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 MARCH 31, 2008

 

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, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   o

 

Accelerated filer   x

 

Non-accelerated filer   o

 

Smaller reporting company   o

(do not check if a smaller reporting company)

 

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 May 2, 2008, there were 45,709,260 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 months ended March 31, 2008 and 2007

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Balance Sheets as of March 31, 2008 and December 31, 2007

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the three months ended March 31, 2008

 

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2008 and 2007

 

 

 

 

 

 

 

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



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Income

 

 

 

Three Months Ended March 31

 

(in thousands except per share amounts)

 

2008

 

2007

 

 

 

 

 

 

 

Revenue

 

$

125,444

 

$

95,447

 

 

 

 

 

 

 

Operating expense (1):

 

 

 

 

 

Cost of goods sold

 

32,938

 

25,855

 

Development

 

10,115

 

8,055

 

Sales and marketing

 

22,224

 

16,729

 

General and administrative

 

19,325

 

16,086

 

Depreciation and amortization

 

6,157

 

4,695

 

Total operating expense

 

90,759

 

71,420

 

 

 

 

 

 

 

Operating income

 

34,685

 

24,027

 

 

 

 

 

 

 

Non-operating income (expense):

 

 

 

 

 

Interest income, net

 

1,519

 

1,749

 

Other income (expense), net

 

24

 

(236

)

Non-operating income, net

 

1,543

 

1,513

 

 

 

 

 

 

 

Income before income taxes and equity in net income of unconsolidated entities

 

36,228

 

25,540

 

 

 

 

 

 

 

Income tax expense

 

13,504

 

10,291

 

 

 

 

 

 

 

Equity in net income of unconsolidated entities

 

352

 

537

 

 

 

 

 

 

 

Net income

 

$

23,076

 

$

15,786

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic

 

$

0.51

 

$

0.37

 

Diluted

 

$

0.47

 

$

0.33

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

Basic

 

45,224

 

42,401

 

Diluted

 

49,010

 

47,381

 

 

 

 

 

 

Three Months Ended March 31

 

 

 

2008

 

2007

 

(1) Includes stock-based compensation expense of:

 

 

 

 

 

Cost of goods sold

 

$

436

 

$

338

 

Development

 

321

 

253

 

Sales and marketing

 

345

 

299

 

General and administrative

 

1,642

 

1,444

 

Total stock-based compensation expense

 

$

2,744

 

$

2,334

 

 

See notes to unaudited condensed consolidated financial statements.

 

3



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Balance Sheets

 

(in thousands except share amounts)

 

March 31
2008

 

December 31
2007

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

135,937

 

$

159,576

 

Investments

 

79,715

 

99,012

 

Accounts receivable, less allowance of $168 and $161, respectively

 

98,403

 

86,812

 

Income tax receivable

 

2,551

 

8,998

 

Other

 

15,202

 

13,163

 

Total current assets

 

331,808

 

367,561

 

 

 

 

 

 

 

Property, equipment, and capitalized software, net of accumulated depreciation of $65,640 and $57,304, respectively

 

25,300

 

19,108

 

Investments in unconsolidated entities

 

20,198

 

19,855

 

Goodwill

 

156,662

 

128,141

 

Intangible assets, net

 

118,594

 

95,767

 

Deferred tax asset, net

 

12,693

 

15,658

 

Other assets

 

3,385

 

3,217

 

Total assets

 

$

668,640

 

$

649,307

 

 

 

 

 

 

 

Liabilities and shareholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued liabilities

 

$

28,792

 

$

22,325

 

Accrued compensation

 

31,168

 

64,709

 

Deferred revenue

 

144,255

 

129,302

 

Deferred tax liability, net

 

641

 

557

 

Other

 

651

 

945

 

Total current liabilities

 

205,507

 

217,838

 

 

 

 

 

 

 

Accrued compensation

 

5,750

 

13,913

 

Other long-term liabilities

 

9,083

 

9,253

 

Total liabilities

 

220,340

 

241,004

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock, no par value, 200,000,000 shares authorized, of which 45,581,443 and 44,843,166 shares were outstanding as of March 31, 2008 and December 31, 2007, respectively

 

4

 

4

 

Treasury stock at cost, 233,332 shares at March 31, 2008 and December 31, 2007

 

(3,280

)

(3,280

)

Additional paid-in capital

 

346,625

 

332,164

 

Retained earnings

 

94,833

 

71,757

 

Accumulated other comprehensive income:

 

 

 

 

 

Currency translation adjustment

 

9,879

 

7,606

 

Unrealized gains on available-for-sale investments

 

239

 

52

 

Total accumulated other comprehensive income

 

10,118

 

7,658

 

Total shareholders’ equity

 

448,300

 

408,303

 

Total liabilities and shareholders’ equity

 

$

668,640

 

$

649,307

 

 

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 Three Months Ended March 31, 2008

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

Common Stock

 

 

 

Additional

 

 

 

Other

 

Total

 

 

 

Shares

 

Par

 

Treasury

 

Paid-in

 

Retained

 

Comprehensive

 

Shareholders’

 

(in thousands, except share amounts)

 

Outstanding

 

Value

 

Stock

 

Capital

 

Earnings

 

Income

 

Equity

 

Balance as of December 31, 2007

 

44,843,166

 

$

4

 

$

(3,280

)

$

332,164

 

$

71,757

 

$

7,658

 

$

408,303

 

Comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

 

23,076

 

 

23,076

 

Unrealized gain on investments, net of income tax $107

 

 

 

 

 

 

 

187

 

187

 

Foreign currency translation adjustment

 

 

 

 

 

 

 

2,273

 

2,273

 

Total comprehensive income

 

 

 

 

 

 

23,076

 

2,460

 

25,536

 

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

 

738,277

 

 

 

5,750

 

 

 

5,750

 

Stock-based compensation

 

 

 

 

 

2,744

 

 

 

2,744

 

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

 

 

 

 

 

5,967

 

 

 

5,967

 

Balance as of March 31, 2008

 

45,581,443

 

$

4

 

$

(3,280

)

$

346,625

 

$

94,833

 

$

10,118

 

$

448,300

 

 

See notes to unaudited condensed consolidated financial statements.

 

5



 

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows

 

 

 

Three Months Ended March 31

 

(in thousands)

 

2008

 

2007

 

 

 

 

 

 

 

Operating activities

 

 

 

 

 

Net income

 

$

23,076

 

$

15,786

 

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

 

 

 

 

 

Depreciation and amortization

 

6,157

 

4,695

 

Deferred income tax expense (benefit)

 

2,876

 

(704

)

Stock-based compensation expense

 

2,744

 

2,334

 

Provision for bad debt

 

(27

)

(19

)

Equity in net income of unconsolidated entities

 

(352

)

(537

)

Foreign exchange loss

 

22

 

75

 

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

 

(5,967

)

(2,132

)

Other, net

 

250

 

(19

)

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

 

 

 

 

 

Accounts receivable

 

(5,706

)

(7,582

)

Other assets

 

(1,967

)

1,243

 

Accounts payable and accrued liabilities

 

2,770

 

2,262

 

Accrued compensation

 

(41,930

)

(26,293

)

Income taxes – current

 

7,102

 

8,457

 

Deferred revenue

 

9,221

 

11,021

 

Deferred rent

 

3,383

 

(45

)

Other liabilities

 

(275

)

(158

)

Cash provided by operating activities

 

1,377

 

8,384

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Purchases of investments

 

(24,301

)

(23,461

)

Proceeds from sale of investments

 

43,951

 

29,545

 

Capital expenditures

 

(6,711

)

(1,990

)

Acquisitions, net of cash acquired

 

(50,902

)

(52,130

)

Other, net

 

 

(3

)

Cash used for investing activities

 

(37,963

)

(48,039

)

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Proceeds from stock options exercises

 

5,750

 

1,574

 

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

 

5,967

 

2,132

 

Cash provided by financing activities

 

11,717

 

3,706

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

1,230

 

27

 

Net decrease in cash and cash equivalents

 

(23,639

)

(35,922

)

Cash and cash equivalents – beginning of period

 

159,576

 

96,140

 

Cash and cash equivalents – end of period

 

$

135,937

 

$

60,218

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid for income taxes

 

$

2,057

 

$

2,143

 

Supplemental information of non-cash investing and financing activities:

 

 

 

 

 

Unrealized gain on available-for-sale investments

 

$

294

 

$

37

 

 

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 expenses. 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, 2007 included in our Annual Report on Form 10-K filed with the SEC on March 7, 2008.

