UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

 


 

FORM 10-K

 


 

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

 

FOR THE FISCAL YEAR ENDED DECEMBER 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
Incorporation or Organization)

 

(I.R.S. Employer
Identification Number)

 

22 West Washington Street
Chicago, Illinois
60602

(Address of Principal Executive Offices)

 

(312) 696-6000

(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common stock, no par value

 

The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act:   None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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. (Check one):

 

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

 

The aggregate market value of shares of common stock held by non-affiliates of the Registrant as of June 30, 2008 was $1,280,180,186. As of February 27, 2009, there were 47,346,236 shares of the Registrant’s common stock, no par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain parts of the Registrant’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 

 

 



 

TABLE OF CONTENTS

 

PART I

 

 

 

Item 1.

Business

Item 1A.

Risk Factors

Item 1B.

Unresolved Staff Comments

Item 2.

Properties

Item 3.

Legal Proceedings

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

PART II

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

Item 6.

Selected Financial Data

Item 7.

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

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

Item 8.

Financial Statements and Supplementary Data

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Item 9A.

Controls and Procedures

Item 9B.

Other Information

 

 

PART III

 

 

 

Item 10.

Directors, Executive Officers, and Corporate Governance

Item 11.

Executive Compensation

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Item 13.

Certain Relationships and Related Transactions, and Director Independence

Item 14.

Principal Accountant Fees and Services

 

 

PART IV

 

 

 

Item 15.

Exhibits and Financial Statement Schedules

 

1



 

Part I

 

Item 1. Business

 

Morningstar is a leading provider of independent investment research to investors around the world. Since our founding in 1984, our mission has been 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. Our company also provides asset management services for advisors, institutions, and retirement plan participants. In addition to our U.S.-based products and services, we offer local versions of our products designed for investors in Asia, Australia, Canada, Europe, Japan, and South Africa. Morningstar serves approximately 6.5 million individual investors, 260,000 financial advisors, and 3,300 institutional clients. We have operations in 19 countries and hold minority ownership positions in companies located in three other countries.

 

We maintain a series of comprehensive databases on many types of investments, focusing on investment vehicles that are widely used by investors globally. After building these databases, we add additional value and insight to the data by applying our core skills of research, technology, and design. As of December 31, 2008, we provided extensive data on more than:

 

·      22,000 mutual fund share classes in the United States;

·      87,000 mutual funds and similar vehicles in international markets;

·      2,600 exchange-traded funds (ETFs);

·      4,000 closed-end funds;

·      24,000 stocks;

·      8,400 hedge funds;

·      8,500 separate accounts and collective investment trusts;

·      103,000 variable annuity/life subaccounts and policies;

·      36,000 insurance, pension, and life funds;

·      80 state-sponsored college savings plans (commonly known as Section 529 College Savings Plans);

·      82 years of capital markets data capturing performance of several major asset classes;

·      Extensive cash flow and ownership data;

·      Comprehensive biographical data on directors and officers from more than 170,000 public companies and 400,000 privately held firms;

·      Real-time market data on more than 4 million exchange-traded equities, derivatives, commodities, futures, foreign exchanges, precious metals, news, company fundamentals, and analytics; and

·      Real-time price quotes for global foreign currencies.

 

Our business model is based on leveraging our investments in these databases by selling a wide variety of products in multiple media to individual investors, financial advisors, and institutions around the world.

 

Our data and proprietary analytical tools such as the Morningstar Rating for mutual funds, which rates past performance based on risk- and cost-adjusted returns, and the Morningstar Style Box, which provides a visual summary of a mutual fund’s underlying investment style, have become important tools that millions of investors and advisors use in making investment decisions. We’ve created other tools, such as the Ownership Zone, Sector Delta, and Market Barometer, which allow investors to see how different investments work together to form a portfolio and to track its progress. We developed a Portfolio X-Ray tool that helps investors reduce risk and understand the key characteristics of their portfolios based on nine different factors.

 

In 2008, we introduced new hedge fund ratings and Style Boxes, a Morningstar Rating for collective investment trusts, a new series of hedge fund categories and indexes, analyst-driven fair value estimates for ETFs, new glide path data for target-date funds, estimated cash flow and market share data for investments in key global markets, and enhanced rider descriptions for variable annuities. We also expanded our qualitative coverage on mutual funds based in the United Kingdom and other markets outside of the United States.

 

Over the past several years, we’ve expanded our research efforts on individual stocks and have worked to popularize the concepts of economic moat, a measure of competitive advantage originally developed by Warren Buffett; and margin of safety, which reflects the size of the discount in a stock’s price relative to its estimated value. The Morningstar Rating for stocks is based on the stock’s current price relative to our analyst-generated fair value estimates, as well as the company’s level of business risk and economic moat. We offer a variety of qualitative measures such as Stewardship Grades, which help investors identify companies and funds that have demonstrated a high level of commitment to shareholders and stewardship of investors’ capital.

 

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We’ve also developed in-depth advice on security selection and portfolio building to meet the needs of investors looking for integrated portfolio solutions. We believe many investors rely on these tools because they offer a useful framework for comparing potential investments and making decisions. Our independence and our history of innovation make us a trusted resource for investors.

 

GRAPHIC

 

Growth Strategies

 

Our mission is to create great products that help investors reach their financial goals. In keeping with our mission, we are pursuing five key growth strategies, which we describe below. We review our growth strategies on a regular basis and refine them as we monitor changes in our business. In 2008, we decided to eliminate expanding the range of services we offer as a separate strategic objective because we’re not pursuing it apart from our other objectives. We added two new strategic objectives: build thought leadership in independent investment research and create a premier global investment database. These aren’t new initiatives for us, but we believe identifying them as strategic objectives will help investors better understand our priorities and how we think about running our business.

 

1.                                   Enhance our position in each of our key market segments by focusing on our three major Internet-based platforms.

 

We believe that individual investors, financial advisors, and institutional clients increasingly want integrated solutions as opposed to using different research tools for different parts of their portfolios. To help meet this need, one of our key strategies is to focus our product offerings on our three major platforms:

 

·                  Morningstar.com for individual investors;

·                  Morningstar Advisor Workstation for financial advisors; and

·                  Morningstar Direct for institutional investment research professionals.

 

These products all include integrated research and portfolio tools, allowing investors to use our proprietary information and analysis across multiple security types. We believe we can achieve deeper penetration of our current audiences with each of these platforms, as well as extend their reach to new customers. With Morningstar.com, we’re continuing to expand the range of content and functionality to increase the site’s page views and Premium members. We’re also working on integrating our global Web sites to leverage our development resources and attract more advertising sales outside the United States. With Advisor Workstation, we plan to build on our large installed base by continuing to add functionality, such as portfolio accounting, client management, and retirement income tools, which will help us reach more advisors around the world. With Morningstar Direct, we plan to continue an aggressive development program to provide data and analysis on securities and investments around the world. We’re focusing on expanding functionality, selling more licenses to existing clients, and reaching new market segments.

 

2.                                   Become a global leader in funds-of-funds investment management.

 

The large number of managed investment products available has made assembling them into well-constructed portfolios a difficult task for many investors. Consequently, funds-of-funds offerings have seen strong growth within the mutual fund, variable annuity, and hedge fund industries. Cerulli Associates estimates that global multimanager assets—including publicly offered funds that invest in other funds as well as investment vehicles managed by multiple subadvisors—totaled approximately $1.7 trillion in 2008. We believe assembling and evaluating funds of funds is a natural extension of our expertise in understanding managed investment products.

 

Our investment management programs combine managed investment vehicles—typically mutual funds—in portfolios designed to help investors meet their financial goals. When we create portfolios made up of other funds, our goal is to simplify the investment process and help investors access portfolios that match their level of risk tolerance, time horizon, and long-term investment objectives. We draw on our extensive experience analyzing funds to combine quantitative research with a qualitative assessment of manager skill and investment style.

 

Morningstar Managed Portfolios is a fee-based discretionary asset management service that includes a series of mutual fund, exchange-traded fund, and stock portfolios tailored to meet specific investment time horizons and risk levels. Through our Retirement Advice platform, which includes Morningstar Retirement Manager and Advice by Ibbotson, we also offer managed retirement account services. We offer these managed accounts for retirement plan participants who choose to delegate management of their portfolios to our managed account programs, which select investment options and make retirement planning choices for the participants. We believe that retirement plan participants will continue to adopt managed accounts because of the complexity involved in retirement planning. In addition, the Pension Protection Act of 2006 may encourage plan sponsors to adopt managed accounts as a default investment option. As of December 31, 2008, we had $1.6 billion in assets under management through Morningstar Managed Portfolios and $11.0 billion in assets under management in our managed retirement accounts.

 

3



 

In addition to the assets we manage directly, we had a total of $66.2 billion in assets under advisement in our Investment Consulting business as of December 31, 2008. Our consulting business focuses on relationships and agreements where we act as a portfolio construction manager or asset allocation program designer for a mutual fund or variable annuity and receive a basis-point fee. We see continued potential to develop this part of our business, including in markets outside the United States. We plan to continue building this business by focusing on performance and client support, building new relationships, and developing new portfolio strategies and products.

 

3.                                   Continue building thought leadership in independent investment research.

 

We believe that our leadership position in independent investment research offers a competitive advantage that would be difficult for competitors to replicate. Our goal is to continue building investment insights that empower investors and focus our research efforts in four major areas:

 

·                  Extend leadership position in fund research to additional markets outside the United States. Over the past several years, we have expanded our analyst coverage in fund markets outside of the United States. We’ve been working to build an integrated team of locally based fund experts who can help us develop a leadership position in additional markets around the world. As of December 31, 2008, we had 75 fund analysts globally, including teams in North America, Europe, and Asia. We currently produce qualitative analyst research on about 1,000 funds outside the United States and plan to continue building our coverage of funds based in Europe and Asia.

 

·                  Expand and leverage our capabilities in stocks. Our equity research complements our approach to mutual fund analysis, where we focus on analyzing the individual stocks that make up each fund’s portfolio. As of December 31, 2008, we provided analyst research on more than 2,250 companies. We’ve focused on building both depth and breadth of coverage by adding additional coverage on initial public offerings and other areas. Building a global equity capability with broad coverage has long been one of our strategic goals. We’re committed to maintaining the broad, high-quality coverage we’ve become known for as one of the largest providers of independent equity research.

 

We currently provide research to six major investment banks under the terms of the Global Analyst Research Settlement, which covers the five-year period ending in July 2009. In 2003 and 2004, 12 leading Wall Street investment banks agreed to a $1.5 billion settlement (the Global Analyst Research Settlement) with the Securities and Exchange Commission (SEC), the New York Attorney General, and other securities regulators to resolve allegations of undue influence of investment banking interests on securities research. Approximately $450 million of the $1.5 billion in fines that the investment banks agreed to pay in the settlement has been designated for independent research over a period of five years, with the independent research to be provided by companies that are not engaged in the investment banking industry. Each firm involved in the settlement is required to provide research from at least three providers of independent research that are not engaged in the investment banking industry. We have entered into agreements with six of these banks to provide independent equity research under the terms of the settlement. The period covered by the Global Analyst Research Settlement will expire in July 2009. After the settlement period expires, the investment banks covered by it will no longer be required to provide independent investment research to their clients. For further discussion about this issue, see Item 1A — Risk Factors.

 

We’re working to sell and distribute our equity research through a variety of other channels, including through financial advisors, buy-side firms, and companies outside of the United States. We believe that investors’ increasing awareness of the value of independent research will strengthen our business over the long term. We’ve also expanded our proprietary stock database, which we view as an important complement to our analyst research.

 

·                  Expand our capabilities in hedge fund research. We plan to expand our research and data on hedge funds with the goal of making the hedge fund industry more transparent to investors. Hedge funds worldwide held about $2.7 trillion in single-fund assets under administration as of November 2008, based on HFM Week’s Hedge Fund Administrator’s Survey. Offering data on hedge funds is a natural extension of our work on other managed investment vehicles. We now provide comprehensive data on about 8,400 hedge funds.

 

·                  Enhance our retirement income capabilities. As the baby boom generation approaches retirement, we believe many investors will need more information to help them manage income during retirement. We believe these trends will lead to a greater need for information and tools focusing on retirement income planning and long-term savings strategies. We currently offer Retirement Income Strategist, a Web-based financial planning tool that allows financial advisors to create comprehensive income analyses for clients who are in or approaching retirement, as part of our Advisor Workstation platform. We’ve developed several retirement income services for institutional clients within our Investment Consulting area, and we plan to incorporate additional retirement income tools and services in other products over the next several years.

 

4



 

4.                                   Create a premier global investment database.

 

We plan to expand our product offerings to better meet the needs of investors. We plan to continue building or acquiring new databases for additional types of investments, including various types of funds outside the United States and other widely used investment products.

 

We currently provide extensive data on mutual funds, stocks, hedge funds, separate accounts, variable annuities, pension and life funds, exchange-traded funds, closed-end funds, 529 plans, and capital markets. With our acquisition of Tenfore Systems Limited, we now offer real-time stock quotes from nearly all of the world’s major stock exchanges, as well as a live data feed that covers exchange-traded equities, derivatives, commodities, futures, foreign exchanges, precious metals, news, company fundamentals, and analytics.

 

Our data is the foundation for all of the products and services we offer. When we build investment databases, we intend to own the data whenever possible and minimize license agreements with outside data providers. We also focus on proprietary, value-added data, such as our comprehensive data on current and historical portfolio holdings for mutual funds and variable annuities. Within each database, we continuously update our data to maintain timeliness and expand the depth and breadth of coverage. We expect to continue building out additional databases, focusing on investment products that are widely used by large numbers of investors. We also plan to continue our efforts to establish our databases as the pre-eminent choice for individual investors, financial advisors, and institutional clients in markets around the world.

 

Over the past several years, we’ve developed a series of proprietary investment indexes that leverage our investment data. The Morningstar Indexes are rooted in our proprietary research and can be used for precise asset allocation and benchmarking and as tools for portfolio construction and market analysis. All of our indexes are based on transparent, rules-based methodologies that are back-tested and supported by original research papers. Consistent methodology and objective rules make the indexes well-suited for creating index-linked investment products, such as exchange-traded funds, mutual funds, and structured products. We’ve significantly expanded the range of indexes we offer and plan to continue building our index business, including in markets outside of the United States.

 

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

 

Over the past several years, we have expanded our product offerings outside the United States. Our recent acquisitions of several Hemscott businesses, Fundamental Data Limited, Tenfore Systems Limited, and InvestData (Proprietary) Limited, (described in more detail below) all significantly expanded our operations outside of the United States. Our operations outside of the United States generated $121.4 million in revenue in 2008, including $19.4 million from acquisitions, compared with $89.7 million in 2007. We plan to continue expanding our non-U.S. operations to meet the increasing demand for wide-ranging, independent investment insight by investors around the globe. Because more than half of the world’s investable assets are located outside of the United States, we believe there are significant opportunities for us in non-U.S. markets. Our strategy is to focus our non-U.S. sales efforts on our major products, including Morningstar Advisor Workstation and Morningstar Direct. We also plan to increase our sales staff, build a larger analyst team outside the United States, and explore new markets, such as India, Latin America, and South Africa.

 

Acquisitions

 

The majority of our revenue has been driven by organic growth as we’ve introduced new products and services and expanded our marketing efforts for existing products. However, we have made and expect to continue making selective acquisitions that support our five growth strategies. In reviewing potential acquisitions, we plan to focus on transactions that:

 

·      offer a good strategic fit with our mission of creating great products that help investors reach their financial goals;

·      help us build our proprietary investment databases, research capabilities, technical expertise, or customer base faster and more cost effectively than we could if we built them ourselves; and

·      offer a good cultural fit with our entrepreneurial spirit and brand leadership.

 

5



 

The table below summarizes our recent acquisitions:

 

Acquisition

 

Description

 

Date Completed

 

Purchase Price*

Hemscott data, media, and investor relations Web site businesses

 

U.K.-based operation providing more than 20 years of comprehensive fundamental data on publicly listed companies in the United States, Canada, the United Kingdom, and Ireland; free and paid investment research sites and data services; online investor relations services in the United Kingdom

 

January 9, 2008

 

$51.3 million

Financial Computer Support, Inc.

 

Leading provider of practice management software for independent advisors

 

September 2, 2008

 

$4.9 million

Fundamental Data Limited

 

Leading provider of data on closed-end funds in the United Kingdom

 

October 2, 2008

 

$18.6 million

10-K Wizard Technology, LLC

 

Leading provider of SEC filing research and alert services

 

December 4, 2008

 

$ 11.5 million

Tenfore Systems Limited

 

Global provider of real-time market data and financial data workstations based in the United Kingdom

 

December 17, 2008

 

$19.2 million

InvestData (Proprietary) Limited

 

Leading provider of fund information in South Africa

 

December 29, 2008

 

Not disclosed

 


*Total purchase price less cash acquired.

 

We have also made other acquisitions over the past several years. For more information, refer to Note 7 of the Notes to our Consolidated Financial Statements.

 

Business Segments, Products, and Services

 

We divide our business operations into three segments:

 

·                  Individual, which focuses on products and services for individual investors;

 

·                  Advisor, which focuses on products and services for financial advisors; and

 

·                  Institutional, which focuses on products and services for institutional clients, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors.

 

Beginning in 2009, we will be changing our segment reporting to focus on two segments: Investment Information and Investment Management. For more information, see page 56 of Management’s Discussion and Analysis. The discussion below is based on the three operating segments that were in place through 2008.

 

The table below shows our revenue by business segment for each of the past three years:

 

 

 

2008

 

2007

 

 

 

2006

 

 

 

Revenue by Segment ($000)

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Individual

 

 

$

107,630

 

21.4%

 

 

$

97,299

 

22.4%

 

 

$

80,706

 

25.6%

 

Advisor

 

 

127,598

 

25.4

 

 

115,739

 

26.6

 

 

94,694

 

30.0

 

Institutional

 

 

276,792

 

55.1

 

 

230,329

 

52.9

 

 

146,085

 

46.4

 

Elimination of intersegment revenue

 

 

(9,563

)

(1.9)

 

 

(8,260

)

(1.9)

 

 

(6,310

)

(2.0)

 

Consolidated revenue

 

 

$

502,457

 

100.0%

 

 

$

435,107

 

100.0%

 

 

$

315,175

 

100.0%

 

 

For information on segment operating income (loss), refer to Note 4 of the Notes to our Consolidated Financial Statements.

 

Individual Segment

 

For individual investors, our largest product based on revenue is our Web site, Morningstar.com, which includes our Premium Membership service and sales of Internet advertising space. Morningstar.com is consistently mentioned in major business publications as one of the best investment sites on the Web. Our Individual business segment also includes Morningstar Equity Research, which we distribute through several channels. Investors can access our equity research through the Premium Membership service on Morningstar.com. Our independent equity research is also distributed through six banks to meet the requirement for independent research under the Global Analyst Research Settlement, which we describe in more detail on pages 4 and 8.

