Morningstar, Inc. 2016 Third-Quarter Form 10-Q Summary
Business Context and Reporting Period
Morningstar provides data, research, software, investment-management, workplace-solutions, credit-rating, and related products to financial advisors, asset managers, retirement providers, and individual investors. The filing covers the three and nine months ended September 30, 2016, and was filed October 28, 2016. Morningstar reports one operating segment and generally generates recurring revenue through subscriptions and license agreements.
Financial Performance and Position
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Revenue | $196.1 million | $195.3 million | $586.4 million | $587.2 million |
| Operating income | $44.2 million | $46.2 million | $130.9 million | $140.5 million |
| Operating margin | 22.5% | 23.7% | 22.3% | 23.9% |
| Net income attributable to Morningstar | $30.2 million | $33.5 million | $90.7 million | $95.3 million |
| Diluted earnings per share | $0.70 | $0.76 | $2.09 | $2.15 |
| Cash provided by operating activities | $60.4 million | $75.6 million | $143.2 million | $188.6 million |
| Free cash flow | $42.3 million | $63.3 million | $95.7 million | $148.7 million |
- Revenue was approximately flat year over year, while profitability declined as operating expenses increased 2.0% in both the quarter and nine-month period.
- Cost of revenue increased to 43.3% of revenue in the quarter and 43.7% for the nine months, compared with 42.7% and 41.8%, respectively, in the prior-year periods.
- Cash, cash equivalents, and investments totaled $265.1 million at September 30, 2016, including $219.4 million of cash and cash equivalents and $45.7 million of investments.
- Short-term debt was $60.0 million, under a $100.0 million revolving credit facility, leaving $40.0 million of borrowing availability.
- Total assets were $1.06 billion and total equity was $662.0 million at September 30, 2016.
- The company paid $28.5 million of dividends and repurchased $38.8 million of common stock during the first nine months. The quarterly dividend was increased to $0.22 per share.
Material Changes Versus the Prior Comparable Period
- Third-quarter revenue increased 0.4%, but nine-month revenue declined 0.1%. Excluding acquisitions and foreign-currency effects, organic revenue increased 1.1% in the quarter and 0.8% for the nine months.
- Foreign currency translation reduced revenue by approximately $1.9 million in the quarter and $6.3 million for the nine months.
- Operating income declined 4.6% in the quarter and 6.9% for the nine months; operating margin contracted by 1.2 and 1.6 percentage points, respectively.
- Net income attributable to Morningstar declined 9.9% in the quarter and 4.8% for the nine months. The third-quarter effective tax rate rose to 35.3% from 30.4%, primarily because the prior-year period benefited from tax credits, incentives, and recognition of certain foreign net operating losses.
- Operating cash flow declined 20.1% in the quarter and 24.1% for the nine months. Free cash flow declined 33.2% and 35.6%, respectively, due to lower operating cash flow and higher capital expenditures.
- License-based revenue increased 3.9% in the quarter and 3.8% for the nine months; asset-based revenue increased 5.0% and 1.1%. Transaction-based revenue declined 37.8% and 32.3%, primarily due to lower credit-ratings and Internet advertising revenue.
- Morningstar Direct revenue increased 9.6% for the nine months and Morningstar Data revenue increased 6.4%. Morningstar Investment Management revenue declined 1.5% for the nine months.
- CMBS new-issue ratings completed declined 71.1% for the nine months, while the related rated asset value declined 77.4%, reflecting weak industry issuance volumes.
- Worldwide headcount increased 10.2% to approximately 4,220. Management attributed higher compensation and investment spending to technology, sales, and analyst hiring.
Guidance, Outlook, Risks, Contingencies, and Unusual Items
- The filing does not provide formal quantitative revenue or earnings guidance. Management expects continued capital expenditures in 2016 for hardware, software, internally developed software, and leasehold improvements.
- Management believed cash, investments, operating cash flow, and available credit would be sufficient for operating and cash needs for at least the next 12 months.
- On October 14, 2016, Morningstar announced an agreement to acquire the remaining approximately 80% of PitchBook Data, Inc. for approximately $180.0 million, subject to working-capital adjustments. The transaction values PitchBook at approximately $225.0 million and was expected to close in the fourth quarter, subject to customary conditions.
- Morningstar intended to fund the PitchBook acquisition by increasing its revolving credit facility to $300.0 million and extending its term to three years.
- Key business risks include financial-sector and market downturns, pressure from passive investing and low interest rates, market-sensitive asset-based fees, declining CMBS issuance, regulatory changes including the U.S. Department of Labor fiduciary rule, cybersecurity and privacy exposure, technology outages, foreign-currency fluctuations, and reliance on offshore operations in China and India.
- The company had $18.7 million of gross unrecognized tax benefits at September 30, 2016, of which $14.7 million would affect income tax expense if recognized. Morningstar was under tax examinations in multiple jurisdictions, but the potential effect could not be estimated.
- Management did not believe existing legal proceedings would have a material adverse effect on the company. The filing reported no material changes to the risk factors in the 2015 Form 10-K.
- Approximately 80% of cash, cash equivalents, and investments was held outside the United States, and approximately 20% was held in U.S. operations. The company had no currency-hedging positions.
- The company early adopted accounting guidance for stock compensation in 2016; the primary effect was recognition of $0.8 million of excess tax benefits in income tax expense rather than additional paid-in capital.
Important Facts for Investors to Verify
- Confirm the closing, financing terms, purchase accounting, and subsequent contribution of the PitchBook acquisition.
- Monitor whether revenue growth improves after the 2016 slowdown, particularly for Morningstar Credit Ratings, Internet advertising, and Morningstar Investment Management.
- Assess whether higher headcount, capitalized software development, and depreciation and amortization continue to pressure operating margins and free cash flow.
- Review the increase in planned borrowing capacity and its effect on leverage, interest expense, liquidity, and share repurchase capacity.
- Track foreign-currency exposure, the concentration of cash outside the United States, and potential tax costs associated with foreign earnings.
- Evaluate the sustainability of the $0.22 quarterly dividend and the remaining approximately $337.7 million share-repurchase authorization.