 

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, 2007.

 

SFAS No. 157, Fair Value Measurements

 

In the first quarter of 2008, we adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The standard applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances and does not require any new fair value measurements.

 

The Statement utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

·      Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.

·      Level 2—Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.

·      Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

 

We hold cash equivalents and investments that are subject to valuation under SFAS No. 157. We do not have any liabilities subject to valuation under this Statement. The table below shows the fair value of our cash equivalents and investments subject to fair value measurements:

 

 

 

Fair Value

 

Fair Value Measurements as of March 31, 2008 

 

 

 

as of

 

Using Fair Value Hierarchy

 

($000)

 

March 31, 2008

 

Level 1

 

Level 2

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

Cash equivalents

 

$

54,395

 

$

54,395

 

$

 

$

 

Available-for-sale investments

 

72,309

 

72,309

 

 

 

Trading securities

 

3,944

 

3,944

 

 

 

Total

 

$

130,648

 

$

130,648

 

$

 

$

 

 

SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities

 

SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, permits entities the option to measure many financial instruments and certain other items at fair value with changes in fair value recognized in earnings each period. SFAS No. 159 allows the fair value option to be elected on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

 

In the first quarter of 2008, we chose not to apply this fair value option to any of our eligible assets. We account for our investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Our available-for-sale investments are reported at fair value with net unrealized holding gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. Our held-to-maturity investments are reported at amortized cost. Our trading securities are reported at fair value, and unrealized gains and losses are included in earnings. We account for our investments in unconsolidated entities using the equity method.

 

 

7



 

3. Acquisitions, Goodwill, and Other Intangible Assets

 

Acquisition of the Hemscott data, media, and investor relations Web site businesses

 

In January 2008, we acquired the Hemscott data, media, and investor relations Web site businesses from Ipreo Holdings, LLC for $50,864,000 in cash including estimated post-closing adjustments and transaction costs directly related to the acquisition, less acquired cash. The acquisition includes Hemscott Data, which has more than 20 years of comprehensive fundamental data on virtually all publicly listed companies in the United States, Canada, the United Kingdom, and Ireland;  Hemscott India, which operates a state-of-the-art data collection center in New Delhi, India; Hemscott.com, a free investment research Web site in the United Kingdom; Hemscott Premium and Premium Plus, subscription-based investment research and data services; and Hemscott IR, a pioneer in best-practice online investor relations and corporate communications services in the United Kingdom. We began including the results of this acquisition in our Condensed Consolidated Financial Statements on January 9, 2008.

 

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

 

$

1,227

 

Accounts receivable

 

4,092

 

Other current assets

 

1,216

 

Fixed assets

 

1,367

 

Other non-current assets

 

309

 

Intangible assets

 

26,058

 

Goodwill

 

25,384

 

Deferred revenue

 

(4,571

)

Accounts payable and accrued liabilities

 

(2,991

)

Total purchase price

 

$

52,091

 

 

If this acquisition had occurred as of January 1, 2007 and 2008, our results of operations would not have been significantly different from the amounts reported for the three months ended March 31, 2007 and 2008, respectively.

 

Acquisition of the mutual fund data business from Standard & Poor’s

 

In March 2007, we acquired the mutual fund data business from Standard & Poor’s for $57,983,000 in cash including post-closing adjustments and transaction costs directly related to the acquisition, less acquired cash. Approximately 80% of this business is generated outside the United States. We began including the financial results of this acquisition in our Condensed Consolidated Financial Statements on March 16, 2007.

 

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 acquisition:

 

 

 

($000)

 

Cash

 

$

2,974

 

Accounts receivable

 

7,529

 

Other current assets

 

1,029

 

Fixed assets

 

126

 

Intangible assets

 

34,080

 

Goodwill

 

37,671

 

Deferred revenue

 

(16,450

)

Accrued liabilities

 

(4,246

)

Deferred tax liabilities

 

(1,626

)

Other non-current liabilities

 

(130

)

Total purchase price

 

$

60,957

 

 

8



 

The allocation includes $34,080,000 of acquired intangible assets. These assets include customer-related assets of $13,040,000 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 $20,580,000 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.

 

The deferred tax liability of $1,626,000 results primarily because the amortization expense related to certain of these intangible assets is not deductible for income tax purposes.

 

Based on the purchase price allocation, we recorded $37,671,000 of goodwill. The goodwill we recorded is not considered deductible for income tax purposes. SFAS No. 109, Accounting for Income Taxes, prohibits recognition of a deferred tax asset or liability for temporary differences in goodwill if goodwill is not amortizable and deductible for tax purposes.

 

The purchase price allocation includes a liability of $1,685,000 for severance and lease termination costs. Substantially all of these liabilities were paid as of March 31, 2008.

 

If this acquisition had occurred as of January 1, 2007, our results of operations would not have been significantly different from the amounts reported in the first quarter of 2007.

 

Goodwill

 

The following table shows the changes in our goodwill balances from January 1, 2007 to March 31, 2008:

 

 

 

($000)

 

Balance as of January 1, 2007

 

$

86,680

 

Acquisition of the mutual fund data business acquired from Standard & Poor’s

 

37,180

 

Acquisition of the minority interest in Morningstar Europe NV

 

1,000

 

Other, primarily currency translation

 

3,281

 

Balance as of December 31, 2007

 

 

128,141

 

Acquisition of the Hemscott data, media, and investor relations Web site businesses

 

25,384

 

Adjustment to the goodwill of the mutual fund data business acquired from Standard & Poor’s

 

491

 

Other, primarily currency translation

 

2,646

 

Balance as of March 31, 2008

 

$

156,662

 

 

We did not record any impairment losses in the first quarter of 2008 or 2007, respectively.

 

The following table summarizes our intangible assets:

 

 

 

As of March 31, 2008

 

As of December 31, 2007

 

($000)

 

Gross

 

Accumulated
Amortization

 

Net

 

Weighted
Average
Useful Life
(years)

 

Gross

 

Accumulated
Amortization

 

Net

 

Weighted
Average
Useful Life
(years)

 

Intellectual property

 

$

27,318

 

$

(6,380

)

$

20,938

 

10

 

$

26,956

 

$

(5,542

)

$

21,414

 

10

 

Customer-related assets

 

59,135

 

(11,957

)

47,178

 

10

 

58,721

 

(10,354

)

48,367

 

10

 

Supplier relationships

 

240

 

(39

)

201

 

20

 

240

 

(36

)

204

 

20

 

Technology-based assets

 

30,201

 

(5,940

)

24,261

 

9

 

30,059

 

(4,881

)

25,178

 

9

 

Non-competition agreement

 

810

 

(249

)

561

 

5

 

810

 

(206

)

604

 

5

 

Intangible assets related to acquisition of the Hemscott businesses

 

26,058

 

(603

)

25,455

 

10

 

 

 

 

 

Total intangible assets

 

$

143,762

 

$

(25,168

)

$

118,594

 

10

 

$

116,786

 

$

(21,019

)

$

95,767

 

10

 

 

We amortize intangible assets using the straight-line method over their expected economic useful lives. Amortization expense was $4,022,000 and $2,540,000 for the three months ended March 31, 2008 and March 31, 2007, respectively.

