Morningstar, Inc. annual report, FY2011

Morningstar, Inc. 2011 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2011. The filing was signed February 24, 2012. Although the request references 2011 Q4, this is an annual Form 10-K; fourth-quarter revenue was $158.6 million and net income attributable to Morningstar was $28.0 million.

Business Context

Morningstar provides independent investment data, software, research, ratings, and investment-management services globally. It operates in two segments: Investment Information and Investment Management, with operations in 27 countries and approximately 3,465 employees at year-end.

Investment Information revenue was $500.9 million, or 79.3% of consolidated revenue.
Investment Management revenue was $130.5 million, or 20.7% of consolidated revenue.
Non-U.S. revenue was $184.9 million, or 29.3% of consolidated revenue.
The five largest products accounted for approximately 59% of consolidated revenue; Licensed Data was the largest product at $106.7 million.

Key Financial Metrics

Metric	2011	2010	Change
Revenue	$631.4 million	$555.4 million	13.7%
Operating income	$138.4 million	$121.1 million	14.3%
Operating margin	21.9%	21.8%	0.1 percentage points
Net income attributable to Morningstar	$98.4 million	$86.4 million	13.9%
Diluted earnings per share	$1.92	$1.70	12.9%
Cash provided by operating activities	$165.0 million	$123.4 million	33.7%
Free cash flow	$141.7 million	$108.6 million	30.4%
Cash used for investing activities	$(110.8) million	$(87.9) million	Higher use
Cash used for financing activities	$(32.6) million	$12.5 million	Change driven by repurchases and dividends

Free cash flow is a non-GAAP measure defined by the company as operating cash flow less capital expenditures. Capital expenditures were $23.3 million in 2011.

Margins, Liquidity, and Capital Structure

Gross profit was $449.3 million and gross margin was 71.2%, down from 71.7% in 2010.
Operating expense increased 13.5% to $493.0 million. Compensation-related costs represented 44.2% of revenue, compared with 42.6% in 2010.
Investment Information operating margin declined to 26.3% from 28.7%; Investment Management operating margin improved to 53.4% from 51.5%.
Cash, cash equivalents, and investments totaled $470.2 million, including $200.4 million of cash and cash equivalents and $269.8 million of investments.
The filing states that Morningstar had not needed significant commercial credit and had not established material credit lines. It reports no significant debt financing; total liabilities were $315.1 million, largely consisting of deferred revenue, accrued compensation, and other operating liabilities.
Working capital was $341.4 million, and deferred revenue was $155.5 million.
The company paid $10.0 million of dividends and repurchased $40.7 million of common stock in 2011. The board expanded the share-repurchase authorization to $300 million in total; $44.5 million had been repurchased under the authorization through year-end.

Material Changes Versus the Prior Comparable Period

Organic revenue, excluding acquisitions and foreign-currency effects, increased 9.1% to $606.0 million. Acquisitions contributed approximately 2.8 percentage points and favorable currency translation contributed approximately 1.8 percentage points to reported growth.
Investment Management revenue grew 18.2%, faster than Investment Information revenue growth of 12.6%. Investment Management operating income increased 22.6%, while Investment Information operating income increased 3.0%.
Morningstar Direct revenue increased materially, with licensed users rising to 6,144 from 4,773. Advisor Workstation licenses increased to 160,287 from 157,395.
Morningstar.com Premium subscriptions declined to 130,354 U.S. subscribers from 138,149, although higher Internet advertising revenue supported product growth.
Revenue from asset-based fees increased to $81.7 million from $67.7 million and represented approximately 13% of consolidated revenue.
Total assets under advisement and management increased to $180.8 billion from $149.2 billion. Investment Consulting assets under advisement and management increased to $140.4 billion from $111.4 billion.
No acquisitions were completed in 2011, compared with seven acquisitions in 2010. The company instead focused on integrating prior acquisitions.
Non-operating income declined to $1.7 million from $6.7 million, primarily because 2010 included a $4.6 million holding gain related to Morningstar Denmark.
The effective tax rate declined to 30.7% from 33.1%, reflecting research and development credits, other incentives, tax-audit settlements, and recognized deferred tax benefits.
Stock-based compensation increased to $15.3 million from $13.8 million. The company recorded an approximately $0.8 million impairment charge on an acquired magazine masthead and $3.2 million of expense related to a former chief operating officer’s separation agreement.

Guidance, Outlook, Risks, and Unusual Items

Guidance: Management does not provide public financial forecasts or earnings guidance. The company expected approximately $25 million of 2012 capital expenditures, approximately $43 million of first-quarter 2012 annual bonus payments, and approximately $23.8 million of 2012 intangible-asset amortization. It also expected recurring quarterly dividends of $0.10 per share in 2012.

A major Investment Consulting client notified Morningstar on February 17, 2012 that it would move several fund-of-funds portfolios in-house in April 2012. These portfolios generated approximately $12.4 million of 2011 revenue, equal to 2.0% of consolidated revenue and 9.5% of Investment Management revenue, with a larger percentage impact on segment operating income.
Key operating risks include financial-market declines, reduced asset-based fees, European sovereign and currency risks, regulatory changes, fiduciary and investment-advice liability, cybersecurity and data-security failures, network outages, and strong competition.
The company does not hedge foreign-currency exposure. Europe represented approximately 16.3% of consolidated revenue, and the euro represented approximately 6.1% of consolidated revenue.
Morningstar had approximately $180.8 billion of assets under advisement and management, increasing potential exposure to fiduciary claims and market-related asset declines.
Significant litigation and regulatory matters included claims related to the Life’s Good S.T.A.B.L. hedge fund rating, an InvestPic patent case, an Egan-Jones dispute, Business Logic trade-secret claims, and a continuing New York Attorney General matter. The company did not estimate potential losses because no reasonable estimate could be made.
Subsequent events included a $6.7 million minority investment in HelloWallet in January 2012 and the client transition described above.
KPMG issued unqualified opinions on the 2011 consolidated financial statements and internal control over financial reporting. Management concluded that disclosure controls and internal control over financial reporting were effective.

Most Important Facts for Investors to Verify

Whether the loss of the large Investment Consulting client’s $12.4 million revenue and associated high-margin income materially affects 2012 results.
Whether Morningstar Direct, Licensed Data, Advisor Workstation, and other subscription or license products can sustain organic growth while Morningstar.com Premium subscriptions decline.
The sustainability of the 21.9% consolidated operating margin given employee growth, compensation costs, acquisitions, and ongoing technology investment.
The sensitivity of asset-based revenue and operating income to market performance, client flows, and the concentration of assets under advisement.
The company’s continued ability to generate operating cash flow while funding capital expenditures, dividends, repurchases, and potential acquisitions without material borrowing.
Developments in the disclosed litigation, tax audits, unrecognized tax benefits, and regulatory matters, none of which had a reasonably estimable loss amount at filing.