Business Context and Reporting Period
Morningstar, Inc. filed an unaudited Form 10-Q for the quarter and nine months ended September 30, 2014. The company provides investment data, software, research, ratings, investment advisory, retirement, and asset-management products. Revenue is primarily recurring through subscriptions, licenses, and asset-based fees. Morningstar reports one operating segment and two product groups: investment information and investment management.
Financial Performance and Position
| Metric | Q3 2014 | Q3 2013 | 9M 2014 | 9M 2013 |
|---|---|---|---|---|
| Revenue | $193.1 million | $173.5 million | $563.7 million | $517.8 million |
| Operating income | $45.3 million | $44.6 million | $59.0 million | $128.8 million |
| Operating margin | 23.4% | 25.7% | 10.5% | 24.9% |
| Net income attributable to Morningstar | $30.2 million | $31.5 million | $46.8 million | $92.2 million |
| Diluted EPS | $0.67 | $0.68 | $1.04 | $1.98 |
| Cash flow from operations | $8.6 million | $47.1 million | $75.3 million | $132.2 million |
| Free cash flow | $(3.4) million | $38.0 million | $32.5 million | $104.3 million |
- Investment information revenue increased 11.0% in Q3 and 7.4% for the nine months. Investment management revenue increased 12.7% and 14.4%, respectively.
- Q3 revenue growth was led by Morningstar Credit Ratings, Morningstar Direct, Advisor Workstation, Retirement Solutions, and Managed Portfolios. Principia revenue declined $2.3 million in Q3 as clients migrated to other products.
- Q3 operating income increased 1.5%, but operating margin declined 2.3 percentage points because operating expenses grew 14.7%, faster than revenue.
- Nine-month results included a $61.0 million litigation settlement expense. Excluding this charge, adjusted operating income was $120.0 million, down 6.8%, and adjusted operating margin was 21.3%, down from 24.9%.
- Cash, cash equivalents, and investments totaled $227.8 million at September 30, 2014, compared with $298.6 million at December 31, 2013. Cash and cash equivalents alone were $189.3 million.
- The company had $30.0 million outstanding under a one-year, $75.0 million revolving credit facility at LIBOR plus 100 basis points, with $45.0 million remaining available.
- Capital expenditures were $42.8 million for the first nine months, up 53.0%, primarily for internally developed software, office improvements, and technology.
- The company paid $22.9 million of dividends and repurchased approximately 0.6 million shares for $45.8 million during the first nine months.
Material Changes Versus the Prior Comparable Period
- Revenue increased 11.3% in Q3 and 8.9% for the first nine months, with organic revenue growth of 9.3% and 7.4%, respectively, excluding acquisitions and currency effects.
- Operating performance for the nine-month period was materially reduced by the Business Logic settlement. The settlement was paid in Q3 but accrued at June 30, 2014.
- Cost of revenue increased 19.5% for the first nine months, partly reflecting higher headcount and the reclassification of approximately $14 million of compensation expense into cost of revenue following organizational centralization.
- Worldwide headcount increased to approximately 3,800 from 3,490, including approximately 100 employees added through the ByAllAccounts and HelloWallet acquisitions.
- Morningstar acquired ByAllAccounts for $27.9 million in April and acquired the remaining 81.3% of HelloWallet for cash consideration that formed part of a $54.0 million preliminary fair value in June. The transactions added approximately $59.3 million of goodwill.
- The HelloWallet transaction generated a preliminary $5.2 million non-taxable holding gain, while the prior-year period included a $3.6 million gain from the Morningstar Sweden step acquisition.
- Investment management growth was strong in Retirement Solutions and Managed Portfolios, but Investment Advisory assets under advisement declined 24.1% to $80.9 billion because variable-annuity clients increasingly managed fund-of-funds portfolios internally.
- Morningstar Direct licenses increased 17.0%, while Principia subscriptions declined 53.5%. U.S. Morningstar.com Premium subscriptions declined 1.1%, while registered users increased 4.3%.
- The company adopted new accounting guidance on foreign currency translation and income-tax presentation without a material effect. It also corrected an immaterial prior-period balance-sheet classification error related to deferred rent.
Outlook, Commentary, Risks, and Unusual Items
Management stated that available cash, investments, operating cash flow, and the credit facility should be sufficient to meet operating and cash needs for at least the next 12 months. The filing does not provide quantitative revenue or earnings guidance.
- Management expects continued capital expenditures in 2014, primarily for internally developed software, leasehold improvements, and computer hardware and software.
- Estimated intangible-asset amortization is approximately $22.1 million for 2014 and $22.3 million for 2015, subject to acquisitions, dispositions, useful-life revisions, and currency changes.
- The financial-services environment remains challenging because of regulatory burdens, low interest rates, pressure on variable-annuity businesses, competition, and industry shifts toward passive investment products.
- Key risks include market volatility affecting asset-based fees, competition and technological change, cybersecurity and personal-information liabilities, service outages, regulatory and compliance actions, litigation and reputational damage, foreign-currency exposure, and challenges involving offshore development in China and India.
- The company paid $61.0 million under a settlement with Business Logic Holding Corporation. Morningstar prevailed in the Life’s Good S.T.A.B.L. hedge fund matter, and plaintiffs subsequently voluntarily dismissed their claims against the company.
- Approximately 66% of cash, cash equivalents, and investments was held outside the United States, and the company does not expect to repatriate foreign earnings in the foreseeable future.
- The company reported no material changes to the risk factors in its 2013 Form 10-K and concluded that disclosure controls and procedures were effective.
Important Facts for Investors to Verify
- Whether recurring revenue growth and product migrations offset the decline in Principia subscriptions and Investment Advisory assets.
- The sustainability of margins after the one-time litigation settlement, including the impact of higher headcount, commissions expensed as incurred, capitalized software development, and amortization.
- The final purchase-price allocations and goodwill or intangible-asset valuations for ByAllAccounts and HelloWallet.
- Cash generation, capital-expenditure requirements, share repurchases, dividends, and repayment or refinancing of the $30.0 million credit-facility balance.
- Exposure to foreign-currency movements and the concentration of cash and investments in foreign subsidiaries.
- The effect of variable-annuity industry conditions, market volatility, regulatory developments, litigation, and data-security or service-disruption risks.