Business Context and Reporting Period
This Form 8-K is a current report filed by Morningstar, Inc. on November 9, 2018. The filing serves as a Regulation FD disclosure, providing answers to investor questions regarding the company's third-quarter 2018 performance, margin profile, and strategic initiatives. Morningstar operates in the financial information and investment management sectors, offering data, analytics, and managed portfolio solutions.
Key Financial Metrics
The filing provides specific data points related to Q3 2018 performance and expense structures:
- One-Time Revenue Impact: A license amendment in Q3 2018 generated $10.5 million in upfront revenue.
- Operating Margin Impact: The license fee contributed 3.1 percentage points to the operating margin. Without this benefit, the operating margin would have contracted by 1.1 percentage points year-over-year to 21.9%.
- Capitalized Software: Through Q3 2018, the company capitalized $40.2 million in labor expenses for software development, a 16.3% increase year-over-year.
- Depreciation: Depreciation related to capitalized software activities was $30.6 million, up 39.7% year-over-year. Total depreciation expense increased 19.6% year-over-year, while amortization expense decreased 5.5%.
- Segment Reporting: Morningstar reports results in a single segment and does not disclose margins by product line.
Material Changes and Trends
Management highlighted several material trends affecting financial results:
- Expense Growth: Higher compensation and depreciation/amortization (D&A) drove strong expense growth. Compensation increases are attributed to headcount investments in high-potential areas and higher bonus accruals due to strong performance.
- Depreciation Drivers: The rise in depreciation is largely driven by higher levels of capitalized software from recent product development and enhancement activities.
- Amortization Trends: Amortization expense decreased as intangible assets from earlier acquisitions were fully amortized.
- PitchBook Integration: Increased compensation costs were primarily related to the growth of the PitchBook acquisition. While PitchBook's margin profile was initially lower than the corporate average, recent revenue growth and resource sharing have improved margins, though investments will continue to impact operating margins in the medium term.
Guidance, Outlook, and Risks
Outlook and Strategy:
- Expense Trajectory: Management anticipates sequential increases in the rate of overall expense growth throughout the year. They expect depreciation related to capitalized software to continue increasing in the near term, with capitalized software expense and associated depreciation expected to converge over time.
- Fee Compression: The company assumes fee compression is a permanent market condition. Growth in assets under management/advisement and value-added services are expected to offset this pressure.
- Product Strategy: Morningstar is shifting focus toward standardized Managed Portfolios and away from customized Institutional Asset Management and Asset Allocation Services. The company is also leveraging Morningstar Mutual Funds to create a more cost-efficient model for clients.
- PitchBook Outlook: The company expects PitchBook to eventually reach an operating margin profile similar to the rest of Morningstar.
Risks and Contingencies:
The filing lists numerous risks, including liability for fiduciary duty breaches, failure to protect brand and reputation, inability to differentiate products, technological changes, trends toward passive investment vehicles, business continuity failures, data privacy liabilities, regulatory compliance issues, technology outages, global economic downturns, market volatility affecting asset-based fees, acquisition integration risks, employee retention challenges, and offshore operational risks in China and India.
Investor Verification Checklist
- Verify the sustainability of the $10.5 million one-time license revenue and its impact on future margin comparisons.
- Monitor the convergence of capitalized software expenses and depreciation to assess future expense growth rates.
- Track the margin improvement trajectory of the PitchBook acquisition against management's medium-term expectations.
- Assess the effectiveness of the shift from customized institutional products to standardized Managed Portfolios in mitigating fee compression.
- Review the impact of increasing compensation costs and bonus accruals on long-term operating leverage.