millions) $ 108.9 $ 120.3 $ 378.6 $ 387.2 Adjusted EBITDA as a % of net revenue 10.0 % 11.4 % 11.6 % 12.7 % Adjusted EBITDA as a % of gross margin(6) 32.9 % 37.9 % 38.2 % 41.7 % Adjusted Earnings (in millions) $ 48.8 $ 59.6 $ 181.6 $ 193.6 Adjusted Earnings per share (diluted) $ 0.48 $ 0.56 $ 1.77 $ 1.81 _______________ (1) 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. Set forth below are other client assets at September 30, 2014 and 2013, including retirement plan assets, and certain trust and high-net-worth assets, that are custodied with third-party providers and therefore excluded from advisory and brokerage assets (in billions): September 30, 2014 2013Retirement plan assets(a) $ 76.2 $ 56.6 Trust assets(b) $ 3.0 $ 12.0 High-net-worth assets(c) $ 83.9 $ 69.3 _______________________(a) Retirement plan assets are held in retirement plans that are supported by advisors licensed with LPL Financial. At September 30, 2014 and 2013, our retirement plan assets represent assets that are custodied with 36 third-party providers and 30 third-party providers, respectively, of retirement plan administrative services who provide reporting feeds. We estimate the total assets in retirement plans supported to be between $110.0 billion and $120.0 billion at September 30, 2014 and between $80.0 billion and $95.0 billion at September 30, 2013. If 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. Since September 30, 2013, we began receiving reporting feeds from 7 such providers, which accounted for $6.6 billion of the $19.6 billion increase in retirement plan assets. 26--------------------------------------------------------------------------------(b) Represents trust assets that are on the wealth management platform of the Concord Trust and Wealth Solutions division of LPL Financial ("Concord"). (c) Represents high-net-worth assets that are on the platform of performance reporting, investment research, and practice management services of Fortigent. (2) 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. (3) Advisory assets under custody, insured cash account balances, and money market account balances are components of advisory and brokerage assets. (4) Represents net new advisory assets consisting of funds from new accounts and additional funds deposited into existing advisory accounts that are custodied in our fee-based advisory platforms, less account attrition and funds withdrawn from advisory accounts. (5) Recurring revenue, which is 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. (6) Gross margin is calculated as net revenues less production expenses. 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 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, and restructuring and conversions 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 (the "Board") 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 EBITDA is not a measure of net income, operating income, or any other performance measure derived in accordance with GAAP. 27 --------------------------------------------------------------------------------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 to Adjusted EBITDA, a non-GAAP measure, for the three and nine months ended September 30, 2014 and 2013 (in thousands): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Net income $ 33,272 $ 37,631 $ 129,498 $ 137,439 Non-operating interest expense 12,897 13,363 38,651 38,190 Provision for income taxes 22,181 23,671 84,663 89,316 Amortization of intangible assets 9,634 9,731 29,046 29,275 Depreciation and amortization of fixed assets 14,885 11,701 41,572 32,176 EBITDA 92,869 96,097 323,430 326,396 EBITDA Adjustments: Employee share-based compensation expense(1) 5,550 2,957 16,087 11,405 Acquisition and integration related expenses(2) (328 ) 3,630 764 7,356 Restructuring and conversion costs(3) 9,958 7,340 26,606 20,925 Debt extinguishment costs(4) - - - 7,968 Other(5) 829 10,259 11,667 13,198 Total EBITDA Adjustments 16,009 24,186 55,124 60,852 Adjusted EBITDA $ 108,878 $ 120,283 $ 378,554 $ 387,248 __________________(1) Represents share-based compensation for equity awards granted to employees, officers, and directors. Such awards are measured based on the grant-date fair value and recognized over the requisite service period of the individual awards, which generally equals the vesting period. (2) 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. (3) Represents organizational restructuring charges, conversion, and other related costs primarily resulting from the expansion of our Service Value Commitment. (4) Represents expenses incurred resulting from the early extinguishment and repayment of amounts outstanding under prior senior secured credit facilities and the establishment of new senior secured credit facilities. (5) Results for the three and nine months ended September 30, 2014 include approximately $0.6 million and $9.8 million, respectively, in parallel rent, property tax, common area maintenance expenses, and fixed asset disposals incurred in connection with our relocation to our San Diego office building. Results for the third quarter of 2013 include costs related to our decision to cease operations