UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549


 

FORM 10-Q

 


 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2007

 

OR

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from         to

 

Commission File Number: 000-51280

 


 

MORNINGSTAR, INC.

(Exact Name of Registrant as Specified in its Charter)

 

Illinois

 

36-3297908

(State or Other Jurisdiction of

 

(I.R.S. Employer

Incorporation or Organization)

 

Identification Number)

 

225 West Wacker Drive

Chicago, Illinois

60606-6303

(Address of Principal Executive Offices)

 

(312) 696-6000

(Registrant’s Telephone Number, Including Area Code)

 


 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x   No  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  o

 

Accelerated filer  x

 

Non-accelerated filer  o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  x

 

As of November 2, 2007, there were 44,015,196 shares of the Company’s common stock, no par value, outstanding.

 



 

MORNINGSTAR, INC. AND SUBSIDIARIES

INDEX

 

PART 1

 

FINANCIAL INFORMATION

 

 

 

 

 

Item 1.

 

Unaudited Condensed Consolidated Financial Statements

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2007 and 2006

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the nine months ended September 30, 2007

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2007 and 2006

 

 

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosure about Market Risk

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

 

 

 

 

PART 2

 

OTHER INFORMATION

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

 

 

 

Item 1A.

 

Risk Factors

 

 

 

 

 

Item 6.

 

Exhibits

 

 

 

 

 

SIGNATURE

 

 

 

 

2



 

PART 1: FINANCIAL INFORMATION

 

Item 1: Unaudited Condensed Consolidated Financial Statements

 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

 

 

Three Months Ended September 30

 

Nine Months Ended September 30

 

(in thousands except per share amounts)

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

111,859

 

$

81,821

 

$

316,991

 

$

228,138

 

 

 

 

 

 

 

 

 

 

 

Operating expense (1):

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

28,674

 

22,389

 

83,549

 

63,114

 

Development

 

9,010

 

7,876

 

26,199

 

21,273

 

Sales and marketing

 

17,132

 

12,971

 

50,332

 

36,511

 

General and administrative

 

19,936

 

13,781

 

57,150

 

39,606

 

Depreciation and amortization

 

5,662

 

4,267

 

15,843

 

10,440

 

Total operating expense

 

80,414

 

61,284

 

233,073

 

170,944

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

31,445

 

20,537

 

83,918

 

57,194

 

 

 

 

 

 

 

 

 

 

 

Non-operating income (expense):

 

 

 

 

 

 

 

 

 

Interest income, net

 

1,812

 

1,169

 

4,998

 

3,086

 

Other income (expense), net

 

408

 

(31

)

103

 

(343

)

Non-operating income, net

 

2,220

 

1,138

 

5,101

 

2,743

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes, equity in net income of unconsolidated entities, and cumulative effect of accounting change

 

33,665

 

21,675

 

89,019

 

59,937

 

 

 

 

 

 

 

 

 

 

 

Income tax expense

 

14,229

 

9,228

 

36,516

 

24,450

 

 

 

 

 

 

 

 

 

 

 

Equity in net income of unconsolidated entities

 

417

 

1,100

 

1,409

 

2,405

 

 

 

 

 

 

 

 

 

 

 

Income before cumulative effect of accounting change

 

19,853

 

13,547

 

53,912

 

37,892

 

 

 

 

 

 

 

 

 

 

 

Cumulative effect of accounting change, net of income tax expense of $171

 

 

 

 

259

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

19,853

 

$

13,547

 

$

53,912

 

$

38,151

 

 

 

 

 

 

 

 

 

 

 

Basic income per share:

 

 

 

 

 

 

 

 

 

Basic income per share before cumulative effect of accounting change

 

$

0.46

 

$

0.33

 

$

1.26

 

$

0.93

 

Cumulative per share effect of accounting change

 

 

 

 

 

Basic net income per share

 

$

0.46

 

$

0.33

 

$

1.26

 

$

0.93

 

Diluted income per share:

 

 

 

 

 

 

 

 

 

Diluted income per share before cumulative effect of accounting change

 

$

0.41

 

$

0.29

 

$

1.13

 

$

0.81

 

Cumulative per share effect of accounting change

 

 

 

 

0.01

 

Diluted net income per share

 

$

0.41

 

$

0.29

 

$

1.13

 

$

0.82

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

43,393

 

41,448

 

42,889

 

40,913

 

Diluted

 

48,232

 

46,578

 

47,919

 

46,598

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30

 

Nine Months Ended September 30

 

 

 

2007

 

2006

 

2007

 

2006

 

(1) Includes stock-based compensation expense of:

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

$

408

 

$

302

 

$

1,259

 

$

859

 

Development

 

302

 

141

 

926

 

386

 

Sales and marketing

 

327

 

152

 

1,038

 

415

 

General and administrative

 

1,560

 

1,663

 

4,911

 

4,611

 

Total stock-based compensation expense

 

$

2,597

 

$

2,258

 

$

8,134

 

$

6,271

 

 

See notes to unaudited condensed consolidated financial statements.

 

3



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Balance Sheets

 

(in thousands except share amounts)

 

September 30
2007

 

December 31
2006

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

86,418

 

$

96,140

 

Investments

 

106,729

 

67,611

 

Accounts receivable, less allowance of $421 and $225, respectively

 

80,268

 

65,176

 

Other

 

12,460

 

8,557

 

Total current assets

 

285,875

 

237,484

 

 

 

 

 

 

 

Property, equipment, and capitalized software, net of accumulated depreciation of $56,071 and $48,256, respectively

 

18,909

 

15,869

 

Investments in unconsolidated entities

 

19,490

 

18,659

 

Goodwill

 

124,304

 

86,680

 

Intangible assets, net

 

98,904

 

72,841

 

Deferred tax asset, net

 

15,521

 

13,789

 

Other assets

 

2,169

 

2,516

 

Total assets

 

$

565,172

 

$

447,838

 

 

 

 

 

 

 

Liabilities and shareholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

21,936

 

$

21,014

 

Accrued compensation

 

45,955

 

40,856

 

Income tax payable

 

2,207

 

1,620

 

Deferred revenue

 

123,576

 

100,525

 

Deferred tax liability, net

 

 

1,266

 

Other

 

1,572

 

2,182

 

Total current liabilities

 

195,246

 

167,463

 

 

 

 

 

 

 

Accrued compensation

 

10,697

 

7,591

 

Other long-term liabilities

 

3,044

 

3,361

 

Total liabilities

 

208,987

 

178,415

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, no par value, 200,000,000 shares authorized, of which 43,645,714 and 42,228,418 shares were outstanding as of September 30, 2007 and December 31, 2006, respectively

 

4

 

4

 

Treasury stock at cost, 233,334 shares as of September 30, 2007 and December 31, 2006

 

(3,280

)

(3,280

)

Additional paid-in capital

 

301,710

 

268,721

 

Retained earnings

 

51,747

 

1,154

 

Accumulated other comprehensive income:

 

 

 

 

 

Currency translation adjustment

 

5,988

 

2,871

 

Unrealized gains (losses) on available-for-sale securities

 

16

 

(47

)

Total accumulated other comprehensive income

 

6,004

 

2,824

 

Total shareholders’ equity

 

356,185

 

269,423

 

Total liabilities and shareholders’ equity

 

$

565,172

 

$

447,838

 

 

See notes to unaudited condensed consolidated financial statements.

