Morningstar, Inc. annual report, FY2013

Business Context and Reporting Period

Morningstar, Inc. filed this Form 10-K for the fiscal year ended December 31, 2013. The company provides independent investment research, data, software, ratings, advisory, retirement, and investment-management services across 27 countries for financial advisors, asset managers, retirement providers and sponsors, and individual investors. Management revised the reporting structure in 2013 to one reportable segment.

The filing includes fourth-quarter 2013 results. Morningstar does not provide public financial forecasts or earnings guidance.

Financial Results and Key Metrics

Metric	FY 2013	FY 2012	Change
Revenue	$698.3 million	$658.3 million	6.1%
Operating income	$170.7 million	$150.7 million	13.3%
Operating margin	24.4%	22.9%	+1.5 percentage points
Net income attributable to Morningstar	$123.5 million	$108.1 million	14.3%
Diluted EPS	$2.66	$2.20	20.9%
Cash flow from operations	$186.7 million	$146.0 million	27.9%
Capital expenditures	$33.6 million	$30.0 million	11.8%
Free cash flow	$153.1 million	$116.0 million	32.0%

Fourth-quarter 2013 revenue was $180.5 million, compared with $170.6 million in the fourth quarter of 2012. Fourth-quarter operating income was $41.9 million versus $39.3 million, and diluted EPS was $0.68 versus $0.69, excluding the 2012 discontinued-operations gain from the quarterly comparison.

Investment information revenue increased 5.6% to $555.6 million, while investment-management revenue increased 7.9% to $142.6 million. Major product revenue included Morningstar Data of $129.3 million, Advisor Workstation of $93.1 million, Morningstar Direct of $79.4 million, Investment Advisory of $59.2 million, and Morningstar.com of $55.6 million.

Revenue from asset-based fees was $88.6 million, or approximately 12.7% of consolidated revenue, compared with $81.4 million, or 12.4%, in 2012. Contract-based renewal rates were estimated at 90% to 95%; subscription retention was estimated at 65% to 70%.

Liquidity, Capital Resources, and Balance Sheet

Cash, cash equivalents, and investments totaled $298.6 million at December 31, 2013, down from $321.4 million at year-end 2012.
Working capital was $166.6 million, compared with $217.2 million in 2012.
Deferred revenue was $149.2 million, providing a source of future revenue recognition and reflecting customer billings collected in advance.
Total liabilities were $339.4 million and total equity was $691.3 million.
Management stated that available liquidity, operating cash flow, and outside sources should meet operating and other cash needs for at least the next 12 months.
The company had not needed significant commercial credit and had not borrowed under its lines of credit; the filing does not disclose material funded debt.
Morningstar repurchased approximately 2.0 million shares for $153.5 million in 2013. The repurchase authorization totaled $700 million, with approximately $230 million remaining available as of February 21, 2014.
Cash dividends paid in 2013 were $17.4 million. The company expected regular quarterly dividends of $0.17 per share in 2014, subject to board approval.

Material Changes Versus the Prior Comparable Period

Revenue growth accelerated to 6.1% from 4.3% in 2012; organic revenue increased 6.7%, after a $3.6 million unfavorable foreign-currency effect.
Operating margin expanded despite a 10.0% increase in cost of revenue. The company attributed improvement partly to lower salary expense as a percentage of revenue, lower stock-based compensation, and lower amortization.
Expense-category changes associated with the centralized organization shifted approximately $14 million of compensation expense into cost of revenue, with approximately $8 million and $6 million shifted out of sales and marketing and general and administrative expense, respectively. These changes did not affect total operating expense or operating income.
Morningstar Direct revenue increased 21.6%, supported by growth in licensed users to approximately 8,500 from 7,400. Advisor Workstation licenses increased 4.1% to approximately 170,000.
Investment Advisory revenue declined 10.8% to $59.2 million. Assets under advisement declined to $83.5 billion from $94.3 billion, primarily because variable-annuity clients brought some fund-of-funds portfolios in-house.
Retirement Solutions assets under management and advisement increased to $65.6 billion from $47.2 billion, while Morningstar Managed Portfolios assets increased to $7.3 billion from $4.7 billion.
Morningstar acquired the remaining 76% of Morningstar Sweden for $14.6 million in cash, becoming its sole owner. The transaction generated a $3.6 million non-cash holding gain and added $8.9 million of goodwill.
Principia subscriptions declined 28.4%. Morningstar stopped selling new Principia subscriptions and planned to migrate customers to Advisor Workstation and other products through the end of 2014.
Weighted-average diluted shares declined to 46.5 million from 49.1 million, principally reflecting share repurchases.

Guidance, Outlook, Commentary, Risks, and Unusual Items

Management emphasizes investment in a next-generation software architecture, beginning with Morningstar Direct in 2014, along with expansion of global fund, equity, credit, retirement, and investment-management capabilities. The company expects significant 2014 capital expenditures, including technology, software, facilities, and potentially material network and systems-security investments. It also expected approximately $40 million of 2013 bonus payments in the first quarter of 2014.

Management cited continued opportunity from growth in data, software, retirement solutions, managed portfolios, passive investments, regulatory-driven demand for independent advice, and international expansion. At the same time, the filing notes pressure from financial-services clients' cautious spending, variable-annuity weakness, increasing regulation, and continued investor migration toward passive products.

Asset-based revenue and operating income are exposed to market declines, portfolio outflows, and changes in assets under management or advisement.
Morningstar faces substantial competition from larger providers with greater financial and technology resources.
Technology failures, cyberattacks, privacy breaches, Internet outages, or problems at concentrated development and data facilities in China and India could disrupt operations and create liability.
Investment-advisory and retirement operations may create fiduciary, ERISA, broker-dealer, NRSRO, and other regulatory exposure. Potential liabilities from advisory services could be substantial and cannot be quantified precisely.
Pending litigation includes claims related to the Life's Good S.T.A.B.L. hedge fund rating. The receiver sought contribution toward a $14.5 million SEC disgorgement judgment; Morningstar estimated no loss because the outcome was not reasonably estimable.
Business Logic litigation involves alleged contract and trade-secret violations. Morningstar estimated a possible compensatory loss range of $0 to $5.4 million, excluding punitive damages and attorneys' fees, while the opposing expert estimated $84 million. Injunctive-relief exposure was not reasonably estimable.
Non-cash or unusual items in 2013 included a $3.6 million holding gain from the Morningstar Sweden step acquisition and a $4.2 million net gain on investment sales.

Most Important Facts for Investors to Verify

Confirm that annual and fourth-quarter results are not being conflated: the filing is a full-year 10-K, while Q4 revenue was $180.5 million and Q4 operating income was $41.9 million.
Assess the sustainability of margin expansion after the reorganization-related expense reclassification and the nonrecurring investment and acquisition gains.
Track Morningstar Direct, Data, Advisor Workstation, Retirement Solutions, and Managed Portfolios growth against continued weakness in Investment Advisory and Principia.
Evaluate exposure to market levels because asset-based fees represented approximately 12.7% of 2013 revenue and a larger percentage of operating income.
Review cash deployment, including $153.5 million of 2013 repurchases, planned dividends, approximately $40 million of bonus payments, and expected technology and security spending.
Monitor the Life's Good and Business Logic proceedings, regulatory obligations, fiduciary exposure, and the absence of a reasonably estimable loss for certain claims.
Consider foreign-exchange risk, as approximately 28% of revenue was international and the company did not hedge currency exposure.
Note governance concentration: Chairman and CEO Joe Mansueto owned approximately 55% of outstanding common stock as of December 31, 2013.