of our subsidiary NestWise LLC (the "NestWise Closure"), consisting of the derecognition of $10.2 million of goodwill, $6.9 million of fixed asset charges that were determined to have no future economic benefit, a $7.8 million decrease in the estimated fair value of contingent consideration as related milestones were not achieved, and severance 28-------------------------------------------------------------------------------- and termination benefits. Results for the nine months ended September 30, 2013 also include $2.7 million of severance and termination benefits related to a change in management structure. Other amounts 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, (c) acquisition and integration related expenses, (d) restructuring and conversion costs, (e) debt extinguishment costs, and (f) other. Reconciling items are tax effected using the income tax rates in effect for the applicable period, adjusted for any potentially non-deductible amounts. Adjusted Earnings per share represents Adjusted Earnings divided by weighted-average outstanding shares on a fully diluted basis. We prepared Adjusted Earnings and Adjusted Earnings per share to eliminate the effects of items that we do not consider indicative of our core operating performance. We believe that Adjusted Earnings and Adjusted Earnings per share, viewed in addition to, and not in lieu of, our reported GAAP results provide useful information to investors regarding our performance and overall results of operations for the following reasons: • because non-cash equity grants made to employees, officers, and directors at a certain price and point in time do not necessarily reflect how our business is performing, the related share-based compensation expense is not a key measure of our current operating performance; • because costs associated with acquisitions and related integrations, debt refinancing, and restructuring and conversions 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 is not considered a key measure in comparing our operating performance. We use 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, which are generally available to investors through our website, include references to 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. 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. 29 -------------------------------------------------------------------------------- The following table sets forth a reconciliation of net income to the non-GAAP measures Adjusted Earnings and Adjusted Earnings per share for the three and nine months ended September 30, 2014 and 2013 (in thousands, except per share data): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Net income $ 33,272 $ 37,631 $ 129,498 $ 137,439 After-Tax: EBITDA Adjustments(1) Employee share-based compensation expense(2) 3,666 2,153 10,778 8,255 Acquisition and integration related expenses(3) (703 ) 2,240 (33 ) 3,186 Restructuring and conversion costs 6,114 4,529 16,336 12,911 Debt extinguishment costs - - - 4,916 Other(4) 509 6,993 7,164 8,806 Total EBITDA Adjustments 9,586 15,915 34,245 38,074 Amortization of intangible assets(1) 5,915 6,004 17,834 18,063 Adjusted Earnings $ 48,773 $ 59,550 $ 181,577 $ 193,576 Adjusted Earnings per share(5) $ 0.48 $ 0.56 $ 1.77 $ 1.81 Weighted-average shares outstanding - diluted 101,834 105,705 102,384 106,934 __________________(1) Generally, EBITDA Adjustments and amortization of intangible assets have been tax effected using a federal rate of 35.0% and the applicable effective state rate, which was 3.6% and 3.3%, net of the federal tax benefit, for the periods ended September 30, 2014 and 2013, respectively, except as noted below. (2) Represents the after-tax expense of non-qualified stock options for which we receive a tax deduction upon exercise, restricted stock awards and restricted stock units for which we receive a tax deduction upon vesting, and the full expense impact of incentive stock options granted to employees that qualify for preferential tax treatment and conversely for which we do not receive a tax deduction. Share-based compensation expense for vesting of incentive stock options was $0.7 million and $0.9 million for the three months ended September 30, 2014 and 2013, respectively, and $2.3 million and $3.2 million for the nine months ended September 30, 2014 and 2013, respectively. (3) Represents the after-tax expense of acquisition and related costs for which we receive a tax deduction. (4) Results for the three and nine months ended September 30, 2013 include the after-tax expense of severance and termination benefits and derecognition of fixed assets related to the NestWise Closure, for which we received a tax deduction, as well as the full expense impact of the derecognition of $10.2 million of goodwill and the $7.8 million decrease in the estimated fair value of contingent consideration related to the NestWise Closure, for which we did not receive a tax deduction. Other amounts include the after-tax expense of excise and other taxes. (5) Represents Adjusted Earnings, a non-GAAP measure, divided by weighted-average number of shares outstanding on a fully diluted basis. Set forth