 

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In addition, we distribute our research to several other companies that provide our analyst reports and research to their affiliated financial advisors or to individual investors.

 

We also offer several print and online publications focusing on stocks, mutual funds, personal finance, and other investing topics, including newsletters and other publications for investors in Australia. In 2008, about 13% of Individual segment revenue was from outside of the United States. Our Web sites and publications for individual investors reach approximately 6.5 million investors worldwide.

 

Within the Individual business segment, most of our products target experienced investors who are actively involved in the investing process and want to take charge of their own investment decisions. We also reach individuals who want to learn more about investing and investors who seek out third-party sources to validate the advice they receive from brokers or financial planners. Our client base in this segment consists of more than 260,000 paying customers, including Premium members of Morningstar.com and Hemscott.com as well as approximately 79,000 subscribers who purchase our investment newsletters designed for individual investors. Approximately 3,800 public and private libraries in the United States subscribe to our services. We also offer a series of books and workbooks about investing, as well as formatted printable reports on individual securities.

 

We promote our individual investor products primarily through traditional direct mail, e-mail, promotions on our 24 investor Web sites worldwide, public relations, and advertising on related Web sites.

 

Our strategy is to increase the number of investors who sign up for Morningstar.com Premium Membership by continuing to develop and promote Premium content to registered users and other investors. We use search marketing as a core marketing strategy for Morningstar.com. This includes working to optimize our site’s ranking in the search results that appear when users search for information about investing and purchasing advertisements on third-party sites such as Yahoo! and Google that can bring investors to relevant content on Morningstar.com.

 

In the Individual business segment, we compete with the personal finance Web sites of AOL Money & Finance, Google Finance, MarketWatch, MSN Money, The Motley Fool, The Street.com, The Wall Street Journal Online, and Yahoo! Finance. Our print publications compete with Agora Publishing, Forbes, The Motley Fool, Phillips Investment Resources, and Value Line in the United States and Fat Prophets, Intelligent Investor, and The Rivkin Report in Australia. Our Equity Research services compete with Renaissance Capital, Standard & Poor’s, Value Line, Zacks Investment Research, and several smaller research firms.

 

We believe the Individual segment has a modest amount of seasonality. The first quarter tends to show more sales activity for Premium Membership on Morningstar.com and our annual reference guides, including the Ibbotson Stocks, Bonds, Bills, and Inflation Yearbook. Sales in the Individual segment tend to be slightly lower over the spring and summer months. However, our diversified product base and recognizing revenue ratably over the term of each subscription moderates the impact of this seasonality.

 

Our largest customer in the Individual segment made up approximately 7% of segment revenue in 2008.

 

Morningstar.com

 

Our largest Web site for individual investors is Morningstar.com in the United States. As of December 31, 2008, the free membership services offered through Morningstar.com had more than 6.4 million registered users worldwide, who have access to comprehensive data on individual stocks, mutual funds, exchange-traded funds, hedge funds, and other investments to help them conduct research and track performance. In addition, Morningstar.com features extensive market data, Morningstar articles, proprietary portfolio tools, and educational content to help investors of all levels access timely, relevant investment information. Morningstar.com also includes Portfolio X-Ray, which helps investors reduce risk and understand key characteristics of their portfolios, and a variety of other portfolio tools.

 

We also offer free local Web sites for investors in Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, Korea, Malaysia, the Netherlands, New Zealand, Norway, People’s Republic of China, Singapore, Spain, Sweden, Switzerland, Taiwan, and the United Kingdom.

 

We use our free content as a gateway into paid Premium Membership, which includes access to written analyst reports on more than 2,250 stocks, 2,000 mutual funds, and 300 exchange-traded funds, as well as Analyst Picks and Pans, Stewardship Grades, and Premium Stock and Fund Screeners. We currently offer Premium Membership services in Australia, China, the United Kingdom, and the United States.

 

In 2008, we completed a site redesign and new home page for Morningstar.com. We also continued adding content to the site, including global indexes, a yield curve, real-time quotes for key market indexes, and new commodity quote and report sections.

 

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We also expanded video content on the site and introduced new features that allow users to share their portfolios with other users and see personalized Morningstar Ratings on their portfolios.

 

As of December 31, 2008, we had 177,518 paid Premium subscribers for Morningstar.com in the United States plus an additional 3,200 Premium subscribers in China. Following our January 2008 acquisition of the Hemscott businesses, we had 1,600 Premium subscribers to Hemscott.com in the United Kingdom. We currently charge $18.95 for a monthly subscription, $174 for an annual subscription, $289 for a two-year subscription, and $389 for a three-year subscription for Morningstar.com’s Premium service in the United States. We also sell advertising space on Morningstar.com.

 

Morningstar.com is one of our five largest products based on revenue and was the largest product in the Individual segment in 2008. This product accounted for 8.6% of our consolidated revenue in 2007 and 2008, compared with 9.9% in 2006.

 

GRAPHIC

 

Morningstar Equity Research

 

As of December 31, 2008, we offered independent equity research on more than 2,250 companies. Our approach to stock analysis focuses on long-term fundamentals. Our analysts evaluate companies by assessing each firm’s competitive advantage, analyzing the level of business risk, and completing an in-depth projection of future cash flows. For the companies we cover, our analysts prepare a fair value estimate, a Morningstar Rating for stocks, a rating for business risk, and an assessment of the company’s economic moat. Economic moat is a concept originally developed by Warren Buffett that describes a company’s competitive advantage relative to other companies. For the remaining stocks included in our database, we offer quantitative grades for growth, profitability, and financial health, as well as an explanation of the company’s business operations. We currently deliver our equity research to individual investors as part of our Premium Membership service on Morningstar.com and to six major investment banks under the terms of 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.

 

The independent equity research we’re providing under the terms of the Global Analyst Research Settlement accounted for approximately 4% of our consolidated revenue in 2008 and 20% of revenue in the Individual segment. The period during which investment banks are required to provide independent equity research to their clients will expire in July 2009. After the settlement period expires, the investment banks covered by it will no longer be required to provide independent investment research to their clients. We don’t know how much of this business we’ll retain after the settlement period expires, but we expect this research revenue to decline significantly. For further discussion about this issue, see Item 1A — Risk Factors.

 

We have significantly expanded our equity research coverage over the past several years. We currently provide analyst reports on virtually all of the most widely held stocks in the S&P 500 index, as well as numerous companies included in other indexes. We had 128 stock analysts around the world as of December 31, 2008, compared with 112 as of December 31, 2007.

 

In 2008, we introduced a new research service that provides coverage on initial public offerings. We incorporated more of our analyst research into Morningstar Advisor Workstation through the new Morningstar Analyst Research Center. We also unveiled Morningstar Select Equity, a new Web portal that allows institutional clients to quickly access research from our analysts, including company reports, discounted cash flow models, research notes, notes from company visits, guidance lists, and more. We also expanded our internal product and sales staff that works on marketing our research to financial advisors and buy-side firms.

 

Pricing for Morningstar Equity Research varies based on the level of distribution, the number of securities covered, the amount of custom coverage required, and the length of the contract term. Morningstar Equity Research, which primarily consists of revenue related to the Global Analyst Research Settlement, was the second-largest product in the Individual segment based on revenue in 2008, following Morningstar.com.

 

Newsletters and Other Publications

 

We offer a variety of print and electronic publications about investing. Some of these include Morningstar Mutual Funds, a reference publication that features our signature one-page reports on approximately 1,500 mutual funds; Morningstar FundInvestor, a monthly newsletter that provides information and insight on 500 of the most popular mutual funds and a list of 150 Analyst Picks; Morningstar StockInvestor, a monthly newsletter that focuses on companies with strong competitive positions and stock prices that we believe are low enough to provide investors with a margin of safety; and the Ibbotson Stocks, Bonds, Bills, and Inflation Yearbook, a definitive study of historical capital markets data in the United States. In addition, we offer several other investment newsletters and a series of books about investing in stocks and funds, which are available directly from us and in bookstores. In 2008, we launched four new investment newsletters: Morningstar InternationalInvestor, Morningstar HealthcareObserver, Morningstar Opportunistic Investor, and Morningstar OptionInvestor.

 

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Our Individual segment also includes several publications for investors in Australia, including IFA Magazine, Australia’s leading magazine for independent financial advisors, and Your Money Weekly, which focuses on investment recommendations and portfolios ideas for companies listed in Australia.

 

Advisor Segment

 

For financial advisors, our largest products based on revenue are Morningstar Advisor Workstation, a comprehensive Web-based investment planning system, and Principia, our CD-ROM-based investment research and planning software. We also offer Morningstar Managed Portfolios, a fee-based discretionary asset management program distributed exclusively through financial advisors. Our advisor products are integrated into the daily operations and research processes of many financial advisors who use our research and tools to provide guidance for individual investors.

 

We sell our advisor-related products both directly to independent financial advisors and through enterprise licenses, which allow financial advisors associated with the licensing enterprise to use our products. Most of our license agreements in the Advisor segment have terms ranging from one to three years. As of December 31, 2008, we had established relationships with approximately 260,000 financial advisors around the world. Approximately 15% of our Advisor segment revenue was from international sales in 2008. In addition to the U.S. versions of our Advisor products, we offer products for financial advisors in a variety of other countries. For example, we have versions of Advisor Workstation tailored for use in Asia, Australia, Canada, and Europe, and we offer a product similar to Principia in Canada.

 

Our products for advisors are sold primarily through our sales force, with promotional support from direct mail, online and print advertising, public relations, and conference exhibits. We also use the annual Morningstar Investment Conference to promote our offerings for advisors. We believe that there are opportunities to increase Advisor Workstation sales by attracting additional brokerage firms and investment advisors and increasing revenue per license from existing clients by expanding the amount of functionality licensed. We plan to expand our offerings for financial advisors outside the United States. Our primary competitors in the Advisor segment include Advent Software, Albridge Solutions, eMoney Advisor, MoneyGuide Pro, NaviPlan, Schwab Portfolio Center, Standard & Poor’s, SunGard, Thomson Reuters, and Wall Street OnDemand. For Morningstar Managed Portfolios, our primary competitors are AssetMark, Brinker Capital, Envestnet PMC, FundQuest, Genworth, SEI Investments, and Symmetry Partners.

 

In the Advisor segment, we historically had higher revenue growth in the second quarter because we hold an investment conference in May. Other products in this segment generally have not shown marked seasonality.

 

Our largest customer in this segment accounted for approximately 3% of segment revenue in 2008.

 

Morningstar Advisor Workstation

 

Morningstar Advisor Workstation, a Web-based investment planning system, provides financial advisors with a comprehensive set of tools for conducting their core business—including investment research, planning, and presentations. It allows advisors to build and maintain a client portfolio database that can be fully integrated with the firm’s back-office technology and resources. Moreover, it helps advisors create customized reports for client portfolios that combine mutual funds, stocks, separate accounts, variable annuity/life subaccounts, ETFs, hedge funds, and closed-end funds. As of December 31, 2008, about 190,000 advisors in the United States were licensed to use Advisor Workstation, which is available in two editions: the Office Edition for independent financial advisors and the Enterprise Edition for financial advisors affiliated with larger firms. Advisor Workstation Enterprise Edition includes a variety of modules, including Retirement Income Strategist, Retirement Income Education Center, Portfolio Builder, Hypothetical Illustrator, and a variety of tools to measure the relative cost and portfolio fit of various types of investments. These modules can be purchased as stand-alone products or combined as part of a full Workstation license. Pricing for the Enterprise Edition varies based on the number of users, as well as the level of functionality offered. We typically charge about $3,100 per licensed user for a base configuration of Enterprise Edition, but pricing varies significantly based on the scope of the license. For clients who purchase more limited tools-only licenses, the price per user is substantially less. We generally charge $5,000 per user for an annual license for Office Edition.

 

In 2008, we introduced an in-retirement solution for Portfolio Builder that incorporates asset allocation research from Ibbotson Associates, launched a new Variable Annuity Analyzer tool, and upgraded our technology platform and development process. We also introduced a new Analyst Research Center, which allows financial advisors to access Morningstar’s library of independent research on stocks, initial public offerings, mutual funds, and ETFs. We continued expanding Portfolio Builder modules globally, with new launches in Sweden and Norway in 2008.

 

With Office Edition, we created a new investment planning module, added additional portfolio accounting functionality, and introduced a new back-office service bureau. We also began selling a local version of Office Edition in Italy in 2008.

 

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Morningstar Advisor Workstation is one of our five largest products based on revenue and made up 13.3%, 12.6%, and 13.7% of our consolidated revenue in 2008, 2007, and 2006, respectively.

 

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Morningstar Principia

 

Principia is our CD-ROM-based investment research and planning software for financial planners and had 43,019 subscriptions as of December 31, 2008. The modules offered in Principia provide data on mutual funds, stocks, separate accounts, variable annuity/life subaccounts, closed-end funds, defined contribution plans, asset allocation, presentations and education, and exchange-traded funds. Each module is available separately or together and features searching, screening, and ranking tools. Principia allows advisors to create integrated portfolios for clients and offers three-page Portfolio Snapshot reports that provide a comprehensive picture of the client’s portfolio. The Snapshot report shows overall style and sector weightings as well as the cumulative exposure to individual stocks. The Snapshot report is among those approved by the National Association of Securities Dealers for financial advisors to distribute and review with their clients.

 

In 2008, we added a new exchange-traded funds module to the Principia product line based on client feedback and market demand.

 

Principia prices generally range from approximately $675 per year for monthly updates on one investment database to $3,345 per year for monthly updates on the complete package spanning all investment universes, or $5,885 for all investment universes plus additional modules for asset allocation, defined contribution plans, and presentations and education.

 

Principia is one of our five largest products based on revenue and accounted for 5.5%, 6.6%, and 9.1% of our consolidated revenue in 2008, 2007, and 2006, respectively.

 

Morningstar Managed Portfolios

 

Morningstar Managed Portfolios is a fee-based discretionary asset management service that includes a series of mutual fund, ETF, and stock portfolios tailored to meet specific investment time horizons and risk levels. This program is only available through financial advisors. Our team of investment professionals uses a disciplined process for asset allocation, fund selection, and portfolio construction. They actively monitor the portfolios and make adjustments as needed. We complement these asset management services with online client-management functions such as risk profiling and access to client statements, transaction capabilities, and performance reports.

 

We had approximately $1.6 billion in assets under management with about 1,700 financial advisors using the service as of December 31, 2008. We charge asset-based fees for Morningstar Managed Portfolios. The management fee is based on a tiered schedule that depends on the client’s average daily portfolio balance. Fees for our mutual fund and exchange-traded fund portfolios generally range from 20 to 40 basis points. We charge 55 basis points for the Select Stock Baskets, which are a managed account service consisting of individually customized stock portfolios based on Morningstar’s proprietary indexes and independent equity research.

 

In 2008, we began incorporating Ibbotson Associates’ asset allocation recommendations in our mutual fund and ETF portfolios. We also expanded the Select Stock Baskets. Advisors can now provide their clients with investable versions of the Dividend, Hare, and Tortoise portfolios featured in our investment newsletters. We also launched a series of mutual-fund portfolios aimed at different stages of retirement with varying drawdown needs.

 

In addition, we made several important upgrades to our technology and operations during 2008. We launched a “middle office” that allows us to directly connect with custodians, trade portfolios on their platforms, and provide daily account reconciliations.

 

The Morningstar Managed Portfolios program is offered through Morningstar Investment Services, Inc., a registered investment advisor, registered broker-dealer, member of FINRA, and wholly owned subsidiary of Morningstar, Inc.

 

In addition to the products described above, we offer a series of FINRA-reviewed Financial Communications materials that advisors can use to educate clients about asset allocation and demonstrate other key investment concepts. In addition, we offer free Web sites, paid advisor conferences, and a magazine for advisors.

 

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Institutional Segment

 

For institutional clients, our largest products and services based on revenue include:

 

·                  Licensed Data, a set of investment data spanning the complete range of Morningstar’s data, available through electronic  feeds;

·                  Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities;

·                  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

·                  Retirement Advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms.

 

The Institutional segment also includes Licensed Tools and Content, a set of online tools and editorial content designed for institutions to use in their Web sites and software; Morningstar EnCorr, an asset allocation software package; Investment Profiles & Guides, which are designed for institutions to use in communicating investment information to individual investors; Morningstar Indexes, a growing product line that currently covers U.S. equities (by style, capitalization, sector, and dividend), commodities, bonds, and equity focus index families; and financial information and data feeds on Australian stocks, which we sell to stock brokers, information providers, and financial Web sites.

 

As of December 31, 2008, we served approximately 3,300 clients through our Institutional segment, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan sponsors and providers. We believe our institutional clients value our independence, breadth of information, and customized services; in addition, we believe our research, tools, and advice reach many individual investors through this channel. Across the Institutional segment, we’ve established relationships with many of the largest companies in the financial services industry, including AEGON/Transamerica, ING, Fidelity, and Wells Fargo. Approximately 33% of our institutional segment revenue is from outside of the United States—primarily in Australia, Canada, and various countries in Europe. We typically sell our institutional products based on a contract term of one to three years.

 

We market our products for institutions almost exclusively through our sales team. We provide marketing support for our sales team with online and print advertising, public relations, direct mail, and conference exhibits. We also have data reselling agreements with third-party providers of investment tools and applications, allowing us to increase the distribution of our data with minimal additional cost.

 

For Licensed Data, our primary competitors are Bloomberg, Eurekahedge, eVestment Alliance, FactSet Research Systems, Hedge Fund Research, Inc., Standard & Poor’s, and Thomson Reuters. For Morningstar Direct, our primary competitors are eVestment Alliance, FactSet Research Systems, Informa PSN, Style Research Limited, Thomson Reuters, Wilshire, and Zephyr Associates. Our Investment Consulting business competes primarily with Mercer, Russell Investments, and Wilshire Associates, as well as some smaller firms in the retirement consulting business. In the retirement advice market, we compete primarily with Financial Engines, Guided Choice, Mesirow Financial, and ProManage.

 

Most products within our Institutional segment have not shown pronounced seasonality.

 

Our largest customer in the Institutional segment accounted for approximately 7% of segment revenue in 2008.

 

Licensed Data

 

Our Licensed Data service gives institutions access to a set of proprietary investment data spanning the full range of our investment data. The data packages we offer include proprietary statistics, such as the Morningstar Style Box and Morningstar Rating, and a wide range of other data, including information on investment performance, risk, portfolios, operations data, fees and expenses, cash flows, and ownership. Institutions can use Licensed Data in a variety of investor communications, including Web sites, print publications, and marketing fact sheets, as well as for internal research and product development. We deliver Licensed Data through electronic data feeds and provide daily updates to clients. Pricing for Licensed Data is based on the number of funds or other securities covered, the amount of information provided for each security, and the level of distribution.

