Business Context and Reporting Period
Company: Morningstar, Inc.
Filing Type: Form 8-K (Current Report)
Date of Report: August 8, 2008
Reporting Period: Second Quarter 2008 (ended June 30, 2008)
Context: This filing serves as a Regulation FD disclosure containing management's responses to investor questions regarding Q2 2008 financial performance, operational metrics, and strategic initiatives.
Key Financial Metrics and Operational Data
- Revenue Impact of Client Loss: A single Investment Consulting client contract expiring in October 2008 represents approximately $11.3 million, or 2%, of consolidated revenue for the 12 months ended June 30, 2008.
- Capital Expenditures (Q2 2008): Total spend was $10.6 million. Approximately 75% was allocated to the new Chicago headquarters, with the remainder for computer equipment, software, and leasehold improvements.
- Capital Expenditures (Full Year 2008 Guidance): Management expects total capex of approximately $55 million, including roughly $40 million for the new office build-out.
- Legal Expense: Declined by approximately $0.8 million year-over-year in Q2 2008.
- Effective Tax Rate: Reduced by 1.6 percentage points in Q2 2008 and 0.7 percentage points for the first half of 2008 due to tax benefits from incentive stock-option transactions (disqualifying dispositions).
- Deferred Revenue: As a percentage of revenue, deferred revenue was 108% in Q2 2008, down from 121% in the prior year and 115% in the prior quarter.
- Client Concentration: In 2007, five clients each contributed at least 2% to consolidated revenue. The departing client is one of these five but not the largest.
Material Changes and Segment Performance
- Operating Margin Improvement: Consolidated operating margin improved in Q2 2008 driven by lower bonus expense, legal expense, and general and administrative (G&A) expenses as a percentage of revenue. Additionally, product implementation expenses for the "Advice by Ibbotson" service declined.
- Bonus Expense: The bonus pool size decreased, reflecting the company's policy of basing the pool on full-year operating income growth relative to the prior year. Management noted this is a self-correcting mechanism in challenging revenue environments.
- Individual Segment Growth: Internal growth accelerated, driven by Morningstar.com Premium Membership (aided by a ~9% price increase in January 2008) and Internet advertising sales. Morningstar Equity Research (Global Analyst Research Settlement) also contributed to growth due to an expanded coverage universe.
- Acquisition Integration: Cost savings from the Standard & Poor's fund data acquisition (March 2007) are largely realized. The Hemscott acquisition (January 2008) was primarily strategic for global equity database capabilities, though some cost synergies were achieved.
Outlook, Risks, and Management Commentary
- Client Retention: Management does not provide specific forecasts for retention rates but noted that rates in 2008 have been consistent with previous levels (historically 95%-100% for contract-based products). The company is seeking to replace the $11.3 million lost contract but cannot predict if new business will fully offset the loss.
- Expense Flexibility: The business model features high fixed costs and low variable costs. In a challenging revenue environment, expense flexibility is limited primarily to hiring freezes, reduced salary increases, and the variable bonus plan.
- Tax Rate Outlook: Management does not forecast the effective tax rate. Future rates may be higher than the first half of 2008 if the variable benefit from stock-option exercises does not recur. However, the lower U.S. state tax rate (due to 2007 law changes) is expected to remain a benefit.
- Global Analyst Research Settlement: The contract expires in July 2009. While the company intends to maintain broad coverage, the total number of companies covered may decrease post-settlement. The business has higher margins than the segment average due to low variable costs.
- Headcount Exposure: Morningstar believes it is less exposed to industry-wide headcount reductions than investment banking-focused providers, as its clients are primarily asset managers. However, Morningstar Direct, Principia, and Advisor Workstation could face pressure if financial advisors reduce technology budgets.
Key Facts for Investor Verification
- Verify the impact of the $11.3 million Investment Consulting contract loss on full-year 2008 revenue and operating income guidance.
- Monitor the sustainability of the Q2 2008 effective tax rate, specifically the volatility introduced by incentive stock-option disqualifying dispositions.
- Track the progress of the new Chicago headquarters build-out against the $40 million budgeted capex for 2008.
- Assess the renewal rate of the Global Analyst Research Settlement clients as the July 2009 expiration approaches.
- Review the trend in deferred revenue as a leading indicator of future revenue growth, given the decline to 108% of revenue in Q2.