Morningstar, Inc. 2018 Q3 Form 10-Q Summary
Business context and reporting period
Morningstar provides subscription and license products, asset-based investment management and advisory services, and transaction-based products for investors, advisors, asset managers, retirement providers, and institutional investors. The filing covers the unaudited quarter and nine months ended September 30, 2018, compared with the same periods in 2017.
The company reports one operating segment. Revenue is primarily generated from recurring license-based products, including Morningstar Data, Morningstar Direct, Advisor Workstation, and PitchBook Data; asset-based services; and transaction-based products such as credit ratings, advertising, and conferences.
Financial performance and key metrics
| Metric | Q3 2018 | Q3 2017 | 9M 2018 | 9M 2017 |
|---|---|---|---|---|
| Revenue | $261.3 million | $229.9 million | $757.2 million | $668.6 million |
| Operating income | $65.4 million | $52.8 million | $166.5 million | $127.2 million |
| Operating margin | 25.0% | 23.0% | 22.0% | 19.0% |
| Net income | $56.9 million | $33.9 million | $140.6 million | $98.0 million |
| Diluted EPS | $1.32 | $0.79 | $3.27 | $2.28 |
| Cash flow from operations | $79.8 million | $62.5 million | $209.5 million | $164.7 million |
| Free cash flow | $60.2 million | $49.4 million | $154.3 million | $118.3 million |
Q3 revenue increased 13.6% and nine-month revenue increased 13.2%. Operating income increased 23.8% in Q3 and 30.9% for the nine-month period. Net income increased 67.8% in Q3 and 43.5% year to date. The effective tax rate declined to 22.1% in Q3 and 23.1% for the first nine months, compared with 33.3% and 29.1%, respectively, in the prior-year periods.
- License-based revenue increased 16.0% in Q3 to $196.7 million and 13.5% for nine months to $559.5 million.
- Asset-based revenue increased 9.3% in Q3 to $50.5 million and 11.9% for nine months to $149.9 million.
- Transaction-based revenue was essentially flat in Q3 at $14.1 million but increased 14.5% for nine months to $47.8 million.
- PitchBook Data revenue increased 52.2% in Q3 and 56.2% for nine months; PitchBook Platform licenses increased 62.7% year over year.
- Average assets under management and advisement declined to $205.5 billion in Q3 from $217.5 billion, while Morningstar Managed Portfolios assets increased 19.7% year over year to $45.6 billion.
- Capital expenditures were $19.6 million in Q3 and $55.2 million for nine months, up 49.6% and 19.0%, respectively.
Liquidity, debt, and capital allocation
Cash, cash equivalents, and investments totaled $366.7 million at September 30, 2018, including cash and cash equivalents of $323.0 million. Approximately 75% of cash, cash equivalents, and investments was held outside the United States.
Outstanding long-term debt was $90.0 million, down from $180.0 million at December 31, 2017, following $90.0 million of debt repayments during the first nine months. The company had $210.0 million of remaining availability under its $300.0 million revolving credit facility, which expires in November 2019. Morningstar was in compliance with its leverage and interest-coverage covenants.
The board approved a quarterly dividend of $0.25 per share payable October 31, 2018. The company repurchased 109,289 shares for $10.5 million during the first nine months under a $500.0 million authorization, leaving approximately $489.5 million available.
Material changes versus the prior comparable period
- Revenue growth was led by PitchBook Data, Morningstar Data, Morningstar Direct, and Morningstar Managed Portfolios.
- A $10.5 million license fee related to an amended license agreement increased Q3 and nine-month revenue and operating income without a commensurate increase in operating expense. Management stated that it contributed 3.1 percentage points to Q3 operating margin and 1.1 percentage points to the nine-month margin.
- Operating leverage improved as total operating expense grew 10.6% in Q3 and 9.1% for nine months, below revenue growth.
- Lower tax rates reflected the U.S. Tax Reform Act, including the reduction of the federal corporate tax rate from 35% to 21%.
- Non-operating results included a $5.6 million gain on the sale of part of Morningstar’s equity interest in Morningstar Japan in Q3 and a $10.5 million gain on the sale of a product line for the nine-month period. The prior-year nine-month period included a $17.5 million gain on the sale of HelloWallet.
- Foreign currency translation reduced comprehensive income by $20.2 million for the first nine months, compared with a $29.9 million increase in the prior-year period.
Accounting, outlook, risks, and unusual items
Morningstar adopted ASC Topic 606 on January 1, 2018 using the modified retrospective method. The adoption increased reported revenue and cost of revenue by $1.7 million in Q3 and $5.0 million for nine months because certain third-party content arrangements are now presented gross. It also created $24.0 million of deferred commission assets at September 30 and increased opening retained earnings by $17.0 million.
Contract liabilities were $203.6 million at September 30, 2018. The company expects to recognize approximately $518.0 million of revenue in future periods from contract liabilities and signed or partially satisfied contracts, subject to applicable exclusions and variable consideration.
Management believes available cash, investments, operating cash flow, and the credit facility will be sufficient for operating and cash needs for at least the next 12 months. The company expects continued capital expenditures and is migrating infrastructure to the cloud over several years, which may temporarily affect capital expenditures and operating expenses. The filing does not provide formal full-year revenue or earnings guidance.
- Key risks include market volatility affecting asset-based fees, pressure from passive investing and lower fees, technology and cybersecurity disruptions, data and intellectual-property liabilities, regulatory and fiduciary obligations, foreign currency exposure, employee retention, and execution of acquisitions and investments.
- The company is defending an amended putative class action alleging RICO violations related to investment-plan fees. Its motion to dismiss was awaiting a court ruling; management cannot predict the outcome.
- Tax accounting related to GILTI and other Tax Reform Act provisions remained subject to further analysis and interpretation. Gross unrecognized tax benefits were $12.6 million at September 30, 2018.
- ASC Topic 842 lease accounting was scheduled for adoption on January 1, 2019. The company was evaluating the impact and expected to use the permitted transition method.
- A 100-basis-point change in LIBOR was estimated to affect annual interest expense by approximately $0.9 million based on the outstanding debt balance.
Important facts for investors to verify
- How much of revenue and margin growth persists after the one-time $10.5 million amended-license fee.
- The sustainability of PitchBook growth, renewal rates, and Morningstar Data and Direct license expansion.
- The effect of shifting away from customized institutional asset management toward Managed Portfolios, including the impact on assets and asset-based fees.
- The ultimate tax effects of GILTI, foreign earnings, and remaining Tax Reform Act accounting estimates.
- The balance-sheet impact and operating-cost implications of cloud migration and the January 2019 lease standard adoption.
- Progress and potential exposure related to the pending litigation, foreign currency risk, and the company’s substantial cash held outside the United States.