below is a reconciliation of earnings per share on a fully diluted basis, as calculated in accordance with GAAP, to Adjusted Earnings per share: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013Earnings per share - diluted $ 0.33 $ 0.36 $ 1.26 $ 1.29 After-Tax: EBITDA Adjustments per share 0.09 0.14 0.33 0.35 Amortization of intangible assets per share 0.06 0.06 0.18 0.17 Adjusted Earnings per share $ 0.48 $ 0.56 $ 1.77 $ 1.81 30-------------------------------------------------------------------------------- Service Value Commitment The Program In February 2013, we committed to an expansion of our Service Value Commitment (the "Program"), an ongoing effort to position us for sustainable long-term growth by improving the service experience of our advisors and delivering efficiencies in our operating model. After assessing our information technology delivery, governance, organization, and strategy, we committed to undertake a course of action 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, and we estimate total charges of $65.0 million for technology transformation costs, outsourcing and other related costs, employee severance obligations and other related costs, and non-cash charges for impairment of certain fixed assets related to internally developed software. We expect to incur approximately $38.4 million of expense during 2014, of which we had incurred $25.4 million as of September 30, 2014, consisting of: $5.0 million for outsourcing and other services such as parallel processing provided by outside consultants; $16.0 million for the implementation of foundational changes to our technology platform and outsourcing of our disaster recovery facilities; and $4.4 million for employee severance and termination benefits related to positions that were outsourced as of September 30, 2014, within accounting, data reconciliation, operations, and insurance processing. We remain focused on the next wave of outsourced functions in the remainder of 2014, including additional opportunities in compliance and back office processing activities. By 2015, we expect annual pre-tax savings to approach $30.0 million. See Note 3. Restructuring, within the notes to unaudited condensed consolidated financial statements for additional information regarding the Program. Derivative Financial Instruments During the second quarter of 2013, and in conjunction with the Program, we entered into a long-term contractual obligation (the "Agreement") with a third-party provider to enhance the quality, speed, and cost of our processes by outsourcing certain functions. The Agreement enables the third-party provider to use the services of its affiliates in India to provide services to us and provides that we settle the cost of our contractual obligation to the third-party provider each month in U.S. dollars. However, the Agreement provides that on each annual anniversary date of the signing of the Agreement, the price for services (as denominated in U.S. dollars) is to be adjusted for the then-current exchange rate between the U.S. dollar and the Indian rupee. Once an annual adjustment is calculated, there are no further modifications to the amounts paid by us to the third-party provider for fluctuations in the exchange rate until the reset on the next anniversary date of the signing of the Agreement. The third-party provider bore the risk of currency movement from the date of signing the Agreement until the reset on the first anniversary of its signing, and bears the risk during each period until the next annual reset date. We bear the risk of currency movement at each of the annual reset dates following the first anniversary. Upon completion of the Program, we estimate annual costs for our long-term contractual obligation with the third-party provider to be approximately $10.0 million. We use derivative financial instruments consisting solely of non-deliverable foreign currency contracts, all of which have been designated as cash flow hedges. These instruments are operating effectively as intended and our use of them has mitigated foreign currency risk arising from a substantial portion of our contract obligation with the third-party provider arising from annual anniversary adjustments. We will continue to assess the effectiveness of our use of cash flow hedges to mitigate risk from foreign currency contracts. See Note 6. Derivative Financial Instruments, within the notes to unaudited condensed consolidated financial statements for additional information regarding our derivative financial instruments. Acquisitions, Integrations, and Divestitures From time to time we undertake acquisitions or divestitures outside the ordinary course of business 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. There have been no material acquisitions, integrations, or divestitures during the nine months ended September 30, 2014. See our 2013 Annual Report on Form 10-K for 2013 activity. Economic Overview and Impact of Financial Market Events Our business is directly and indirectly sensitive to several macroeconomic factors, primarily in the United States. One of these factors is the current and expected future level of