 

In 2008, we introduced data licenses covering our Global Document Library, which allows users to easily access PDF and HTML versions of SEC filings; new glide path data and images that allow clients to compare investment strategies and conduct competitive analysis on lifecycle funds; new information on future fund distributions; and a global data warehouse that incorporates data in multiple currencies and country-specific data points. We also added new databases covering investments based in Japan, Israel, Thailand, South Korea, and Mexico. During 2008, FINRA and the British Columbia Securities Commission both selected Morningstar data for use in their member tools and Web sites.

 

Several of our recent acquisitions have expanded the range of data we provide through our Licensed Data service. Following our acquisition of Tenfore Systems Limited, we now offer real-time stock quotes from nearly all of the world’s major stock exchanges, as well as a live data feed that covers exchange-traded equities, derivatives, commodities, futures, foreign exchanges, precious metals, news, company fundamentals, and analytics. During 2008, we also added data on funds based in South Africa (through InvestData), SEC filing research and alert services (through 10-K Wizard Technology, LLC), additional data on closed-end funds in the United Kingdom (through Fundamental Data Limited), and more than 20 years of comprehensive fundamental data on publicly listed companies in the United States, Canada, the United Kingdom, and Ireland (through our purchase of several Hemscott businesses).

 

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Licensed Data was our largest product in 2008 and accounted for 15.6%, 13.6%, and 12.0%, of our consolidated revenue in 2008, 2007, and 2006, respectively.

 

Investment Consulting

 

Our Investment Consulting area provides a broad range of services, many of which emphasize investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities. We offer Investment Consulting services primarily through Morningstar Associates, LLC and Ibbotson Associates, Inc., which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. In both areas, we emphasize contracts where we’re paid a percentage of assets under management for ongoing investment management and consulting, as opposed to one-time relationships where we’re paid a flat fee.

 

Morningstar Associates generally focuses on a small number of large relationships. We emphasize innovative solutions that improve the investor experience and help our clients build their businesses. We provide customized solutions that help clients differentiate their businesses.

 

Our investment professionals evaluate investment plans, recommend strategies, help set investment policies, develop asset allocation programs, construct portfolios, and monitor ongoing performance. We offer these consulting services to clients in the United States, Asia, Australia, Canada, and Europe, including insurance companies, investment management companies, mutual fund companies, and broker-dealers. We also provide services for retirement plan sponsors and providers, including developing plan lineups, creating investment policy statements, and monitoring investment performance.

 

Our team of investment consultants draws on both quantitative research tools and qualitative expertise to assess investment programs, provide detailed analysis of performance and portfolio characteristics, and make comprehensive recommendations for improvement. We also offer investment manager search services. Our staff combines the depth of Morningstar’s historical fundamental databases with detailed investment knowledge and investment experience to recommend qualified candidates for subadvisory firms, mutual fund managers, variable insurance trust managers, and separate account managers. Our investment monitoring services include analyst reports, customizable board reports, select lists, watch lists, and in-depth attribution analysis.

 

In 2008, Morningstar Associates expanded its services to include fund lineup selection services for 403(b) plans, which are defined contribution plans for educational and non-profit institutions.

 

We significantly expanded our Investment Consulting area in 2006 when we acquired Ibbotson Associates, which has a well-established consulting business that began in 1977. Ibbotson’s Investment Consulting unit is a leading authority on asset allocation and draws on its knowledge of capital markets and portfolio building to construct portfolios from the top down, starting at the asset class level. Ibbotson develops customized asset allocation programs for mutual fund firms, banks, broker-dealers, and insurance companies.

 

Ibbotson provides a range of consulting services, including licensing its asset allocation models, providing consulting services, and acting as a portfolio sub-advisor. Ibbotson works with different types of investment options, including mutual funds, variable annuities, and exchange traded funds, and provides both strategic and dynamic asset allocation services. The group offers consulting services and funds-of-funds subadvisory services, as well as tailored model portfolios, fund classification schemes, and questionnaire design.

 

In 2008, Ibbotson expanded the range of portfolios and asset allocation solutions by launching portfolios that help investors incorporate alternative investment types with traditional asset classes, introducing a series of more actively managed momentum portfolios, and continuing to develop solutions that provide guidance on how much of an investor’s portfolio should be allocated to variable or immediate annuities.

 

Pricing for the consulting services we provide through both Morningstar Associates and Ibbotson Associates is based on the scope of work and the level of service required. In the majority of our contracts, we receive asset-based fees, reflecting our work as a portfolio construction manager or subadvisor for a mutual fund or variable annuity.

 

Investment Consulting was our second-largest product based on revenue in 2008 and accounted for 15.5%, 17.4%, and 14.8% of our consolidated revenue in 2008, 2007, and 2006 respectively.

 

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Morningstar Direct

 

Morningstar Direct is a Web-based institutional research platform that provides advanced research on the complete range of securities in Morningstar’s global database. This comprehensive research platform allows research and marketing professionals to conduct advanced performance comparisons and in-depth analyses of a portfolio’s underlying investment style. Morningstar Direct includes access to numerous investment universes, including U.S. mutual funds; European and offshore funds; funds based in most major markets around the world; stocks; separate accounts; hedge funds; closed-end funds; exchange-traded funds; global equity ownership data; variable annuity and life portfolios; and market indexes.

 

In 2008, we significantly upgraded the functionality, content, and data included in Morningstar Direct. Major features added include additional tools for performance reporting and customized output reports, functionality that allows users to incorporate tools from Microsoft Excel, a Global Document Library that allows users to easily access PDF and HTML versions of SEC filings, expanded portfolio data including shorts and derivatives, expanded data coverage on several investment types outside of the United States, expanded stock ownership data, and more than 400 new data points on individual stocks. We also implemented a new sales and service structure to better align our sales and marketing efforts with market needs and provide clients with more targeted training and support.

 

In early 2009, we introduced a new version of Morningstar Direct that incorporates holdings-based performance attribution. This new functionality allows users to quantify and analyze the impact of portfolio decisions, like sector weightings or security selection, on equity performance.

 

Morningstar Direct had 2,961 licensed users worldwide as of December 31, 2008.

 

Pricing for Morningstar Direct is based on the number of licenses purchased. We charge $16,000 for the first user, $10,500 for the second user, and $8,000 for each additional user.

 

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Retirement Advice

 

We offer two Retirement Advice offerings that help retirement plan participants plan and invest for retirement: Morningstar Retirement Manager, a service of Morningstar Associates, LLC, and Advice by Ibbotson, a service of Ibbotson Associates, Inc.  Both companies are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc.

 

Morningstar Retirement Manager is designed to help retirement plan participants determine how much to invest and which investments are most appropriate for their portfolios. It gives guidance explaining whether participants’ suggested plans are on target to meet their retirement goals. As part of this service, we deliver personalized recommendations for a target savings goal, a recommended contribution rate to help achieve that goal, a portfolio mix based on risk tolerance, and specific fund recommendations. Morningstar Retirement Manager includes a managed account service designed for plan participants who choose to delegate management of their portfolios to Morningstar’s investment professionals. We offer these services primarily through retirement plan providers—typically third-party asset management companies or companies that offer administrative services to retirement plans. These providers often offer proprietary mutual funds to retirement plan sponsors and their participants.

 

In 2008, we developed a new service through Morningstar Retirement Manager that allows retirement plan providers and sponsors to develop custom target retirement date or lifestyle portfolios using the plan’s investment lineup. We also created functionality to allow our managed account service to be used as a qualified default investment alternative (QDIA) under the Pension Protection Act of 2006 and expanded the range of plans and contribution types supported by the platform.

 

As of December 31, 2008, approximately 8.3 million plan participants had access to Morningstar Retirement Manager through approximately 72,000 plan sponsors and 17 plan providers. Pricing for Morningstar Retirement Manager depends on the number of participants, as well as the level of service we provide.

 

Advice by Ibbotson offers a set of services and proprietary software to give retirement plan participants access to investment education, self-service advice, and managed retirement accounts. We offer these services mainly through retirement plan providers. The platform includes installed software advice solutions that can be co-branded by retirement plan sponsors and providers. Advice by Ibbotson combines asset allocation and patented human capital methodologies that help participants determine how to prepare for retirement based on their financial assets as well as their future earnings and savings power. Advice by Ibbotson’s customized software can be integrated with existing systems to help investors accumulate wealth, transition into retirement, and manage income during retirement.

 

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In 2008, we began working with large plan providers—a new area for Ibbotson Associates—to build customized target-date portfolios based on specific plan participant demographics. This allows us to create portfolios using a variety of best-of-breed managers from different investment companies instead of the single-company approach offered in most packaged target-date funds.

 

As of December 31, 2008, approximately 8.9 million plan participants had access to Advice by Ibbotson through approximately 68,000 plan sponsors and seven plan providers. Pricing for Advice by Ibbotson depends on the number of participants, as well as the level of service we provide.

 

Morningstar Indexes

 

We offer an extensive set of investment indexes that can be used to benchmark the market and create investment products. Our index family includes a series of U.S. equity indexes that track the U.S. market by capitalization, sector, and investment style; a dividend index; a focused stock index capturing performance of “wide moat” stocks with the best valuations; a series of bond indexes that track the U.S. market by sector and term structure; global bond indexes; commodity indexes; and asset allocation indexes. Investment firms can license the Morningstar Indexes to create investment vehicles, including mutual funds, ETFs, and derivative securities. We charge licensing fees for the Morningstar Indexes, with fees consisting of an annual licensing fee as well as fees linked to assets under management.

 

We currently license the Morningstar Indexes to several institutions which offer exchange-traded funds or exchange-traded notes based on the indexes, including Barclays Global Investors, First Trust, Merrill Lynch, and Claymore Investments.

 

In 2008, we expanded our bond indexes to include a series of international indexes, including European bond indexes. We plan to continue expanding our index lineup in 2009 with additional global indexes and series of target-date and target-risk benchmarks that incorporate Ibbotson’s asset allocation research and combine components from our other indexes. In early 2009, we introduced a series of asset allocation indexes that incorporate research from Ibbotson Associates and combine components from our other indexes to create 10 post-retirement and three pre-retirement indexes. We believe we’re the only index provider that offers indexes spanning all asset categories, which allows us to develop indexes that blend various asset classes.

 

Marketing and Sales

 

We promote our print, software, Web-based products and services, and consulting services with a staff of sales and marketing professionals, as well as an in-house public relations team. Our marketing staff includes both product specialists and a corporate marketing group that manages company initiatives. Our sales team includes several strategic account managers who oversee all aspects of our largest institutional client relationships. We also have a sales operations staff, which focuses on tracking sales, forecasting sales, and other tasks to support our sales team. Across all three of our segments, we emphasize high levels of product support to help our customers use our products effectively and provide our product managers with feedback from customers. We had approximately 380 sales and marketing professionals on staff as of December 31, 2008.

 

International Operations

 

We conduct our business operations outside of the United States through wholly owned or majority-owned operating subsidiaries doing business in each of the following countries: Australia, Canada, France, Germany, India, Italy, Japan, the Netherlands, New Zealand, Norway, People’s Republic of China (both Hong Kong and the mainland), Singapore, South Africa, Spain, Switzerland, Taiwan, Thailand, and the United Kingdom. See Note 4 of the Notes to our Consolidated Financial Statements for additional information concerning revenue from customers and long-lived assets from our business operations outside the United States.

 

In addition, we hold minority ownership positions in operating companies based in Denmark, Japan, Korea, and Sweden. As of December 31, 2008, we owned approximately 34% of the outstanding shares in Morningstar Japan K.K. (Morningstar Japan) and our share had a market value of approximately $33 million. Morningstar Japan is publicly traded under ticker 4765 on the Osaka Stock Exchange “Hercules Market.” See Note 8 of the Notes to our Consolidated Financial Statements for information on our investments in unconsolidated entities.

 

To enable these companies to do business in their designated territories, we provide them with the rights to the Morningstar name and logo and with access to certain of our products and technology. Each company is responsible for developing marketing plans tailored to meet the specific needs of investors within its country and working with Morningstar’s data collection and development centers to create and maintain databases, develop new products, and enhance existing products.

 

See Item 1A—Risk Factors for a discussion of the risks related to our business operations outside of the United States.

 

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Intellectual Property and Other Proprietary Rights

 

We treat our brand, product names and logos, software, technology, databases, and other products as proprietary. We try to protect this intellectual property by using trademark, copyright, patent and trade secrets laws, licensing and nondisclosure arrangements, and other security measures. For example, in the normal course of business, we only provide our intellectual property to third parties through standard licensing agreements. The purposes of these agreements are to both define the extent and duration of any third-party usage rights and to provide for our continued ownership in any intellectual property furnished.

 

Because of the value of our brand name and logo, we have tried to register one or both of them in all of the relevant international classes under the trademark laws of most of the jurisdictions in which we maintain operating companies. As we move into new countries, we consider adding to these registrations and, in some jurisdictions, register certain product identifiers as well. We have registered our name and/or logo in numerous countries and the European Union and have applied for registrations in several other countries.

 

From time to time, we encounter jurisdictions in which one or more third parties have a pre-existing trademark registration in certain relevant international classes that may prevent us from registering our own marks in those jurisdictions. It is possible that our continued ability to use the “Morningstar” name or logo, either on a stand-alone basis or in association with certain products or services, could be compromised in those jurisdictions because of these pre-existing registrations. Similarly, from time to time, we encounter situations in certain jurisdictions where one or more third parties are already using the Morningstar name, either as part of a registered corporate name, a registered domain name or otherwise. Our ability to effectively market certain products and/or services in those locations could be adversely affected by these pre-existing usages.

 

“Morningstar” and the Morningstar logo are registered marks of Morningstar in the United States and in certain other jurisdictions. The table below includes some of the trademarks or service marks that we use:

 

Advice by Ibbotson ®

 

Morningstar ® Managed Portfolios SM

Hemscott ®

 

Morningstar ® Managed Portfolios SM Select Stock Baskets

Ibbotson ® SBBI ®

 

Morningstar ® Mutual Funds TM

Morningstar® Advisor Workstation SM

 

Morningstar ® OptionsInvestor TM

Morningstar® Advisor Workstation SM Enterprise Edition

 

Morningstar ® Ownership Zone SM

Morningstar® Advisor Workstation SM Office Edition

 

Morningstar ® Portfolio Builder SM

Morningstar® Analyst Research Center

 

Morningstar® Portfolio X-Ray ®

Morningstar Direct SM

 

Morningstar ® Principia ®

Morningstar ® EnCorr ®

 

Morningstar Rating TM

Morningstar ® Equity Research Services SM

 

Morningstar ® Retirement Income Strategist SM

Morningstar ® Essentials TM

 

Morningstar ® Retirement Manager SM

Morningstar ® ETFInvestor TM

 

Morningstar® Site Builder SM

Morningstar ® FundInvestor TM

 

Morningstar ® Stewardship Grade SM

Morningstar ® Global Document Library SM

 

Morningstar ® StockInvestor TM

Morningstar ® HealthcareObserver TM

 

Morningstar Style Box TM

Morningstar ® Investment Profiles TM

 

Morningstar ® Wide Moat Focus SM Index

Morningstar ® Licensed Data SM

 

Morningstar.com ®

Morningstar ® Licensed Tools and Content

 

 

 

In addition to trademarks, we currently hold five patents (three in the United States, one in the United Kingdom, and one in Canada). We are in the process of registering another patent in the United States. We believe these patents represent our commitment to developing innovative products and tools for investors.

 

License Agreements

 

In the majority of our licensing agreements, we license our products and/or other intellectual property to our customers for a fee. We generally use our standard agreements, whether in paper or electronic form, and we do not provide our products and services to customers or other users without having an agreement in place.

 

We maintain licensing agreements with each of our minority-owned operations.  We put these agreements in place so these companies can use our intellectual property, such as our products and trademarks, to develop and market similar products under our name in their operating territories.

 

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In the ordinary course of our business, we obtain and use intellectual property from a wide variety of sources. We license some of this intellectual property from third parties and obtain other portions of it directly from public filings.

 

Seasonality

 

We believe our business has a modest amount of seasonality. Some of our smaller products, such as the Ibbotson Stocks, Bonds, Bills, and Inflation Yearbook and one of our investment conferences, generate the majority of their revenue in the first or second quarter of the year. Most of our products are sold with subscription or license terms of at least one year, though, and we recognize revenue ratably over the term of each subscription or license agreement. This tends to moderate seasonality in sales patterns for individual products. Refer to the discussion in Business Segments, Products, and Services above for additional information on the seasonality of each segment.

 

Largest Customer

 

In 2008, our largest customer accounted for less than 5% of our consolidated revenue.

 

Competitive Landscape

 

The economic and financial information industry has been marked by increased consolidation over the past five years, with the strongest players generally gaining market share at the expense of smaller competitors. Some of our major competitors include Thomson Reuters; Standard & Poor’s, a division of The McGraw-Hill Companies; Bloomberg; and Yahoo!. These companies have financial resources that are significantly greater than ours. We also have a number of smaller competitors in each of our three business segments, which we discuss in Business Segments, Products, and Services above. Most of our competitors compete with individual products or segments of our business; we are not aware of any company that offers substantially similar product solutions in all three of our segments.

 

We believe the most important competitive factors in our industry are brand and reputation, data accuracy and quality, breadth of data coverage, quality of investment analysis and analytics, design, product reliability, and value of the products and services provided.

 

Competitors by Product

 

 

 

Licensed Data

 

Investment 
Consulting

 

Morningstar 
Advisor 
Workstation

 

Morningstar.com

 

Principia

 

Morningstar 
Direct

Advent Software

 

 

 

 

 

·

 

 

 

·

 

 

Bloomberg

 

·

 

 

 

 

 

·

 

 

 

·

eVestment Alliance

 

·

 

 

 

 

 

 

 

 

 

·

FactSet Research Services

 

·

 

 

 

 

 

 

 

 

 

·

Financial Express

 

·

 

 

 

·

 

 

 

 

 

 

Interactive Data Corporation

 

·

 

 

 

 

 

 

 

 

 

 

Mercer

 

 

 

·

 

 

 

 

 

 

 

·

MSN Money

 

 

 

 

 

 

 

·

 

 

 

 

News Corporation*

 

 

 

 

 

 

 

·

 

 

 

 

Standard & Poor’s

 

·

 

 

 

·

 

 

 

 

 

 

Thomson Reuters**

 

·

 

 

 

·

 

 

 

·

 

·

Van Eyk Research

 

 

 

 

 

 

 

·

 

 

 

 

Wilshire Associates

 

 

 

·

 

 

 

 

 

 

 

·

Yahoo!