 

As of March 31, 2008, we estimate that aggregate amortization expense for intangible assets will be $16,275,000 in 2008; $15,961,000 in 2009; $14,445,000 in 2010; $13,290,000 in 2011; $12,626,000 in 2012; and $11,785,0000 in 2013. Our estimates of

 

9



 

future amortization expense for intangible assets may be affected by changes to the preliminary purchase price allocations, primarily the allocation associated with our acquisition of the Hemscott data, media, and investor relations Web site businesses.

 

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 dilutive effect of outstanding employee stock options and restricted stock units is reflected in the denominator using the treasury stock 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 March 31

 

(in thousands, except per share amounts)

 

2008

 

2007

 

 

 

 

 

 

 

Basic income per share:

 

 

 

 

 

Net income

 

$

23,076

 

$

15,786

 

Weighted average common shares outstanding

 

45,224

 

42,401

 

Basic net income per share

 

$

0.51

 

$

0.37

 

 

 

 

 

 

 

Diluted income per share:

 

 

 

 

 

Net income

 

$

23,076

 

$

15,786

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

45,224

 

42,401

 

Net effect of dilutive stock options and restricted stock units

 

3,786

 

4,980

 

Weighted average common shares outstanding for computing diluted income per share

 

49,010

 

47,381

 

 

 

 

 

 

 

Diluted net income per share

 

$

0.47

 

$

0.33

 

 

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. As a result of the Hemscott acquisition in the first quarter of 2008, this segment also includes revenue from the Hemscott Premium and Premium Plus subscription-based services and sales of Internet advertising space on Hemscott.com.

 

Our Individual segment also includes Morningstar Equity Research, which we distribute through several channels. 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 that purchase our research for their own use or provide our research to their affiliated financial advisors or to individual investors. In addition, investors can access our equity research through our Premium Membership offering on Morningstar.com. We also offer a variety of print publications about investing, 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. 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 advisors. 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 meet a range of investment time horizons and risk levels that financial advisors can use for their clients’ taxable and tax-deferred accounts.

 

10



 

· 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 ten core databases, available through electronic data feeds; 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; Retirement Advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms; Licensed Tools and Content, a set of online tools and editorial content designed for institutions to use in their Web sites and software; the institutional Workstation product acquired from Standard & Poor’s; Investment Profiles & Guides, which are designed for institutions to use in communicating investment information to individual investors; and Morningstar EnCorr, an asset allocation software package.

 

With the January 2008 Hemscott acquisition, our Licensed Data offerings include Hemscott Data, which has more than 20 years of comprehensive fundamental data on virtually all publicly listed companies in the United States, Canada, the United Kingdom, and Ireland. Other products that have been added to this segment include Hemscott Guru, a leading online research tool that contains financial data and directors’ biographies on more than 2,500 UK-quoted companies and 400,000 private companies; Hemscott Adviser Rankings Guide, a comprehensive listing of more than 1,800 leading providers of professional services to all UK- and Irish-registered companies listed on the London Stock Exchange; and Hemscott IR, a pioneer in best-practice online investor relations and corporate communications services in the United Kingdom.

 

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, 2007, 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. Therefore, we do not present balance sheet information, including goodwill or other intangibles, by segment.

 

The following tables show selected segment data for the three months ended March 31, 2008 and 2007:

 

 

 

Three months ended March 31, 2008

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items
& Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

26,191

 

$

30,682

 

$

68,571

 

$

 

$

125,444

 

Intersegment

 

1,168

 

12

 

1,357

 

(2,537

)

 

Total revenue

 

27,359

 

30,694

 

69,928

 

(2,537

)

125,444

 

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

 

20,650

 

20,526

 

43,208

 

(2,526

)

81,858

 

Stock-based compensation expense

 

515

 

835

 

1,394

 

 

2,744

 

Depreciation and amortization

 

433

 

527

 

1,149

 

4,048

 

6,157

 

Operating income (loss)

 

$

5,761

 

$

8,806

 

$

24,177

 

$

(4,059

)

$

34,685

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

1,609

 

$

2,264

 

$

2,539

 

$

299

 

$

6,711

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

95,163

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

30,281

 

 

 

 

 

 

 

 

 

 

 

 

March 31, 2008

 

U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

14,354

 

Non-U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

10,946

 

 

11



 

 

 

Three months ended March 31, 2007

 

($000)

 

Individual

 

Advisor

 

Institutional

 

Corporate Items
& Eliminations

 

Total

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

External customers

 

$

23,070

 

$

25,921

 

$

46,456

 

$

 

$

95,447

 

Intersegment

 

991

 

56

 

896

 

(1,943

)

 

Total revenue

 

24,061

 

25,977

 

47,352

 

(1,943

)

95,447

 

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

 

17,870

 

17,937

 

30,537

 

(1,953

)

64,391

 

Stock-based compensation expense

 

476

 

714

 

1,144

 

 

2,334

 

Depreciation and amortization

 

387

 

460

 

748

 

3,100

 

4,695

 

Operating income (loss)

 

$

5,328

 

$

6,866

 

$

14,923

 

$

(3,090

)

$

24,027

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital expenditures

 

$

80

 

$

219

 

$

541

 

$

1,150

 

$

1,990

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. revenue

 

 

 

 

 

 

 

 

 

$

79,861

 

Non-U.S. revenue

 

 

 

 

 

 

 

 

 

$

15,586

 

 

 

 

 

 

 

 

 

 

 

 

March 31, 2007

 

U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

11,086

 

Non-U.S. long-lived assets

 

 

 

 

 

 

 

 

 

$

4,606

 

 

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)

 

March 31
2008

 

December 31
2007

 

Available-for-sale

 

$

72,309

 

$

91,546

 

Held-to-maturity

 

3,462

 

3,428

 

Trading securities

 

3,944

 

4,038

 

Total

 

$

79,715

 

$

99,012

 

 

Held-to-maturity investments include a $2,500,000 certificate of deposit held as collateral against two bank guarantees for our office space lease in Australia.

 

7. Investments In Unconsolidated Entities

 

Our investments in unconsolidated entities consist primarily of the following:

 

Morningstar Japan K.K. Morningstar Japan K.K. (MJKK) develops and markets products and services customized for the Japanese market. MJKK’s shares are traded on the Osaka Stock Exchange, “Hercules Market,” using the ticker 4765. As of March 31, 2008 and December 31, 2007, 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 $17,766,000 and $17,522,000 as of March 31, 2008 and December 31, 2007, respectively. The market value of our investment in MJKK was approximately Japanese Yen 5.3 billion (approximately U.S. $53,546,000) as of March 31, 2008 and Japanese Yen 5.4 billion (approximately U.S. $48,007,000) as of December 31, 2007.

 

Morningstar Korea, Ltd. 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 March 31, 2008 and December 31, 2007. We account for this investment using the equity method. Our investment totaled $1,511,000 and $1,512,000 as of March 31, 2008 and December 31, 2007, respectively.

 

Other Investments in Unconsolidated Entities. As of March 31, 2008 and December 31, 2007, the book value of our other investments in unconsolidated entities totaled $921,000 and $821,000, respectively, and consist primarily of our investments in Morningstar Danmark A/S (Morningstar Denmark) and Morningstar Sweden AB (Morningstar Sweden). Morningstar Denmark and Morningstar Sweden develop and market products and services customized for their respective markets. Our ownership interest in both Morningstar Denmark and Morningstar Sweden was approximately 25% as of March 31, 2008 and December 31, 2007. We account for our investments in Morningstar Denmark and Morningstar Sweden using the equity method.

