Morningstar, Inc. 10-Q Summary
Reporting period: Quarterly and six months ended June 30, 2014. The filing was dated July 31, 2014. Financial statements are unaudited and presented under U.S. GAAP. Morningstar reports one operating segment, with revenue from investment information and investment management products.
Key Financial Metrics
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Revenue | $189.4 million | $175.4 million | $370.6 million | $344.3 million |
| Revenue growth | 8.0% | — | 7.6% | — |
| Operating income (loss) | $(24.8) million | $43.6 million | $13.8 million | $84.1 million |
| Operating margin | (13.1)% | 24.8% | 3.7% | 24.4% |
| Net income (loss) attributable to Morningstar | $(9.8) million | $31.1 million | $16.6 million | $60.7 million |
| Diluted EPS | $(0.22) | $0.66 | $0.37 | $1.30 |
| Cash provided by operating activities | $54.8 million | $58.5 million | $66.7 million | $85.1 million |
| Free cash flow | $44.8 million | $48.7 million | $35.9 million | $66.3 million |
Revenue mix: Investment information revenue increased 6.8% to $149.5 million in the quarter and 5.7% to $290.8 million for the first half. Investment management revenue increased 12.6% to $39.9 million in the quarter and 15.3% to $79.8 million for the first half.
Adjusted profitability: Excluding the $61.0 million litigation settlement, adjusted operating income was $36.2 million in Q2 and $74.8 million for the first six months, down 16.9% and 11.2%, respectively. Adjusted operating margin was 19.1% in Q2 and 20.2% for the first half, compared with 24.8% and 24.4% in the prior-year periods.
Liquidity, Capital Resources, and Balance Sheet
- Cash and cash equivalents were $176.3 million at June 30, 2014, compared with $168.2 million at December 31, 2013.
- Investments were $44.7 million, down from $130.4 million at year-end. Cash, cash equivalents, and investments totaled approximately $221.0 million, compared with $298.6 million at December 31, 2013.
- Total liabilities were $382.6 million and total equity was $668.7 million at June 30, 2014.
- The filing does not report outstanding borrowings or conventional long-term debt. In July 2014, the company established a $75 million single-bank revolving credit facility for general corporate purposes.
- First-half cash uses included $64.4 million for acquisitions, $36.7 million for share repurchases, $30.8 million for capital expenditures, and $15.3 million for dividends.
- Management stated that available cash, investments, and operating cash flow should be sufficient to meet operating and cash needs for at least the next 12 months.
- Approximately 69% of cash, cash equivalents, and investments was held outside the United States at June 30, 2014. Management does not expect to repatriate foreign earnings in the foreseeable future.
Material Changes Versus the Prior Comparable Period
- Revenue grew, but profitability declined substantially because of the $61.0 million Business Logic litigation settlement recorded in Q2.
- Cost of revenue increased 26.3% in Q2 and 24.6% in the first half, driven primarily by higher compensation, headcount growth, acquisitions, and the reclassification of development expense.
- Approximately 180 net positions shifted from sales and marketing and general and administrative expense into cost of revenue following the organizational centralization. This changed expense classification but did not affect total operating expense or operating income.
- Headcount increased to approximately 3,800 from 3,425, including approximately 100 employees added through the ByAllAccounts and HelloWallet acquisitions.
- Free cash flow declined 8.0% in Q2 and 45.8% in the first half, reflecting lower operating cash flow and higher capital expenditures.
- Morningstar acquired ByAllAccounts for $27.9 million in April and acquired the remaining 81.3% of HelloWallet for $40.5 million in June, increasing ownership to 100%. Purchase-price allocations remained preliminary.
- Goodwill increased to $388.8 million from $326.5 million at year-end, primarily due to the acquisitions.
- Shares repurchased in the first half totaled approximately 489,801 for $36.7 million. Cumulative repurchases under the authorization totaled 7.6 million shares for $486.5 million as of June 30.
Guidance, Outlook, Commentary, and Risks
- Management expected recurring quarterly dividends of $0.17 per share during 2014 and continued capital expenditures primarily for internally developed software, leasehold improvements, and computer hardware and software.
- Management estimated intangible-asset amortization of approximately $22.5 million in 2014 and $22.7 million in 2015.
- The company described generally positive equity-market and fund-flow conditions but noted a challenging financial-services environment, regulatory cost pressures, low interest rates, and pressure on variable-annuity clients.
- Investment Advisory assets under advisement declined 18.4% year over year to $82.7 billion, primarily because variable-annuity clients increasingly managed fund-of-funds portfolios internally. Retirement Solutions assets rose 33.1% to $74.4 billion and Morningstar Managed Portfolios assets rose 45.8% to $8.6 billion.
- The company expects additional commission expense in coming quarters because it changed from amortizing commissions over contract terms to expensing commissions as incurred, while continuing to amortize its prior prepaid commission balance.
- The $61.0 million Business Logic settlement was accrued at June 30. Morningstar paid $15.0 million in late July, with the remaining $46.0 million due by August 17, 2014. Management stated that the case was dismissed with prejudice.
- A separate hedge-fund-rating matter remained unresolved after a January 2014 bench trial. The company contested liability, could not estimate a loss, and had not accrued an amount for that matter.
- Key risks include litigation and fiduciary-liability exposure, technology and service outages, data privacy, regulatory changes, competition, market volatility affecting asset-based fees, foreign-currency movements, and reliance on offshore development operations.
- There were no material changes to the risk factors disclosed in the 2013 Form 10-K.
Facts Investors Should Verify
- Final cash payments and liquidity impact from the $61.0 million Business Logic settlement, including the post-quarter payment of the remaining $46.0 million.
- Whether the acquisitions of HelloWallet and ByAllAccounts generate expected revenue growth and operating efficiencies, and the final purchase-price allocations and goodwill amounts.
- The sustainability of adjusted operating margins after excluding the one-time settlement, given higher headcount, compensation, commission, and technology costs.
- Progress in migrating Principia clients to Advisor Workstation and other products, and the effect on recurring investment-information revenue.
- Trends in Investment Advisory assets, Retirement Solutions assets, and Morningstar Managed Portfolios assets, particularly sensitivity to market conditions and variable-annuity client behavior.
- Future free cash flow after acquisitions, capital expenditures, dividends, share repurchases, and settlement payments.
- Potential exposure from the unresolved Life's Good S.T.A.B.L. hedge-fund litigation and the company’s unrecognized tax benefits of $11.5 million.