Business Context and Reporting Period
This Form 8-K, filed on September 6, 2017, by Morningstar, Inc., serves as a Regulation FD disclosure containing responses to investor inquiries regarding the company's second quarter of 2017 performance and strategic outlook. The filing addresses operational metrics, revenue drivers, and the integration of the PitchBook acquisition.
Key Financial Metrics
- Revenue Growth: Q2 2017 revenue increased $20 million sequentially from Q1 2017. Organic revenue grew 9.2% year-over-year compared to Q2 2016.
- Cost of Revenue: Decreased by $2 million sequentially in Q2 2017, driven by higher levels of capitalized software development.
- Gross Margin: Improved approximately 470 basis points sequentially. Management noted this was influenced by capitalization policies and expects margins to vary based on development activity and headcount.
- Capitalized Software: Increased to $24 million year-to-date through Q2 2017, compared to $12 million in the same period of 2016.
- Assets Under Management (AUM): Total Investment Management AUM/AUA reached $96 billion in 2016, including a $4 billion inflow into Managed Portfolios.
- PitchBook Impact: The acquisition reduced Morningstar's operating margin by approximately three percentage points for the first six months of 2017 due to incremental expenses and amortization.
Material Changes and Revenue Composition
Revenue growth in Q2 2017 was broad-based across all major categories, with no significant one-time items boosting the rate:
- License-based Revenue: Increased 16.5% year-over-year, representing nearly three-fourths of consolidated revenue. Growth was driven by Morningstar Data, Direct, Advisor Workstation, and PitchBook.
- Asset-based Revenue: Expanded 13.5% year-over-year, comprising about 20% of consolidated revenue, driven by Managed Portfolios and Workplace Solutions.
- Transactional Revenue: Increased 13.1% year-over-year, making up about 7% of revenue, primarily from Morningstar Credit Ratings.
- Strategic Shift: The company has shifted focus from legacy institutional asset management (which saw revenue declines) to Morningstar Managed Portfolios, which now accounts for approximately two-thirds of Investment Management revenue.
Guidance, Outlook, and Risks
Management Commentary and Outlook
- Long-term Revenue Targets: Management reaffirmed expectations that Morningstar Direct and Morningstar Indexes will each add at least $100 million in annual revenue over the next 10 years.
- Product Migration: The migration of Morningstar Advisor Workstation users to the Morningstar Direct platform is expected to be revenue neutral over time.
- Fee Pressure: While acknowledging industry-wide pricing pressure on asset-based fees, management believes expanding assets under management will offset fee compression. Plans include launching low-cost collective investment trusts (CITs).
- Equity Research: The business is profitable on a stand-alone basis and growing faster than the company's overall rate. Management anticipates potential tailwinds from MiFID II as traditional sell-side brokers exit the space, though overall research spending may decline.
- Capitalization Trends: The high level of capitalized software in 2017 is viewed as a re-investment year; the company does not expect this rate of increase to continue in future years.
Risks and Contingencies
- Operational Risks: Risks include database outages, failure to maintain brand independence, and challenges in offshore operations (China and India).
- Market Risks: Exposure to market volatility affecting asset-based fees and trends toward passively managed investment vehicles.
- Regulatory Risks: Compliance failures and changes in laws affecting investment advisory or credit rating operations.
Investor Verification Checklist
- Verify the sustainability of the 470 basis point sequential gross margin improvement given the reliance on capitalized software development.
- Monitor the integration progress of PitchBook and its trajectory toward matching the corporate operating margin profile.
- Track the execution of the $100 million revenue targets for Morningstar Direct and Indexes over the 10-year horizon.
- Assess the impact of MiFID II implementation in 2018 on the profitability and growth of the Equity Research segment.
- Review future quarterly reports for the stabilization of capitalized software expenses as the company moves past the 2017 re-investment phase.