 

12



 

The following table shows condensed combined financial information, a portion of which is unaudited, for our investments in unconsolidated entities.

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Revenue

 

$

20,742

 

$

8,279

 

Operating income

 

$

1,626

 

$

2,158

 

Net income

 

$

1,129

 

$

1,174

 

 

The increase in revenue mainly reflects MJKK’s revenue from acquisitions.

 

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, 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 the 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 March 31, 2008, we had 2,651,873 shares available for future grants under our 2004 Stock Incentive Plan, compared with 2,657,982 as of December 31, 2007.

 

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.  As a result, all of these options are vested as of March 31, 2008.  Because the options granted under all three plans expire 10 years after the date of grant, some of these options remain outstanding.  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.  As of March 31, 2008, there were 116,076 options remaining to be exercised, compared with 217,286 as of December 31, 2007.

 

Accounting for Stock-Based Compensation Awards

 

In accordance with SFAS No. 123 (R), Stock Based Compensation, we estimate forfeitures of all employee stock-based awards and recognize compensation cost only for those awards expected to vest. We determine forfeiture rates based on historical experience.  Estimated forfeitures are adjusted to actual forfeiture experience as needed.

 

The following table summarizes stock-based compensation expense:

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Stock-based compensation expense

 

$

2,744

 

$

2,334

 

 

We recorded tax benefits related to this of $891,000 and $839,000 for the three months ended March 31, 2008 and 2007, respectively.

 

13



 

Restricted Stock Units

 

We measure the fair value of our restricted stock units on the date of grant based on the closing market price of the underlying common stock on the day prior to grant. We amortize that value to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period.  The total grant date fair value of restricted stock units granted in the first quarter of 2008 was approximately $2,367,000. As of March 31, 2008, the total amount of unrecognized stock-based compensation expense related to restricted stock units was approximately $16,769,000. We expect to  recognize this expense over an average period of approximately 36 months.

 

The following table summarizes restricted stock unit activity in the first three months of 2008:

 

Restricted Stock Units (RSUs)

 

Unvested

 

Vested but
Deferred

 

Total

 

Weighted
Average
Grant Date
Fair Value

 

RSUs outstanding—December 31, 2007

 

414,282

 

6,621

 

420,903

 

$

48.41

 

Granted

 

39,347

 

 

39,347

 

60.15

 

Vested

 

(1,765

)

 

(1,765

)

60.15

 

Forfeited

 

(12,087

)

 

(12,087

)

48.11

 

RSUs outstanding— March 31, 2008

 

439,777

 

6,621

 

446,398

 

$

49.45

 

 

Stock Options

 

The following tables summarize stock option activity in the first three months of 2008 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.

 

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

 

Underlying
Shares

 

Weighted
Average
Exercise
Price

 

Options outstanding—December 31, 2007

 

2,068,590

 

$

12.84

 

Canceled

 

(6,725

)

16.78

 

Exercised

 

(142,610

)

6.06

 

Options outstanding—March 31, 2008

 

1,919,255

 

$

13.41

 

 

 

 

 

 

 

Options exercisable—March 31, 2008

 

1,613,122

 

$

12.75

 

 

All Other Option Grants, Excluding Activity Shown Above

 

Underlying
Shares

 

Weighted
Average
Exercise
Price

 

Options outstanding—December 31, 2007

 

4,377,089

 

$

13.61

 

Canceled

 

(14,426

)

20.86

 

Exercised

 

(595,429

)

8.56

 

Options outstanding—March 31, 2008

 

3,767,234

 

$

14.44

 

 

 

 

 

 

 

Options exercisable—March 31, 2008

 

3,305,487

 

$

13.30

 

 

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 during the three months ended March 31, 2008 and 2007 was $41,636,000 and $10,767,000, respectively.

 

14



 

The table below shows additional information for options outstanding and options exercisable as of March 31, 2008:

 

 

 

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)

 

 

$2.77

 

292,923

 

0.67

 

$

2.77

 

$

17,160

 

292,506

 

0.67

 

$

2.77

 

$

17,136

 

 

$8.57 - $14.70

 

3,677,353

 

2.75

 

12.49

 

179,669

 

3,676,391

 

2.75

 

12.49

 

179,619

 

 

$16.89 - $38.16

 

1,716,213

 

6.97

 

19.45

 

71,917

 

949,712

 

6.91

 

18.74

 

40,468

 

 

$2.77 - $38.16

 

5,686,489

 

3.91

 

$

14.09

 

$

268,746

 

4,918,609

 

3.43

 

$

13.12

 

$

237,223

 

Vested or Expected to Vest:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$2.77 - $38.16

 

5,607,013

 

3.87

 

$

14.00

 

$

265,482

 

 

 

 

 

 

 

 

 

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $61.35 on March 31, 2008, which would have been received by the option holders had all option holders exercised their options as of that date.

 

As of March 31, 2008, the total amount of unrecognized stock-based compensation expense related to non-vested stock options was approximately $3,208,000.  We expect to recognize this expense over a weighted average period of approximately 12 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.

 

In May 2006, Don Phillips entered into a Rule 10b5-1 sales plan contemplating the sale of shares to be acquired through stock option exercises. Upon exercise of these stock options, we will make payments to him, as prescribed by the Agreement. In the first three months of 2008, Don exercised 101,210 options, of which 72,710 were sold under his 10b5-1 plan.  As of March 31, 2008 and December 31, 2007, our Condensed Consolidated Balance Sheets include a liability of $312,000 and $585,000, respectively, for the Agreement. The liability is classified as “Other current liabilities.”  The reduction in the liability since December 31, 2007 reflects amounts paid to Don in the first quarter of 2008 in accordance with the Agreement.

 

10. Income Taxes

 

The following table shows our effective income tax rate for the three months ended March 31, 2008 and 2007:

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Income before income taxes and equity in net income of unconsolidated entities

 

$

36,228

 

$

25,540

 

Equity in net income of unconsolidated entities

 

352

 

537

 

Total

 

$

36,580

 

$

26,077

 

Income tax expense

 

$

13,504

 

$

10,291

 

Effective income tax expense rate

 

36.9%

 

39.5%

 

 

Our effective tax rate declined by 2.6 percentage points in the first quarter of 2008.  The 2008 effective tax rate reflects a decrease in our U.S. state tax rate related to a change in state tax law enacted in 2007.  The effective tax rate also reflects the favorable impact of lower tax rates on earnings generated outside of the United States.

 

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. 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 2004 to the present. In

 

15



 

non-U.S. jurisdictions, the statute of limitations generally extends to years prior to 2003. There were no significant changes to uncertain tax positions in the first quarter of 2008 due to lapses of statutes of limitation or audit activity.

 

We are currently under audit by various state and local tax authorities in the United States. 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 2008. It is not possible to estimate the impact of current audits on previously recorded unrecognized tax benefits.

 

As of December 31, 2007 we had approximately $7,195,000 of gross unrecognized tax benefits, of which $4,741,000, if recognized, would result in a reduction of our effective income tax rate, and $2,383,000 of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of the deduction.  In the first quarter of 2008 we reduced the unrecognized tax benefit in the amount of $2,383,000 and recorded a corresponding decrease to our deferred tax assets due to expected resolution concerning the timing of the deduction. Because of the impact of deferred tax accounting, other than interest and penalties, this liability did not affect our 2008 effective tax rate. Adjustments recorded to other unrecognized tax benefits in the first three months of 2008 were not material.