short-term interest rates, particularly overnight rates. The Federal Reserve remained highly accommodative in the third quarter of 2014, extending, but 31 -------------------------------------------------------------------------------- continuing to wind down, its bond buying program while maintaining a 0.0% to 0.25% target range for the federal funds rate. At its September policy meeting, the Federal Reserve reaffirmed its rate policy and stated that it would continue to assess labor markets, inflation levels, financial developments, and general economic conditions to determine how long to keep the federal funds target rate near zero. It also restated that rates would be held near zero for a "considerable time" after it ended its bond purchase program, which did end in late October 2014. The Federal Reserve has underscored that it would take a balanced approach once it began to raise rates and that it could keep rates below what members would consider normal in the longer term if conditions warranted, even if inflation and labor markets were near levels consistent with its mandate. As a result of the accommodative monetary policy, interest rates, including the rate on overnight funds, remain low on a historical basis, with the average federal funds effective rate for the third quarter of 2014 at 9 basis points. The lower interest rate environment and fee compression, resulting from contract repricing in order to keep yields on our cash sweep programs competitive, has had a negative impact on our profitability on our cash sweep programs, and fee compression is expected to increase further in 2015 and 2016. Additionally, we've seen decreasing levels of demand for fixed income and fixed annuity products as investors move to equity and alternative products. Another macro-economic factor affecting our business is the valuation of equity securities across the various markets in the United States. The S&P 500 index closed the quarter at 1,972, up 0.6% from its close on June 30, 2014, the seventh consecutive quarter of positive returns, and reflected a 6.7% year-to-date gain through September 30, 2014. Investor confidence remained stable as the market showed signs of incremental economic growth despite volatility and continued tapering of the Federal Reserve's bond buying program. Consumer spending rebounded toward the end of the summer while September marked the sixth consecutive month of job gains, and the third quarter also included strong performance by the U.S. dollar. While the market demonstrated impressive resilience through the third quarter, lingering economic worries remain about geopolitical concerns, Federal Reserve monetary policy, U.S. and global growth rates, and policy uncertainty in Washington, D.C. 32 -------------------------------------------------------------------------------- Results of Operations The following discussion presents an analysis of our results of operations for the three and nine months ended September 30, 2014 and 2013. Where appropriate, we have identified specific events and changes that affect comparability or identification or monitoring of trends, and where possible and practical, have quantified the impact of such items. Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 % Change 2014 2013 % Change (In thousands) Revenues Commission $ 520,388 $ 527,419 (1.3 )% $ 1,590,139 $ 1,521,390 4.5 % Advisory 340,369 299,101 13.8 % 998,016 878,421 13.6 % Asset-based 121,283 107,447 12.9 % 354,494 318,718 11.2 % Transaction and fee 94,674 93,799 0.9 % 276,284 271,808 1.6 % Other 12,520 25,446 (50.8 )% 50,461 56,591 (10.8 )% Net revenues 1,089,234 1,053,212 3.4 % 3,269,394 3,046,928 7.3 % Expenses Production 758,091 736,195 3.0 % 2,278,800 2,119,033 7.5 % Compensation and benefits 106,290 102,310 3.9 % 317,459 299,317 6.1 % General and administrative 122,056 102,834 18.7 % 323,232 265,075 21.9 % Depreciation and amortization 24,519 21,432 14.4 % 70,618 61,451 14.9 % Restructuring charges 9,928 6,482 53.2 % 26,473 19,851 33.4 % Other - 9,294 (100.0 )% - 9,294 (100.0 )% Total operating expenses 1,020,884 978,547 4.3 % 3,016,582 2,774,021 8.7 % Non-operating interest expense 12,897 13,363 (3.5 )% 38,651 38,190 1.2 % Loss on extinguishment of debt - - * - 7,962 (100.0 )% Total expenses 1,033,781 991,910 4.2 % 3,055,233 2,820,173 8.3 % Income before provision for income taxes 55,453 61,302 (9.5 )% 214,161 226,755 (5.6 )% Provision for income taxes 22,181 23,671 (6.3 )% 84,663 89,316 (5.2 )% Net income $ 33,272 $ 37,631 (11.6 )% $ 129,498 $ 137,439 (5.8 )% 33--------------------------------------------------------------------------------Revenues Commission Revenues The following table sets forth our commission revenue, by product category, included in our unaudited condensed consolidated statements of income for the three months ended September 30, 2014 and 2013 (in thousands): Three Months Ended September 30, 2014 2013 $ Change % Change Variable annuities $ 206,382 $ 189,401 $ 16,981 9.0 % Mutual funds 153,875 135,992 17,883 13.2 % Alternative investments 41,911 81,193 (39,282 ) (48.4 )% Fixed annuities 36,631 35,772 859 2.4 % Equities 26,624 32,429 (5,805 ) (17.9 )% Fixed income 21,165 21,352 (187 ) (0.9 )% Insurance 20,293 19,125 1,168 6.1 % Group annuities 13,350 12,019 1,331 11.1 % Other 157 136 21 15.4 % Total commission revenue $ 520,388 $ 527,419 $ (7,031 ) (1.3 )% The following table sets forth our commission revenue, by sales-based and trailing commission revenue, for the three months ended September 30, 2014 and 2013 (in thousands): Three Months Ended September 30, 2014 2013 $ Change % Change Sales-based $ 278,375 $ 319,526 $ (41,151 ) (12.9 )% Trailing 242,013 207,893 34,120 16.4 % Total commission revenue $ 520,388 $ 527,419 $ (7,031 ) (1.3 )% Commission revenue decreased by $7.0 million, or 1.3%, for the three months ended September 30, 2014 compared with the same period in 2013, due primarily to a decrease in alternative investments, namely non-traded real estate investment trusts ("REITs"). Activity in the third quarter of 2013, benefited from liquidity events in several large REITs that allowed for reinvestment into the same type of investments. This resulted in third quarter 2013 alternative investment commissions being much higher than previous or subsequent periods. Increases in trailing revenues for mutual funds and variable and group annuities reflects improved investor engagement and strong market conditions, resulting in the increase of the underlying assets. 34 --------------------------------------------------------------------------------The following table sets forth our commission revenue, by product category, included in our unaudited condensed consolidated statements of income for the nine months ended September 30, 2014 and 2013 (dollars in thousands): Nine Months Ended September 30, 2014 2013 $ Change % Change Variable annuities $ 611,286 $ 597,925 $ 13,361 2.2 % Mutual funds 456,839 423,289 33,550 7.9 % Alternative investments 148,285 168,001 (19,716 ) (11.7 )% Fixed annuities 126,187 77,544 48,643 62.7 % Equities 82,245 88,889 (6,644 ) (7.5 )% Fixed income 65,591 65,814 (223 ) (0.3 )% Insurance 57,615 60,993 (3,378 ) (5.5 )% Group annuities 41,571 38,229 3,342 8.7 % Other 520 706 (186 ) (26.3 )% Total commission revenue $ 1,590,139 $ 1,521,390 $ 68,749 4.5 % The following table sets forth our commission revenue, by sales-based and trailing commission revenue, for the nine months ended September 30, 2014 and 2013 (dollars in thousands): Nine Months Ended September 30, 2014 2013 $ Change % Change Sales-based $ 893,628 $ 917,042 $ (23,414 ) (2.6 )% Trailing 696,511 604,348 92,163 15.2 % Total commission revenue $ 1,590,139 $ 1,521,390 $ 68,749 4.5 % Commission revenue increased by $68.7 million, or 4.5%, for the nine months ended September 30, 2014 compared with the same period in 2013, due primarily to an increase in sales-based activity for fixed annuities and increases in trailing revenues for mutual funds and variable and group annuities. Such growth reflects improved investor engagement and strong market conditions, resulting in the increase of the underlying assets. Fixed annuity sales-based commissions have risen, despite historically low interest rates, as investors have sought income streams with minimal risk to principal. Commissions from fixed annuities also include commissions earned on indexed annuities. The decrease in alternative investments was due primarily to activity in the nine months ended September 30, 2013, in which commission revenues benefited from liquidity events in several large REITs that allowed for reinvestment into the same type of investments. This resulted in the nine months ended September 30, 2013, alternative investment commissions being much higher than previous or subsequent periods. Advisory Revenues The following table summarizes the activity within our advisory assets under custody for the three and nine months ended September 30, 2014 and 2013 (in billions): Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 2014 2013 Balance - Beginning of period $ 167.3 $ 132.4 $ 151.6 $ 122.1 Net new advisory assets 4.8 4.0 13.5 10.7 Market impact and other (2.6 ) 4.7 2.2 8.3 Balance - End of period $ 169.5 $ 141.1 $ 167.3 $ 141.1 Net new advisory assets for the three and nine months ended September 30, 2014 and 2013 have only a limited impact on advisory fee revenue for those respective periods, given the comparatively large assets at the beginning of each period. Rather, net new advisory assets are anticipated to be a larger driver of advisory revenue 35 -------------------------------------------------------------------------------- in future reporting periods. Net new advisory assets were $4.8 billion for the three months ended September 30, 2014, resulting from the continued shift by our existing advisors from brokerage towards more advisory business. Advisory revenue for a particular quarter is predominately driven by the prior quarter-end advisory assets under management. Advisory revenues increased by $41.3 million, or 13.8%, for the three months ended September 30, 2014 compared to the same period in 2013. The growth in advisory revenue is due to net new advisory assets resulting from increased investor engagement and strong advisor productivity, newly recruited advisors that were