Morningstar, Inc. Form 10-Q Summary
Reporting period: Three months ended March 31, 2012; filed May 1, 2012. The interim financial statements are unaudited. Morningstar operates through Investment Information and Investment Management segments and generates significant recurring subscription, license, and asset-based fee revenue.
Financial Performance and Position
| Metric | Q1 2012 | Q1 2011 | Change |
|---|---|---|---|
| Revenue | $160.8 million | $151.8 million | +5.9% |
| Operating income | $30.4 million | $31.8 million | -4.4% |
| Operating margin | 18.9% | 21.0% | -2.1 percentage points |
| Net income attributable to Morningstar | $20.1 million | $22.5 million | -10.6% |
| Diluted earnings per share | $0.40 | $0.44 | -9.1% |
| Cash provided by operating activities | $5.6 million | $14.3 million | -60.8% |
| Free cash flow | $(3.4) million | $9.3 million | Declined $12.7 million |
Gross profit was $110.4 million, with gross margin declining to 68.7% from 73.2%. Operating expenses increased 8.7% to $130.4 million, primarily due to higher salaries, bonuses, benefits, and headcount. The effective tax rate rose to 36.4% from 31.8%, primarily because of valuation allowances in 2012 and deferred tax benefits recorded in 2011.
At March 31, 2012, cash and cash equivalents were $165.3 million, investments were $278.3 million, and total cash, cash equivalents, and investments were approximately $443.6 million. Total assets were $1.17 billion and total liabilities were $302.1 million. The filing does not present significant traditional borrowings or outstanding debt facilities; management states that it has not needed significant commercial credit or established lines of credit.
Investment Information generated $126.9 million of revenue and $28.7 million of operating income, while Investment Management generated $33.8 million of revenue and $17.3 million of operating income. International revenue represented 28.8% of consolidated revenue.
Material Changes Versus the Prior Comparable Period
- Revenue increased 5.9%; organic revenue, excluding acquisitions and currency effects, increased 6.1%.
- Investment Information revenue increased 5.4%, led by Morningstar Direct, software, and data products. Its operating margin declined to 22.6% from 26.8% because expense growth exceeded revenue growth.
- Investment Management revenue increased 7.9%, primarily from Investment Advisory Services. Its operating margin declined to 51.1% from 54.3%.
- Morningstar Direct licenses increased to 6,460 from 5,092. U.S. Advisor Workstation licenses and Morningstar.com premium subscriptions declined modestly, while Principia subscriptions decreased to 29,604 from 32,884.
- Structured Credit Ratings revenue declined approximately $1.1 million due to fewer new-issue ratings and competitive pricing pressure.
- Operating expense increased $10.4 million. Salary-related costs accounted for approximately $6.8 million of the increase, with additional increases in benefits and incentive compensation.
- General and administrative expense declined 8.0%, partly because a $3.2 million separation-agreement charge recorded in Q1 2011 did not recur. Q1 2012 included approximately $1.6 million related to a litigation settlement and an impairment charge for a smaller product.
- Operating cash flow declined primarily because annual bonus payments increased to $42.8 million from $37.5 million.
- The company repurchased 441,905 shares for approximately $26.9 million during the quarter and paid $5.0 million in dividends. The quarterly dividend was increased to $0.10 per share from $0.05 per share in the prior-year period.
Outlook, Commentary, Risks, and Unusual Items
- Management expects available cash, investments, and operating cash flow to meet operating and cash needs for at least the next 12 months.
- Management expects 2012 capital expenditures of approximately $24 million to $28 million, primarily for computer hardware and software, leasehold improvements, and capitalized software.
- Management expects recurring quarterly dividends of $0.10 per share in 2012. The company had repurchased 1,240,242 shares for $71.3 million under its authorization as of March 31, 2012, with approximately $228.7 million remaining under the program.
- Management estimates intangible-asset amortization of approximately $24.0 million in 2012 and $21.3 million in 2013. Stock-based compensation expense was $3.9 million in Q1 and was estimated at approximately $13.9 million for 2012 based on awards outstanding at March 31.
- The largest Investment Management client began managing several fund-of-funds portfolios in-house in April 2012. Those portfolios generated approximately $3.2 million of Q1 revenue and represented 8.7% of Investment Advisory Services assets under advisement and management at March 31.
- Key risks include financial-market volatility affecting asset-based fees, industry competition and consolidation, foreign-currency exposure, prolonged database or network outages, reputational damage, potential fiduciary or rating-related liability, challenges in non-U.S. operations, and competition from free or low-cost investment information.
- Morningstar is involved in litigation involving the Life's Good S.T.A.B.L. hedge fund rating, Egan-Jones, and Business Logic. Damages in the Life's Good matters are unspecified, and the company cannot predict the outcomes. The InvestPic patent litigation was resolved through a March 2012 license agreement.
- The company had $12.2 million of gross unrecognized tax benefits at March 31, 2012, of which $9.9 million would reduce income tax expense if recognized. Tax audits are ongoing in U.S. and non-U.S. jurisdictions.
- The company adopted the fair-value measurement amendments in ASU 2011-04 without a material impact and did not expect the 2012 goodwill-testing amendments to have a material effect.
Important Facts for Investors to Verify
- Whether revenue growth can continue while salary, bonus, benefit, and development costs grow faster than revenue.
- The effect of the major Investment Management client bringing fund-of-funds portfolios in-house after the quarter ended.
- Trends in Morningstar Direct, Advisor Workstation, Principia, Morningstar.com, and Structured Credit Ratings licenses and revenue.
- Whether weak operating cash flow and negative free cash flow were primarily timing-related from bonus payments or indicate a broader deterioration.
- Future share repurchases, dividend funding, and the company’s continued reliance on internal liquidity rather than debt financing.
- Potential exposure from the Life's Good, Egan-Jones, Business Logic, and tax matters, for which the filing does not provide a reliable loss estimate.
- Sensitivity to interest rates and foreign currency: management estimated that a 100-basis-point interest-rate change would affect investment-portfolio fair value by approximately $0.8 million and reported no currency hedging.