 

4



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statement of Shareholders’ Equity and Comprehensive Income

For the Nine Months Ended September 30, 2007

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

Common Stock

 

 

 

Additional

 

Retained

 

Other

 

Total

 

 

 

Shares

 

Par

 

Treasury

 

Paid-in

 

Earnings

 

Comprehensive

 

Shareholders’

 

(in thousands, except share amounts)

 

Outstanding

 

Value

 

Stock

 

Capital

 

(Deficit)

 

Income

 

Equity

 

Balance as of December 31, 2006

 

42,228,418

 

$

4

 

$

(3,280

)

$

268,721

 

$

1,154

 

$

2,824

 

$

269,423

 

Cumulative effect of accounting change

 

 

 

 

 

(3,319

)

 

(3,319

)

Balance as of January 31, 2007

 

42,228,418

 

4

 

(3,280

)

268,721

 

(2,165

)

2,824

 

266,104

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

53,912

 

 

53,912

 

Unrealized gain on investments, net of income tax $41

 

 

 

 

 

 

 

63

 

63

 

Foreign currency translation adjustment

 

 

 

 

 

 

 

3,117

 

3,117

 

Total comprehensive income

 

 

 

 

 

 

53,912

 

3,180

 

57,092

 

Issuance of common stock upon stock option exercises and vesting of restricted stock units, net

 

1,417,296

 

 

 

11,580

 

 

 

11,580

 

Stock-based compensation

 

 

 

 

 

8,134

 

 

 

8,134

 

Tax benefit derived from stock option exercises and vesting of restricted stock units

 

 

 

 

 

13,275

 

 

 

13,275

 

Balance as of September 30, 2007

 

43,645,714

 

$

4

 

$

(3,280

)

$

301,710

 

$

51,747

 

$

6,004

 

$

356,185

 

 

See notes to unaudited condensed consolidated financial statements.

 

5



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows

 

 

 

Nine Months Ended September 30

 

(in thousands)

 

2007

 

2006

 

 

 

 

 

 

 

Operating activities

 

 

 

 

 

Net income

 

$

53,912

 

$

38,151

 

Adjustments to reconcile net income to net cash flows from operating activities:

 

 

 

 

 

Cumulative effect of accounting change, net of tax

 

 

(259

)

Depreciation and amortization

 

15,843

 

10,440

 

Deferred income tax expense (benefit)

 

436

 

(2,310

)

Stock-based compensation expense

 

8,134

 

6,271

 

Provision for (recovery of) bad debt

 

(9

)

161

 

Equity in net income of unconsolidated entities

 

(1,409

)

(2,405

)

Foreign exchange loss

 

83

 

450

 

Excess tax benefits from stock option exercises and vesting of restricted stock units

 

(13,275

)

(8,820

)

Other, net

 

(186

)

13

 

Changes in operating assets and liabilities, net of effects of acquisitions:

 

 

 

 

 

Accounts receivable

 

(6,978

)

(2,375

)

Other assets

 

(141

)

1,120

 

Accounts payable and accrued liabilities

 

698

 

(473

)

Accrued compensation

 

1,237

 

2,431

 

Income taxes payable

 

13,766

 

22,695

 

Deferred revenue

 

2,872

 

3,589

 

Other liabilities

 

(2,107

)

348

 

Cash provided by operating activities

 

72,876

 

69,027

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Purchases of investments

 

(90,221

)

(57,369

)

Proceeds from sale of investments

 

51,364

 

65,239

 

Capital expenditures

 

(9,354

)

(2,876

)

Acquisitions, net of cash acquired

 

(60,315

)

(116,859

)

Other, net

 

(3

)

(308

)

Cash used for investing activities

 

(108,529

)

(112,173

)

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Proceeds from stock option exercises

 

11,576

 

13,212

 

Excess tax benefits from stock option exercises and vesting of restricted stock units

 

13,275

 

8,820

 

Cash provided by financing activities

 

24,851

 

22,032

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

1,080

 

(72

)

Net decrease in cash and cash equivalents

 

(9,722

)

(21,186

)

Cash and cash equivalents - beginning of period

 

96,140

 

92,367

 

Cash and cash equivalents - end of period

 

$

86,418

 

$

71,181

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid for taxes

 

$

21,505

 

$

3,481

 

Supplemental information of non-cash investing and financing activities:

 

 

 

 

 

Unrealized gain on available-for-sale investments

 

$

104

 

$

91

 

 

See notes to unaudited condensed consolidated financial statements.

 

6



 

MORNINGSTAR, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation of Interim Financial Information

 

The accompanying unaudited condensed consolidated financial statements of Morningstar, Inc. and subsidiaries (Morningstar, we, our, the Company) included herein have been prepared to conform to the rules and regulations of the Securities and Exchange Commission (SEC). The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue, and expense. Actual results could differ from those estimates. In the opinion of management, the statements reflect all adjustments, which are of a normal recurring nature, necessary to present fairly our financial position, results of operations, stockholders’ equity, and cash flows. These financial statements and notes should be read in conjunction with our Consolidated Financial Statements and Notes thereto as of December 31, 2006 included in our Annual Report on Form 10-K filed with the SEC on March 16, 2007.

 

2. Summary of Significant Accounting Policies

 

Our significant accounting policies are discussed in Note 2 of our Consolidated Financial Statements included in our Annual Report on Form 10-K filed with the SEC for the year ended December 31, 2006.

 

Adoption of Financial Accounting Standard Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109

 

On January 1, 2007, we adopted Financial Accounting Standard Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48), which prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, and disclosure for uncertain tax positions.

 

The adoption of FIN 48 did not result in a material adjustment in the liability for unrecognized income tax benefits, and as a result, we did not record a cumulative effect adjustment to retained earnings at the beginning of the period. As of January 1, 2007, we had approximately $2,700,000 of gross unrecognized tax benefits, of which $2,300,000, if recognized, would result in a reduction of our effective income tax expense rate. We recognize interest and penalties related to unrecognized tax benefits as a component of income tax expense in our Consolidated Statements of Income. Interest and penalties were not material as of the date of adoption. Adjustments recorded to these balances in the first nine months of 2007 were not material.

 

We conduct business globally and as a result, we file income tax returns in U.S. Federal, state, local, and foreign jurisdictions. In the normal course of business we are subject to examination by tax authorities throughout the world.  During the third quarter of 2007, the statute of limitations lapsed on our 2003 U.S. Federal tax return. In addition, the audit of our 2004 U.S. Federal tax return was closed during the quarter without change to the 2004 tax liability. The open tax years for our U.S. Federal tax return include the years 2004 to the present. Most of our state tax returns have open tax years from 2003 to the present. We are currently under audit by various state and local tax authorities in the United States.  In non-U.S. jurisdictions, the statute of limitations generally extends to years prior to 2003. We are also under audit by the tax authorities in certain non-U.S. jurisdictions.  It is likely that the examination phase of some of these state, local, and non-U.S. audits will conclude in 2007. There were no significant changes to uncertain tax positions in the quarter due to lapses of statutes of limitation or audit activity. Further, it is not possible to estimate the impact of current audits on previously recorded uncertain tax positions.