 

 

 

 

 

 

 

·

 

 

 

 

Zephyr Associates

 

 

 

 

 

 

 

 

 

 

 

·

 

*   News Corporation includes Dow Jones, MarketWatch, and SmartMoney

**  Thomson Reuters includes Lipper

 

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Research and Development

 

A key aspect of our growth strategy is to expand our investment research capabilities and enhance our existing products and services. We strive to rapidly adopt new technology that can improve our products and services. We have also built a flexible technology platform that allows our products to work together across a full range of investment databases, delivery formats, and market segments. As a general practice, we manage our own Web sites and build our own software applications rather than relying on outside vendors. This allows us to control our development and better manage costs, enabling us to respond quickly to market changes and to meet customer needs efficiently. As of December 31, 2008, our technology team consisted of approximately 500 programmers and technology and infrastructure professionals.

 

In 2008, 2007, and 2006, our development expense represented 8.0%, 8.1%, and 9.4%, respectively, of our revenue. We expect that development expense will continue to represent a meaningful percentage of our revenue in the future.

 

Government Regulation

 

United States

 

Investment advisory and broker-dealer businesses are subject to extensive regulation in the United States at both the federal and state level, as well as by self-regulatory organizations. Financial services companies are among the nation’s most extensively regulated. The SEC is responsible for enforcing the federal securities laws and oversees federally registered investment advisors and broker-dealers.

 

As of December 31, 2008, four of our subsidiaries, Ibbotson Associates, Inc., Ibbotson Associates Advisors, LLC, Morningstar Associates, LLC, and Morningstar Investment Services, Inc. are registered as investment advisors with the SEC under the Investment Advisers Act of 1940, as amended (Advisers Act). As registered investment advisors, these companies are subject to the requirements and regulations of the Advisers Act. Such requirements relate to, among other things, record-keeping, reporting, and standards of care, as well as general anti-fraud prohibitions.

 

In addition, because these four subsidiaries  provide investment advisory services to retirement plans and their participants, they may be acting as fiduciaries under the Employee Retirement Income Security Act of 1974 (ERISA). As fiduciaries under ERISA, they have duties of loyalty and prudence, as well as duties to diversify investments and to follow plan documents to comply with the applicable portions of ERISA.

 

We provide each of our investment advisor companies with financial, operational, and administrative support. However, each of them operates independently from other areas of Morningstar, using separate personnel and supervisory structures and making independent investment decisions.

 

Morningstar Investment Services is a broker-dealer registered under the Securities Exchange Act of 1934 (Exchange Act) and a member of FINRA. The regulation of broker-dealers has, to a large extent, been delegated by the federal securities laws to self-regulatory organizations, including FINRA. Subject to approval by the SEC, FINRA adopts rules that govern its members. FINRA conducts periodic examinations of the operations of Morningstar Investment Services. Broker-dealers are subject to regulations that cover all aspects of the securities business, including sales capital structure, record-keeping, and the conduct of directors, officers, and employees. Violation of applicable regulations can result in the revocation of a broker-dealer license, the imposition of censures or fines, and the suspension or expulsion of a firm or its officers or employees. Morningstar Investment Services is subject to certain net capital requirements under the Exchange Act. The net capital requirements, which specify minimum net capital levels for registered broker-dealers, are designed to measure the financial soundness and liquidity of broker-dealers.

 

Additional legislation and regulations, including those relating to the activities of investment advisors and broker-dealers, changes in rules imposed by the SEC or other U.S. or non-U.S. regulatory authorities and self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may adversely affect our business and profitability. Our businesses may be materially affected not only by regulations applicable to it as an investment advisor or broker-dealer, but also by regulations that apply to companies generally.

 

Australia

 

In order to provide financial information services in Australia, our Australian subsidiaries, Morningstar Research Pty Limited (Morningstar Australia) and Morningstar Australasia Pty Limited, must hold an Australian Financial Services License and submit to the jurisdiction of the Australian Securities and Investments Commission (ASIC). This license requires Morningstar Australia and Morningstar Australasia to maintain positive net asset levels and sufficient cash resources to cover three months of expenses and to comply with the audit requirements of the ASIC.

 

17



 

United Kingdom

 

Morningstar Associates Europe Limited is authorized and regulated by the U.K. Financial Services Authority as an investment advisor. As an authorized firm, this company is subject to the requirements and regulations of the Financial Services Authority. Such requirements relate to, among other things, financial reporting and other reporting obligations, record keeping, and cross-border requirements.

 

Employees

 

We had approximately 2,375 employees as of December 31, 2008, including approximately 550 data analysts, 45 designers, 270 investment analysts (including consulting and quantitative research analysts), 500 programmers and technology staff, and 380 sales and marketing professionals. Our employees are not represented by any unions and we have never experienced a walkout or strike.

 

Executive Officers

 

As of March 1, 2009, we had 13 executive officers. The table below summarizes information about each of these officers.

 

Name

 

Age

 

Position

Joe Mansueto

 

52

 

Chairman, Chief Executive Officer, and Director

Chris Boruff

 

43

 

President, Advisor Software

Peng Chen

 

38

 

President, Ibbotson Associates, Inc.

Scott Cooley

 

40

 

Chief Financial Officer

Bevin Desmond

 

42

 

President, International Division and Institutional Software

Catherine Gillis Odelbo

 

46

 

President, Equity Research

Tao Huang

 

46

 

Chief Operating Officer

Kunal Kapoor

 

33

 

President, Individual Investor Software

Elizabeth Kirscher

 

44

 

President, Data Services

Don Phillips

 

46

 

President, Fund Research and Managing Director

Patrick Reinkemeyer

 

43

 

President, Morningstar Associates LLC

Richard Robbins

 

46

 

General Counsel and Corporate Secretary

David W. Williams

 

48

 

Managing Director, Design

 

Joe Mansueto

 

Joe Mansueto founded Morningstar in 1984. He has served as our chairman since our inception and as our chief executive officer from our inception to 1996 and from 2000 to the present. He holds a bachelor’s degree in business administration from The University of Chicago and a master’s degree in business administration from The University of Chicago Booth School of Business.

 

Chris Boruff

 

Chris Boruff has been the president of our advisor business since 2000 and became president of our advisor software business in 2009. He is responsible for overseeing strategy, development, and marketing associated with our software for financial advisors. He joined us in 1996 as product manager for Principia, and from 1997 to 1998, he served as senior product manager of advisor products. From 1999 to 2000, he served as vice president of advisor products, where he was responsible for all marketing related to financial advisors. He holds a bachelor’s degree in economics and psychology from Northwestern University.

 

Peng Chen

 

Peng Chen has been president of Ibbotson Associates, Inc. since August 2006. Prior to Morningstar’s acquisition of Ibbotson in 2006, he served as Ibbotson’s managing director and chief investment officer. He joined Ibbotson in 1997 and played a key role in the development of its investment consulting and 401(k) advice/managed retirement account services. He received a bachelor’s degree in industrial management engineering from Harbin Institute of Technology and a master’s and doctorate degrees in consumer economics from The Ohio State University.

 

Scott Cooley

 

Scott Cooley has been our chief financial officer since August 2007. Before joining Morningstar in 1996 as a stock analyst, he was a bank examiner for the Federal Deposit Insurance Corporation (FDIC), where he focused on credit analysis and asset-backed securities. From 1996 until 2003, he was an analyst, editor, and manager for Morningstar.com, Morningstar Mutual Funds, and other Morningstar publications. He became CEO of Morningstar Australia and Morningstar New Zealand in 2003 and served as co-CEO of these operations following our acquisition of Aspect Huntley in July 2006. He holds a bachelor’s degree in economics and social science and a master’s degree in history from Illinois State University.

 

 

 

18



Bevin Desmond

 

Bevin Desmond has been president of our international business since 2000. She is responsible for identifying and developing our business in new countries, managing and directing operations, and launching new products. In 2009, Bevin took on additional responsibilities as president of institutional software, including oversight of Morningstar Direct and other institutional software platforms. She joined us in 1993 and was one of three employees who started our international business. From 1998 to 2000, she served as manager of all international ventures. She holds a bachelor’s degree in psychology from St. Mary’s College.

 

Catherine Gillis Odelbo

 

Catherine Gillis Odelbo has been president of our Individual segment since 2000 and became president of our equity research business in 2009. She joined us in 1988 as a mutual fund analyst and from 1999 to 2000 served as senior vice president of content development for the company, as well as publisher and editor of our stock and closed-end fund research. She holds a bachelor’s degree in American history from The University of Chicago and a master’s degree in business administration from The University of Chicago Booth School of Business.

 

Tao Huang

 

Tao Huang has been our chief operating officer since 2000. He is responsible for corporate strategy and overseeing our business results and  day-to-day operations. He joined us in 1990 as a software developer and from 1996 to 1998 served as chief technology officer. From 1998 to 2000, he served as senior vice president of business development and head of international operations. He holds a bachelor’s degree in computer science from Hunan University in China, a master’s degree in computer science from Marquette University, and a master’s degree in business administration from The University of Chicago Booth School of Business.

 

Kunal Kapoor

 

Kunal Kapoor has been president of individual investor software since 2009. He joined us in 1997 as a data analyst and became a fund analyst in 1998. In 2001 he joined Morningstar Investment Services as a senior research analyst. He was named editor of Morningstar Mutual Funds in 2003, and in 2004 was appointed director of mutual fund analysis. In 2006, he was named director of business strategy for Morningstar’s international operations. He became president and chief investment officer of Morningstar Investment Services in 2007. Kunal holds a bachelor’s degree in economics and environmental policy from Monmouth College and a master’s degree in business administration from The University of Chicago Booth School of Business. He also holds the Chartered Financial Analyst (CFA) designation and is a member of the Investment Analysts Society of Chicago.

 

Elizabeth Kirscher

 

Elizabeth Kirscher has been president of our data services business since 2000. She is responsible for managing our investment databases and related products. She joined us in 1995 as a major accounts manager in our institutional sales area. From 1998 to 1999, she served as international product manager and worked on the launch of Morningstar Japan. From 1999 to 2000, she was director of sales and business development for Morningstar.com and marketed Morningstar.com data and tools to other Web sites. She holds a bachelor’s degree from Vassar College and a master’s degree in business administration from the Columbia Business School at Columbia University.

 

Don Phillips

 

Don Phillips has been a managing director since 2000 and in 2009 took on additional responsibilities as president of fund research. He is responsible for overseeing our research on mutual funds, exchange-traded funds, and alternative investments. He joined us in 1986 as our first analyst. He served as our vice president and publisher from 1991 to 1996, as our president from 1996 to 1998, and as our chief executive officer from 1998 to 2000. He has served on our board of directors since August 1999. He also serves on the board of directors for Morningstar Japan. He holds a bachelor’s degree in English from the University of Texas and a master’s degree in American literature from The University of Chicago.

 

Patrick Reinkemeyer

 

Patrick Reinkemeyer has been president of Morningstar Associates LLC since October 2004. He is responsible for Morningstar’s investment consulting and retirement businesses. He joined us in 1996 and directed our print and software variable annuity/life products from 1996 to 1997. From 1998 until 2001, he was director of Morningstar’s investment consulting business. From 2001 until October 2004, he served as president of investment consulting.  He holds a bachelor’s degree in history from Middlebury College and a master’s degree in business administration from The University of Chicago Booth School of Business. He also holds the Chartered Financial Analyst (CFA) designation and is a member of the Investment Analysts Society of Chicago.

 

19



 

Richard Robbins

 

Richard Robbins has been our general counsel and corporate secretary since August 2005. He is responsible for directing Morningstar’s legal department and managing our relationships with outside counsel. From May 1999 until he joined Morningstar, he was a partner at Sidley Austin Brown & Wood LLP (now Sidley Austin LLP), which he joined as an associate in August 1991. He holds bachelor’s and master’s degrees in computer science and electrical engineering from the Massachusetts Institute of Technology and a juris doctor degree from The University of Chicago Law School.

 

David W. Williams

 

David W. Williams has been one of our managing directors since 2000. He is in charge of design and its application to brand identity, products, communications, and the workplace. He joined us in 1993 and has been instrumental in establishing design as one of our recognized core capabilities. He holds a bachelor’s degree in industrial design from The Ohio State University and a master’s degree in fine arts from the Yale University School of Art.

 

Company Information

 

We were incorporated in Illinois on May 16, 1984. Our corporate headquarters are located at 22 West Washington Street, Chicago, Illinois, 60602.

 

We maintain a Web site at http://corporate.morningstar.com. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to any of these documents are available free of charge on this site as soon as reasonably practicable after the reports are filed with or furnished to the SEC. We also post quarterly press releases on our financial results and other documents containing additional information related to our company on this site. We provide this Web site and the information contained in or connected to it for informational purposes only. That information is not part of this Annual Report on Form 10-K.

 

Item 1A. Risk Factors

 

You should carefully consider the risks described below and all of the other information included in this Form 10-K when deciding whether to invest in our common stock or otherwise evaluating our business. If any of the following risks materialize, our business, financial condition, or operating results could suffer. In this case, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Continued downturns in the financial sector, global financial markets, and global economy may adversely impact our business.

 

The global financial crisis that began in 2007 became significantly worse throughout 2008. Because of problems associated with investments in subprime mortgage and other securities, many high-profile companies in the financial sector have had to restructure their operations. Several large firms have declared bankruptcy, been acquired, accepted funding from the U.S. government, or otherwise restructured their operations.

 

In response to these events, the global financial markets have shown unusually high levels of volatility, which became increasingly severe as 2008 progressed. In response to the market upheaval, the mutual fund industry has experienced historically high levels of monthly net redemptions. Other investment vehicles have also suffered asset declines because of negative market performance and net redemptions.

 

We believe the disruption in the financial markets continues to cause widespread investor uncertainty, and the market downturn has also led to spending cutbacks among asset management firms and other financial services companies, which make up a large percentage of our client base.

 

Because of pressures related to the current crisis, institutional clients have become increasingly cautious and price-sensitive. Many of them have also implemented additional review processes for new contracts. Some institutional firms have also begun to provide certain services, particularly investment advisory services, in-house rather than hiring external service providers.

 

We can’t predict how long this situation will persist or what its ultimate impact will be on our financial results. If financial markets around the world continue to experience negative performance and volatility, demand for our products and services may decline, and our revenue, operating income, and other financial results could suffer. The financial markets and many businesses operating in the financial services industry are highly volatile and are affected by factors, such as U.S. and foreign economic conditions and general trends in business and finance, which are beyond our control.

 

20



 

Competition could reduce our share of the investment research market and hurt our financial performance.

 

We operate in a highly competitive industry, with many investment research providers competing for business from individual investors, financial advisors, and institutional clients. We compete with many different types of companies that vary in size, product scope, and media focus, including large and well-established distributors of financial information, such as Thomson Reuters; Standard & Poor’s, a division of The McGraw-Hill Companies; Bloomberg; and Yahoo!. We compete with a variety of other companies in different areas of our business, which we discuss in greater detail in the Business Segments, Products, and Services section in Item 1—Business.

 

Many of our competitors have larger customer bases and significantly greater resources than we do. This may allow them to respond more quickly to new technologies and changes in demand for products and services, devote greater resources to developing and promoting their services, and make more attractive offers to potential clients, subscribers, and strategic partners. Industry consolidation may also lead to more intense competition. Increased competition could result in price reductions, reduced margins, or loss of market share, any of which could hurt our business, operating results, or financial condition.

 

If we do not maintain and increase the number of subscriptions and license agreements, our operating results could suffer.

 

We generate a substantial portion of our revenue from subscriptions and license agreements. In general, our subscriptions are paid in advance. We may be obligated to refund a portion of prepaid subscription fees when a customer cancels. Cancellations may have a negative impact on our revenue and cash position. Our license agreements, which typically do not allow for cancellation, have terms ranging from one to three years. Our future success depends on our maintaining (through renewals) and increasing (through new subscriptions and license agreements) the number of customers who pay for our investment research and services. Further, if the market for our products and services develops more slowly than we expect, or declines, and the number of customers who pay for our services does not increase, or declines, our business, operating results, or financial condition could suffer.

 

Certain products and services have historically made up a large percentage of our revenue base. Our business could suffer if sales of these products and services decline.

 

In 2008, our five largest products based on revenue (Licensed Data, Investment Consulting, Morningstar Advisor Workstation, Morningstar.com, and Principia) accounted for approximately 58% of our consolidated revenue. We believe that sales of these products and services will continue to make up a substantial portion of our consolidated revenue for the foreseeable future. If we experience a significant decline in sales of any of these products for any reason, it would have a material adverse impact on our revenue and could harm our business.

 

During 2008, one of our Investment Consulting clients informed us that it was not planning to renew its contract. Also, in the first quarter of 2009, we did not reach an agreement on renewal terms with another consulting client. Combined, these contracts represented about $17 million of revenue in 2008.

 

We also have significant revenue from the independent equity research we’re providing under the terms of the Global Analyst Research Settlement, which accounted for approximately 4% of our consolidated revenue and 20% of revenue in the Individual segment in 2008. In 2003 and 2004, 12 leading Wall Street investment banks agreed to a $1.5 billion settlement (the Global Analyst Research Settlement) with the SEC, the New York Attorney General, and other securities regulators to resolve allegations of undue influence of investment banking interests on securities research. Approximately $450 million of the $1.5 billion in fines that the investment banks agreed to pay in the settlement has been designated for independent research over a period of five years, with the independent research to be provided by companies that are not engaged in the investment banking industry. Each firm involved in the settlement is required to provide research from at least three providers of independent research that are not engaged in the investment banking industry. We have entered into agreements with six of these banks to provide independent equity research under the terms of the settlement.

 

The period during which investment banks are required to provide independent equity research to their clients will expire in July 2009. After the settlement period expires, the investment banks covered by it will no longer be required to provide independent investment research to their clients. We don’t know how much of this business we’ll retain after the settlement period expires, but we expect this research revenue to decline significantly.

 

21



 

Industry consolidation may adversely impact our competitive position, our relationships with our clients, and business results.

 

Industry consolidation in the financial services sector has accelerated because of the market downturn. We can’t predict the impact on our business if one of our clients is acquired. We may lose business following an acquisition of one of our clients if we’re not able to continue providing services or expand our business with the combined organization. Any loss of business because of increased consolidation could have a negative effect on our revenue and profitability.

 

The investment information industry is dominated by a few large players, and industry consolidation has increased in the past several years. If providers of data and investment analysis continue to consolidate, our competitive position may suffer.

 

Our revenue from asset-based fees could be affected by continued market declines.

