MORN

Business Context and Reporting Period

Company: Morningstar, Inc.
Filing Type: Form 8-K (Current Report)
Date of Report: August 5, 2014
Reporting Period: This filing serves as a Regulation FD disclosure containing responses to investor questions received through July 30, 2014. It addresses financial performance and strategic initiatives for the first half of 2014 and provides context for the full fiscal year.

Key Financial Metrics

Revenue and Profitability:

• 2013 Revenue: $698.3 million (6.1% increase over 2012; 6.7% organic growth).
• 2013 Operating Income: $171 million (up from $139 million in 2008).
• Revenue Composition (H1 2014): Approximately 81% recurring revenue, 12% asset-based fees, and 6% one-time/transaction-based revenue.
• Profitability Impact: Profitability in 2014 is below prior years due to heavy investment in business initiatives and a significant litigation settlement.

• Cash Balance (June 30, 2014): Total cash, cash equivalents, and investments were $221 million. Approximately 31% was held in the United States.
• Excess Cash Definition: Management considers balances exceeding roughly $100 million as "excess."
• Credit Facility: Entered into a $75 million revolving credit facility in the U.S. for general corporate purposes.
• Share Repurchases: $36.7 million in the first six months of 2014 (compared to $90.7 million in Q4 2013).

• Capital Expenditures (H1 2014): $30.8 million (vs. $18.9 million in H1 2013). Includes $8.5 million in capitalized software costs.
• Headcount: Increased by approximately 375 employees year-over-year to ~3,800 globally as of June 30, 2014.
• Compensation: Accounts for more than two-thirds of total operating expense.

Material Changes and Unusual Items

Legal Settlement (Business Logic):

• Morningstar settled intellectual property infringement claims with Business Logic for $61.0 million.
• This expense was recorded in the second quarter of 2014, significantly increasing operating expenses.
• Payment schedule: $15.0 million paid in July 2014; remaining $46.0 million to be paid in August 2014.
• The settlement is tax-deductible, which is expected to reduce income tax payments in the second half of 2014.

• ByAllAccounts (April 2014): Acquired 81.3% interest to enhance data aggregation capabilities for financial advisors.
• HelloWallet (June 2014): Acquired remaining ownership interest to expand retirement solutions and financial wellness tools.
• Financial Impact: These acquisitions added approximately $2.6 million in revenue and $4.9 million in operating expenses in Q2 2014. They are currently not accretive to shareholders.

• Software Replatforming: Major investment in next-generation software platforms (cloud migration, mobile access, unified architecture) began ~4 years ago. This is a multi-year initiative.
• Commission Accounting Change: Shifted to expensing commissions as incurred rather than amortizing them, increasing reported commission expense by $5.0 million in H1 2014.
• Headcount Expansion: Hiring focused on product management, technology, and data analysts to support strategic initiatives.

Guidance, Outlook, and Risks

Guidance Policy:

Morningstar does not issue financial forecasts or guidance. Management declined to provide specific revenue growth targets or long-term profitability ranges.

• Growth Drivers: Focus on Retirement Solutions, Morningstar Managed Portfolios, credit research/ratings, institutional software, and holistic advisor solutions.
• Industry Context: Industry-wide spending on financial information grew only 1.1% in 2013. Morningstar aims to grow faster than the industry despite a larger revenue base.
• Passive Investing: Rising market share of passive investments is putting pressure on asset management firm spending, indirectly affecting Morningstar. The company is increasing development in "strategic beta" to address this.

• Technology Risks: Risks associated with prolonged outages, failures in electronic delivery systems, and the complexity of the ongoing software replatforming.
• Competitive Landscape: Competition from large distributors (Bloomberg, S&P, Thomson Reuters) and specialized firms. Risk of clients bringing work in-house.
• Regulatory Environment: Changes in laws regarding investment advisory, credit ratings, and compliance (e.g., MiFID II, Solvency II) create both risks and opportunities.
• Offshore Operations: Concentration of development work in China and India poses operational challenges.

Investor Verification Checklist

• Settlement Impact: Verify the full $61.0 million Business Logic settlement payment schedule and its specific impact on Q3 2014 cash flow and liquidity.
• Expense Run Rate: Confirm whether the elevated capital expenditure and operating expense levels (driven by replatforming and acquisitions) are expected to normalize in the second half of 2014 or persist.
• Acquisition Integration: Monitor the integration progress of ByAllAccounts and HelloWallet to determine when they become accretive to earnings.
• Recurring Revenue Stability: Validate the 81% recurring revenue figure and assess retention rates given the mention of discounting strategies for individual investor products.
• Share Repurchase Activity: Track the resumption of share buybacks, noting management's comment that U.S. cash balances must rebuild or the credit facility must be utilized before significant repurchases resume.
• Software Project Timeline: Review future disclosures regarding the timeline and cost overruns of the next-generation software platform migration.