 

Our effective income tax rate reflects the fact that we are not recording an income tax benefit related to losses recorded by certain of our non-U.S. operations. The net operating losses (NOLs) may become deductible in certain non-U.S. tax jurisdictions to the extent these non-U.S. operations become profitable. In the year certain non-U.S. entities record a loss, we do not record a corresponding tax benefit, thus increasing our effective tax rate. For each of our operations, we evaluate whether it is more likely than not that the tax benefits related to NOLs 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 NOLs will be realized, we reduce the tax valuation allowances related to these NOLs, which results in a reduction to our income tax expense and our effective tax rate in the period.  In the first quarter of 2008 and 2007, we recorded a net reduction of the valuation allowances related to the NOLs for certain of our non-U.S. operations, reducing our effective tax rate in each of these years.

 

11. Contingencies

 

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 providers, including fund lineup recommendations for retirement plan sponsors. In July 2005, the SEC issued a subpoena to Morningstar Associates that was virtually identical to its February 2005 request.

 

Subsequently, the SEC focused on disclosure relating to an optional service offered to retirement plan sponsors (employers) that select 401(k) plan services from ING, one of Morningstar Associates’ clients. In response to the SEC investigation, ING and Morningstar Associates revised certain documents for plan sponsors to further clarify the roles of ING and Morningstar Associates in providing that service. The revisions also help reinforce that Morningstar Associates makes its selections only from funds available within ING’s various retirement products.

 

In January 2007, the SEC notified Morningstar Associates that it ended its investigation, with no enforcement action, fines, or penalties.

 

New York Attorney General’s Office

 

In December 2004, Morningstar Associates received a subpoena from the New York Attorney General’s office seeking information and documents related to an investigation the New York Attorney General’s office is conducting. The request is similar in scope to the SEC subpoena described above. Morningstar Associates has provided the requested information and documents.

 

In January 2007, Morningstar Associates received a Notice of Proposed Litigation from the New York Attorney General’s office. The Notice centers on the same issues that became the focus of the SEC investigation described above. The Notice gave Morningstar Associates the opportunity to explain why the New York Attorney General’s office should not institute proceedings. Morningstar Associates promptly submitted its explanation and has cooperated fully with the New York Attorney General’s office.

 

16



 

We cannot predict the scope, timing, or outcome of this matter, which may include the institution of administrative, civil, injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key employees, and the loss of customers. We also cannot predict what impact, if any, this matter may have on our business, operating results, or financial condition.

 

United States Department of Labor

 

In May 2005, Morningstar Associates received a subpoena from the United States Department of Labor, seeking information and documents related to an investigation the Department of Labor is conducting. The Department of Labor subpoena is substantially similar in scope to the SEC and New York Attorney General subpoenas.

 

In January 2007, the Department of Labor issued a request for additional documents pursuant to the May 2005 subpoena, including documents and information regarding Morningstar Associates’ retirement advice products for plan participants. Morningstar Associates continues to cooperate fully with the Department of Labor.

 

We cannot predict the scope, timing, or outcome of this matter, which may include the institution of administrative, civil, injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key employees, and the loss of customers. We also cannot predict what impact, if any, these matters may have on our business, operating results, or financial condition.

 

In addition to these proceedings, we are involved in legal proceedings and litigation that have arisen in the normal course of our business. Although the outcome of a particular proceeding can never be predicted, we do not believe that the result of any of these matters will have a material adverse effect on our business, operating results, or financial condition.

 

12. Recently Issued Accounting Pronouncements

 

In March 2008, the Financial Accounting Standards Board (FASB) issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of SFAS No. 133. The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. To date, we have not engaged in currency or other hedging activities, and we do not currently have any positions in derivative instruments. Therefore, we do not expect the adoption of SFAS No. 161 will have any impact on our Consolidated Financial Statements.

 

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations. SFAS No. 141(R) modifies the financial accounting and reporting of business combinations. SFAS No. 141(R) requires the acquirer to recognize and measure the fair value of the acquired operation as a whole, and the assets acquired and liabilities assumed at their full fair values as of the date control is obtained, regardless of the percentage ownership in the acquired operation or how the acquisition was achieved. SFAS No. 141(R) is effective for business combination transactions with acquisition dates on or after the first annual reporting period beginning on or after December 15, 2008. SFAS No. 141(R) is required to be adopted concurrently with SFAS No. 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. SFAS No. 141(R) requires prospective application and prohibits earlier application. We are in the process of determining the effect the adoption of SFAS No. 141 (R) will have on our Consolidated Financial Statements.

 

In December 2007, the FASB issued SFAS No. 160, Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. SFAS No. 160 amends the financial accounting and reporting of noncontrolling (or minority) interests in consolidated financial statements. SFAS No. 160 is required to be adopted concurrently with SFAS No. 141(R) and is effective for the first annual reporting period beginning on or after December 15, 2008. Earlier application is prohibited. We are in the process of determining the effect the adoption of SFAS No. 160 will have on our Consolidated Financial Statements.

 

17



 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The discussion included in this section, as well as other sections of this Quarterly Report on Form 10-Q, contains forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995. These statements are based on our current expectations about future events or future financial performance. Forward-looking statements by their nature address matters that are, to different degrees, uncertain, and often contain words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue.” These statements involve known and unknown risks and uncertainties that may cause the events we discussed not to occur or to differ significantly from what we expected. For us, these risks and uncertainties include, among others, general industry conditions and competition; damage to our reputation resulting from claims made about possible conflicts of interest; liability for any losses that result from an actual or claimed breach of our fiduciary duties; legal, regulatory, or political issues related to our data center in China; the potential impact of market volatility on revenue from asset-based fees; a prolonged outage of our database and network facilities; challenges faced by our non-U.S. operations; and the availability of free or low-cost investment information.

 

A more complete description of these risks and uncertainties can be found in our other filings with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2007. If any of these risks and uncertainties materialize, our actual future results may vary significantly from what we projected. We do not undertake to update our forward-looking statements as a result of new information or future events.

 

Understanding our Company

 

Our Business

 

Our mission is to create great products that help investors reach their financial goals. We offer an extensive line of Internet, software, and print-based products for individual investors, financial advisors, and institutional clients. We also offer asset management services for advisors, institutions, and retirement plan participants. Many of our products are sold through subscriptions or license agreements. As a result, we typically generate recurring revenue.

 

We emphasize a decentralized approach to running our business to empower our managers and to create a culture of responsibility and accountability. We operate our decentralized business structure in three global business segments: Individual, Advisor, and Institutional. In all three of these segments, we believe our work helps individual investors make better investment decisions.

 

Historically, we have focused primarily on organic growth by introducing new products and services and expanding our marketing efforts for existing products.  However, we have made and expect to continue to make selective acquisitions that support our four key growth strategies, which are:

 

·      Enhance our position in each of our three operating segments by focusing on our three major Internet-based platforms;

·      Become a global leader in funds-of-funds investment management;

·      Expand the range of services we offer investors, financial advisors, and institutional clients; and

·      Expand our international brand presence, products, and services.

 

Industry Overview

 

We monitor developments in the economic and financial information industry on an ongoing basis and use these insights to help inform our company strategy, product development plans, and marketing initiatives.

 

In the first quarter of 2008, the U.S. equity markets were volatile, with stock market indexes reaching an 18-month low in March. Morningstar’s U.S. Market Index, a broad market benchmark, was down 9.5% through March 31, 2008. Most global markets also experienced losses during the quarter. Total U.S. mutual fund assets declined to $11.7 trillion as of March 31, 2008, based on data from the Investment Company Institute (ICI), compared with $12.0 trillion as of December 31, 2007. Many stock and bond funds experienced net outflows in the aftermath of the global financial turmoil that began in late 2007.