 

Adoption of Emerging Issues Task Force No. 06-2, Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, “Accounting for Compensated Absences”

 

In certain of our operations, we offer employees a sabbatical leave. Although the sabbatical policy varies by region, in general, Morningstar’s full-time employees are eligible for six weeks of paid time off after four years of continuous service. On January 1, 2007, we adopted Emerging Issues Task Force (EITF) No. 06-2, Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, “Accounting for Compensated Absences,” which requires that we record a liability for employees’ sabbatical benefits over the period employees earn the right for sabbatical leave. Accordingly, on January 1, 2007, we recorded a cumulative-effect adjustment to retained earnings of $3,319,000, net of tax, to reflect the portion of employee sabbatical leave that had been earned at that date. Besides recording this cumulative effect of an accounting change, the adoption of EITF No. 06-2 did not have a significant impact on our financial position, results of operations, or cash flows.

 

7



 

3. Acquisitions, Goodwill, and Other Intangible Assets

 

Acquisition of the minority interest of Morningstar Europe NV

 

Morningstar Europe NV is the holding company for Morningstar’s European subsidiaries. Morningstar, Inc., the U.S. parent company, owned 98% of the shares of Morningstar Europe NV. Stadsporten Citygate AB (Citygate) owned the remaining 2% of the shares. In April 2007, Morningstar acquired the remaining 2% share ownership from Citygate for $1,000,000 in cash. As a majority-owned subsidiary, the financial results of Morningstar Europe NV have been included in our Condensed Consolidated Financial Statements for all periods presented. We assigned the purchase price of $1,000,000 to goodwill.

 

Acquisition of Standard & Poor’s mutual fund data business

 

On March 16, 2007, we acquired Standard & Poor’s mutual fund data business for $57,728,000 in cash including post-closing adjustments and transaction costs directly related to the acquisition less acquired cash. Approximately 80% of the mutual fund data business acquired from Standard & Poor's is outside the United States.

 

The following table summarizes our preliminary allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition:

 

 

 

($000)

 

Cash

 

$

2,974

 

Accounts receivable

 

7,642

 

Other current assets

 

1,022

 

Other non-current assets

 

133

 

Intangible assets

 

34,240

 

Goodwill

 

35,228

 

Deferred revenue

 

(16,451

)

Accrued liabilities

 

(3,953

)

Other non-current liabilities

 

(133

)

Total purchase price

 

$

60,702

 

 

The preliminary allocation includes $34,240,000 of acquired intangible assets. These assets include customer-related assets of $13,400,000 that will be amortized over a weighted average period of 10 years; technology-based assets, including software and a database covering managed investment vehicles, including mutual funds, exchange-traded funds, hedge funds, and offshore funds, of $20,380,000 that will be amortized over a weighted average period of nine years; and a non-compete agreement of $460,000 that will be amortized over five years. Based on the preliminary purchase price allocation, we recorded $35,228,000 of goodwill.

 

Based on plans in place at the time of acquisition, we recorded a liability of $1,685,000 for severance and lease termination costs. We expect that substantially all of these liabilities will be paid within the next year.

 

We began including the financial results of this acquisition in our Condensed Consolidated Financial Statements on March 16, 2007. If the acquisition of Standard & Poor’s mutual fund data business had occurred as of January 1 of each period presented, our results of operations would not have been significantly different from the amounts reported for the three and nine months ended September 30, 2007 or 2006.

 

8



 

Institutional Hedge Fund and Separate Accounts Database Division of InvestorForce, Inc.

 

In August 2006, we acquired the institutional hedge fund and separate account database division of InvestorForce, Inc. (InvestorForce), a financial software and data integration company based in Wayne, Pennsylvania, for $10,051,000 in cash, including expenses directly related to the acquisition. We began including the financial results of this acquisition in our Condensed Consolidated Financial Statements on August 1, 2006.

 

The following table summarizes our allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

 

 

 

($000)

 

Accounts receivable

 

$

343

 

Intangible assets

 

5,290

 

Goodwill

 

6,032

 

Deferred revenue

 

(1,614

)

Total purchase price

 

$

10,051

 

 

The purchase price allocation includes $5,290,000 of acquired intangible assets. These assets include technology-based assets of $2,500,000 that will be amortized over a weighted average period of five years; customer-based assets of $2,350,000 that will be amortized over a weighted average period of five years; trade names of $390,000 that will be amortized over a weighted average period of four years; and a non-compete agreement of $50,000 that will be amortized over three years.

 

The value assigned to goodwill and intangibles of $11,322,000 is deductible for U.S. income tax purposes over a period of 15 years.

 

If the acquisition of the database division of InvestorForce had occurred as of January 1, 2006, our results of operations would not have been significantly different from the amounts reported for the three and nine months ended September 30, 2006.

 

Aspect Huntley Pty Limited

 

In July 2006, we acquired Aspect Huntley Pty Limited (Aspect Huntley), a leading provider of equity information, research, and financial trade publishing in Australia. The purchase price of $23,374,000 represents Australian $30,000,000 in cash (of which Australian $2,000,000 was paid in July 2007), and includes transaction costs directly related to the acquisition and post-closing adjustments.  In 2006, the cash paid for Aspect Huntley, including transaction costs and post-closing adjustments, was $20,914,000 (net of acquired cash).

 

The following table summarizes our allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

 

 

 

($000)

 

Cash

 

$

922

 

Accounts receivable

 

671

 

Other current assets

 

324

 

Fixed assets

 

273

 

Deferred tax asset

 

359

 

Intangible assets

 

11,019

 

Goodwill

 

16,905

 

Deferred revenue

 

(5,141

)

Other current liabilities

 

(1,850

)

Income taxes payable

 

(108

)

Total purchase price

 

$

23,374

 

 

9



 

The purchase price allocation includes $11,019,000 of acquired intangible assets. These assets include trade names of $6,622,000 that will be amortized over a weighted average period of 10 years; technology-based assets (primarily including a database) of $2,593,000 that will be amortized over a weighted average period of 18 years; and customer-related assets of $1,804,000 that will be amortized over 10 years.

 

The goodwill we recorded of $16,905,000 is not deductible for U.S. or Australian income tax purposes.

 

We began including the results of Aspect Huntley’s operations in our Condensed Consolidated Financial Statements on July 25, 2006. If the acquisition of Aspect Huntley had occurred as of January 1, 2006, our results of operations would not have been significantly different from the amounts reported for the three and nine months ended September 30, 2006.

 

Ibbotson Associates, Inc.

 

In March 2006, we acquired Ibbotson Associates, Inc. (Ibbotson), a firm specializing in asset allocation research and services, for $86,169,000 in cash, including transaction costs directly related to the acquisition and post-closing adjustments for working capital and other items. In the third quarter of 2007 we received a payment of $301,000 representing a post-closing adjustment. This post-closing adjustment reduced the total purchase price paid and the goodwill previously reported. We began including the results of Ibbotson’s operations in our Condensed Consolidated Financial Statements on March 1, 2006.