 

Our fee-based asset management business has increased as a percentage of total revenue and become more important to our financial results. In 2008, revenue from asset-based fees made up approximately 13% of our consolidated revenue and a greater percentage of our operating income. The amount of revenue we earn from asset-based fees depends on the value of assets on which we provide advisory services, and the size of our asset base can increase or decrease along with trends in market performance. The value of assets under advisement may show substantial declines during periods of significant market volatility. The size of these portfolios can also be affected if net inflows into the portfolios on which we provide investment advisory services drop or these portfolios experience redemptions. If the level of assets on which we provide investment advisory services goes down, we expect that our fee-based revenue will show a corresponding decline.

 

Our results could suffer if the mutual fund industry experiences slower growth.

 

A significant portion of our revenue is generated from products and services related to mutual funds. The mutual fund industry has experienced substantial growth over the past 25 years. Mutual fund assets may not continue to expand at the same rate in future years. Continued downturns or volatility in the financial markets, increased investor interest in other investment vehicles, or a lack of investor confidence in mutual funds following the market-timing scandal that emerged in 2003 could reduce investor interest and investment activity in mutual funds. A slower growth rate in mutual fund assets could decrease demand for some of our products.

 

Our reputation and business may be harmed by allegations made about possible conflicts of interest.

 

We offer products and services to our institutional clients, which include banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors. Our institutional business generated revenue, before intersegment eliminations, of $276.8 million, or 55.1% of our consolidated revenue, in 2008, and $230.3 million, or 52.9% of our consolidated revenue, in 2007. We provide ratings, analyst research, and investment recommendations on mutual funds and other investment products offered and securities issued by our institutional clients. We also provide investment advisory and investment management services. The fact that our institutional clients pay us for certain products and services as well as the fact that in some cases we make investment recommendations within the framework of client constraints may create the perception that our ratings, research, and recommendations are not impartial. This perception may undermine the confidence of our customers and potential customers in our reputation as a provider of independent research. Any such loss of confidence or damage to our reputation could hurt our business.

 

Our investment advisory operations may subject us to liability for any losses that result from a breach of our fiduciary duties.

 

Our investment advisory operations involve fiduciary obligations that require us to act in the best interests of our clients. We may face liabilities for actual or claimed breaches of our fiduciary duties, particularly in areas where we provide retirement advice and managed retirement accounts. We may not be able to prevent clients from taking legal action against us for an actual or claimed breach of a fiduciary duty. The current market downturn may increase the likelihood of legal action and claims that we have breached our fiduciary duties. Because we provided investment advisory services on more than $66.2 billion in assets as of December 31, 2008, we could face substantial liabilities if we breach our fiduciary duties.

 

In addition, we may face other legal liabilities based on the quality and outcome of our investment advisory recommendations, even in the absence of an actual or claimed breach of fiduciary duty.

 

Changes in laws applicable to our investment advisory operations, compliance failures, or regulatory action could adversely affect our business.

 

Our investment advisory operations are a growing part of our overall business. Our acquisition of Ibbotson Associates in 2006 substantially increased our business in this area. The securities laws and other laws that govern our activities as a registered investment advisor are complex. The activities of our investment advisory operations are primarily subject to provisions of the

 

22



 

Investment Advisers Act of 1940 (the Advisers Act) and the Employee Retirement Income Security Act of 1974 (ERISA). In addition, our investment management business is conducted through a broker-dealer registered under the Securities Exchange Act of 1934 (the Exchange Act) and is subject to the rules of FINRA. We also provide investment advisory services in other areas around the world, and our operations may be subject to additional regulations in markets outside the United States. It is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting our business. The laws, rules, and regulations applicable to our business may change in the future, and we may not be able to comply with any such changes. If we fail to comply with any applicable law, rule, or regulation, we could be fined, sanctioned, or barred from providing investment advisory services in the future, which could materially adversely affect our business, operating results, or financial condition.

 

We could be subject to fines, penalties, or other sanctions as a result of investigations by the New York Attorney General’s Office and the Department of Labor related to some of the services Morningstar Associates, LLC provides.

 

As we originally disclosed in 2004, the New York Attorney General’s Office and the Department of Labor are conducting separate investigations related to some of the products and services offered by Morningstar Associates, LLC. See Item 3—Legal Proceedings for a description of these matters. We cannot predict the scope, timing, or outcome of these matters, 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. We have not established any reserves relating to these matters.

 

Our operations outside of the United States are expanding and involve additional challenges that we may not be able to meet.

 

Over the past three years, our operations outside of the United States have generated an increasing amount of revenue, expanding to $121.4 million in 2008 from $44.3 million in 2006. Our 2006 acquisition of Aspect Huntley in Australia, our 2007 acquisition of the fund data business from Standard & Poor’s, and our January 2008 acquisition of the Hemscott data, media, and investor relations businesses substantially increased our business operations in Europe, Australia, and other areas outside the United States. Our recent acquisitions of InvestData (Proprietary) Limited, Tenfore Systems Limited, and Fundamental Data Limited also expanded our international operations. There are risks inherent in doing business outside the United States, including challenges in reaching new markets because of established competitors and limited brand recognition; difficulties in staffing, managing, and integrating non-U.S. operations; difficulties in coordinating and sharing information globally; differences in laws and policies from country to country; exposure to varying legal standards, including intellectual property protection laws; and currency exchange rates and exchange controls. These risks could hamper our ability to expand around the world, which may hurt our financial performance and ability to grow.

 

Our offshore data centers also involve additional risks. We now have approximately 470 programmers and data analysts working in our data and technology development center in Shenzhen, China. Over the past several years, we have been moving a significant percentage of our data collection and development operations to this location. Because China has a restrictive government under centralized control, we cannot predict the level of political and regulatory risk that may affect our operations. The concentration of development and data work carried out at this facility also involves operational risks for our network infrastructure. Any difficulties that we face in successfully maintaining our development center in China may harm our business and have a negative impact on the products and services we provide, particularly because of our increasing reliance on this facility.

 

Following the Hemscott acquisition, we have approximately 200 employees who work at our data collection facility in New Delhi, India, which may also be subject to political and regulatory risk. Like the Shenzhen operation, this facility also involves operational risks for our network infrastructure.

 

We do not currently hedge any of our currency exposure, which may adversely impact our financial results.

 

As our non-U.S. revenue increases as a percentage of consolidated revenue, fluctuations in foreign currencies present a greater potential risk. To date, we have not engaged in currency hedging, and we do not currently have any positions in derivative instruments to hedge our currency risk. Our reported revenue could suffer if certain foreign currencies decline relative to the U.S. dollar, although the impact on operating income may be offset by an opposing currency impact on locally based operating expense. In addition, because we use the local currency of our subsidiaries as the functional currency, our financial results are affected by the translation of foreign currencies into U.S. dollars.

 

23



 

The availability of free or low-cost investment information could lead to lower demand for our products and adversely affect our financial results.

 

Investment research and information relating to publicly traded companies and mutual funds is widely available for little or no cost from various sources, including the Internet and public libraries. Investors can also access information directly from publicly traded companies and mutual funds. The Interactive Data Electronic Applications (IDEA) database available through the SEC Web site provides real-time access to SEC filings, including annual, semi-annual, and quarterly reports. Many brokerage firms also provide financial and investment research to their clients. The widespread availability of free or low-cost investment information may make it difficult for us to maintain or increase the prices we charge for our publications and services and could lead to a lower demand for our products. A loss of a significant number of customers would hurt our financial results.

 

Our failure to successfully integrate acquisitions could strain our resources.

 

We’ve completed numerous acquisitions over the past three years, including six acquisitions in 2008. We cannot guarantee that we will successfully integrate the employees, product lines, business systems, and operations following any acquisition. We expect to continue making acquisitions and establishing investments and joint ventures as part of our long-term business strategy. Acquisitions, investments, and joint ventures involve a number of risks. They can be time-consuming and may divert management’s attention from day-to-day operations. Financing an acquisition could result in dilution from issuing equity securities, reduce our financial flexibility because of reductions in our cash balance, or result in a weaker balance sheet from incurring debt.

 

Acquisitions might also result in losing key employees. We may fail to successfully complete an acquisition, investment, or joint venture. We may also fail to generate enough revenue or profits from an acquisition to earn a return on the associated purchase price.

 

A prolonged outage of our database and network facilities could result in reduced revenue and the loss of customers.

 

The success of our business depends upon our ability to deliver time-sensitive, up-to-date data and information. We rely on our computer equipment, database storage facilities, and other office equipment, which are mainly located in our Chicago headquarters or elsewhere in the Chicago area. Our operations and those of our suppliers and customers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks, wars, Internet failures, computer viruses, and other events beyond our control, including disasters affecting Chicago. We maintain off-site back-up facilities for our database and network equipment, but these facilities could be subject to the same interruptions that may affect our headquarters. We’re not currently able to immediately switch over all of our systems to a back-up facility. If we experience a significant database or network facility outage, our business may be disrupted until we fully implement our back-up systems. Any losses, service disruption, or damages incurred by us could have a material adverse effect on our business, operating results, or financial condition.

 

Our business relies heavily on electronic delivery systems and the Internet. Any failures or disruptions could result in reduced revenue and the loss of customers.

 

Most of our products and services depend heavily on our electronic delivery systems and the Internet. Our ability to deliver information using the Internet may be impaired because of infrastructure failures, service outages at third-party Internet providers, or increased government regulation. If disruptions, failures, or slowdowns of our electronic delivery systems or the Internet occur, our ability to distribute our products and services effectively and to serve our customers may be impaired.

 

We could face liability related to our storage of personal information about our users.

 

Customers routinely input personal investment and financial information, including portfolio holdings and credit card information, on our Web sites. We could be subject to liability if we were to inappropriately disclose any user’s personal information or if third parties were able to penetrate our network security or otherwise gain access to any user’s name, address, portfolio holdings, or credit card information. Any such event could subject us to claims for unauthorized credit card purchases, impersonation or other similar fraud claims, or claims for other misuses of personal information, such as unauthorized marketing or unauthorized access to personal portfolio information.

 

We could face liability for the information we publish, including information based on data we obtain from other parties.

 

We may be subject to claims for securities law violations, defamation (including libel and slander), negligence, or other claims relating to the information we publish. For example, investors may take legal action against us if they rely on published information that contains an error, or a company may claim that we have made a defamatory statement about it or its employees. We could also be subject to claims based upon the content that is accessible from our Web site through links to other Web sites. We rely on a variety of outside parties as the original sources for the information we use in our published data. These sources include securities exchanges, fund companies, and transfer agents. Accordingly, in addition to possible exposure for publishing incorrect information that results directly from our own errors, we could face liability based on inaccurate data provided to us by others.

 

24



 

Defending claims based on the information we publish could be expensive and time-consuming and could adversely impact our business, operating results, and financial condition.

 

Our future success depends on our ability to recruit and retain qualified employees, including our executive officers.

 

We experience competition for analysts and other employees from financial institutions and financial services organizations. These organizations generally have greater resources than we do and therefore may be able to offer significantly more attractive compensation packages to potential employees. Competition for these employees is intense, and we may not be able to retain our existing employees or be able to recruit and retain other highly qualified personnel in the future.

 

Our future success also depends on the continued service of our executive officers, including Joe Mansueto, our chairman, chief executive officer, and controlling shareholder. The loss of one or more of our executive officers could hurt our business, operating results, or financial condition. We do not carry any life insurance on our executive officers. We do not have employment agreements or non-compete agreements in place with any of our executive officers. They may leave us and work for our competitors or start their own competing businesses.

 

Failure to protect our intellectual property rights could harm our brand-building efforts and ability to compete effectively.

 

The steps we have taken to protect our intellectual property may not be adequate to safeguard our proprietary information. Further, effective trademark, copyright, and trade secret protection may not be available in every country in which we offer our services. Our continued ability to market one or more of our products under their current names could be adversely affected in those jurisdictions where another person registers, or has a pre-existing registration on, one or more of them. Failure to adequately protect our intellectual property could harm our brand, devalue our proprietary content, and affect our ability to compete in the marketplace.

 

Control by a principal shareholder could adversely affect our other shareholders.

 

As of December 31, 2008, Joe Mansueto, our chairman and chief executive officer, owned approximately 57% of our outstanding common stock. As a result, he has the ability to control substantially all matters submitted to our shareholders for approval, including the election and removal of directors and any merger, consolidation, or sale of our assets. He also has the ability to control our management and affairs. This concentration of ownership may delay or prevent a change in control; impede a merger, consolidation, takeover, or other business combination involving us; discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us; or result in actions that may be opposed by other shareholders.

 

Moreover, because of Joe’s substantial ownership, we are a “controlled company” for purposes of the NASDAQ Marketplace Rules. This means that, if in the future we elect to be treated as a controlled company under the NASDAQ Marketplace Rules, we will not be required by NASDAQ to have a majority of independent directors or to maintain compensation and nominating and corporate governance committees composed entirely of independent directors to continue to list our shares on NASDAQ.

 

Fluctuations in our operating results may negatively impact our stock price.

 

We believe our business has relatively large fixed costs and low variable costs, which magnify the impact of revenue fluctuations on our operating results. As a result, a decline in our revenue may lead to a larger decline in operating income. A substantial portion of our operating expense is related to personnel costs, marketing programs, and corporate overhead, none of which can be adjusted quickly. Our operating expense levels are based on our expectations for future revenue. If actual revenue falls below our expectations, or if our expenses increase before revenues do, our operating results would be materially and adversely affected. In addition, we do not provide earnings guidance or hold one-on-one meetings with institutional investors and research analysts. Because of this policy and limited analyst coverage on our stock, our stock price may be volatile. If our operating results or other operating metrics fail to meet the expectations of outside research analysts and investors, the market price of our common stock may decline.

 

The future sale of shares of our common stock may negatively impact our stock price.

 

If our shareholders sell substantial amounts of our common stock, the market price of our common stock could fall. A reduction in ownership by Joe Mansueto or any other large shareholder could cause the market price of our common stock to fall. In addition, the average daily trading volume in our stock is relatively low. The lack of trading activity in our stock may lead to greater fluctuations in our stock price. Low trading volume may also make it difficult for shareholders to make transactions in a timely fashion.

 

25



 

Our shareholders may experience dilution in their ownership positions.

 

In the past, we’ve granted options to employees as a significant part of their overall compensation package. In 2006 we began granting restricted stock units to our employees and non-employee directors. As of December 31, 2008, our employees and non-employee directors held options to acquire 4,053,358 shares of common stock, 3,825,044 of which were exercisable at a weighted average price of approximately $14.66 per share and 228,314 were not exercisable. As of December 31, 2008 there were 516,524 restricted stock units outstanding, the majority of which vest over a period of four years. Generally speaking, a share is issued when a restricted stock unit vests. Some holders have elected to defer when shares are issued and many holders satisfy tax withholding obligations by forfeiting the right to have some of their shares issued. To the extent that option holders exercise outstanding options to purchase common stock and shares are issued when restricted stock units vest, there will be further dilution. Future grants of stock options or restricted stock units may also result in dilution. We may raise additional funds through future sales of our common stock. Any such financing would result in additional dilution to our shareholders.

 

Stock option exercises and other factors may create volatility in our cash flows.

 

Our cash provided by financing activities primarily consists of proceeds from stock option exercises and excess tax benefits related to stock option exercises and vesting of restricted stock units. Excess tax benefits occur at the time a stock option is exercised if the intrinsic value of the option (the difference between the exercise price of the option and the fair value of our stock on the date of exercise) exceeds the fair value of the option at the time of grant. Similarly, excess tax benefits are generated upon vesting of restricted stock units when the market value of our common stock at vesting is greater than the grant price of the restricted stock units. These excess tax benefits reduce the cash we pay for income taxes in the year they are recognized.  It is not possible to predict the timing of stock option exercises or the intrinsic value that will be achieved. Because of this uncertainty, there may be additional volatility in our cash flows from financing activities from year to year.

 

26



 

Item 1B. Unresolved Staff Comments

 

We do not have any unresolved comments from the Staff of the Securities and Exchange Commission regarding our periodic or current reports under the Exchange Act.

 

Item 2. Properties

 

As of December 31, 2008 we lease approximately 290,000 square feet of office space for our U.S. operations, primarily for our office located in Chicago, Illinois. We also lease approximately 199,000 square feet of office space in 18 countries around the world. We believe that our existing and planned office facilities are adequate for our needs and that additional or substitute space is available to accommodate growth and expansion.

 

Item 3. Legal Proceedings

 

NewRiver, Inc.

 

On January 30, 2009, NewRiver, Inc. filed a lawsuit in the Superior Court of the Commonwealth of Massachusetts against Morningstar, Inc. alleging that Morningstar inappropriately accessed a database containing SEC-filed mutual fund disclosure documents. On February 4, 2009, the case was removed to the United States District Court for the District of Massachusetts. NewRiver seeks, among other things, a permanent injunction preventing Morningstar from accessing NewRiver’s Prospectus Express “Web-based data warehouse,” and unspecified damages. While Morningstar is vigorously contesting the claims against it, we cannot predict the outcome of the proceeding.

 

Morningstar Associates, LLC Subpoenas from the Securities and Exchange Commission, the 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.

 

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.

 

27



 

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 other matters will have a material adverse effect on our business, operating results, or financial condition.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of our security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 2008.

 

Part II

 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

 

Our common stock is listed on the Nasdaq Global Select Market under the symbol “MORN.”

 

The following table shows the high and low price per share of our common stock for the periods indicated, as reported on the Nasdaq Global Select Market:

 

 

 

2008

 

2007

 

 

 

High

 

Low

 

High

 

Low

 

First Quarter

 

$

77.81

 

$

58.00

 

$

54.57

 

$

44.60

 

Second Quarter

 

76.95

 

53.67

 

54.72

 

46.10

 

Third Quarter

 

71.54

 

52.51

 

67.16

 

46.48

 

Fourth Quarter

 

61.86

 

25.78

 

85.50

 

61.50

 

 

As of February 27, 2009, the last reported price on the Nasdaq Global Select Market for our common stock was $27.90 per share and there were approximately 1,106 shareholders of record of our common stock.

 

We do not currently pay cash dividends, nor have we paid cash dividends during the period covered by the financial statements included in this Annual Report on Form 10-K. Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law, and other factors deemed relevant by the board of directors. Future indebtedness and loan facilities may also prohibit or restrict our ability to pay dividends and make distributions to our shareholders.

 

Rule 10b5-1 Plans

 

Our directors and executive officers may exercise stock options or purchase or sell shares of our common stock in the market from time to time. We encourage them to make these transactions through plans that comply with Exchange Act Rule 10b5-1(c). Morningstar will not receive any proceeds, other than proceeds from the exercise of stock options, related to these transactions.