added in the second quarter of 2014, as well as market gains as represented by higher levels of the S&P 500 index on the applicable billing dates in 2014 compared to 2013. The S&P 500 index closed at 1,960 on June 30, 2014, which is a 22.0% increase over the close of 1,606 on June 30, 2013. The Independent RIA model has continued to attract advisors as they seek the freedom to run their business in a manner that best enables them to meet their clients' needs. This continued shift of advisors to the Independent RIA platform (for which we custody assets but do not earn advisory revenues for managing such assets) has caused the rate of revenue growth of advisory assets under management to lag behind the rate of growth of advisory assets under custody. Advisory revenues do not include fees for advisory services charged by Independent RIA advisors to their clients. Accordingly, there is no corresponding payout. However, there are administrative fees charged to Independent RIA advisors including custody and clearing fees, based on the value of assets. Advisory revenues increased by $119.6 million, or 13.6%, for the nine months ended September 30, 2014 compared with the same period in 2013. This growth is attributable to the same net new advisory asset flows and shift of advisors toward more advisory business that has impacted our quarterly performance, and to a positive market impact for the nine months ended September 30, 2014. The following table summarizes the composition of our advisory assets under custody as of September 30, 2014 and 2013 (in billions): September 30, 2014 2013 $ Change % Change Advisory assets under management $ 123.1 $ 111.8 $ 11.3 10.1 % Independent RIA assets in advisory accounts custodied by LPL Financial 46.4 29.3 17.1 58.4 % Total advisory assets under custody $ 169.5 $ 141.1 $ 28.4 20.1 % 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 $13.8 million, or 12.9%, to $121.3 million for the three months ended September 30, 2014 compared with the same period in 2013. Revenues for sponsorship programs and record-keeping services, which are largely based on underlying asset values, increased due to the impact of the higher average market indices on the value of such underlying assets and net new sales of eligible assets. The S&P 500 index for the three months ended September 30, 2014 averaged 1,976, an increase of 18.0% over the average in the prior-year period. Asset-based revenues also include revenues from our cash sweep programs, which decreased by $4.1 million, or 14.0%, to $25.2 million for the three months ended September 30, 2014 from $29.3 million for the three months ended September 30, 2013. The decrease in our cash sweep revenues is a result of fee compression resulting from contract repricing and a decrease of 7.9% in average assets in our cash sweep programs, which were $23.3 billion and $25.3 billion for the three months ended September 30, 2014 and 2013, respectively. Asset-based revenues increased by $35.8 million, or 11.2%, to $354.5 million for the nine months ended September 30, 2014 compared with the same period in 2013. Revenues for record-keeping services and from product sponsors, which are each largely based on underlying asset values, increased due to the impact of the higher average market indices on the value of such underlying assets and net new sales of eligible assets. The S&P 500 index for the nine months ended September 30, 2014 averaged 1,905, an increase of 19.0% over the average in the prior year period. Asset-based revenues also include revenues from our cash sweep programs, which decreased by $17.9 million, or 19.5%, to $73.9 million for the nine months ended September 30, 2014 from 36 -------------------------------------------------------------------------------- $91.8 million for the nine months ended September 30, 2013. The decrease is due to fee compression that resulted from a repricing of certain contracts that underlie our cash sweep programs, a year-over-year 3 basis point decline in the average federal funds effective rate to 0.08% for the nine months ended September 30, 2014, and a decrease of 2.1% in average assets in our cash sweep programs, which were $23.6 billion and $24.1 billion for the nine months ended September 30, 2014 and 2013, respectively. Transaction and Fee Revenues Transaction and fee revenues increased by $0.9 million, or 0.9%, for the three months ended September 30, 2014 compared with the same period in 2013, which were driven primarily by higher trade volumes in certain advisory accounts and an increase in the average number of advisors. Transaction and fee revenues increased by $4.5 million, or 1.6%, for the nine months ended September 30, 2014 compared with the same period in 2013, which were driven primarily by higher trade volumes in certain advisory accounts and a 2.8% increase in the average number of advisors. Other Revenues Other revenues decreased by $12.9 million, or 50.8%, to $12.5 million for the three months ended September 30, 2014 compared with the same period in 2013. The primary contributor to such decrease for the three months ended September 30, 2014 was alternative investment