 

The following table summarizes our allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

 

 

 

($000)

 

Cash

 

$

103

 

Accounts receivable

 

6,770

 

Income tax benefits, net

 

13,047

 

Other current assets

 

1,398

 

Fixed assets

 

1,407

 

Other assets

 

156

 

Intangible assets

 

55,280

 

Goodwill

 

45,920

 

Deferred revenue

 

(10,772

)

Accrued liabilities

 

(4,882

)

Deferred tax liability, net

 

(21,497

)

Other non-current liabilities

 

(761

)

Total purchase price

 

$

86,169

 

 

As part of the purchase price allocation, we recorded an asset of $13,047,000, primarily for the income tax benefit related to payment for the cancellation of Ibbotson’s stock options. This cash income tax benefit reduced the amount of cash we paid for income taxes in 2006. This cash income tax benefit did not impact our income tax expense or net income in 2006.

 

The purchase price allocation also includes $55,280,000 of acquired intangible assets. These assets include customer-related assets of $34,200,000 that will be amortized over a weighted average period of nine years; intellectual property (including patents and trade names) of $17,710,000 that will be amortized over a weighted average period of 10 years; technology-based assets of $3,070,000 that will be amortized over a weighted average period of five years; and a non-compete agreement of $300,000 that will be amortized over five years. The deferred tax liability of $21,497,000 results primarily because the amortization expense for these intangible assets is not deductible for U.S. income tax purposes.

 

Based on the purchase price allocation, we recorded $45,920,000 of goodwill. The goodwill we recorded is not deductible for U.S. income tax purposes. Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, prohibits recognition of a deferred tax asset or liability for goodwill temporary differences if goodwill is not amortizable and deductible for tax purposes.

 

10



 

Based on plans in place at the time of acquisition, we recorded a liability of $596,000 for severance and $761,000 for lease termination costs, net of estimated sub-lease income. As of September 30, 2007, we have made all of the related severance payments. We expect to pay the lease termination costs in 2008, which is when we plan to vacate Ibbotson’s office space.

 

The following unaudited pro forma information presents a summary of our Consolidated Statement of Income for the nine months ended September 30, 2006 as if we had acquired Ibbotson as of January 1, 2006. In calculating the pro forma information below, we made an adjustment to eliminate stock-based compensation expense previously recorded by Ibbotson based on the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. We also made an adjustment to record stock-based compensation expense for an estimated value of stock options assumed to be granted to Ibbotson employees. We recorded stock-based compensation expense based on the recognition and measurement principles of SFAS No. 123, Accounting for Stock-Based Compensation.

 

(in thousands, except per share amounts)

 

Pro forma Nine months ended September 30, 2006

 

Revenue

 

$

235,529

 

Operating income

 

$

57,535

 

Income before cumulative effect of accounting change

 

$

37,867

 

Net income

 

$

38,126

 

 

 

 

 

Basic income per share:

 

 

 

Income per share before cumulative effect of accounting change

 

$

0.93

 

Net income per share

 

$

0.93

 

 

 

 

 

Diluted income per share:

 

 

 

Income per share before cumulative effect of accounting change

 

$

0.81

 

Net income per share

 

$

0.82

 

 

Goodwill

 

The following table shows the changes in our goodwill balances from January 1, 2006 to September 30, 2007:

 

 

 

($000)

 

Balance as of January 1, 2006

 

$

17,500

 

Goodwill acquired related to Ibbotson

 

46,221

 

Goodwill acquired related to Aspect Huntley

 

17,274

 

Goodwill acquired related to the database division of InvestorForce

 

6,020

 

Reversal of valuation allowances related to non-U.S. deferred tax assets, primarily related to net operating losses

 

(1,200

)

Other, primarily currency translation

 

865

 

Balance as of December 31, 2006

 

$

86,680

 

Goodwill acquired related to the mutual fund data business of Standard & Poor’s

 

35,228

 

Goodwill acquired related to the purchase of the minority interest in Morningstar Europe NV

 

1,000

 

Adjustment to Aspect Huntley goodwill

 

(369

)

Adjustment to Ibbotson goodwill

 

(301

)

Adjustment to Morningstar Australia goodwill

 

299

 

Other, primarily currency translation

 

1,767

 

Balance as of September 30, 2007

 

$

124,304

 

 

11


 


In August 2007, we settled the litigation related to Morningstar Research Pty Ltd (Morningstar Australia) and paid Australian $4,000,000 (approximately U.S. $3,300,000).  In the third quarter of 2007, we recorded $299,000 of this settlement payment as an adjustment to the goodwill initially recorded when we acquired Morningstar Australia in 2001.

 

At the date of acquisition of certain of our non-U.S. operations, we recorded a valuation allowance against the deferred tax assets related to the acquired entities’ deductible temporary differences and net operating losses. In 2006, we reversed these valuation allowances because we considered that it is more likely than not that we will realize these tax benefits. In accordance with SFAS No. 109, tax benefits recognized after the acquisition date (by eliminating the valuation allowance) are applied first to reduce any goodwill related to the acquisition. We therefore recorded in 2006 a reduction to goodwill in the amount of $1,200,000 related to the reduction of these valuation allowances.

 

We did not record any impairment losses in the third quarter or first nine months of 2007 or 2006.

 

We amortize intangible assets using the straight-line method over their expected economic useful lives. The following table summarizes our intangible assets:

 

 

 

As of September 30, 2007

 

As of December 31, 2006

 

($000)

 

Gross

 

Accumulated
Amortization

 

Net

 

Weighted
Average
Useful Life
(years)

 

Gross

 

Accumulated
Amortization

 

Net

 

Weighted
Average
Useful Life
(years)

 

Intellectual property

 

$

27,059

 

$

(4,797

)

22,262

 

10

 

$

26,185

 

$

(2,455

)

$

23,730

 

10

 

Customer-related assets

 

58,653

 

(8,918

)

49,735

 

10

 

45,015

 

(4,410

)

40,605

 

10

 

Supplier relationships

 

240

 

(33

)

207

 

20

 

240

 

(24

)

216

 

20

 

Technology-based assets

 

29,899

 

(3,845

)

26,054

 

9

 

9,177

 

(1,180

)

7,997

 

9

 

Non-competition agreement

 

810

 

(164

)

646

 

5

 

350

 

(57

)

293

 

5

 

Total intangible assets

 

$

116,661

 

$

(17,757

)

$

98,904

 

10

 

$

80,967

 

$

(8,126

)

$

72,841

 

10

 

 

Amortization expense was $3,667,000 and $2,199,000 for the three months ended September 30, 2007 and 2006, respectively, and $9,487,000 and $4,653,000 for the nine months ended September 30, 2007 and September 30, 2006, respectively.

 

As of September 30, 2007, we estimate that aggregate amortization expense for intangible assets will be $12,828,000 in 2007; $13,582,000 in 2008; $13,217,000 in 2009; $11,709,000 in 2010; $10,556,000 in 2011; and $9,893,000 in 2012.