 

Market volatility took a toll on alternative asset classes, such as hedge funds. Based on data from Hedge Fund Research, hedge funds had $16.5 billion in net inflows during the first quarter of 2008, which was down significantly from inflow levels in previous quarters.

 

Assets in exchange-traded funds (ETFs) also declined to $571 billion as of March 31, 2008, compared with $601 billion as of December 31, 2007, based on data from the ICI.

 

18



 

Industry trends haven’t been uniformly negative, though. Online advertising has remained strong as advertisers have continued to shift spending from traditional media to the Internet. Industry publication eMarketer projects that total online ad spending will reach $25.9 billion in 2008, a 23% increase from 2007. Based on data from Nielsen/Net Ratings, aggregate page views and unique users to financial and investment sites both increased by about 25% in the first quarter of 2008 compared with the same period in 2007, although the number of pages viewed per visit declined. We believe this indicates that while some investors may be disengaged because of the market downturn, many people are still interested in investment-related content.

 

Overall, we believe the disruption in the financial markets has caused fairly widespread investor uncertainty, and the market downturn has also created some spending cutbacks among asset management firms and other financial services companies. We continue to monitor the potential impact of these developments on our business.

 

Three Months Ended March 31, 2008 vs. Three Months Ended March 31, 2007

 

Consolidated Results

 

 

 

Three Months Ended March 31

 

Key Metrics ($000)

 

2008

 

2007

 

Change

 

Revenue

 

$

125,444

 

$

95,447

 

31.4

%

Operating income

 

34,685

 

24,027

 

44.4

%

Operating margin

 

27.6

%

25.2

%

2.4

pp

 

 

 

 

 

 

 

 

Cash used for investing activities

 

$

(37,963

)

$

(48,039

)

(21.0

)%

Cash provided by financing activities

 

11,717

 

3,706

 

216.2

%

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

1,377

 

$

8,384

 

(83.6

)%

Capital expenditures

 

(6,711

)

(1,990

)

237.2

%

Free cash flow

 

$

(5,334

)

$

6,394

 

NMF

 

 

 

 

 

 

 

 

 

NMF — not meaningful

pp — percentage points

 

We define free cash flow as cash provided by or used for operating activities less capital expenditures. We present free cash flow solely as supplemental disclosure to help you better understand how much cash is available after we spend money to operate our business. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not a measure of performance set forth under U.S. generally accepted accounting principles (GAAP). Also, the free cash flow definition we use may not be comparable to similarly titled measures used by other companies.

 

First-Quarter Highlights

 

 

·

Revenue increased 31.4% compared with the same period in 2007, driven by organic growth as well as revenue from acquisitions. Despite the difficult market environment, we continued to generate relatively strong organic revenue growth as well as incremental revenue from acquisitions.

 

 

 

 

·

Our first-quarter financial results include the results of operations of the Hemscott data, media, and investor relations Web site businesses, which we acquired on January 9, 2008 as well as the mutual fund data business we acquired from Standard and Poor’s on March 16, 2007. Overall, revenue from acquisitions contributed 11.6 percentage points of the first-quarter revenue growth.

 

 

 

 

·

Licensed Data and Investment Consulting were the two largest contributors to organic revenue growth during the quarter.

 

 

 

 

·

International revenue nearly doubled compared with the first quarter of 2007, driven by acquisitions as well as strong organic revenue growth. Nearly one-fourth of our first-quarter revenue was from outside the United States. More than half of the growth in international revenue was from acquisitions.

 

 

 

 

·

Operating margin increased by about 2.4 percentage points relative to the prior-year period, and was about on par with the operating margin in the fourth quarter of 2007. We had $1.3 million of product implementation expense related to the Advice by Ibbotson platform in the first quarter of 2007, which did not recur in the current quarter. While costs for office leases, amortization of intangibles, and seasonal marketing campaigns for certain products rose, several other expense categories declined as a percentage of revenue.

 

19



 

 

·

Free cash flow decreased by approximately $11.7 million compared with the prior-year period, reflecting a $7.0 million decline in cash flow from operations and a $4.7 million increase in capital expenditures.

 

Consolidated Revenue

 

Because we’ve made several acquisitions in recent years, comparing our financial results from year to year is complex. To make it easier for investors to compare our results in different periods, we provide information on both organic revenue, which reflects our underlying business excluding acquisitions, and revenue from acquisitions. We include an acquired operation as part of our revenue from acquisitions for 12 months after we complete the acquisition. After that, we include it as part of our organic revenue.

 

The table below shows the period in which we included each acquired operation in revenue from acquisitions.

 

Acquisition

 

Three Months Ended March 31, 2008

 

 

 

 

 

Mutual fund data business acquired from Standard & Poor’s

 

January 1, 2008 through March 15, 2008

 

 

 

 

 

Hemscott data, media, and investor relations Web site businesses

 

January 9, 2008 through March 31, 2008

 

 

In the first quarter of 2008, our consolidated revenue increased 31.4% to $125.4 million. We had relatively strong organic growth as well as new revenue from acquisitions. Acquisitions contributed $11.1 million to our consolidated revenue in the first quarter of 2008. Organic revenue growth was $16.6 million, or 17.4%, in the first quarter of 2008 compared with the first quarter of 2007.

 

Consolidated revenue excluding acquisitions and the impact of foreign currency translations (organic revenue) is considered a non-GAAP financial measure. The definition of organic revenue we use may not be the same as similarly titled measures used by other companies. Organic revenue should not be considered an alternative to any measure of performance as promulgated under GAAP.

 

The table below reconciles consolidated revenue with revenue excluding acquisitions and the impact of foreign currency translations (organic revenue):

 

 

 

Three Months Ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Consolidated revenue

 

$

125,444

 

$

95,447

 

31.4

%

Less: acquisitions

 

(11,098

)

 

NMF

 

Less: impact of foreign currency translations

 

(2,281

)

 

NMF

 

Consolidated revenue excluding acquisitions and foreign currency translations

 

$

112,065

 

$

95,447

 

17.4

%

 

While organic revenue growth and acquisitions had the most significant impact on revenue in the first quarter of 2008, we also enjoyed a benefit from foreign currency translations because of the continued weakness in the U.S. dollar.

 

Our revenue growth was diversified by segment, with contributions from all three segments. However, the Institutional segment remained the largest contributor, generating about three-fourths of the increase in revenue for the quarter. Institutional segment revenue increased $22.6 million, or 47.7%, in the first quarter of 2008, with acquisitions contributing $9.5 million to segment revenue in the quarter. Our two other segments also contributed to revenue growth, but to a lesser extent. Advisor segment revenue rose $4.7 million, or 18.2%, with acquisitions accounting for $1.1 million of the increase. Individual segment revenue increased $3.3 million, or 13.7%, with acquisitions contributing $0.5 million.

 

The table below shows our consolidated revenue by segment for the three months ended March 31, 2008 and March 31, 2007:

 

 

 

Three Months Ended March 31

 

 

 

2008

 

2007

 

Revenue by Segment ($000)

 

Amount

 

% of total

 

Amount

 

% of total

 

Individual

 

$

27,359

 

21.8

%

$

24,061

 

25.2

%

Advisor

 

30,694

 

24.5

 

25,977

 

27.2

 

Institutional

 

69,928

 

55.7

 

47,352

 

49.6

 

Elimination of intersegment revenue

 

(2,537

)

(2.0

)

(1,943

)

(2.0

)

Consolidated revenue

 

$

125,444

 

100.0

%

$

95,447

 

100.0

%

 

20



 

On a product level, Investment Consulting and Licensed Data were the two largest contributors to growth in organic revenue. Much of our Investment Consulting business focuses on asset allocation services that we provide for funds of funds, where we typically act as a portfolio consultant or portfolio construction manager. While we saw significant growth in assets under advisement year over year, asset levels declined slightly compared with the fourth quarter of 2007. Changes in the value of assets under advisement can come from two primary sources: gains or losses related to overall trends in market performance, and net inflows or outflows caused when investors add to or redeem shares from these portfolios. The downtrend in market returns was the main factor behind the sequential asset decline in the first quarter of 2008.

