Business Context and Reporting Period
This Form 8-K is a current report filed by Morningstar, Inc. on March 1, 2013. The filing serves as a Regulation FD disclosure containing responses to investor questions regarding the company's business operations and financial performance for the period ending December 31, 2012, with specific focus on the fourth quarter of 2012.
Key Financial Metrics
- Deferred Revenue: Ended 2012 at $146 million, representing an 11% decline from the third quarter and a 6% decline from the prior year.
- Investment Management Segment Revenue: Reported at $32 million for the fourth quarter of 2012, essentially flat (+0.2%) compared to the third quarter.
- Operating Margin Drivers (2012): Incremental margins were boosted by 1.3 percentage points due to lower bonus expense and 0.5 percentage points due to capitalized software expense. Conversely, a one-time $3.2 million stock-based compensation charge for accelerated vesting reduced margins.
- Asset Levels: Investment Advisory Services assets declined from $142 billion to $94 billion. Variable annuity industry assets stood at approximately $1.5 trillion as of year-end 2012.
- Fee Structures: Mutual fund and ETF portfolio fees range from 30 to 40 basis points; Select Stock Baskets are charged at 55 basis points. Specific fee ranges for Investment Advisory Services and Retirement Solutions are not disclosed.
Material Changes and Operational Drivers
- Deferred Revenue Adjustment: The decline in deferred revenue was primarily driven by a $17.5 million reduction resulting from a change in accounting interpretation for certain installment-based subscriptions and licenses. Management stated this was not material to free cash flow or working capital.
- Revenue Growth Resumption: Fourth-quarter sales growth resumed, driven largely by Morningstar Direct (accounting for nearly one-third of the year-over-year increase), Equity Data, Structured Credit Ratings, and Morningstar Managed Portfolios. Investment Advisory Services and individual software (Premium Memberships) were exceptions to this growth trend.
- Investment Management Segment Pressure: Sequential revenue flatness in the fourth quarter was attributed to a change in the scope of services for an existing client, which reduced assets by approximately $42.9 billion. The loss of a client in April 2012 was already fully reflected in prior quarters.
- Client Diversification: The largest customer for Investment Advisory Services accounted for 11% of segment revenue in 2012. Exposure to the variable annuity industry declined from 15% of segment revenue in 2012 to less than 10% in the fourth quarter.
Outlook, Risks, and Management Commentary
- Variable Annuity (VA) Outlook: Management expects continued pressure on revenue from VA clients due to record-low interest rates increasing liabilities for providers. While the industry remains sizeable, many providers are exiting or halting sales. Management does not know the duration of this retrenchment but expects it to persist.
- Margin Sustainability: Management views the high incremental operating margins of 2012 as partially dependent on specific items (lower bonuses, capitalized software). Future margin improvement is expected to correlate with revenue growth.
- Strategic Focus: The company is actively diversifying its revenue stream across a greater number of clients and expanding product offerings to reduce volatility.
- Risks: Key risks include global financial uncertainty, market volatility impacting asset-based fees, reputation damage from conflict of interest claims, industry consolidation, and the availability of free investment information.
Investor Verification Checklist
- Verify the impact of the $17.5 million deferred revenue accounting change on future cash flow projections.
- Monitor the trajectory of the $42.9 billion asset reduction in the Investment Management segment and its effect on recurring revenue.
- Assess the sustainability of operating margins excluding the one-time $3.2 million stock-based compensation charge and bonus expense fluctuations.
- Track the percentage of revenue derived from the variable annuity industry to gauge exposure to sector-specific headwinds.
- Confirm the rate of client diversification to reduce reliance on the top customer (currently 11% of Investment Advisory Services revenue).