 

12



 

4. Income Per Share

 

The numerator for both basic and diluted income per share is net income. The denominator for basic income per share is the weighted average number of common shares outstanding during the period. For diluted income per share, the denominator includes the dilutive effect of outstanding employee stock options and restricted stock units using the treasury method. The following table shows how we reconcile our net income and the number of shares used in computing basic and diluted income per share:

 

 

 

Three Months Ended September 30

 

Nine Months Ended September 30

 

(in thousands, except per share amounts)

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

 

 

Basic income per share:

 

 

 

 

 

 

 

 

 

Income before cumulative effect of accounting change

 

$

19,853

 

$

13,547

 

$

53,912

 

$

37,892

 

Cumulative effect of accounting change, net of tax

 

 

 

 

259

 

Net income

 

$

19,853

 

$

13,547

 

$

53,912

 

$

38,151

 

Weighted average common shares outstanding

 

43,393

 

41,448

 

42,889

 

40,913

 

 

 

 

 

 

 

 

 

 

 

Basic income per share before cumulative effect of accounting change

 

$

0.46

 

$

0.33

 

$

1.26

 

$

0.93

 

Cumulative per share effect of accounting change, net of tax

 

 

 

 

 

Basic net income per share

 

$

0.46

 

$

0.33

 

$

1.26

 

$

0.93

 

 

 

 

 

 

 

 

 

 

 

Diluted income per share:

 

 

 

 

 

 

 

 

 

Income before cumulative effect of accounting change

 

$

19,853

 

$

13,547

 

$

53,912

 

$

37,892

 

Cumulative effect of accounting change, net of tax

 

 

 

 

259

 

Net income

 

$

19,853

 

$

13,547

 

$

53,912

 

$

38,151

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

43,393

 

41,448

 

42,889

 

40,913

 

Net effect of dilutive stock options and restricted stock units based on the treasury stock method

 

4,839

 

5,130

 

5,030

 

5,685

 

Weighted average common shares outstanding for computing diluted income per share

 

48,232

 

46,578

 

47,919

 

46,598

 

 

 

 

 

 

 

 

 

 

 

Diluted income per share before cumulative effect of accounting change

 

$

0.41

 

$

0.29

 

$

1.13

 

$

0.81

 

Cumulative per share effect of accounting change, net of tax

 

 

 

 

0.01

 

Diluted net income per share

 

$

0.41

 

$

0.29

 

$

1.13

 

$

0.82

 

 

13



 

5. Segment and Geographical Area Information

 

We organize our operations based on products and services sold in three primary business segments: Individual, Advisor, and Institutional.

 

                  Individual segment. Our Individual segment focuses on products and services for individual investors. The largest product in this segment based on revenue is our U.S.-based Web site, Morningstar.com, which includes both paid Premium Membership service and sales of Internet advertising space. Our Individual segment also includes Morningstar Equity Research, which we distribute through several channels. Investors can access our equity research through our Premium Membership offering on Morningstar.com. In addition, our equity research is distributed through six major investment banks to meet the requirements for independent research under the Global Analyst Research Settlement, as well as to several other companies who provide our research to their affiliated financial advisors or to individual investors. We also offer a variety of print publications on stocks and mutual funds, including our monthly newsletters, Morningstar FundInvestor and Morningstar StockInvestor, and our twice-monthly publication, Morningstar Mutual Funds. We sell several annual reference guides, including the Morningstar Funds 500, the Morningstar Stocks 500, the Morningstar ETFs 150, and the Stocks, Bonds, Bills, and Inflation Yearbook (acquired with Ibbotson). With the addition of Aspect Huntley, this segment also includes several newsletters and other publications for investors in Australia.

 

                  Advisor segment. Our Advisor segment focuses on products and services for financial advisors. Key products in this segment based on revenue are Morningstar Advisor Workstation and Morningstar Principia. Advisor Workstation is a Web-based investment planning system that provides financial advisors with a comprehensive set of tools for conducting their core business, including investment research, planning, and presentations. Advisor Workstation is available in two editions: the Office Edition for independent financial advisors and the Enterprise Edition for financial advisors affiliated with larger firms. Principia is our CD-ROM-based investment research and planning software for financial planners. In addition, we offer Morningstar Managed Portfolios, a fee-based discretionary asset management service that includes a series of mutual fund and exchange-traded fund portfolios tailored to different investment time horizons and risk levels that financial advisors can use for their clients’ taxable and tax-deferred accounts.

 

                  Institutional segment. Our Institutional segment focuses on products and services for institutions, including banks, insurance companies, mutual fund companies, brokerage firms, media firms, and retirement plan providers and sponsors. Key products and services in this segment based on revenue are Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities; Licensed Data, a set of investment data spanning 10 core databases, available through electronic data feeds; Retirement Advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms; the institutional Workstation product acquired from Standard & Poor’s; Morningstar Direct, a Web-based institutional research platform that provides advanced research and tools on the complete range of securities in Morningstar’s global database; and Licensed Tools and Content, a set of online tools and editorial designed for institutions to use in their Web sites and software

 

We measure the operating results of these segments based on operating income (loss), including an allocation of corporate costs. We include intersegment revenue and expenses in segment information. We sell services and products between segments at predetermined rates primarily based on cost. The recovery of intersegment cost is shown as “Intersegment revenue.”

 

Our segment accounting policies are the same as those described in Note 2 to our Consolidated Financial Statements included in our Annual Report on Form 10-K as of December 31, 2006, except for the capitalization and amortization of internal product development costs and amortization of intangible assets. We exclude these items from our operating segment results to provide our chief operating decision maker with a better indication of each segment’s ability to generate cash flow. This information is one of the criteria used by our chief operating decision maker in determining how to allocate resources to each segment. We include the capitalization and amortization of internal product development costs, the amortization of intangible assets, and the elimination of intersegment revenue and expense, in the Corporate Items and Eliminations category to arrive at the consolidated financial information. Our segment disclosures include the business segment information provided to our chief operating decision maker on a recurring basis, and, therefore, we do not present balance sheet information, including goodwill or other intangibles, by segment.

 

14



 

The following tables show selected segment data for the three and nine months ended September 30, 2007 and 2006:

 

 

 

Three months ended September 30, 2007

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items & Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

22,605

 

$

29,295

 

$

59,959

 

$

 

$

111,859

 

Intersegment

 

1,062

 

41

 

886

 

(1,989

)

 

Total revenue

 

23,667

 

29,336

 

60,845

 

(1,989

)

111,859

 

Operating expense, excluding stock-based compensation expense, depreciation, and amortization

 

16,624

 

19,404

 

38,098

 

(1,971

)

72,155

 

Stock-based compensation expense

 

492

 

792

 

1,313

 

 

2,597

 

Depreciation and amortization

 

364

 

472

 

758

 

4,068

 

5,662

 

Operating income (loss)

 

$

6,187

 

$

8,668

 

$

20,676

 

$

(4,086

)

$

31,445

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

275

 

$

734

 

$

1,081

 

$

1,376

 

$

3,466

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

87,006

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

24,853

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended September 30, 2006 

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items & Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

19,515

 

$

24,367

 

$

37,939

 

$

 

$

81,821

 

Intersegment

 

874

 

30

 

630

 

(1,534

)

 

Total revenue

 

20,389

 

24,397

 

38,569

 

(1,534

)

81,821

 

Operating expense, excluding stock-based compensation expense, depreciation, and amortization

 

13,976

 

15,545

 

27,288

 

(2,050

)

54,759

 

Stock-based compensation expense

 

555

 

716

 

987

 

 

2,258

 

Depreciation and amortization

 

349

 

417

 

633

 

2,868

 

4,267

 

Operating income (loss)

 

$

5,509

 

$

7,719

 

$

9,661

 

$

(2,352

)

$

20,537

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

117

 

$

98

 

$

307

 

$

331

 