 

Revenue for Licensed Data increased partly because of new revenue from the fund data business acquired from Standard & Poor’s and the Hemscott data business. Even without the effect of acquisitions, however, Morningstar’s existing Licensed Data business was a major contributor to revenue growth in the quarter because of strong renewal rates and continued growth in client demand.

 

The remaining increase in organic revenue on a product level was driven primarily by Morningstar Advisor Workstation, Morningstar Direct, and, to a lesser extent, Morningstar.com, which includes Premium Membership service and Internet advertising sales.

 

Revenue from international operations continues to become a more important part of our business. Because the fund data business acquired from Standard & Poor’s and the Hemscott businesses we acquired both have extensive operations outside the United States, revenue from international operations nearly doubled compared with the first quarter of 2007. Revenue from international operations grew $14.7 million, or 94.3%, to $30.3 million in the first quarter of 2008, with acquisitions contributing $8.9 million of the increase. International revenue accounted for 24.1% of consolidated revenue in the first quarter of 2008—nearly 8 percentage points higher than in the first quarter of 2007.

 

Foreign currency translations had a much smaller, but still favorable, impact on international revenue. Foreign currency translations contributed $2.3 million to international revenue during the period. Excluding the impact of foreign currency translations and acquisitions, international revenue increased approximately 22.5% compared with the prior-year period. This growth rate was higher than the U.S. organic revenue growth rate and was largely driven by our Australian and European operations.

 

The table below presents a reconciliation from international revenue to international revenue excluding acquisitions and the impact of foreign currency translations (international organic revenue):

 

 

 

Three Months Ended March 31

 

($000)

 

2008

 

2007

 

Change

 

International revenue

 

$

30,281

 

$

15,586

 

94.3

%

Less: acquisitions

 

(8,904

)

 

NMF

 

Less: impact of foreign currency translations

 

(2,281

)

 

NMF

 

International revenue excluding acquisitions and foreign currency translations

 

$

19,096

 

$

15,586

 

22.5

%

 

We present international revenue excluding acquisitions and the impact of foreign currency translations (international organic revenue) because we believe this non-GAAP financial measure helps investors better compare period-to-period results. International organic revenue should not be considered an alternative to any measure of performance as promulgated under GAAP.

 

Consolidated Operating Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Operating expense

 

$

90,759

 

$

71,420

 

27.1

%

% of revenue

 

72.4

%

74.8

%

(2.4

)pp

 

In the first quarter of 2008, our consolidated operating expense increased $19.4 million, or 27.1%, compared with the prior-year period. Two primary factors impacted all of our operating expense categories: compensation-related costs, including incentive compensation expense, and recent acquisitions. Because of the timing of acquisitions made in 2008 and 2007, we had additional expense in the first quarter of 2008 that did not exist in the same period in 2007.

 

Compensation-related expense, excluding bonuses, rose in all of our expense categories and represented $10.5 million, or approximately half of the increase in consolidated operating expense. Part of the increase was driven by additional headcount from acquisitions, but we also had incremental costs from our existing operations. We had approximately 2,040 employees worldwide as of March 31, 2008, compared with approximately 1,650 as of March 31, 2007. This growth mainly reflects employees from acquisitions and continued hiring in our development center in China and in the United States. Bonus expense recorded in the first quarter of 2008

 

21



 

increased by $2.5 million, or 25.3%, because of acquisitions and year-over-year improvement in our financial performance. Changes in the size of our bonus pool are based on growth in our operating income, which may or may not recur.

 

Other factors contributing to the increase in operating expenses include higher office lease expense related to our new corporate headquarters and our other operations around the world, and higher marketing expense, primarily because of expanded campaigns to promote annual publications published in the first quarter.  We also had higher amortization expense in the first quarter of 2008 related to acquisitions. This additional amortization expense contributed $1.5 million to the operating expense increase in the first quarter compared with the prior-year period. We expect that amortization of intangible assets will be an ongoing cost through the useful lives of these assets, which generally range from two to 25 years. These expense increases were partially offset by a substantial reduction in product implementation costs related to the Advice by Ibbotson service and, to a lesser extent, by lower legal and professional fees.

 

Cost of Goods Sold

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Cost of goods sold

 

$

32,938

 

$

25,855

 

27.4

%

% of revenue

 

26.3

%

27.1

%

(0.8

)pp

Gross profit

 

$

92,506

 

$

69,592

 

32.9

%

Gross margin

 

73.7

%

72.9

%

0.8

pp

 

Cost of goods sold is our largest category of operating expense, accounting for more than one-third of our total operating expense in both the first quarter of 2008 and 2007. Our business relies heavily on human capital, and cost of goods sold includes the compensation expense for employees who produce our products and services.

 

Cost of goods sold increased $7.1 million in the first quarter of 2008. The increase was almost entirely driven by higher compensation expense, including bonus. However, this was partly offset by a substantial reduction in product implementation expense. In the first quarter of 2007, we recorded $1.3 million of outsourced product implementation expense associated with the Advice by Ibbotson service, which did not recur in the first quarter of 2008.

 

Our gross margin in the first quarter of 2008 increased slightly to 73.7%, compared with 72.9% in the first quarter of 2007.

 

Development Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Development expense

 

$

10,115

 

$

8,055

 

25.6

%

% of revenue

 

8.1

%

8.4

%

(0.3

)pp

 

Development expense rose $2.1 million in the first quarter of 2008. This increase was mainly driven by higher compensation costs, including bonus expense. As a percentage of revenue, development expense declined modestly in the first quarter of 2008 compared with the first quarter of 2007.

 

Sales and Marketing Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Sales and marketing expense

 

$

22,224

 

$

16,729

 

32.8

%

% of revenue

 

17.7

%

17.5

%

0.2

pp

 

Sales and marketing expense increased $5.5 million in the first quarter of 2008. Higher compensation expense, including incremental costs added by acquisitions, was the largest driver behind the increase. However, sales and marketing expense also rose because of expanded marketing campaigns and incremental marketing for new products introduced after the first quarter of 2007. We typically incur higher marketing expense for our annual publications in the first quarter, and we also increased marketing spending this year versus 2007 levels.

 

As a percentage of revenue, sales and marketing expense increased slightly in the first quarter of 2008 compared with the first quarter of 2007.

 

22



 

General and Administrative Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

General and administrative expense

 

$

19,325

 

$

16,086

 

20.1

%

% of revenue

 

15.4

%

16.9

%

(1.5

)pp

 

General and administrative expense increased $3.2 million in the first quarter of 2007. Office lease expense increased because we’re now recording expense for the new corporate headquarters we expect to move into later this year, in addition to the lease costs we’re paying for our current headquarters. Compensation expense also was up versus the prior-year period. However, higher costs in these areas were partially offset by declines in other areas, such as legal fees.

 

As a percentage of revenue, general and administrative expense dropped 1.5 percentage points in the first quarter of 2008 compared with the same period in 2007 as revenue growth outpaced growth in this expense category.