 

28



 

The following table, which we are providing on a voluntary basis, shows the Rule 10b5-1 sales plans entered into by our directors and executive officers that were in effect as of March 1, 2009:

 

Name and Position

 

Date of
Plan

 

Plan
Termination
Date

 

Number of
Shares
to be
Sold under
the Plan

 

Timing of Sales under the Plan

 

Number of
Shares
Sold under
the Plan through
March 1,
2009

 

Projected
Beneficial
Ownership (1)

Joe Mansueto

Chairman and

Chief Executive

Officer

 

08/13/08

 

12/31/09

 

1,075,000

 

Shares to be sold ratably over the course of the plan

 

139,375

 

25,851,246

Chris Boruff

President,

Advisor Software

 

05/12/08

 

11/15/09

 

80,000

 

Shares to be sold under the plan if the stock reaches specified prices

 

12,000

 

81,739

Tao Huang

Chief Operating

Officer

 

02/24/09

 

05/31/10

 

470,000

 

Shares to be sold under the plan if the stock reaches specified prices beginning May 5, 2009

 

 

580,303

Elizabeth

Kirscher

President, Data

Services

 

05/22/08

 

06/30/09

 

100,000

 

Shares to be sold under the plan if the stock reaches specified prices

 

 

81,123

Catherine Odelbo

President, Equity

Research

 

08/13/08

 

12/31/09

 

28,165

 

Weekly increments of up to 3,500 shares

 

 

141,750

Don Phillips

President, Fund

Research and

Managing

Director

 

05/09/06

 

12/01/09

 

1,506,097

 

Weekly increments of up to 17,500 shares

 

1,197,251

 

434,292

Patrick

Reinkemeyer

President,

Morningstar

Associates

 

09/10/08

 

10/31/09

 

15,000

 

Weekly increments of up to 1,000 shares

 

 

305,276

Richard Robbins

General Counsel

and Corporate

Secretary

 

08/15/08

 

06/30/09

 

7,061

 

Biweekly increments of up to 500 shares

 

2,061

 

13,578

Paul Sturm

Director

 

03/12/08

 

04/30/09

 

120,000

 

Monthly increments of up to 20,000 shares

 

86,000

 

107,871

David Williams

Managing

Director,

Design

 

09/10/08

 

09/30/09

 

10,000

 

Weekly increments of up to 2,500 shares

 

 

90,934

 


(1)   This column reflects an estimate of the number of shares each identified director and executive officer will beneficially own following the sale of all shares under the Rule 10b5-1 sales plans identified above. This information reflects the beneficial ownership of our common stock on December 31, 2008, and includes shares of our common stock subject to options that were then exercisable or that will have become exercisable by March 1, 2009 and restricted stock units that will vest by March 1, 2009. The estimates do not reflect any changes to beneficial ownership that may have occurred since December 31, 2008. Each director and executive officer identified in the table may amend or terminate his or her Rule 10b5-1 sales plan and may adopt additional Rule 10b5-1 plans in the future.

 

29



 

Item 6. Selected Financial Data

 

The selected historical financial data shown below should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and related notes included elsewhere in this Annual Report on Form 10-K. We have derived our Consolidated Statements of Income Data and Other Consolidated Financial Data for the years ended December 31, 2008, 2007, and 2006 and Consolidated Balance Sheet Data as of December 31, 2008 and 2007 from our audited Consolidated Financial Statements included in this Annual Report on Form 10-K. The Consolidated Statements of Income Data and Other Consolidated Financial Data for the years ended December 31, 2005 and 2004 and Consolidated Balance Sheet Data as of December 31, 2006, 2005, and 2004 were derived from our audited Consolidated Financial Statements that are not included in this Annual Report on Form 10-K.

 

Consolidated Statements of Income Data
(in thousands except per share amounts)

 

2004

 

2005

 

2006

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

179,658

 

$

227,114

 

$

315,175

 

$

435,107

 

$

502,457

 

Operating expense

 

161,923

 

180,634

 

237,648

 

317,853

 

363,338

 

Operating income

 

17,735

 

46,480

 

77,527

 

117,254

 

139,119

 

Non-operating income, net

 

1,805

 

3,199

 

4,164

 

6,229

 

3,855

 

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

 

19,540

 

49,679

 

81,691

 

123,483

 

142,974

 

Income tax expense

 

11,574

 

20,224

 

32,975

 

51,255

 

51,763

 

Equity in net income of unconsolidated entities

 

843

 

1,662

 

2,787

 

1,694

 

1,321

 

Income before cumulative effect of accounting change

 

8,809

 

31,117

 

51,503

 

73,922

 

92,532

 

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

 

 

 

259

 

 

 

Net income

 

$

8,809

 

$

31,117

 

$

51,762

 

$

73,922

 

$

92,532

 

Basic income per share:

 

 

 

 

 

 

 

 

 

 

 

Basic income per share before cumulative effect of accounting change

 

$

0.23

 

$

0.79

 

$

1.25

 

$

1.71

 

$

2.01

 

Cumulative per share effect of accounting change

 

 

 

0.01

 

 

 

Basic net income per share

 

$

0.23

 

$

0.79

 

$

1.26

 

$

1.71

 

$

2.01

 

Weighted average common shares outstanding—basic

 

38,418

 

39,392

 

41,176

 

43,216

 

46,139

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted income per share:

 

 

 

 

 

 

 

 

 

 

 

Diluted income per share before cumulative effect of accounting change

 

$

0.21

 

$

0.70

 

$

1.10

 

$

1.53

 

$

1.88

 

Cumulative per share effect of accounting change

 

 

 

0.01

 

 

 

Diluted net income per share

 

$

0.21

 

$

0.70

 

$

1.11

 

$

1.53

 

$

1.88

 

Weighted average common shares outstanding—diluted

 

41,858

 

44,459

 

46,723

 

48,165

 

49,213

 

 

 

 

 

 

 

 

 

 

 

 

 

Other Consolidated Financial Data ($000)

 

2004

 

2005

 

2006

 

2007

 

2008

 

Consolidated revenue

 

$

179,658

 

$

227,114

 

$

315,175

 

$

435,107

 

$

502,457

 

Revenue from acquisitions

 

(2,386

)

(2,443

)

(36,434

)

(44,226

)

(27,125

)

Impact of foreign currency translations

 

(1,906

)

(694

)

(793

)

(3,808

)

(1,850

)

Revenue excluding acquisitions and impact of foreign currency translations (organic revenue) (1)

 

$

175,366

 

$

223,977

 

$

277,948

 

$

387,073

 

$

473,482

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense under the equity method

 

$

7,760

 

$

8,085

 

$

8,575

 

$

10,978

 

$

11,281

 

Stock-based compensation expense under the liability method

 

8,963

 

2,810

 

 

 

 

Total stock-based compensation expense (2)

 

$

16,723

 

$

10,895

 

$

8,575

 

$

10,978

 

$

11,281

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash used for investing activities (3)

 

$

(22,750

)

$

(16,913

)

$

(129,002

)

$

(102,838

)

$

(179,124

)

Cash provided by (used for) financing activities (4) (8)

 

$

(6,367

)

$

25,256

 

$

33,983

 

$

52,465

 

$

47,630

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

32,862

 

$

48,445

 

$

98,677

 

$

112,368

 

$

152,446

 

Capital expenditures

 

(7,730

)

(7,451

)

(4,722

)

(11,346

)

(48,519

)

Free cash flow (5)

 

$

25,132

 

$

40,994

 

$

93,955

 

$

101,022

 

$

103,927

 

 

Consolidated Balance Sheet Data
As of December 31 ($000)

 

2004

 

2005

 

2006

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents, and investments

 

$

95,463

 

$

153,190

 

$

163,751

 

$

258,588

 

$

297,577

 

Working capital

 

16,902

 

90,374

 

70,021

 

149,723

 

180,295

 

Total assets

 

213,361

 

296,311

 

447,838

 

649,307

 

803,940

 

Deferred revenue (6)

 

63,363

 

71,155

 

100,525

 

129,302

 

130,270

 

Long-term liabilities (7)

 

30,128

 

6,756

 

10,952

 

23,166

 

34,967

 

Total shareholders’ equity (7) (8)

 

64,381

 

173,714

 

269,423

 

408,303

 

535,532

 

 

30



 


(1)

 

Because we have 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. In addition, we provide information on the impact foreign currency translations have on our recorded revenue. Consolidated revenue excluding acquisitions and the impact of foreign currency translations (organic revenue) is considered a non-GAAP financial measure under the regulations of the Securities and Exchange Commission (SEC). 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 U.S. generally accepted accounting principles (GAAP).

 

 

 

(2)

 

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)). Prior to this date, we accounted for our equity plans in accordance with the fair value provisions of SFAS No. 123, Stock-Based Compensation. The total expense for stock-based compensation is distributed with other employee compensation costs in the appropriate operating expense categories of our Consolidated Statements of Income. Prior to our initial public offering in May 2005, in accordance with SFAS No. 123, we used two accounting methods. For options granted under plans that may have required us to settle the options in cash, we used the liability method. Under this method we recorded a liability for a vested option equal to the difference between the option exercise price and the fair value of the shares of common stock underlying the option at the end of the reporting period. If this fair value increased over the reporting period, we recorded an expense and, if it decreased, we recorded income. For options granted under plans that did not require us to settle the options in cash, we used the equity method. Under this method we calculated the fair value of the option at the time of grant using a Black-Scholes model and recorded expense over the vesting period. In each year, our aggregate stock-based compensation expense reflects the impact of options granted in prior years. Subsequent to our initial public offering, we no longer settle stock options for cash. As a result, all of our options are currently accounted for under the equity method.

 

 

 

 

 

In 2006, we began granting 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. Refer to Note 11 of the Notes to our Consolidated Financial Statements for more information on our stock-based compensation.

 

 

 

(3)

 

Cash used for investing activities consists primarily of cash used for acquisitions; purchases of investments, net of proceeds from the sale of investments; and capital expenditures. The level of investing activities can vary from period to period depending on the level of activity in these three categories. Cash used for investing activities increased substantially in 2008, 2007, and 2006, primarily for acquisitions. Over the past three years, Morningstar made several acquisitions. In addition, capital expenditures increased in 2008 and in 2007 compared with prior years’ spending levels because of the build-out of our new corporate headquarters in Chicago. Refer to Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources, for more information concerning cash used for investing activities.

 

 

 

(4)

 

Cash provided by financing activities consists primarily of proceeds from stock option exercises and excess tax benefits. Refer to Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources, for more information concerning cash provided by financing activities.

 

 

 

(5)

 

Free cash flow is considered a non-GAAP financial measure under SEC regulations. We present this measure as supplemental information to help investors better understand trends in our business results over time. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not equivalent to any measure of performance required to be reported under GAAP, nor should this data be considered an indicator of our overall financial performance or liquidity. Moreover, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

 

 

 

(6)

 

We frequently invoice or collect cash in advance of providing services or fulfilling subscriptions for our customers. These amounts are recorded as deferred revenue on our Consolidated Balance Sheets.

 

 

 

(7)

 

In the second quarter of 2005, upon completion of our initial public offering, we reclassified $24.9 million related to stock options accounted for as long-term liabilities, in accordance with SFAS No. 123, to additional paid-in capital.

 

 

 

(8)

 

In May 2005, we completed our initial public offering of 7,612,500 shares of our common stock. These shares commenced trading on May 3, 2005 and now trade on the Nasdaq Global Select Market under the symbol “MORN.” All of these shares were sold by affiliates of SOFTBANK Finance Corporation, a wholly owned subsidiary of SOFTBANK Corp. We did not receive any proceeds from the sale of these shares. In addition, we granted the underwriters the right to purchase up to an additional 1,141,875 shares at the initial public offering price to cover over-allotments. In May 2005, the underwriters exercised their over-allotment option in full. We received net proceeds of $18.1 million based on our initial public offering price of $18.50 per share, after deducting the underwriting discounts and commissions and approximately $2.6 million of offering expenses.

 

31



 

Item 7. 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 Annual Report on Form 10-K, 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 discuss not to occur or to differ significantly from what we expect. For us, these risks and uncertainties include, among others, general industry conditions and competition, including the current global financial crisis that began in 2007; the impact of market volatility on revenue from asset-based fees; 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; financial services industry consolidation; 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 Item 1A — Risk Factors of this Annual Report on Form 10-K. If any of these risks and uncertainties materialize, our actual future results may vary significantly from what we expected. We do not undertake to update our forward-looking statements as a result of new information or future events.

 

All dollar and percentage comparisons, which are often accompanied by words such as “increase,” “decrease,” “grew,” “declined,” “was up,” “was down,” “was flat,” or “was similar” refer to a comparison with the same period in the prior year unless otherwise stated.

 

Understanding Our Company

 

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. During 2008 and previous years, we operated our business in three global 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 marketing our existing products. However, we have made and expect to continue to make selective acquisitions that support our five key growth strategies, which are:

 

·

 

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

·

 

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

·

 

Continue building thought leadership in independent investment research;

·

 

Create a premier global investment database; and

·

 

Expand our international brand presence, products, and services.

 

 

GRAPHIC

 

Key Business Characteristics

 

Revenue

 

We generate revenue by selling a variety of investment-related products and services. We sell many of our offerings, such as our newsletters, Principia software, and Premium service on Morningstar.com, via subscriptions. These subscriptions are mainly offered for a one-year term, although we also offer terms ranging from one month to three years. We also sell advertising on our Web sites throughout the world. Several of our other products are sold through license agreements, including Morningstar Advisor Workstation, Morningstar Equity Research, Morningstar Direct, Retirement Advice, and Licensed Data. Our license agreements typically range from one to three years. For some of our other institutional services, mainly Investment Consulting, we generally base our fees on the scope of work and the level of service we provide and calculate them as a percentage of assets under advisement. We also earn fees relating to Morningstar Managed Portfolios and the managed retirement accounts offered through Morningstar Retirement Manager and Advice by Ibbotson that we calculate as a percentage of assets under management. Overall, revenue tied to asset-based fees accounted for about 13% of our consolidated revenue in 2008.

 

32



 

Deferred Revenue

 

We frequently invoice our clients and collect cash in advance of providing services or fulfilling subscriptions for our customers. As a result, we use some of this cash to fund our operations and invest in new product development. The businesses we acquired over the past several years have similar business models, and as a result, we acquired their deferred revenue. Deferred revenue is the largest liability on our Consolidated Balance Sheets and totaled $130.3 million as of December 31, 2008 and $129.3 million as of December 31, 2007. We expect to recognize this deferred revenue in future periods as we fulfill our service obligations under our subscription, license, and service agreements.

 

Significant Operating Leverage

 

Our business requires significant investments to create and maintain proprietary databases and content. We strive to leverage these costs by selling a wide variety of products and services to multiple investor segments, through multiple media, and in many geographic markets. We believe that while the fixed costs of the investments in our business are relatively high, the variable cost of adding customers is considerably lower, particularly as a significant portion of our products and services focus on Internet-based platforms and assets under management. At times, we will make investments in building our databases and content that will hurt our short-term operating results. During other periods, our profitability will improve because we’re able to increase revenue without increasing our cost base at the same rate. When revenue decreases, however, the significant operating leverage in our business may reduce our profitability. In general, our businesses have high fixed costs, and we expect our revenue to increase or decrease more quickly than our expenses.

 

Operating Expense

 

We classify our operating expense into separate categories for cost of goods sold, development, sales and marketing, general and administrative, and depreciation and amortization, as described below. We include stock-based compensation expense, as appropriate, in each of these categories.

 

·     Cost of goods sold. This category includes compensation expense for employees who produce the products and services we deliver to our customers. For example, this category covers production teams and analysts who write investment research reports. Cost of goods sold also includes other expense such as postage, printing, and CD-ROM replication, as well as shareholder servicing fees for Morningstar Managed Portfolios.

 

·     Development. This category mainly includes compensation expense for programmers, designers, and other employees who develop new products and enhance existing products. In some cases, we capitalize the compensation costs associated with certain development projects. This reduces the expense that we would otherwise report in this category. We amortize these capitalized costs over the estimated economic life of the software, which is generally three years, and include this expense in depreciation and amortization.

 

·     Sales and marketing. This category includes compensation expense for our sales teams, product managers, and other marketing professionals. We also include the cost of advertising, direct mail campaigns, and other marketing programs to promote our products.

 

·     General and administrative. This category consists mainly of compensation expense for each segment’s management team, as well as human resources, finance, and support employees for each segment. The category also includes compensation expense for senior management and other corporate costs, including corporate systems, finance and accounting, legal, and facilities expense.

 

·     Depreciation and amortization. Our capital expenditures consist mainly of computers, leasehold improvements, and capitalized product development costs related to certain software development projects. We depreciate property and equipment primarily using the straight-line method based on the useful life of the asset, which ranges from three to seven years. We amortize leasehold improvements over the lease term or their useful lives, whichever is shorter. We amortize capitalized product development costs over their estimated economic life, which is generally three years. We also include amortization related to intangible assets, which is mainly driven by acquisitions, in this category.

 

International Operations

 

We have majority-owned operations in 18 countries outside of the United States and include these in our consolidated financial statements. We account for our minority-owned investments in Japan, Korea, Denmark, and Sweden using the equity method.

 

33



 

How We Evaluate Our Business

 

When our analysts evaluate a stock, they focus on assessing the company’s estimated intrinsic value—the value of the company’s future cash flows, discounted to their worth in today’s dollars. Our approach to evaluating our own business works the same way. Our goal is to increase the intrinsic value of our business over time, which we believe is the best way to create value for our shareholders.

 

We do not make public financial forecasts for our business because we want to avoid creating any incentives for our management team to make speculative statements about our financial results that could influence the stock price, or to take actions that help us meet short-term forecasts but may not be in the long-term interest of building shareholder value.

 

We provide three specific measures that can help investors generate their own assessment of how our intrinsic value has changed over time:

 

·                  Revenue;

 

·                  Operating income (loss); and

 

·                  Free cash flow, which we define as cash provided by or used for operating activities less capital expenditures.

 

Free cash flow is considered a non-GAAP financial measure under Securities and Exchange Commission (SEC) regulations. We present this measure as supplemental information to help investors better understand trends in our business results over time. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow is not equivalent to any measure of performance required under U.S. generally accepted accounting principles (GAAP) and should not be considered an indicator of our overall financial performance or liquidity. Moreover, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

 

To evaluate how successful we’ve been in maintaining existing business for products and services that have renewable revenue, we calculate a retention rate. We use two different methods for calculating retention. For subscription-based products (including our print newsletters, Morningstar.com Premium Membership service, and Principia software), we track the number of subscriptions retained during the year. For products sold through contracts and licenses, we use the contract value method, which is based on tracking the dollar value of renewals compared with the total dollar value of contracts up for renewal during the period. We include changes in the contract value in the renewal amount, unless the change specifically results from adding a new product that we can identify. We also include variable-fee contracts in this calculation and use the previous quarter’s actual revenue as the base rate for calculating the renewal percentage. The retention rate excludes setup and customization fees, migrations to other Morningstar products, and contract renewals that were pending as of January 31, 2009.

