Morningstar, Inc. 2016 Second-Quarter Form 10-Q Summary
Business context and reporting period
Morningstar provides investment research, data, software, credit ratings, investment management, and workplace solutions to financial advisors, asset managers, retirement providers, and individual investors. The filing covers the unaudited quarter and six months ended June 30, 2016, compared with the same periods in 2015. The company reports one operating segment and generates substantial recurring revenue through subscriptions and licenses.
Key financial metrics
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $198.2 million | $202.1 million | $390.3 million | $391.9 million |
| Operating income | $44.4 million | $49.7 million | $86.7 million | $94.3 million |
| Operating margin | 22.4% | 24.6% | 22.2% | 24.1% |
| Net income attributable to Morningstar | $31.8 million | $32.2 million | $60.5 million | $61.8 million |
| Diluted EPS | $0.73 | $0.72 | $1.40 | $1.39 |
| Cash flow from operations | $71.4 million | $76.9 million | $82.8 million | $113.0 million |
| Free cash flow | $55.5 million | $63.7 million | $53.4 million | $85.4 million |
Net margin was approximately 16.0% in the second quarter and 15.5% for the first six months. Asset-based fees represented approximately 17% of revenue in both periods, up from approximately 15% in the comparable 2015 periods.
- Cash, cash equivalents, and investments totaled $246.2 million at June 30, 2016, including $202.4 million of cash and cash equivalents and $43.8 million of investments.
- Short-term debt was $75.0 million, under a $100.0 million revolving credit facility bearing interest at LIBOR plus 100 basis points. Remaining availability was $25.0 million.
- Total assets were $1.052 billion and total liabilities were $412.6 million at June 30, 2016.
- The company paid $19.0 million of dividends and repurchased $38.8 million of common stock during the first six months.
Material changes versus the prior comparable period
- Second-quarter revenue declined 1.9%; six-month revenue declined 0.4%. Excluding acquisitions and foreign currency effects, organic revenue declined 1.3% in the quarter but increased 0.6% for the first six months.
- Operating income fell 10.7% in the quarter and 8.0% year to date. Operating margin contracted by 2.2 percentage points and 1.9 percentage points, respectively.
- Cost of revenue increased 3.5% in the quarter and 5.9% year to date, driven primarily by higher salaries and headcount. Total employees increased to approximately 4,070 from 3,740.
- Revenue from Morningstar Credit Ratings decreased $5.8 million in the quarter, reflecting a significant decline in commercial mortgage-backed securities issuance.
- Growth in Morningstar Direct, Morningstar Data, and Morningstar Research partially offset declines in credit ratings, investment management, and Internet advertising revenue.
- International revenue increased 3.9% in the quarter and 3.4% year to date, while U.S. revenue declined 3.9% and 1.7%, respectively.
- Operating cash flow decreased 26.7% year to date, primarily reflecting bonus payments and other working-capital changes. Capital expenditures increased 6.5% year to date, reducing free cash flow by 37.5%.
- Morningstar acquired RightPond on March 31, 2016 and InvestSoft on May 31, 2016. Acquisition-related cash outflows totaled $15.8 million, and goodwill increased to $371.5 million.
- The effective tax rate declined to 32.7% in the quarter and 33.2% year to date, partly due to adoption of ASU 2016-09 and recognition of excess tax benefits in income tax expense.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide formal revenue or earnings guidance. Management expects available cash, investments, operating cash generation, and the credit facility to meet operating and cash needs for at least the next 12 months. The company expects continued 2016 capital expenditures for computer hardware, software, internally developed software, and office improvements.
- Management characterized the financial-services environment as challenging because of low interest rates, pressure on asset managers from passive investing, market uncertainty following the United Kingdom’s EU referendum, and lower CMBS issuance.
- Key product metrics were mixed: Morningstar Direct licenses increased 11.3%, while U.S. Premium Membership subscriptions declined 2.6% and Morningstar Office licenses declined 3.3%. Workplace Solutions assets increased 11.6%, while Morningstar Investment Management assets declined 4.3%.
- CMBS new-issue ratings completed declined 75.0% in the quarter and 71.9% year to date; rated asset value declined 82.4% and 74.7%, respectively.
- Foreign currency translation reduced second-quarter revenue by approximately $1.6 million and first-half revenue by approximately $4.4 million. The company does not hedge currency risk.
- Approximately 79% of cash, cash equivalents, and investments was held outside the United States, while approximately 21% was held in the United States. The company does not expect to repatriate foreign earnings in the foreseeable future.
- Unrecognized tax benefits totaled $16.1 million, including $11.7 million recorded as liabilities. The company is under tax audits in multiple jurisdictions, but the potential effect is not estimable.
- Management does not believe existing legal proceedings will have a material adverse effect. No material changes were reported to the risk factors in the 2015 Form 10-K.
- Estimated intangible-asset amortization for the remainder of 2016 is $8.6 million. No goodwill impairment was recorded in the first six months.
Important facts for investors to verify
- Whether weak CMBS issuance and credit-ratings revenue continue to pressure consolidated growth.
- Whether headcount and investment in technology can produce sufficient revenue growth to restore operating margins.
- The sustainability of operating cash flow and free cash flow after bonus payments, capital expenditures, acquisitions, dividends, and share repurchases.
- Revolving-credit-facility usage, interest costs, and the company’s ability to fund repurchases and acquisitions without increasing leverage.
- The effect of passive-investing trends, market volatility, low interest rates, and foreign exchange movements on asset-based fees and international results.
- Potential outcomes of tax audits and the realization of unrecognized tax benefits.
- The financial contribution and integration progress of RightPond and InvestSoft.
- Future accounting effects from the pending revenue-recognition and lease standards, which the company was still evaluating.