 

Depreciation and Amortization Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Depreciation expense

 

$

2,135

 

$

2,155

 

(0.9

)%

Amortization expense

 

4,022

 

2,540

 

58.3

%

Total depreciation and amortization expense

 

$

6,157

 

$

4,695

 

31.1

%

% of revenue

 

4.9

%

4.9

%

 

 

Depreciation and amortization expense rose $1.5 million in the first quarter of 2008. The increase was entirely driven by amortization of intangible assets related to acquisitions. As a percentage of revenue, however, this category of expense has remained flat.

 

We expect that amortization of intangible assets will be an ongoing cost for the remaining life of the assets. Based on acquisitions completed through March 31, 2008, we estimate that aggregate amortization expense for intangible assets will be $16.3 million in 2008.

 

Stock-Based Compensation Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Stock-based compensation expense

 

$

2,744

 

$

2,334

 

17.6

%

% of revenue

 

2.2

%

2.4

%

(0.2

)pp

 

Stock-based compensation expense increased $0.4 million in the first quarter of 2008 and declined slightly as a percentage of revenue compared with the same period in 2007.

 

In 2008, we expect to record total stock-based compensation expense of approximately $9.9 million for employee stock options and restricted stock units granted as of March 31, 2008. Under Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share Based Payment, we record stock-based compensation cost only for those awards that ultimately vest. As a result, our stock-based compensation expense reflects an estimate of an expected forfeiture rate. This amount is subject to change based on additional equity grants or changes in our estimated forfeiture rate related to these grants. We usually make this adjustment in the second quarter, which is when most of our larger equity grants typically vest. We typically issue the majority of our equity grants in May.

 

Bonus Expense

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Bonus expense

 

$

12,537

 

$

10,006

 

25.3

%

% of revenue

 

10.0

%

10.5

%

(0.5

)pp

 

As a percentage of revenue, bonus expense declined slightly in the first quarter of 2008 compared with the prior-year period. Bonus expense increased $2.5 million in the first quarter of 2008, because of improved financial performance versus the first quarter of 2007 and incremental bonus expense for increased headcount from acquisitions. Changes in the size of our bonus pool are based on operating income growth, which may or may not recur. We include bonus expense in each of our operating expense categories.

 

23



 

Consolidated Operating Income

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Operating income

 

$

34,685

 

$

24,027

 

44.4

%

% of revenue

 

27.6

%

25.2

%

2.4

pp

 

Consolidated operating income increased $10.7 million in the first quarter of 2008, reflecting the $30.0 million growth in revenue partially offset by the $19.4 million growth in operating expense. The margin improvement reflects the impact of lower product implementation costs related to the Advice by Ibbotson service, which were negligible in the first quarter of 2008. In addition, although office lease expense increased as a percentage of revenue, lower legal fees, professional fees and other G&A-related spending, as a percentage of revenue more than offset the increase.

 

Consolidated Free Cash Flow

 

Historically, free cash flow has been lower in the first quarter compared with the other three quarters of the year. This results from the timing of our annual bonus payments. We typically pay bonuses in the first quarter of the year and these payments reduce our cash flow from operations. As a result of our annual bonus payments in the first quarter of 2008, we generated negative free cash flow of $5.3 million in the first quarter of 2008, reflecting cash provided by operating activities of $1.4 million and capital expenditures of approximately $6.7 million.

 

Free cash flow decreased by $11.7 million in the first quarter of 2008 compared with the prior-year period, reflecting a $7.0 million decrease in cash provided by operating activities combined with a $4.7 million increase in capital expenditures.

 

Capital expenditures were $6.7 million in the first quarter of 2008, compared with $2.0 million in the prior-year quarter.  The increase was almost entirely driven by capital expenditures for our new office space in Chicago for our corporate headquarters and U.S. operations. In the first quarter of 2007, we made capital expenditures for computer hardware to keep our operations up and running in the event of a disaster, as well as design work related to our new office space in Chicago.

 

To provide investors with additional insight into our financial results, we provide a comparison between the increase in net income with the change in cash flow provided by operating activities. Despite the $7.3 million increase in net income, cash flow provided by operating activities decreased by $7.0 million in the first quarter of 2008 compared with the prior-year period.

 

Cash provided by operating activities declined mainly because of a $14.0 million increase in the amount of cash paid for bonuses in the first quarter of 2008. In the first quarter of 2008 we made annual bonus payments of approximately $49.3 million, compared with $35.3 million in the first quarter of 2007. The higher bonuses in 2008 were driven by improved financial performance in 2007 versus the prior year and incremental bonuses from acquisitions. Other assets increased by $2.0 million in the first quarter of 2008 compared with a decline of $1.2 million in the first quarter of 2007. The increase is primarily from a receivable related to the tenant improvement allowance for our new corporate headquarters and U.S.-based operations. We will be reimbursed for a portion of the payments we made related to the build-out of our new office space. A slightly lower increase in deferred revenue also contributed to the decline in cash provided by operating activities.

 

Higher deferred rent partially offset these negative impacts on cash from operations.  Included in our deferred rent balance is the tenant improvement allowance we have received in connection with our build-out of our new office space in Chicago for our corporate headquarters and U.S. operations. We will amortize this allowance over the lease term as a reduction in office lease expense.

 

24



 

The table below presents a reconciliation between the increase in net income and the decrease in cash flow provided by operating activities:

 

 

 

Three months ended March 31

 

($000)

 

2008

 

2007

 

Change

 

Net income

 

$

23,076

 

$

15,786

 

$

7,290

 

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

 

 

 

 

 

 

 

Excess tax benefits in accordance with SFAS No. 123(R)

 

(5,967

)

(2,132

)

(3,835

)

Depreciation and amortization expense

 

6,157

 

4,695

 

1,462

 

Stock-based compensation expense

 

2,744

 

2,334

 

410

 

All other non-cash items included in net income

 

2,769

 

(1,204

)

3,973

 

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

 

 

 

 

 

 

 

Cash paid for bonuses

 

(49,253

)

(35,269

)

(13,984

)

Cash paid for income taxes

 

(2,057

)

(2,143

)

86

 

Accounts receivable

 

(5,706

)

(7,582

)

1,876

 

Deferred revenue

 

9,221

 

11,021

 

(1,800

)

Income taxes — current

 

9,159

 

10,600

 

(1,441

)

Accrued compensation

 

7,323

 

8,976

 

(1,653

)

Deferred rent

 

3,383

 

(45

)

3,428

 

Other assets

 

(1,967

)

1,243

 

(3,210

)

Accounts payable and accrued liabilities

 

2,770

 

2,262

 

508

 

All other

 

(275

)

(158

)

(117

)

Cash provided by operating activities

 

$

1,377

 

$

8,384

 

$

(7,007

)

 

 

 

 

 

 

 

 

Segment Results

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended March 31

 

Key Metrics ($000)

 

2008

 

2007

 

% Change

 

Revenue

 

 

 

 

 

 

 

Individual

 

$

27,359

 

$

24,061

 

13.7

%

Advisor

 

30,694

 

25,977

 

18.2

%

Institutional

 

69,928

 

47,352

 

47.7

%

Eliminations

 

(2,537

)

(1,943

)

30.6

%

Consolidated revenue

 

$

125,444

 

$

95,447

 

31.4

%

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

 

 

 

 

 

Individual

 

$

5,761

 

$

5,328

 

8.1

%

Advisor

 

8,806

 

6,866

 

28.3

%

Institutional

 

24,177

 

14,923

 

62.0

%

Corporate items and eliminations

 

(4,059

)

(3,090

)

31.4

%

Consolidated operating income

 

$

34,685

 

$

24,027

 

44.4

%

 

 

 

 

 

 

 

 

Operating margin

 

 

 

 

 

 

 

Individual

 

21.1

%

22.1

%

(1.0

)pp

Advisor

 

28.7

%

26.4

%

2.3

pp