 

The Year 2008 in Review

 

Industry Overview

 

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

 

Investment Landscape, Research, and Data

 

The year 2008 was one of the most turbulent times on record in the past 75 years. The ongoing financial crisis worsened throughout the year as high-profile investment bank Lehman Brothers declared bankruptcy, the U.S. government took over mortgage lenders Fannie Mae and Freddie Mac, financial firms received large cash infusions and guarantees from the U.S. government, the Federal Reserve began lending directly to corporations to ease the credit crisis, and then-President Bush signed a $700 billion financial rescue package into law. Other large investment banks underwent significant changes as several troubled firms were bought out and Morgan Stanley and Goldman Sachs chose to obtain bank charters, which subject them to strict banking regulations.

 

In response to these events, the U.S. equity market suffered its worst performance since 1931. Including a 22% drop in the fourth quarter alone, the market declined 37% for the year as measured by Morningstar’s U.S. Market Index, a broad market benchmark. Many global markets also lost ground during the year, and bonds—with the exception of Treasuries—also posted negative returns because of the market’s flight to quality and fears about credit risk. Problems in the credit markets had widespread effects even on traditional safe havens such as money market funds and high-grade commercial paper. As the year progressed, market volatility and uncertainty became increasingly severe.

 

34



 

Total U.S. mutual fund assets dropped to $9.6 trillion as of December 31, 2008 based on data from the Investment Company Institute (ICI), compared with $12.0 trillion as of December 31, 2007. Because of the market downturn, stock mutual funds had negative net cash flows of about $200 billion as investors moved into more conservative areas. That was the highest level of annual redemptions over the 25-year history tracked by the ICI. Hybrid funds also had net redemptions for the year, although the decline was less severe than in stock funds. Money market funds, meanwhile, had net cash inflows of about $600 billion for the year, despite the high-profile news of one money market fund dropping below a $1 net asset value.

 

Interest in alternative asset classes, such as hedge funds, also suffered with the market downturn in 2008. Based on information from Morningstar’s hedge fund database, we estimate that hedge funds had about $70 billion in net outflows during 2008, compared with about $48 billion in net inflows in 2007.

 

In December 2008, hedge fund investment advisor Bernard Madoff was arrested for an alleged fraud involving billions of investor assets that were pooled and used to pay off other investors. Madoff’s clients reportedly included numerous hedge funds and international banks. We believe these events are significant because of their likely negative impact on investor confidence in hedge funds.

 

Lawmakers recently proposed a Hedge Fund Transparency Act, which would increase filing and record-keeping requirements for hedge funds and require them to operate as regulated investment companies. As debate about hedge fund regulation continues, we are continuing our efforts to improve transparency in the hedge fund industry.

 

Assets in other areas also declined amid the global market downturn. Based on data from Cerulli Associates, assets invested in separate accounts totaled about $500 billion as of December 31, 2008, down from $850 billion as of December 31, 2007. Based on our data, we estimate that total assets invested in variable annuities totaled about $1.3 trillion as of September 30, 2008, down about 13% from the same period in 2007.

 

Despite the severe market downturn, exchange-traded funds (ETFs) did not suffer large asset losses. While total ETF assets declined slightly to $531 billion as of December 31, 2008, compared with $608 billion as of December 31, 2007 based on data from the ICI, net issuance was still positive for the year. During 2008, the number of U.S.-based ETFs rose to more than 700, compared with about 600 previously.

 

ETFs have gained share from mutual funds in some areas of the market and have also become more popular in defined contribution plans, such as 401(k)s. To meet greater investor demand for information on ETFs, we have continued to increase analyst coverage in this area and now cover about 300 ETFs. We also launched a new ETF module for Principia in 2008.

 

Individual Investor Market

 

Based on research from Nielsen/NetRatings, total page views to retail investment Web sites increased 32% for the year over 2007. Most of the large portal sites displayed large gains while the smaller niche sites had smaller increases or even decreases in page views. The number of unique users for retail investment Web sites increased by 27% compared with 2007 based on Nielsen’s data. For Morningstar.com, unique users increased 5% over 2007. Page views for Morningstar.com were down by 4% over 2007 because of reduced traffic to some areas of the site during the market downturn. Morningstar.com continued to perform better than most competing sites, though, based on metrics such as time spent per visit and the number of pages viewed per visit.

 

Because of the uncertain economic environment, some industry surveys indicate that many investment management firms plan to reduce their marketing budgets in 2009. As a result, online advertising has been under pressure, particularly in the financial sector. In response to the difficult market for advertising sales, we are continuing our efforts to develop value-added content and ad sales inventory on Morningstar.com.

 

Financial Advisor Market

 

The turmoil in the financial markets led to widespread job cuts in a variety of areas in 2008. Based on data from executive search firm Heidrick & Struggles and published in The New York Times, total employment on Wall Street declined by 240,000 over the 18 months ending December 31, 2008. That total reflects job losses for a variety of areas, a smaller portion of which includes financial advisors. However, industry consolidation also led to a reduction in financial advisors employed by large brokerage firms in 2008. With fewer financial advisors employed by large firms, more advisors have been moving to independent distributors.

 

We believe the shift toward financial advisors becoming independent has led to greater demand for prepackaged portfolio and asset management solutions (often referred to as “turnkey asset management programs”). We offer these solutions through our Morningstar Managed Portfolios service. We introduced three additional Select Stock Baskets in 2008, as well as a series of mutual-fund portfolios aimed at different stages of retirement with varying drawdown needs.

 

35



 

Institutional Market

 

Numerous firms in the financial services sector consolidated in 2008. For example, Wells Fargo purchased Wachovia; Barclays bought many of the assets of Lehman Brothers following Lehman’s bankruptcy filing in September; Bank of America purchased Merrill Lynch; and JP Morgan Chase acquired both Washington Mutual and Bear Stearns. Several companies in the financial services sector outside of the United States were also acquired during the year.

 

When our clients are acquired, the impact on us may be positive, negative, or neutral. We may lose business following an acquisition of one of our clients, but we also often have opportunities to continue providing services or expand our business with the new parent organization. We are actively monitoring business conditions for all of our major clients and continuing to work closely with them to align our products and services to meet their needs.

 

Because of the market downturn and asset losses from redemptions, many institutional firms have been under pressure to reduce costs. This trend has had a negative impact on new and renewal business. However, we are also working to adapt our offerings to help institutions reduce costs. For example, we introduced a new business process outsourcing service in 2008, which we expect to market to institutions seeking to reduce their technology processing costs.

 

Other major trends in the institutional market include continued growth in target-date funds as a default investment option in retirement plans. This trend has been driven by new Department of Labor rules that define guidelines for “qualified default investment options” for automatic enrollment in defined contribution plans. Despite the overall net outflows from mutual funds in 2008, target-date funds had net inflows of close to $40 billion for the year based on data from Strategic Insight. In response, we have continued to expand the range of data we provide on target-date funds. Our Ibbotson Associates unit has begun working with large defined contribution plans to build custom target-date portfolios based on their unique plan participant demographics. The solution uses the plan’s existing investment options. This allows us to customize the portfolios based on participants’ overall time horizon and risk preferences.

 

In November, the SEC voted to require a summary prospectus and electronic prospectus delivery for mutual funds. We are offering services to meet these compliance needs through our Global Document Library product, which we launched in late 2008.

 

Worldwide Markets

 

Because of the global credit crisis and economic downturn, asset management firms around the world were also in turmoil in 2008. Several major banks in the United Kingdom, the Netherlands, Iceland, and Germany accepted government funding to rescue their operations. Some banks spun off their asset management operations, and numerous asset management firms were purchased by other firms.

 

Some fund markets had large asset outflows in 2008 as investors sought refuge in lower-risk areas, such as bank deposits. For example, Italy and Spain had combined asset outflows of about €90 billion in the third quarter of 2008.

 

In Australia, regulators placed restrictions on investors’ ability to withdraw money from many funds holding mortgage-backed securities. We believe this is significant because it demonstrates the wide-ranging impact of poor market liquidity on individual investors and the level of confidence they have in investing in funds.

 

In Canada, the government created a new Tax-Free Savings Account program that allows individuals to invest money without paying taxes upon withdrawal (similar to the Roth IRA in the United States). Similarly, the KiwiSaver plan introduced in New Zealand in 2007 has prompted more individual investors to invest in mutual funds. We are continuing to develop new data and tools to meet investors’ needs for information in these and other markets, and we plan to launch a Web site for New Zealand-based individual investors in 2009.

 

In Germany, the market downturn led to outflows in equity and fixed-income funds, particularly in October. The liquidity crisis also led to several direct real estate funds being closed. During the credit crisis, the government implemented new guarantees for savings deposits, leading to greater competition for money-market funds and other lower-risk vehicles.

 

Conclusion

 

Overall, we believe the disruption in the financial markets continues to cause widespread investor uncertainty. The market downturn has also led to spending cutbacks among asset management firms and other financial services companies.

 

36



 

The financial crisis has had two main effects on our business: lengthening the sales cycle and increasing pressure on renewal pricing. With new business, we’ve been seeing longer sales cycles, tightening budgets, and more review by senior management at client organizations. We’ve also seen some pressure on renewal and retention rates, which both declined from previous levels in 2008.

 

On the positive side, many of our contracts have multiyear terms, and we believe the services we provide are fairly entrenched within many areas of our clients’ organizations. These two factors have mitigated the effect of the downturn on our business to some extent.

 

Overall, we remain cautious because of the difficult and uncertain market environment. However, we’re continuing to invest in our business and manage it for the long term. We’re also looking for business opportunities that may emerge from the current crisis.

 

Performance Summary

 

Our revenue grew to more than $502 million in 2008, and operating income rose 18.6% to $139.1 million. We generated free cash flow of about $104 million and maintained a healthy balance sheet with nearly $300 million in cash, cash equivalents, and investments. However, our organic growth decelerated during the year and dipped below zero in the fourth quarter, largely because of lower revenue from our Investment Consulting business. About 13% of our revenue base is tied to asset-based fees, so the severe market downturn had a negative impact on revenue. Because many of our clients have been cutting back on spending, new business and renewals in other parts of the company also suffered in the latter part of the year.

 

Because the current economic environment is so uncertain, we’ve taken steps to reduce our cost structure in 2009—mainly by reducing employee benefit costs and bonus expense. We’re continuing to invest in our business, though, and believe we’ll be well-positioned when conditions improve.

 

The list below summarizes the key accomplishments and challenges that our management team has highlighted related to our 2008 performance:

 

Accomplishments

 

·

 

We completed six acquisitions, four of which were outside the United States. We invested $105.4 million for these acquisitions, which represent approximately $40 million in annual revenue.

 

 

 

·

 

We continued to invest in our global investment databases, with significantly improved stock data coverage as well as new mutual fund databases in several markets outside the United States. We also expanded our business to include global real-time price data from UK-based Tenfore Systems Limited, a strategic acquisition. We now provide data on more than 300,000 investments, up from about 265,000 a year ago.

 

 

 

·

 

We made numerous enhancements to our major product platforms, including a new home page and site relaunch for Morningstar.com; a new ETF module for Principia; a new Alternative Investment Edition for Morningstar Direct; and several new managed portfolios through Morningstar Investment Services. Total licenses for Morningstar Direct and Morningstar Advisor Workstation grew 33% and 8%, respectively, compared with the prior year.

 

 

 

·

 

Our Ibbotson Associates unit entered into 14 new funds-of-funds relationships across a variety of client types and strategies, which will help support future growth.

 

 

 

·

 

We created a new organizational structure effective January 1, 2009 that will help us further globalize our operations and better align the business with our key growth strategies. The table on page 56 contains more information about the new structure and changes to our operating segments.

 

 

 

·

 

International revenue rose 35% to $121.4 million and represented 24.2% of consolidated revenue in 2008—3.6 percentage points more than in 2007.

 

Challenges

 

·

 

The market downturn has been severe and has hit many of our clients in the financial services industry hard. Because of the difficult economic environment, we’ve also experienced slower growth in new business, increased pressure on renewal spending, and cutbacks on Internet advertising. This challenging environment has persisted into the first quarter of 2009.

 

 

 

·

 

We’ve seen a sharp drop in asset-based fees because of the global market downturn, mainly in our Investment Consulting business. In addition, during 2008, one of our Investment Consulting clients informed us that it was not planning to renew its contract. As a result, assets under advisement for Morningstar Associates declined more than the market for the year.

 

37



 

 

 

Also, in the first quarter of 2009, we did not reach an agreement on renewal terms with another consulting client. Combined, these contracts represented about $17 million of revenue in 2008.

 

 

 

·

 

The independent equity research we’re providing to six banks under the terms of the Global Analyst Research Settlement made up about 4% of our consolidated revenue in 2008. After the settlement period expires in July 2009, these banks will no longer be required to provide independent investment research to their clients. We don’t know how much of this business we’ll retain after the settlement period expires, and we expect this research revenue to decline significantly.

 

Consolidated Results

 

($000)

 

2008

 

2007

 

2006

 

2008 Change

 

2007 Change

 

Revenue

 

$

502,457

 

$

435,107

 

$

315,175

 

15.5%

 

38.1%

 

Operating income

 

139,119

 

117,254

 

77,527

 

18.6%

 

51.2%

 

Operating margin

 

27.7%

 

26.9%

 

24.6%

 

0.8pp

 

2.3pp

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash used for investing activities

 

$

(179,124

)

$

(102,838

)

$

(129,002

)

74.2%

 

(20.3)%

 

Cash provided by financing activities

 

47,630

 

52,465

 

33,983

 

(9.2)%

 

54.4%

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

152,446

 

$

112,368

 

$

98,677

 

35.7%

 

13.9%

 

Capital expenditures

 

(48,519

)

(11,346

)

(4,722

)

327.6%

 

140.3%

 

Free cash flow

 

$

103,927

 

$

101,022

 

$

93,955

 

2.9%

 

7.5%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

pp—percentage point(s)

 

As noted in How We Evaluate Our Business, 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 investors better understand how much cash is available after we spend money to operate our business.

 

Because we have 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 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.

 

Consolidated organic revenue (revenue excluding acquisitions and the impact of foreign currency translations) 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.

 

38



 

The table below shows the periods in which we included each acquired operation in revenue from acquisitions:

 

Acquisition

 

2008

 

2007

 

2006

Hemscott data, media, and investor relations Web site businesses

 

January 9 through December 31, 2008

 

 

Financial Computer Support, Inc.

 

September 2 through December 31, 2008

 

 

Fundamental Data Limited

 

October 2 through December 31, 2008

 

 

10-K Wizard Technology, LLC

 

December 4 through December 31, 2008

 

 

Tenfore Systems Limited

 

December 17 through December 31, 2008

 

 

InvestData (Proprietary) Limited

 

December 29 through December 31, 2008

 

 

Mutual fund data business from Standard & Poor’s

 

January 1 through March 15, 2008

 

March 16 through December 31, 2007

 

Hedge fund and separate account database division of InvestorForce, Inc.

 

 

January 1 through July 31, 2007

 

August 1 through December 31, 2006

Aspect Huntley Pty Limited

 

 

January 1 through July 24, 2007

 

July 25 through December 31, 2006

Ibbotson Associates, Inc.

 

 

January 1 through February 28, 2007

 

March 1 through December 31, 2006

 

Consolidated Revenue

 

In 2008, our consolidated revenue increased 15.5% to $502.5 million. More than half of the increase (about 9 percentage points) was from organic growth. Acquisitions also expanded our revenue in 2008, with the majority driven by the Hemscott businesses we acquired in January 2008. As a whole, acquisitions contributed $27.1 million, or 6 percentage points, to our consolidated revenue growth in 2008.

 

Our consolidated revenue increased 38.1% to $435.1 million in 2007 from strong organic growth as well as new revenue from acquisitions, the majority of which was from the fund data business we acquired from Standard & Poor’s in March 2007. Acquired operations contributed $44.2 million of revenue and represented 14 percentage points of our consolidated revenue growth in 2007.

 

Organic revenue growth was $38.4 million, or 8.8%, in 2008, which was significantly lower than our 22.8% organic growth rate in 2007 and our 22.4% organic growth rate in 2006. The severe market downturn in the latter part of 2008 caused our organic growth rate to decelerate during the year and dip below zero in the fourth quarter.

 

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

 

2008 vs. 2007 ($000)

 

2008

 

2007

 

Change

 

Consolidated revenue

 

$

502,457

 

$

435,107

 

15.5%

 

Less: acquisitions

 

(27,125

)

 

NMF

 

Less: impact of foreign currency translations

 

(1,850

)

 

NMF

 

Organic revenue

 

$

473,482

 

$

435,107

 

8.8%

 

 

2007 vs. 2006 ($000)

 

2007

 

2006

 

Change

 

Consolidated revenue

 

$

435,107

 

$

315,175

 

38.1%

 

Less: acquisitions

 

(44,226

)

 

NMF

 

Less: impact of foreign currency translations

 

(3,808

)

 

NMF

 

Organic revenue

 

$

387,073

 

$

315,175

 

22.8%

 

 

2006 vs. 2005 ($000)

 

2006

 

2005

 

Change

 

Consolidated revenue

 

$

315,175

 

$

227,114

 

38.8%

 

Less: acquisitions

 

(36,434

)

 

NMF

 

Less: impact of foreign currency translations

 

(793

)

 

NMF

 

Organic revenue

 

$

277,948

 

$

227,114

 

22.4%

 

 

While organic revenue growth and acquisitions had the most significant impact on revenue in 2008 and 2007, we also enjoyed a benefit from foreign currency translations because of the weakness in the U.S. dollar during 2007 and the first half of 2008. Late in 2008, the currency trend reversed, resulting in a negative impact on revenue of $3.8 million in the fourth quarter.

 

In both 2008 and 2007, our growth was diversified by segment, with all three segments contributing to revenue growth. However, the Institutional segment, which makes up more than half of our consolidated revenue, generated approximately two-thirds of our company-wide revenue increase in 2008. Acquisitions contributed $23.2 million to Institutional segment revenue in 2008. The Institutional segment was also the main contributor to revenue gains in 2007, accounting for about 70% of the change in revenue before eliminating intersegment revenue. Acquisitions contributed $33.4 million to Institutional segment revenue in 2007.

 

39



 

Our two other segments also contributed to revenue growth, though to a lesser degree. Advisor segment revenue rose $11.9 million, or 10.2%, in 2008, accounting for approximately 17% of the revenue increase before eliminating intersegment revenue. Acquisitions contributed $1.9 million to Advisor segment revenue in 2008. Advisor segment revenue rose approximately 22.2% in 2007, with acquisitions contributing $5.8 million of the revenue increase.

 

Individual segment revenue increased $10.3 million, or 10.6%, in 2008 and $16.6 million, or 20.6%, in 2007. Acquisitions contributed approximately $2.0 million to the Individual segment in 2008 and $5.1 million in 2007.

