Morningstar, Inc. 2017 Q3 Form 10-Q Summary
Business context and reporting period
Morningstar provides investment research, data, software, advisory, investment management, retirement, credit ratings, and related products. Revenue is generated primarily from recurring subscriptions and licenses, asset-based fees, and transaction-based services. This unaudited Form 10-Q covers the three and nine months ended September 30, 2017, compared with the corresponding 2016 periods.
The company reports one operating segment. The December 2016 acquisition of PitchBook materially affected the 2017 comparison; PitchBook contributed $16.6 million of third-quarter revenue and $44.8 million for the first nine months.
Financial performance and liquidity
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Revenue | $229.9 million | $196.1 million | $668.6 million | $586.4 million |
| Operating income | $52.8 million | $44.2 million | $127.2 million | $130.9 million |
| Operating margin | 23.0% | 22.5% | 19.0% | 22.3% |
| Net income | $33.9 million | $30.2 million | $98.0 million | $90.7 million |
| Diluted EPS | $0.79 | $0.70 | $2.28 | $2.09 |
| Cash flow from operations | $62.5 million | $60.4 million | $164.7 million | $143.2 million |
| Free cash flow | $49.4 million | $42.3 million | $118.3 million | $95.7 million |
Q3 revenue increased 17.3%, operating income increased 19.7%, and diluted EPS increased 12.9%. For the first nine months, revenue increased 14.0%, while operating income declined 2.8% and operating margin contracted 3.3 percentage points.
At September 30, 2017, cash, cash equivalents, and investments totaled $324.0 million, including $270.3 million of cash and cash equivalents and $53.7 million of investments. Long-term debt was $205.0 million, down from $250.0 million at December 31, 2016. The company had $95.0 million of undrawn credit capacity under its $300.0 million facility and was in compliance with its leverage and interest-coverage covenants.
Approximately 73% of cash, cash equivalents, and investments was held outside the United States. Management stated that available liquidity, operating cash flow, and credit capacity should meet operating and cash needs for at least the next 12 months.
Material changes versus the prior comparable period
- Organic revenue increased 8.7% in Q3 and 7.0% for the first nine months, excluding acquisitions, divestitures, and foreign currency effects.
- License-based revenue increased 18.4% in Q3 and 15.5% for the first nine months. Asset-based revenue increased 10.0% and 10.1%, respectively; transaction-based revenue increased 31.1% and 10.5%.
- Morningstar Direct, Morningstar Data, Morningstar Investment Management, Workplace Solutions, Morningstar Managed Portfolios, and Morningstar Credit Ratings were primary growth contributors.
- Operating expenses increased 16.6% in Q3 and 18.9% for the first nine months. Sales and marketing and general and administrative expenses grew faster than revenue, while cost of revenue as a percentage of revenue declined.
- PitchBook contributed $18.5 million of Q3 operating expense and $53.9 million for the first nine months. Excluding PitchBook, adjusted operating income was $54.7 million in Q3 and $136.3 million for the first nine months.
- Morningstar sold HelloWallet in June 2017 and recorded a $17.5 million noncash gain. The sale did not qualify as a discontinued operation.
- The effective tax rate declined to 33.3% in Q3 from 35.3% and to 29.1% for the first nine months from 33.9%, partly because the HelloWallet book gain was not taxable and related deferred tax effects reduced the rate.
- The company repurchased 533,371 shares for $40.6 million during the first nine months and had approximately $286.5 million remaining under its repurchase authorization, which expired December 31, 2017.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide specific quantitative revenue, earnings, or margin guidance. Management cited continued equity-market strength and growth in subscription, data, advisory, and investment-management products, but described the financial-services environment as challenging because of low interest rates, the shift toward passive investing, fee pressure, and evolving fiduciary standards.
Management expected continued 2017 capital expenditures for computer hardware and software, internally developed software, and leasehold improvements. Estimated remaining 2017 intangible amortization was $5.6 million.
- The company is exposed to market volatility, asset-based fee fluctuations, foreign currency movements, interest-rate changes, technology outages, cybersecurity and data-related liabilities, regulatory changes, and risks associated with acquisitions and investments.
- No currency hedges or derivative instruments were in place. A 100-basis-point increase in LIBOR was estimated to increase annual interest expense by approximately $2.1 million.
- Morningstar faces a putative class-action RICO lawsuit filed in August 2017 concerning alleged steering of pension-plan participants into high-cost investments. The company moved to dismiss the complaint, but cannot predict the outcome.
- Gross unrecognized tax benefits were $18.1 million at September 30, 2017, and the company was under audit in multiple U.S. and non-U.S. jurisdictions.
- The company plans to adopt the new revenue-recognition standard on January 1, 2018 using the modified retrospective method. Management did not expect a material change in revenue timing, but was still evaluating principal-versus-agent and contract-cost effects.
- PitchBook was excluded from management’s internal-control assessment for the period; management was documenting and testing PitchBook controls for inclusion in the 2017 annual assessment. Other than this matter, no material changes in internal control were reported.
In October 2017, the board approved a quarterly dividend of $0.23 per share, totaling approximately $9.8 million.
Investor verification checklist
- Assess the sustainability of organic revenue growth after separating PitchBook contributions, foreign currency effects, and the HelloWallet divestiture.
- Monitor whether sales and marketing, compensation, stock-based compensation, amortization, and other integration costs continue to pressure margins.
- Verify the remaining share-repurchase authorization, dividend policy, debt repayments, LIBOR exposure, and compliance with credit-facility covenants.
- Evaluate the concentration of liquidity held outside the United States and the potential tax consequences of repatriation or permanently reinvested foreign earnings.
- Review the effects of adopting the new revenue-recognition standard in 2018 and the finalization of PitchBook’s purchase-price allocation.
- Track the HelloWallet sale tax effects, the Green litigation, tax audits, and any developments in regulatory or fiduciary-duty matters.