Morningstar, Inc. 2012 Second-Quarter Form 10-Q Summary
Business context and reporting period
Morningstar, Inc. filed an unaudited Form 10-Q for the quarter and six months ended June 30, 2012. The company operates through two segments: Investment Information, which provides investment data, software, research, ratings, and related services; and Investment Management, which provides asset management, advisory, retirement, and managed portfolio services. Many offerings generate recurring subscription or license revenue.
Key financial metrics
| Metric | Three months ended June 30 | Six months ended June 30 |
|---|---|---|
| Revenue | $166.0 million, up 3.1% | $326.7 million, up 4.5% |
| Operating income | $41.1 million, up 6.6% | $71.5 million, up 1.6% |
| Operating margin | 24.8%, versus 24.0% | 21.9%, versus 22.5% |
| Net income attributable to Morningstar | $27.9 million, versus $26.5 million | $48.0 million, versus $49.0 million |
| Diluted earnings per share | $0.56, versus $0.52 | $0.95, versus $0.96 |
| Cash flow from operating activities | $49.2 million | $54.8 million, versus $61.2 million |
| Free cash flow | $40.2 million, down 7.3% | $36.9 million, down 30.1% |
Gross margin was 70.2% in the second quarter and 69.5% year to date, down from 71.9% and 72.6%, respectively. The decline primarily reflected cost of goods sold increasing faster than revenue. The effective tax rate increased to 34.6% in the quarter and 35.3% year to date, compared with 32.5% and 32.2% in the prior-year periods.
As of June 30, 2012, cash and cash equivalents were $147.5 million and investments were $242.4 million, for combined cash, cash equivalents, and investments of approximately $389.9 million. Total assets were $1.106 billion and total liabilities were $308.6 million. The filing does not report significant borrowings or debt; management stated that the company had not needed significant commercial credit or established lines of credit.
Cash flow was affected by $42.8 million of annual bonus payments, $17.9 million of capital expenditures, $10.0 million of dividends, approximately $105.4 million of share repurchases, and approximately $6.8 million invested in HelloWallet. Capital expenditures were substantially higher than in the prior-year period. Management expected 2012 capital expenditures of approximately $28 million to $31 million.
Material changes versus the prior comparable period
- Investment Information revenue increased 5.2% in the quarter and 5.3% year to date. Investment Information operating income increased 15.9% in the quarter and 3.3% year to date.
- Investment Management revenue decreased 5.1% in the quarter but increased 1.2% year to date. Segment operating income decreased 27.1% in the quarter and 13.4% year to date, while operating margin fell to 43.2% from 56.2% in the quarter and to 47.3% from 55.3% year to date.
- A major Investment Management client moved several fund-of-funds portfolios in-house in April 2012. Revenue from those portfolios declined to approximately $0.6 million in the quarter from $3.2 million in the prior-year quarter, and to $3.8 million year to date from $6.2 million.
- Morningstar Direct and Morningstar Data were the leading contributors to Investment Information growth. Morningstar Direct licenses increased to 6,771 from 5,442 at June 30, 2011.
- Morningstar.com revenue declined because of weak advertising markets and lower U.S. Premium subscriptions. U.S. Premium subscriptions fell to 126,410 from 136,008 at June 30, 2011.
- Operating expense increased 2.0% in the quarter and 5.3% year to date. Higher salaries, benefits, production costs, professional fees, and headcount were partly offset by lower bonus expense.
- Share repurchases materially reduced liquidity. The company repurchased 1.862 million shares for approximately $109.5 million during the first half, and 2.661 million shares for approximately $153.9 million cumulatively under the program through June 30, 2012.
- Quarterly dividends increased to $0.10 per share from $0.05 per share in the prior-year period. Management expected recurring quarterly dividends of $0.10 per share during 2012.
- Comprehensive income attributable to Morningstar declined to $18.5 million in the quarter and $46.7 million year to date, primarily because of unfavorable foreign currency translation adjustments.
Guidance, outlook, risks, contingencies, and unusual items
Management believed available cash, investments, and operating cash flow would be sufficient to meet operating and cash needs for at least the next 12 months. The filing did not provide formal revenue or earnings guidance. Management expected approximately $28 million to $31 million of 2012 capital expenditures, approximately $23.8 million of 2012 intangible amortization, and approximately $15.6 million of 2012 stock-based compensation expense, subject to changes in grants, forfeitures, acquisitions, useful lives, and currency movements.
Management cited slowing economic growth, the European debt crisis, financial-market volatility, cautious spending, pressure in the variable-annuity market, and low interest rates as adverse industry conditions. Asset-based fee revenue is exposed to market levels and volatility. Other identified risks include competition, financial-services consolidation, reputational damage, alleged fiduciary-duty breaches, data-security or privacy issues, network and database outages, non-U.S. operating challenges, foreign exchange movements, and free or low-cost competing investment information.
Material contingencies include litigation relating to the Life's Good S.T.A.B.L. hedge fund rating, the Egan-Jones data-sharing agreement, and alleged trade-secret misappropriation claims by Business Logic. The New York Attorney General matter remained unresolved. Morningstar stated that it could not predict the outcomes and had not accrued an estimated loss because no reasonable estimate could be made.
Gross unrecognized tax benefits were $12.4 million at June 30, 2012, of which $12.1 million would affect income tax expense if recognized. The company was under examination by U.S. and non-U.S. tax authorities. Approximately 25% of cash, cash equivalents, and investments were held outside the United States, and the company had not recorded deferred tax liabilities on certain permanently reinvested foreign earnings.
The company adopted updated fair-value measurement guidance without a material impact. No significant goodwill or equity-method investment impairment losses were recorded in the first half of 2012.
Important facts for investors to verify
- Whether Investment Information growth, particularly Morningstar Direct and Morningstar Data, offsets continued weakness in Morningstar.com and other products.
- The ongoing revenue and margin impact of the lost Investment Management client and the segment's elevated operating expenses.
- Whether higher capital spending and bonus payments continue to depress free cash flow.
- The pace and valuation of further share repurchases relative to cash generation and the remaining authorization.
- Exposure to foreign currency translation, market volatility, interest-rate changes, and asset-based fee revenue.
- Developments and potential financial or reputational consequences from the disclosed litigation, regulatory investigations, and tax audits.
- The filing's non-GAAP organic revenue and free cash flow measures, including the company's definitions and comparability with other issuers.