$

853

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

69,517

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

12,304

 

 

15



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine months ended September 30, 2007 

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items & Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

68,611

 

$

85,356

 

$

163,024

 

$

 

$

316,991

 

Intersegment

 

3,286

 

166

 

2,727

 

(6,179

)

 

Total revenue

 

71,897

 

85,522

 

165,751

 

(6,179

)

316,991

 

Operating expense, excluding stock-based compensation expense, depreciation, and amortization

 

51,129

 

58,063

 

105,981

 

(6,077

)

209,096

 

Stock-based compensation expense

 

1,628

 

2,483

 

4,023

 

 

8,134

 

Depreciation and amortization

 

1,160

 

1,418

 

2,280

 

10,985

 

15,843

 

Operating income (loss)

 

$

17,980

 

$

23,558

 

$

53,467

 

$

(11,087

)

$

83,918

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

604

 

$

2,514

 

$

3,249

 

$

2,987

 

$

9,354

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

253,405

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

63,586

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sept. 30, 2007

 

U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

9,745

 

Non-U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

9,164

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine months ended September 30, 2006

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items & Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

56,232

 

$

70,435

 

101,471

 

$

 

$

228,138

 

Intersegment

 

2,660

 

33

 

1,966

 

(4,659

)

 

Total revenue

 

58,892

 

70,468

 

103,437

 

(4,659

)

228,138

 

Operating expense, excluding stock-based compensation expense, depreciation, and amortization

 

39,001

 

47,102

 

73,487

 

(5,357

)

154,233

 

Stock-based compensation expense

 

1,738

 

1,920

 

2,613

 

 

6,271

 

Depreciation and amortization

 

860

 

1,250

 

1,663

 

6,667

 

10,440

 

Operating income (loss)

 

$

17,293

 

$

20,196

 

25,674

 

$

(5,969

)

$

57,194

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

237

 

$

278

 

$

967

 

$

1,394

 

$

2,876

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

197,879

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

30,259

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sept. 30, 2006

 

U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

11,955

 

Non-U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

4,147

 

 

16



 

6. Investments

 

We monitor the concentration, diversification, maturity, and liquidity of our investment portfolio, which is primarily invested in fixed-income securities. We classify our investment portfolio as follows:

 

($000)

 

September 30 2007

 

December 31 2006

 

Available-for-sale

 

$

99,158

 

$

63,122

 

Held-to-maturity

 

3,412

 

2,339

 

Trading securities

 

4,159

 

2,150

 

Total

 

$

106,729

 

$

67,611

 

 

7. Investments In Unconsolidated Entities

 

Morningstar Japan K.K.  In April 1998, we entered into an agreement with Softbank Corporation to form a joint venture, Morningstar Japan K.K. (MJKK), which develops and markets products and services customized for the Japanese market. In June 2000, MJKK became a public company, and its shares are traded on the Osaka Stock Exchange, “Hercules Market,” using the ticker number 4765. Subsequent to MJKK’s initial public offering, the joint venture agreement between us and Softbank Corporation was terminated, but we continued to hold shares of MJKK stock. As of September 30, 2007 and December 31, 2006, we owned approximately 35% of MJKK. We account for our investment in MJKK using the equity method. The book value of our investment in MJKK totaled $17,294,000 and $16,693,000 as of September 30, 2007 and December 31, 2006, respectively. The market value of our investment in MJKK was approximately Japanese Yen 4.5 billion (approximately U.S. $38,794,000) as of September 30, 2007 and Japanese Yen 10.2 billion (approximately U.S. $85,482,000) as of December 31, 2006.

 

Morningstar Korea, Ltd. In June 2000, we entered into a joint venture agreement with Shinheung Securities Co., Ltd. and SOFTBANK Finance Corporation to establish a Korean limited liability company Morningstar Korea Ltd. (Morningstar Korea). Morningstar Korea provides financial information and services for investors in South Korea. Our ownership interest and profit- and loss-sharing interest in Morningstar Korea was 40% as of September 30, 2007 and December 31, 2006. We account for this investment using the equity method. Our investment totaled $1,522,000 and $1,415,000 as of September 30, 2007 and December 31, 2006, respectively.

 

Other Investments in Unconsolidated Entities. As of September 30, 2007 and December 31, 2006, the book value of our other investments in unconsolidated entities totaled $674,000 and $551,000, respectively, and consist primarily of our investments in Morningstar Danmark A/S (Morningstar Denmark) and Morningstar Sweden AB (Morningstar Sweden). In August 2001, we entered into a joint venture agreement with Phosphorus A/S to establish Morningstar Denmark, which develops and markets products and services customized for the Danish market. In April 2001, we entered into a joint venture agreement with Stadsporten Citygate AB to establish Morningstar Sweden, which develops and markets products and services customized for the Swedish market. Our ownership interest in both Morningstar Denmark and Morningstar Sweden was approximately 25% as of September 30, 2007 and December 31, 2006. We account for our investments in Morningstar Denmark and Morningstar Sweden using the equity method.

 

The following table shows condensed combined unaudited financial information for our investments in unconsolidated entities:

 

 

 

Three months ended September 30

 

Nine months ended September 30

 

($000)

 

2007

 

2006

 

2007

 

2006

 

Revenue

 

$

13,999

 

$

4,201

 

$

33,402

 

$

13,921

 

Operating income

 

$

1,343

 

$

951

 

$

5,413

 

$

3,836

 

Net income

 

$

868

 

$

2,954

 

$

3,309

 

$

6,073

 

 

17



 

8. Stock-Based Compensation

 

Stock-Based Compensation Plans

 

In November 2004, we adopted the 2004 Stock Incentive Plan. The 2004 Stock Incentive Plan provides for grants of options, stock appreciation rights, restricted stock units, and performance shares. All of our employees are eligible for awards under the 2004 Stock Incentive Plan. Our non-employee directors are also eligible for awards under the 2004 Stock Incentive Plan. Joe Mansueto, our chairman and chief executive officer, does not participate in the 2004 Stock Incentive Plan or prior plans.

 

Since the adoption of the 2004 Stock Incentive Plan, we have granted stock options and, beginning in 2006, restricted stock units. Stock options granted under the 2004 Stock Incentive Plan generally vest ratably over a four-year period and expire 10 years after the date of grant. Almost all of the options granted under the 2004 Stock Incentive Plan have a premium feature in which the exercise price increases over the term of the option at a rate equal to the 10-year Treasury bond yield as of the date of grant. Restricted stock units represent the right to receive a share of Morningstar common stock when that unit vests. Restricted stock units granted under the 2004 Stock Incentive Plan generally vest ratably over a four-year period.  At the time of grant, employees may elect to defer receipt of the Morningstar common stock issued upon vesting of the restricted stock unit. As of September 30, 2007, we had 2,661,495 shares available for future grants under our 2004 Stock Incentive Plan compared with 2,827,006 as of December 31, 2006.

