Morningstar, Inc. 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2013; filed November 6, 2013. Financial statements are unaudited. Beginning in the third quarter, Morningstar reported as one operating segment following a shift to a more centralized organizational structure.
Business Context
Morningstar provides investment data, software, research, ratings, and investment management services to individual investors, advisors, asset managers, and retirement-plan providers. Revenue is primarily recurring through subscriptions, licenses, and asset-based fees. Investment information represented approximately 80% of revenue and investment management approximately 20%.
Key Financial Metrics
| Metric | Q3 2013 | Q3 2012 | Change | 9M 2013 | 9M 2012 | Change |
|---|---|---|---|---|---|---|
| Revenue | $173.5 million | $161.0 million | 7.8% | $517.8 million | $487.7 million | 6.2% |
| Operating income | $44.6 million | $39.9 million | 11.9% | $128.8 million | $111.4 million | 15.6% |
| Operating margin | 25.7% | 24.8% | +0.9 pp | 24.9% | 22.8% | +2.1 pp |
| Net income attributable to Morningstar | $31.5 million | $27.1 million | 16.2% | $92.2 million | $75.1 million | 22.8% |
| Diluted EPS | $0.68 | $0.56 | 21.4% | $1.98 | $1.51 | 31.1% |
| Cash flow from operations | $47.1 million | $37.5 million | 25.5% | $132.2 million | $92.3 million | 43.2% |
| Free cash flow | $38.0 million | $32.6 million | 16.7% | $104.3 million | $69.4 million | 50.1% |
Q3 net margin was approximately 18.1%, compared with approximately 16.8% in the prior-year quarter. The nine-month net margin was approximately 17.8%, compared with approximately 15.4% in the prior-year period.
Revenue and Operating Trends
- Investment information revenue increased 6.9% in Q3 and 6.1% for the first nine months, led by Morningstar Data and Morningstar Direct.
- Morningstar Direct licenses increased to 8,367 from 7,115, or 17.6%.
- Investment management revenue increased 11.4% in Q3 and 6.3% year to date, driven by Retirement Solutions and Morningstar Managed Portfolios.
- Organic revenue increased 8.8% in Q3 and 7.2% year to date, excluding acquisitions, divestitures, and foreign currency effects.
- Operating expense increased 6.4% in Q3 and 3.4% year to date. Higher bonus expense was the primary driver.
- A reorganization shifted approximately 180 positions and about $7 million of compensation expense into cost of revenue, with approximately $4 million and $3 million shifted out of sales and marketing and general and administrative expense, respectively. The reclassification did not affect total operating expense or operating income.
- The effective tax rate declined to 31.2% in Q3 from 35.9% and to 31.6% for nine months from 35.6%, primarily due to deferred tax adjustments, tax credits, and incentives.
Cash, Liquidity, Debt, and Capital Allocation
- Cash and cash equivalents were $177.0 million at September 30, 2013, compared with $163.9 million at December 31, 2012.
- Investments were $165.9 million, bringing cash, cash equivalents, and investments to $342.9 million, up from $321.4 million at year-end 2012.
- Management believes available liquidity and operating cash flow are sufficient for operating and cash needs for at least the next 12 months.
- The filing does not report significant borrowings or a material credit facility; management stated that the company has not needed significant commercial credit.
- Capital expenditures were $28.0 million in the first nine months, compared with $22.9 million in the prior-year period.
- The company repurchased 829,291 shares for approximately $58.1 million during the first nine months and had repurchased 5.9 million shares for $359.1 million cumulatively under a $500 million authorization.
- The company paid $11.7 million of dividends during the first nine months and declared a quarterly dividend of $0.125 per share in October 2013.
Material Changes, Transactions, and Unusual Items
- In May 2013, Morningstar acquired the remaining 76% of Morningstar Sweden AB for $14.6 million in cash, increasing ownership from 24% to 100%. The acquisition added $9.1 million of goodwill and $9.7 million of customer-related intangible assets.
- The acquisition generated a $3.6 million non-cash holding gain from revaluing the previously owned 24% interest.
- Nine-month 2013 revenue did not include approximately $3.8 million of revenue recognized in the comparable 2012 period from a large investment advisory client that brought certain fund-of-funds portfolios in-house.
- Foreign currency translation reduced revenue by approximately $1.4 million in Q3 and $2.6 million year to date, primarily due to the weaker Australian dollar.
- Approximately 43% of cash, cash equivalents, and investments were held outside the United States. Management stated that U.S. liquidity should meet foreseeable U.S. needs without repatriating foreign earnings.
Outlook, Risks, and Contingencies
- No specific revenue or earnings guidance is provided in the filing. Management expects continued pressure from the variable annuity industry, which represented approximately 2% of nine-month revenue, due to low interest rates and industry challenges.
- Management expects approximately $21.5 million of intangible amortization expense for 2013 and $20.5 million for 2014, subject to acquisitions, dispositions, useful-life changes, and currency movements.
- Further investment in network and systems security may be material.
- Key risks include financial-market volatility affecting asset-based fees, competition and free investment information, financial-services consolidation, data-storage and privacy liabilities, network or database outages, foreign operations and currency exposure, reputational damage, and pending litigation.
- Morningstar is defending litigation related to ratings assigned to the Life’s Good S.T.A.B.L. hedge fund. No loss estimate or range can reasonably be made.
- In the Business Logic matter, management estimated a possible compensatory loss range of $0 to $5.4 million, excluding potentially recoverable punitive damages and attorneys’ fees; the opposing expert estimated $84 million. The company disputes that estimate and cannot predict the outcome.
- A 100-basis-point change in interest rates was estimated to change the fair value of the investment portfolio by approximately $1.0 million. The company had no currency hedges or derivative instruments.
Important Facts to Verify
- Whether revenue growth in Morningstar Direct, Morningstar Data, Retirement Solutions, and Managed Portfolios remains durable after the period.
- The impact of the Morningstar Sweden acquisition on revenue, margins, goodwill, and amortization.
- Whether the loss of the large investment advisory client and continued variable-annuity pressure create additional revenue headwinds.
- Cash conversion, capital expenditures, share repurchases, and dividend funding relative to operating cash flow.
- The outcome and potential financial exposure of the Life’s Good S.T.A.B.L. and Business Logic litigation.
- Changes in tax audits, unrecognized tax benefits of $14.9 million, and the sustainability of the lower effective tax rate.
- The effect of foreign exchange movements and market volatility on international revenue and asset-based fees.