Morningstar, Inc. — Form 10-Q Summary
Business context and reporting period
Morningstar, Inc. filed an unaudited Form 10-Q for the quarter ended March 31, 2014. The company provides investment data, software, research, ratings, investment advisory, retirement, and asset-management products. It reports one operating segment and generates substantial recurring revenue through subscriptions and license agreements.
Investment information represented approximately 78% of first-quarter revenue, while investment management represented approximately 22%. International revenue was approximately 28% of consolidated revenue.
Financial performance and liquidity
| Metric | Q1 2014 | Q1 2013 | Change |
|---|---|---|---|
| Revenue | $181.2 million | $168.9 million | 7.3% |
| Operating income | $38.5 million | $40.6 million | (5.0%) |
| Operating margin | 21.3% | 24.0% | (2.7 percentage points) |
| Net income attributable to Morningstar | $26.4 million | $29.6 million | (10.9%) |
| Diluted earnings per share | $0.58 | $0.63 | (7.9%) |
| Cash provided by operating activities | $11.9 million | $26.7 million | (55.4%) |
| Capital expenditures | $20.8 million | $9.1 million | 128.0% |
| Free cash flow | $(8.9) million | $17.6 million | Declined $26.5 million |
Investment information revenue increased 4.6% to $141.3 million, and investment management revenue increased 18.1% to $39.9 million. The company reported an additional $1.7 million of investment management revenue from a change in accounting estimate for certain minimum-fee contracts; this revenue is not expected to recur.
As of March 31, 2014, cash and cash equivalents were $204.6 million and investments were $59.3 million, for total cash, cash equivalents, and investments of approximately $264.0 million. Total current assets were $424.9 million versus current liabilities of $247.9 million. The filing states that the company had not borrowed under significant credit lines and expected available liquidity and operating cash flow to meet operating and cash needs for at least the next 12 months.
Total liabilities were $310.7 million and total equity was $696.7 million. The filing does not identify material traditional debt balances. The company paid $7.6 million of dividends and repurchased 282,307 shares for $21.7 million during the quarter. The share-repurchase program had approximately $228.5 million remaining authorization at March 31, 2014.
Material changes versus the prior comparable period
- Revenue grew 7.3%, led by Morningstar Data, Morningstar Direct, Morningstar Advisor Workstation, Retirement Solutions, and Morningstar Managed Portfolios.
- Operating expenses increased 11.2%, faster than revenue, reducing operating margin from 24.0% to 21.3%.
- Compensation expense increased by approximately $8.9 million, primarily due to additional headcount. Worldwide headcount increased approximately 5.8% to 3,645.
- A revised sales commission structure resulted in additional quarterly commission expense of approximately $2.7 million and is expected to increase expense for several subsequent quarters.
- Approximately 180 positions were reclassified among expense categories following a centralized organizational restructuring. This shifted approximately $7 million of compensation expense into cost of revenue and approximately $4 million and $3 million out of sales and marketing and general and administrative expense, respectively, without affecting total operating expense or operating income.
- Operating cash flow decreased substantially because of lower earnings, higher income-tax payments, bonus payments, and working-capital movements. Capital expenditures were unusually high, producing negative free cash flow.
- The effective tax rate increased to 34.1% from 29.6%, primarily because the prior-year period benefited from deferred-tax benefits and additional tax credits and incentives.
- The company adopted two tax and foreign-currency accounting updates effective January 1, 2014; neither had a material effect on the financial statements.
- On April 1, 2014, after quarter-end, Morningstar acquired ByAllAccounts, Inc. for $28 million in cash, subject to post-closing adjustments.
Guidance, outlook, commentary, risks, and unusual items
Management expected quarterly capital expenditures to be lower for the remainder of 2014 after unusually high first-quarter spending. It expected to pay a recurring quarterly dividend of $0.17 per share during 2014 and stated that liquidity was sufficient for at least the next 12 months.
Management cited generally favorable equity-market performance and growth in mutual-fund and exchange-traded-fund assets, but described the financial-services environment as challenging because of regulatory burdens, low interest rates, cautious client spending, and pressure on variable-annuity businesses. Investment Advisory assets under advisement declined $12.0 billion year over year as some clients brought fund-of-funds management in-house.
Key operating risks include competition and technological change, service or network outages, data privacy and cybersecurity exposure, regulatory and compliance changes, market volatility affecting asset-based fees, foreign-currency movements, international operating risks, and reputational or litigation-related liabilities. The company does not currently hedge its foreign-currency exposure.
Morningstar is defending litigation related to the Life's Good S.T.A.B.L. hedge fund. A receiver sought contribution toward a $14.5 million disgorgement judgment, but Morningstar contested liability and recorded no estimated loss because the outcome and potential loss could not reasonably be estimated. In the Business Logic litigation, the company's estimated possible compensatory loss range was $0 to $5.4 million, excluding potential punitive damages and attorneys' fees; a jury trial was scheduled for July 7, 2014.
Approximately 57% of cash, cash equivalents, and investments were held outside the United States for tax purposes, while management stated that U.S. liquidity was sufficient without foreseeable repatriation. Unrecognized tax benefits totaled $11.1 million, and the company was subject to tax audits in multiple jurisdictions.
Important facts for investors to verify
- Whether revenue growth can continue after excluding the nonrecurring $1.7 million investment-management revenue benefit and acquisition effects.
- Whether operating margins recover after increased hiring, bonus expense, commission expense, and other compensation-related costs.
- The timing and magnitude of capital expenditures, internally developed software spending, and resulting free cash flow.
- Progress on the ByAllAccounts integration and its contribution to revenue and expenses.
- Developments and potential exposure in the Life's Good S.T.A.B.L. and Business Logic legal proceedings.
- The sustainability of asset-based revenue given the decline in Investment Advisory assets and continuing variable-annuity pressure.
- Future share repurchases, dividends, and the effect of capital returns on liquidity and diluted share count.
- Foreign-currency exposure, international cash balances, tax audits, and unrecognized tax benefits.