 

Prior to November 2004, we granted stock options under various plans, including the 1993 Stock Option Plan (the 1993 Plan), the 2000 Morningstar Stock Option Plan (the 2000 Plan), and the 2001 Morningstar Stock Option Plan (the 2001 Plan). Options granted under the 1993 Plan, the 2000 Plan, and the 2001 Plan generally vested over a four-year period and as a result are substantially all vested at September 30, 2007; however, because the options under all three plans expire 10 years after the date of grant, some options granted under these plans remain outstanding at September 30, 2007. The 2004 Stock Incentive Plan amends and restates the 1993 Plan, the 2000 Plan, and the 2001 Plan (collectively, the Prior Plans). Under the 2004 Stock Incentive Plan, we will not grant any additional options under any of the Prior Plans, and any shares subject to an award under any of the Prior Plans that are forfeited, canceled, settled, or otherwise terminated without a distribution of shares, or withheld by us in connection with the exercise of options or in payment of any required income tax withholding, will not be available for awards under the 2004 Stock Incentive Plan.

 

In February 1999, we entered into an Incentive Stock Option Agreement and a Nonqualified Stock Option Agreement under the 1999 Incentive Stock Option Plan (the 1999 Plan) with Don Phillips, an officer of Morningstar. Under these agreements, we granted Don options to purchase 1,500,000 shares of common stock at an exercise price of $2.77 per share, equal to the fair value at the grant date. These options are fully vested and expire in February 2009. On the date of grant, 1,138,560 options were fully exercisable and an additional 36,144 shares became and continue to become exercisable each year from 1999 through 2008. As of September 30, 2007, there were 430,574 options remaining to be exercised, compared with 710,174 as of December 31, 2006.

 

Accounting for Stock-Based Compensation Awards

 

Effective January 1, 2006, we adopted SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)), using the modified prospective transition method. We estimate forfeitures of all employee stock-based awards and recognize compensation cost only for those awards expected to vest.  Because our largest annual equity grants typically have vesting dates in the second quarter, we adjusted the stock-based compensation expense to reflect those awards that ultimately vested. In addition, we reduced our estimate of the forfeiture rate that will be applied to awards not yet vested.  As a result, in the second quarter of 2007, we recorded approximately $720,000 of additional stock-based compensation expense related to these changes in estimates.

 

Stock-Based Compensation Expense

 

The following table summarizes stock-based compensation expense recorded in our Condensed Consolidated Statements of Income:

 

 

 

Three months ended September 30

 

Nine months ended September 30

 

($000)

 

2007

 

2006

 

2007

 

2006

 

Stock-based compensation expense

 

$

2,597

 

$

2,258

 

$

8,134

 

$

6,271

 

 

18



 

The tax benefit recorded related to the stock-based compensation expense above was $927,000 and $831,000 for the three months ended September 30, 2007 and 2006, respectively, and $2,947,000 and $2,221,000 for the nine months ended September 30, 2007 and 2006, respectively.

 

Restricted Stock Units

 

We measure the fair value of our restricted stock units on the date of grant based on the market price of the underlying common stock as of the close of trading on the day prior to grant. We amortize that value to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period. We granted restricted stock units for the first time in May 2006. The total grant date fair value of restricted stock units granted in the first nine months of 2007 was approximately $12,053,000. As of September 30, 2007, the total amount of unrecognized stock-based compensation expense related to restricted stock units was approximately $17,069,000. We expect to recognize this expense over an average period of approximately 39 months.

 

The following table summarizes restricted stock unit activity in the first nine months of 2007:

 

 

 

Nine months ended September 30, 2007

 

Restricted Stock Units

 

Unvested

 

Vested but Deferred

 

Total

 

Weighted
Average
Grant Date
Fair Value

 

Restricted Stock Units—January 1, 2007

 

260,462

 

 

260,462

 

$

44.01

 

Granted

 

237,219

 

 

237,219

 

$

50.81

 

Vested

 

(52,979

)

 

(52,979

)

$

45.17

 

Vested but deferred

 

(6,621

)

6,621

 

 

 

Forfeited

 

(18,999

)

 

(18,999

)

$

46.38

 

Restricted Stock Units—September 30, 2007

 

419,082

 

6,621

 

425,703

 

$

47.76

 

 

Stock Option Activity

 

The following tables summarize stock option activity in the first nine months of 2007 for our various stock option grants. The first table includes activity for options granted at an exercise price below the fair value per share of our common stock on the grant date; the second table includes activity for all other option grants.

 

 

 

Nine months ended September 30, 2007

 

Options Granted At an Exercise Price Below the Fair Value Per Share on the Grant Date

 

Underlying
Shares

 

Weighted
Average
Exercise
Price

 

Options outstanding—January 1, 2007

 

2,871,310

 

$

11.11

 

Granted

 

569

 

$

14.70

 

Canceled

 

(21,341

)

$

16.37

 

Exercised

 

(395,660

)

$

6.31

 

Options outstanding—September 30, 2007

 

2,454,878

 

$

7.87

 

 

 

 

 

 

 

Options exercisable—September 30, 2007

 

2,075,730

 

$

6.58

 

 

19



 

 

 

Nine months ended September 30, 2007

 

All Other Option Grants, Excluding Activity Shown Above

 

Underlying
Shares

 

Weighted
Average
Exercise
Price

 

Options outstanding—January 1, 2007

 

6,098,594

 

$

12.55

 

Canceled

 

(34,033

)

$

21.66

 

Exercised

 

(873,653

)

$

11.52

 

Options outstanding—September 30, 2007

 

5,190,908

 

$

12.78

 

 

 

 

 

 

 

Options exercisable—September 30, 2007

 

4,699,148

 

$

11.79

 

 

The total intrinsic value (difference between the market value of our stock on the date of exercise and the exercise price of the option) of options exercised in the nine months ended September 30, 2007 and 2006 was $55,701,000 and $41,717,000, respectively.

 

Stock Options Outstanding and Exercisable

 

The table below shows additional information for options outstanding and options exercisable as of September 30, 2007:

 

 

 

Options Outstanding

 

Options Exercisable

 

Range of Exercise Prices

 

Outstanding
Shares

 

Weighted
Average
Remaining
Contractual
Life

 

Weighted
Average
Exercise
Price

 

Aggregate
Intrinsic
Value
($000)

 

Exercisable
Shares

 

Weighted
Average
Remaining
Contractual
Life

 

Weighted
Average
Exercise
Price

 

Aggregate
Intrinsic
Value
($000)

 

$2.00 - $2.77

 

1,268,245

 

0.93

 

$

2.51

 

$

74,681

 

1,228,267

 

0.91

 

$

2.51

 

$

72,335

 

$8.57 - $14.70

 

4,414,703

 

3.20

 

$

12.66

 

215,155

 

4,411,675

 

3.20

 

$

12.67

 

214,997

 

$16.56 - $37.37

 

1,962,838

 

7.36

 

$

18.86

 

83,503

 

1,134,936

 

7.30

 

$

18.06

 

49,194

 

$2.00 - $37.37

 

7,645,786

 

3.89

 

$

12.57

 

$

373,339

 

6,774,878

 

3.47

 

$

11.73

 

$

336,526

 

Vested or Expected to Vest

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$2.00 - $36.37

 

7,545,511

 

3.87

 

$

12.55

 

$

368,627

 

 

 

 

 

 

 

 

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $61.40 on September 28, 2007, which would have been received by the option holders had all option holders exercised their options as of that date.

 

As of September 30, 2007, the total amount of unrecognized stock-based compensation expense related to nonvested stock options was approximately $6,200,000. We expect to recognize this expense over a weighted average period of approximately 15 months.