marketing allowances received from product sponsor programs, which decreased by $9.8 million compared to the same period in 2013, driven primarily by decreased sales of alternative investments. Other revenue includes gains or losses on assets held for the advisor non-qualified deferred compensation plan. Losses were $1.8 million for the three months ended September 30, 2014, compared to gains of $1.6 million for the three months ended September 30, 2013. The gains or losses on assets held for the advisor non-qualified deferred compensation plan were offset by increases or decreases in non-GDC sensitive production expenses as noted below. Other revenues decreased by $6.1 million, or 10.8%, to $50.5 million for the nine months ended September 30, 2014 compared to 2013. The primary contributor to such decrease for the nine months ended September 30, 2014 was alternative investment marketing allowances received from product sponsor programs, which decreased by $3.7 million compared to the same period in 2013, driven primarily by decreased sales of alternative investments. Other revenue includes gains or losses on assets held for the advisor non-qualified deferred compensation plan. Gains were $0.8 million for the nine months ended September 30, 2014, compared to gains of $4.3 million for the same period in 2013. The gains or losses on assets held for the advisor non-qualified deferred compensation plan were offset by the increases or decreases in non-GDC sensitive production expenses as noted below. Expenses Production Expenses The following table shows our production payout ratio for the three and nine months ended September 30, 2014 and 2013: Three Months Ended September 30, Nine Months Ended September 30, 2014 2013 Change 2014 2013 Change Base payout rate 83.50 % 84.14 % (64 bps) 83.86 % 84.04 % (18 bps) Production based bonuses 3.18 % 3.14 % 4 bps 2.41 % 2.45 % (4 bps) GDC sensitive payout 86.68 % 87.28 % (60 bps) 86.27 % 86.49 % (22 bps) Non-GDC sensitive payout (0.01 )% 0.42 % (43 bps) 0.41 % 0.44 % (3 bps) Total Payout Ratio 86.67 % 87.70 % (103 bps) 86.68 % 86.93 % (25 bps) Production expenses increased by $21.9 million, or 3.0%, for the three months ended September 30, 2014 compared with the same period in 2013. The increase correlates with our commission and advisory revenues, which increased by 4.1% during the same period. Our GDC sensitive payout ratio was 86.68% for the three months ended September 30, 2014, compared to 87.28% for the prior-year period. The base payout rate decreased by 64 basis points in part due to the growth of our advisory platform, which on average has a lower base rate than our brokerage platform. The decrease in non-GDC sensitive payout is attributable to decreased advisor share-based 37 -------------------------------------------------------------------------------- compensation for the three months ended September 30, 2014 compared to the same period in 2013 correlating to market movement in our stock and the advisor non-qualified deferred compensation plan as noted above. Production expenses increased by $159.8 million, or 7.5%, for the nine months ended September 30, 2014 compared with the same period in 2013. The increase correlates with our commission and advisory revenues, which increased by 7.8% during the same period. Our production payout was 86.68% for the nine months ended September 30, 2014, compared to 86.93% for the prior year period. The decrease in non-GDC sensitive payout ratio is attributable to decreased advisor share-based compensation correlating to market movement in our stock and production expenses related to the advisor non-qualified deferred compensation plan as noted above. Compensation and Benefits Expense Compensation and benefits expense increased by $4.0 million, or 3.9%, for the three months ended September 30, 2014 compared with the same period in 2013. This was primarily driven by a 9.4% increase in our average number of full-time employees from 3,094 for the three months ended September 30, 2013 to 3,386 for the three months ended September 30, 2014, to support business growth and investments in staffing related to service and compliance. Compensation and benefits expense increased by $18.1 million, or 6.1%, for the nine months ended September 30, 2014 compared with the same period in 2013. Our average number of full-time employees increased 10.2% from 3,012 for the nine months ended September 30, 2013 to 3,320 for the nine months ended September 30, 2014, due to higher staffing levels to support investments in staffing related to service and compliance and increased levels of advisor and client activities. General and Administrative Expenses General and administrative expenses increased by $19.2 million, or 18.7%, to $122.1 million for the three months ended September 30, 2014 compared with the same period in 2013. The primary driver behind the increase was an increase of $19.2 million for professional services. The increase in professional services includes the estimated costs of the investigation, settlement, and resolution of regulatory matters. General and administrative expenses increased by $58.2 million, or 21.9%, to $323.2 million for the nine months ended September 30, 2014 compared with the same period in 2013. The primary drivers behind the increase were increases of $35.1 million for professional services, $8.3 million for business development and promotional expenses, and $9.8 million for parallel rent, property tax, common area maintenance expenses, and fixed asset disposals incurred in connection with the relocation to our San Diego office building. The increase in professional services includes the estimated costs of the investigation, settlement, and resolution of regulatory matters. Depreciation and Amortization Expense For the three and nine months ended September 30, 2014, depreciation and amortization increased by $3.1 million, or 14.4%, and $9.2 million, or 14.9%, respectively, compared with the same periods in 2013. The increases were due primarily to capital assets placed into service during the latter half of 2013 related to the San Diego office building and capitalized software. Restructuring Charges Restructuring charges increased by $3.4 million, or 53.2%, and $6.6 million, or 33.4%, for the three and nine months ended September 30, 2014, respectively, compared with the same periods in 2013. These charges relate primarily to consulting fees paid to support our technology transformation as well as employee severance obligations and other related costs and non-cash charges for impairment incurred through our expansion of our Service Value Commitment. Refer to Note 3. Restructuring, within the notes to unaudited condensed consolidated financial statements for additional details regarding this matter. Other Expenses Other expenses for the three and nine months ended September 30, 2013 include the derecognition of fixed assets of $6.9 million and goodwill of $10.2 million, incurred as a result of the NestWise Closure, which ceased operations during the third quarter of 2013. The assets were from the 2012 acquisition of Veritat by NestWise, and were determined to have no future economic benefit. Additionally, we revised our estimate of the potential payment obligation to the former shareholders of Veritat, which resulted in a $7.8 million decrease in the estimated fair value of contingent consideration during the three and nine months ended September 30, 2013. 38-------------------------------------------------------------------------------- Interest Expense Interest expense represents non-operating interest expense for our senior secured credit facilities. Interest expense decreased by $0.5 million, or 3.5%, for the three months ended September 30, 2014 compared with the same period in 2013. Additionally, interest expense increased by $0.5 million, or 1.2%, for the nine months ended September 30, 2014, compared with the same periods in 2013. The changes in interest expense for the 2014 periods are due to changes in the level of outstanding indebtedness following the amendment to the credit agreement in May 2013. Loss on Extinguishment of Debt Losses from the extinguishment of debt totaled $8.0 million for the nine months ended September 30, 2013. In May 2013, we refinanced and amended our previous credit agreement and effectively increased our borrowing by approximately $236.1 million, with net proceeds used primarily for working capital requirements and other general corporate purposes. Accordingly, we wrote off $8.0 million of unamortized debt issuance costs that had no future economic benefit related to our prior credit agreement. Provision for Income Taxes We estimate our full-year effective income tax rate at the end of each reporting period. This estimate is used in providing for income taxes on a year-to-date basis and may change in subsequent interim periods. The tax rate in any quarter can be affected positively and negatively by adjustments that are required to be reported in the quarter in which resolution of the item occurs. The effective income tax rates reflect the impact of state taxes, settlement contingencies, and expenses that are not deductible for tax purposes. During the three months ended September 30, 2014, we recorded income tax expense of $22.2 million, compared with $23.7 million in the prior year period. Our effective income tax rate was 40.0% and 38.6% for the three months ended September 30, 2014 and 2013, respectively. During the nine months ended September 30, 2014, we recorded income tax expense of $84.7 million, compared with $89.3 million in the prior year period. Our effective income tax rate was 39.5% and 39.4% for the nine months ended September 30, 2014 and 2013, 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 on, among other things, projected profitability and cash flow, risks of the business, regulatory capital requirements, and future liquidity needs for strategic activities. Our Treasury 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 the executive business strategies while ensuring ongoing and sufficient liquidity. Cash requirements and liquidity needs are primarily funded through our cash flow from operations and our capacity for additional borrowing. A summary of changes in our cash flow is provided as follows (in thousands): |