 

9. Related Party Transactions

 

In 1989, under our 1989 Nonqualified Stock Option Plan (the 1989 Plan), we granted options to purchase 1,500,000 shares of common stock at an exercise price of $0.075 per share, equal to the fair value at date of issue, to Don Phillips, an officer of Morningstar. These options were not exercised and expired in February 1999. In February 1999, in conjunction with the expiration of options granted under the 1989 Plan, we entered into a Deferred Compensation Agreement (the Agreement) with Don. Under the terms of the Agreement, on any date that Don exercises the right to purchase shares under the 1999 Plan, we shall pay to him $2.69 per share in the form of cash or, at our election, shares of common stock. If on the date of purchase the fair value of Morningstar’s stock is below $2.77 per share, the amount paid per share will be reduced based on the terms of the Agreement. Our obligation to pay deferred compensation will not be increased by any imputed interest or earnings amount.

 

20



 

In May 2006, Don Phillips entered into a Rule 10b5-1 plan contemplating the sale of shares to be acquired through stock option exercises. Upon exercise of certain stock options, we will make payments to him, as prescribed by the Agreement. In the first nine months of 2007, Don exercised 279,600 options, of which 229,600 were sold under his 10b5-1 plan. As of September 30, 2007 and December 31, 2006, our Condensed Consolidated Balance Sheets include a liability of $1,246,000 and $1,963,000, respectively, for the Agreement. The liability is primarily classified as “Other current liabilities.” The reduction in the liability since December 31, 2006 reflects amounts paid to Don in the first nine months of 2007 in accordance with the Agreement.

 

10. Income Taxes

 

On January 1, 2007, we adopted FIN 48. See Note 2, Summary of Significant Accounting Policies, for additional information concerning the adoption of FIN 48.

 

The following table shows our effective income tax expense rate for the three and nine months ended September 30, 2007 and 2006:

 

 

 

Three months ended September 30

 

Nine months ended September 30

 

($000)

 

2007

 

2006

 

2007

 

2006

 

Income before income taxes, equity in net income of unconsolidated entities, and cumulative effect of accounting change

 

$

33,665

 

$

21,675

 

$

89,019

 

$

59,937

 

Equity in net income of unconsolidated entities

 

417

 

1,100

 

1,409

 

2,405

 

Total

 

$

34,082

 

$

22,775

 

$

90,428

 

$

62,342

 

Income tax expense

 

$

14,229

 

$

9,228

 

$

36,516

 

$

24,450

 

Effective income tax expense rate

 

41.7

%

40.5

%

40.4

%

39.2

%

 

In the third quarter and year-to-date periods of 2007, our effective income tax expense rate increased 1.2 percentage points compared with the prior-year periods.  The increase primarily reflects an increase to our overall U.S. state tax rate in 2007.  In addition, in the third quarter of 2007 we recorded additional state income tax expense of $700,000 related to a change in state tax law enacted in the quarter. The state income tax expense recorded in the third quarter reflects a reduction of our net deferred tax assets as of the date of enactment because we expect to realize a lower tax benefit when we use our net deferred tax assets in future periods.

 

In both 2007 and 2006, our effective income tax expense rate reflects the fact that we have not recorded an income tax benefit related to losses recorded by certain of our non-U.S. operations.  In the year non-U.S. entities record a loss, we historically have not recorded a corresponding tax benefit, thus increasing our effective tax rate. To the extent our international operations become profitable, the foreign net operating losses may become deductible in certain international tax jurisdictions.  We evaluate whether it is more likely than not that the tax benefits related to net operating losses will be realized. As part of this evaluation, we consider evidence such as tax planning strategies, historical operating results, forecasted taxable income, and recent financial performance. Upon determining that it is more likely than not that the net operating losses will be realized, we reduce the tax valuation allowances related to these net operating losses which results in a reduction to our income tax expense and our effective income tax rate in the period.

 

11. Contingencies

 

Morningstar Australia

 

In 2001, Mr. Graham Rich, the then managing director and chief executive officer of Morningstar Research Pty Limited (Morningstar Australia), and one of two companies controlled by Mr. Rich, filed a suit in the Supreme Court of New South Wales, Australia against Morningstar and certain of its officers and nominee directors on the board of Morningstar Australia. Mr. Rich was also a beneficial owner of shares in Morningstar Australia. Mr. Rich and his company originally sought an injunction which, if granted, would have precluded Morningstar Australia from terminating the services of Mr. Rich and from issuing additional shares to Morningstar in exchange for the provision of further funding by Morningstar to Morningstar Australia. Further, Mr. Rich and his company sought an order that a provisional liquidator be appointed for Morningstar Australia. The court rejected this injunction application. The application for the appointment of a provisional liquidator also failed. The services of Mr. Rich were terminated in November 2001.

 

21



 

Mr. Rich and the two companies controlled by Mr. Rich thereafter filed additional claims, alleging among other things, breaches by Morningstar of contracts and statutory and general law duties, misleading, deceptive, and unconscionable conduct by Morningstar, oppression by Morningstar and its nominee directors, claims under the Industrial Relations Act of New South Wales, breaches of directors’ duties by Morningstar’s nominee directors, and conflict of interest. The claims sought various forms of relief, including monetary damages in the amount of Australian $25,000,000, the setting aside of transactions which resulted in Morningstar obtaining control of Morningstar Australia, and an order either setting aside Morningstar’s acquisition of the shares formerly beneficially owned by Mr. Rich and his companies or determining a different price for this acquisition. In the alternative, Mr. Rich and his companies sought an order that they be entitled to purchase the shares in Morningstar Australia at a price to be determined by the court or book value (as defined in the Morningstar Australia shareholders agreement). Morningstar denied the claims and filed counter-claims against Mr. Rich and certain of his companies, alleging breaches of statutory, general law, and contractual duties.

 

In May 2005, Mr. Rich obtained conditional leave of the court to begin a proceeding in the name of Morningstar Australia against Morningstar and its nominee directors.

 

In the fourth quarter of 2003, Morningstar offered to settle all claims for Australian $1,250,000, which then approximated U.S. $942,000, and, in accordance with SFAS No. 5, Accounting for Contingencies, Morningstar recorded a reserve in this amount. In December 2005, Morningstar increased its offer to settle all claims to approximately Australian $2,500,000 (which then approximated U.S. $1,800,000) and in accordance with SFAS No. 5, Morningstar had a reserve recorded in this amount.

 

In August 2007, the parties agreed to a settlement pursuant to which the parties dismissed and released all claims in the proceedings and Morningstar paid Australian $4,000,000 (approximately U.S. $3,300,000) at the date of settlement.  This amount was higher than the previously recorded reserve of Australian $2,500,000 (approximately U.S. $2,100,000 at the settlement date).  We recorded about $900,000 of the difference as legal expense. We accounted for the remainder as an adjustment to the goodwill we initially recorded when we acquired Morningstar Australia in 2001.

 

Morningstar Associates, LLC Subpoenas from Securities and Exchange Commission, New York Attorney General’s Office, and the Department of Labor

 

Securities and Exchange Commission

 

In February 2005, Morningstar Associates, LLC, a wholly owned subsidiary of Morningstar, Inc., received a request from the SEC for the voluntary production of documents relating to the investment consulting services the company offers to retirement plan