 

GRAPHIC

 

On a product level, Morningstar Advisor Workstation was the largest contributor to organic revenue growth in 2008. Total licenses for Morningstar Advisor Workstation in the United States were up 8.3% as of December 31, 2008. The year-over-year growth in Advisor Workstation revenue was mainly driven by adding additional functionality and users for existing clients, as well as growth in new clients. While Advisor Workstation licenses were up year over year, they were up only slightly in the fourth quarter of 2008 compared with third-quarter levels because of the market downturn. Some of our clients reduced the number of users because of staff reductions or other efforts to lower costs.

 

Advisor Workstation was the second-largest driver of our organic revenue increase in 2007, as total licenses in the United States increased by about 14% in 2007. Growth during 2008 and in 2007 reflects additional users at existing clients, changes in the scope of some contracts, and new clients.

 

Licensed Data and Morningstar Direct were also major contributors to organic growth in 2008. Licensed Data revenue was driven by both new clients and higher contract values for existing clients. Total licenses for Morningstar Direct rose 33% during the year, including continued strong growth outside the United States. In 2007, Licensed Data was the third-largest contributor to organic revenue growth, driven by both new clients and higher contract values for existing clients.

 

Because of the impact of acquisitions and organic growth, Licensed Data now ranks as our largest product based on revenue. Several of our recent acquisitions have added to our Licensed Data business. For example, Licensed Data revenue in 2007 included additional business from Aspect Huntley and the fund data business acquired from Standard & Poor’s, while 2008 revenue included additional revenue from Hemscott, Fundamental Data, and others.

 

Investment Consulting was the largest driver behind organic revenue growth in 2007, but this trend reversed in 2008. 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. Assets under advisement decreased about 32% in 2008 after rising 76% in 2007. Excluding specific changes from client retention and renewals, 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 or institutions add to or redeem shares from these portfolios. The U.S. equity market declined about 37% in 2008, and our total assets under advisement declined about 32%. Since September 30, 2008, our assets under advisement have declined 22%. Because about 13% of our 2008 consolidated revenue is tied to asset-based fees, the market decline has had a negative impact on revenue for Investment Consulting. In addition, during the second quarter of 2008, an Investment Consulting client informed us that it was not planning to renew its contract. As a result, assets under management for Morningstar Associates declined more than the market for the year. Also, in the first quarter of 2009, we did not reach an agreement on renewal terms with another consulting client. Combined, these contracts represented about $17 million of revenue in 2008.

 

Revenue from international operations increased as a percentage of total revenue in 2008 and 2007. Our non-U.S. revenue increased to 24.2% of consolidated revenue in 2008—3.6 percentage points higher than in 2007. The fund data business acquired from Standard & Poor’s, the Hemscott data business, and the more recently acquired Fundamental Data Limited and Tenfore Systems Limited all have extensive operations outside the United States. Revenue from international operations grew $31.7 million, or 35.4%, to $121.4 million in 2008, with acquisitions contributing $19.4 million of the increase. In 2007, revenue from international operations increased $45.4 million, or 102.5%, to $89.7 million. Approximately 70% of this revenue increase came from acquisitions, primarily the fund data business acquired from Standard & Poor’s.

 

Foreign currency translations had a much smaller, but still favorable, impact on international revenue in both 2008 and 2007. Foreign currency translations contributed $1.9 million of the increase in non-U.S. revenue in 2008 and $3.8 million in 2007. Excluding acquisitions and the impact of foreign currency translations, our non-U.S. revenue increased 11.7% in 2008 and 22.4% in 2007.

 

40



 

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

 

2008 vs. 2007 ($000)

 

2008

 

2007

 

Change

 

International revenue

 

$

121,436

 

$

89,680

 

35.4%

 

Less: acquisitions

 

(19,426

)

 

NMF

 

Less: impact of foreign currency translations

 

(1,850

)

 

NMF

 

International organic revenue

 

$

100,160

 

$

89,680

 

11.7%

 

 

2007 vs. 2006 ($000)

 

2007

 

2006

 

Change

 

International revenue

 

$

89,680

 

$

44,276

 

102.5%

 

Less: acquisitions

 

(31,690

)

 

NMF

 

Less: impact of foreign currency translations

 

(3,808

)

 

NMF

 

International organic revenue

 

$

54,182

 

$

44,276

 

22.4%

 

 

2006 vs. 2005 ($000)

 

2006

 

2005

 

Change

 

International revenue

 

$

44,276

 

$

29,442

 

50.4%

 

Less: acquisitions

 

(8,268

)

 

NMF

 

Less: impact of foreign currency translations

 

(793

)

 

NMF

 

International organic revenue

 

$

35,215

 

$

29,442

 

19.6%

 

 

GRAPHIC

 

Our five largest products based on revenue—Licensed Data, Investment Consulting, Morningstar Advisor Workstation, Morningstar.com, and Principia—made up about 58% of consolidated revenue in 2008. While the percentage of revenue made up by our top five products has remained relatively consistent over the past three years, the relative size of products within the top five has changed each year. Investment Consulting became our largest product in 2006 and remained there in 2007, but moved to second-largest in 2008. Organic growth as well as new revenue from acquisitions helped Licensed Data became our largest product in 2008 after rising to the second-largest product in 2007. Acquisition revenue included Hemscott in 2008 and Aspect Huntley and the mutual fund data business acquired from Standard & Poor’s in 2007.

 

Top Five Products (Segment) 2008

 

Revenue 
($000)

 

% of
Consolidated
Revenue

 

Licensed Data (Institutional)

 

$

78,329

 

15.6%

 

Investment Consulting (Institutional)

 

77,757

 

15.5%

 

Advisor Workstation (Advisor)

 

66,675

 

13.3%

 

Morningstar.com (Individual)

 

43,274

 

8.6%

 

Principia (Advisor)

 

27,791

 

5.5%

 

 

Top Five Products (Segment) 2007

 

Revenue 
($000)

 

% of
Consolidated
Revenue

 

Investment Consulting (Institutional)

 

$

75,595

 

17.4%

 

Licensed Data (Institutional)

 

59,207

 

13.6%

 

Advisor Workstation (Advisor)

 

54,980

 

12.6%

 

Morningstar.com (Individual)

 

37,630

 

8.6%

 

Principia (Advisor)

 

28,760

 

6.6%

 

 

Top Five Products (Segment) 2006

 

Revenue 
($000)

 

% of
Consolidated
Revenue

 

Investment Consulting (Institutional)

 

$

46,597

 

14.8

%

 

Advisor Workstation (Advisor)

 

43,140

 

13.7

%

 

Licensed Data (Institutional)

 

37,730

 

12.0

%

 

Morningstar.com (Individual)

 

31,311

 

9.9

%

 

Principia (Advisor)

 

28,735

 

9.1

%

 

 

41



 

As discussed in How We Evaluate Our Business, we calculate retention and renewal rates to help measure how successful we’ve been in maintaining existing business for products and services that have renewable revenue. The following graph illustrates these two metrics over the past four years:

 

GRAPHIC

 

In 2008, we estimate that our retention rate for subscription-based products, such as Principia, Morningstar.com Premium Membership service, and print and online newsletters, averaged between 60% and 65%, down from 65% to 70% in 2007. For contract-based products and services, we estimate that our weighted average renewal rate was on the low end of the range between 90% and 95% and was down about 6 percentage points from our renewal rate in 2007. The decline in renewal rates in 2008 was largely driven by lower assets in Investment Consulting and, to a smaller extent, a lower renewal rate for Advisor Workstation in the latter part of the year. The figure for contract-based products includes the impact of price changes and changes to the contract value upon renewal, as well as changes in the value of variable-fee contracts.

 

The renewal rate for contract-based products and services in 2007 was consistent with 2006, but still lower than 2005.

 

Consolidated Operating Expense

 

($000)

 

2008

 

2007

 

2006

 

Operating expense

 

$

363,338

 

$

317,853

 

$

237,648

 

% change

 

14.3%

 

33.7%

 

31.6%

 

 

 

 

 

 

 

 

 

% of revenue

 

72.3%

 

73.1%

 

75.4%

 

Change

 

(0.8)pp

 

(2.3)pp

 

(4.1)pp

 

 

Our consolidated operating expense increased $45.4 million, or 14.3%, in 2008. Compensation-related expense, excluding bonuses, accounted for two-thirds of the increase in 2008, mainly because of a 38% increase in worldwide headcount and higher sales commission expense. Lower bonus expense partially offset the increase in these costs. We had approximately 2,375 employees worldwide as of December 31, 2008, compared with 1,720 as of December 31, 2007. Approximately half of the growth in headcount was from acquisitions. In addition, in 2008 we hired 50 employees for the Morningstar Development Program, a two-year rotational training program for entry-level college graduates. Bonus expense declined $2.1 million because of lower growth in our financial performance compared with the previous year. Changes in the size of our bonus pool are based on changes in full-year operating income growth relative to the previous year. The size of the bonus pool varies each year, and we review it and update it quarterly.

 

Excluding compensation-related expense and bonus expense, operating expense increased $18.5 million in 2008. About one-third of this operating expense increase was from higher lease expense for our new headquarters and other global offices. During 2008, we recorded lease expense for our new headquarters as well as for our former headquarters, which was occupied until December 2008. Depreciation and amortization rose $4.7 million in 2008, and we incurred additional costs across all operating expense categories from acquisitions. Higher costs in these areas were partially offset by lower legal and professional fees, which declined $2.1 million. In 2007, we recorded $0.9 million in expense related to the settlement of litigation in Australia. In addition, we had about $1.6 million in product implementation costs for Advice by Ibbotson in 2007 that did not recur in 2008.

 

As a percentage of revenue, operating expense in 2008 declined 0.8 percentage points.

 

In 2007, our consolidated operating expense increased $80.3 million. Two key factors impacted all of our operating expense categories in 2007: compensation-related costs (including incentive compensation) and acquisitions.

 

Compensation-related expense, mainly including salaries, benefits, and sales commissions, increased $33.2 million in 2007 because of increased headcount, as well as annual salary increases. We had approximately 1,720 employees worldwide as of December 31, 2007, compared with approximately 1,440 as of December 31, 2006. Bonus expense recorded in 2007 increased $13.7 million because of improvements in our financial performance, as well as increased headcount.

 

42



 

Excluding compensation-related expense, general and administrative expense increased $10.7 million in 2007. We incurred additional costs from acquisitions, including transition costs, rent and facilities expense, and professional fees. We also incurred $0.9 million of expense related to settling our Australian litigation.

 

We had higher amortization expense in 2008 and 2007 because of acquisitions. This item contributed $3.8 million to the increase in operating expense in 2008 and $5.8 million to the operating expense increase in 2007. 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.

 

Cost of Goods Sold

 

($000)

 

2008

 

2007

 

2006

 

Cost of goods sold

 

$

130,085

 

$

113,777

 

$

86,975

 

% change

 

14.3%

 

30.8%

 

35.0%

 

 

 

 

 

 

 

 

 

% of revenue

 

25.9%

 

26.1%

 

27.6%

 

Change

 

(0.2)pp

 

(1.5)pp

 

(0.8)pp

 

 

 

 

 

 

 

 

 

Gross profit

 

$

372,372

 

$

321,330

 

$

228,200

 

% change

 

15.9%

 

40.8%

 

40.3%

 

 

 

 

 

 

 

 

 

Gross margin

 

74.1%

 

73.9%

 

72.4%

 

Change

 

0.2pp

 

1.5pp

 

0.8pp

 

 

Cost of goods sold is our largest category of operating expense, accounting for more than one-third of our total operating expense over the past three years. 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 $16.3 million in 2008. Three-quarters of the increase was driven by higher compensation expense, excluding incentive compensation, which was partly offset by a reduction in product implementation expense. In 2007, we recorded $1.6 million for outsourced product implementation expense associated with the Advice by Ibbotson service. These costs did not recur in 2008. Incremental costs from acquisitions contributed to the higher compensation expense, and were the largest contributor to the remainder of the cost increases. Incentive compensation in 2008 was about the same as in 2007.

 

Cost of goods sold increased $26.8 million in 2007. Approximately two-thirds of the growth was due to higher compensation expense, including incentive compensation. These costs rose because of continued hiring as well as additional headcount from acquisitions. Acquisitions also contributed the largest portion of the remaining growth in cost of goods sold. Outsourced product implementation expense associated with the Advice by Ibbotson service was $1.1 million lower in 2007 compared with 2006, which offset some of the growth in other expenses.

 

Over the past three years, our gross margin has increased to 74.1% in 2008 from 72.4% in 2006, as revenue growth has outpaced growth in cost of goods sold. The gross margin improved at a faster pace in 2007 than in 2008 because of a stronger business environment in 2007.

 

Development Expense

 

($000)

 

2008

 

2007

 

2006

 

Development expense

 

$

40,340

 

$

35,116

 

$

29,494

 

% change

 

14.9%

 

19.1%

 

50.1%

 

 

 

 

 

 

 

 

 

% of revenue

 

8.0%

 

8.1%

 

9.4%

 

Change

 

(0.1)pp

 

(1.3)pp

 

0.7pp

 

 

Development expense increased $5.2 million in 2008. Development expense as a percentage of revenue in 2008 was consistent with 2007 after declining about 1.3 percentage points in 2007, when bonus costs included in this category increased at a lower rate than in 2006.

 

43



 

Sales and Marketing Expense

 

($000)

 

2008

 

2007

 

2006

 

Sales and marketing expense

 

$

81,651

 

$

68,835

 

$

50,614

 

% change

 

18.6%

 

36.0%

 

29.5%

 

 

 

 

 

 

 

 

 

% of revenue

 

16.3%

 

15.8%

 

16.1%

 

Change

 

0.5pp

 

(0.3)pp

 

(1.1)pp

 

 

Sales and marketing expense increased $12.9 million in 2008 and $18.2 million in 2007. Higher compensation expense, including sales commissions, was the main contributor to the change in both periods. In addition, we had incremental costs from acquisitions because of growth in headcount and the number of products and services sold. As a percentage of revenue, sales and marketing expense has been similar over the past three years, but increased slightly in 2008 compared with a small decline in 2007.

 

General and Administrative Expense

 

($000)

 

2008

 

2007

 

2006

 

General and administrative expense

 

$

85,266

 

$

78,868

 

$

55,590

 

% change

 

8.1%

 

41.9%

 

12.9%

 

 

 

 

 

 

 

 

 

% of revenue

 

17.0%

 

18.1%

 

17.6%

 

Change

 

(1.1)pp

 

0.5pp

 

(4.1)pp

 

 

General and administrative (G&A) expense increased $6.4 million in 2008 as lease costs grew. In 2008, lease costs rose because we recorded lease expense for our new headquarters as well as for the former headquarters building we occupied until December 2008. Compensation expense also increased, but was offset by the favorable impact of lower bonus expense in this cost category. Increases in this cost category were also offset by a $2.1 million reduction in legal and professional fees.

 

As a percentage of revenue, G&A expense declined 1.1 percentage points in 2008, reflecting the reduction in compensation expense, including bonus, and legal fees as a percentage of revenue.

 

In 2007, the $23.3 million increase in G&A was mainly driven by higher compensation and bonus expense. In addition, we incurred additional costs in our operations outside the United States primarily from temporary transition costs associated with the fund data operations acquired from Standard & Poor’s. Incremental costs from acquisitions in the United States, including rent and professional fees, also added to the increase in this category. An expense of $0.9 million related to settling our Australian litigation also contributed to the growth in G&A. Because of these additional costs, G&A increased slightly as a percentage of revenue in 2007 after declining significantly in 2006.

 

Depreciation and Amortization Expense

 

($000)

 

2008

 

2007

 

2006

 

Depreciation expense

 

$

9,348

 

$

8,488

 

$

7,971

 

Amortization expense

 

16,648

 

12,769

 

7,004

 

Total depreciation and amortization expense

 

$

25,996

 

$

21,257

 

$

14,975

 

% change

 

22.3%

 

41.9%

 

81.2%

 

 

 

 

 

 

 

 

 

% of revenue

 

5.2%

 

4.9%

 

4.8%

 

Change

 

0.3pp

 

0.1pp

 

1.2pp

 

 

Depreciation and amortization expense rose $4.7 million in 2008 and $6.3 million in 2007 as amortization of intangible assets related to acquisitions increased substantially. As a percentage of revenue, however, this category of expense has remained consistent in recent years.

 

We expect that amortization of intangible assets will be an ongoing cost for the remaining life of the assets. We estimate that aggregate amortization expense for intangible assets will be $20.2 million in 2009. Our estimates of future amortization expense for intangible assets may be affected by changes to the preliminary purchase price allocations associated with our 2008 acquisitions.

 

44



 

Stock-Based Compensation Expense

 

($000)

 

2008

 

2007

 

2006

 

Restricted stock units

 

$

7,571

 

$

4,503

 

$

1,406

 

Stock options

 

3,710

 

6,475

 

7,169

 

Stock-based compensation expense

 

$

11,281

 

$

10,978

 

$

8,575

 

% change

 

2.8%

 

28.0%

 

(21.3)%

 

 

 

 

 

 

 

 

 

% of revenue

 

2.2%

 

2.5%

 

2.7%

 

Change

 

(0.3)pp

 

(0.2)pp

 

(2.1)pp

 

 

Stock-based compensation expense increased $0.3 million in 2008 and $2.4 million in 2007 and declined slightly as a percentage of revenue in both years.

 

We include stock-based compensation expense in each of our operating expense categories. We began granting restricted stock units (RSUs) in May 2006 and made additional grants in 2007 and 2008, primarily in the second quarter of each year. We recognize the expense related to RSUs over the vesting period, which is generally four years. Our stock-based compensation expense related to RSUs has increased over the past three years, reflecting the additional RSU grants. In contrast, the stock-based compensation expense related to stock options has declined over the past three years reflecting no stock option grants in 2008, a small number of stock option grants in 2007 and 2006, and that stock options granted prior to 2006 are becoming fully expensed.

 

We determine stock-based compensation expense in accordance with Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)), which we adopted on January 1, 2006. We record stock-based compensation expense only for those awards that ultimately vest. As a result, the stock-based compensation expense recorded since the beginning of 2006 reflects an estimate of an expected forfeiture rate. We usually adjust our estimate of the forfeiture rate in the second quarter, which is when most of our larger equity grants typically vest. The adjustment recorded in the second quarter of 2008 was an expense of $0.2 million, compared with an adjustment of $0.8 million of expense recorded in the second quarter of 2007.

 

Based on grants made through December 31, 2008, we anticipate that stock-based compensation expense will be $9.5 million in 2009. This amount is subject to change based on additional equity grants or any change in our estimated forfeiture rate.

 

Bonus Expense

 

($000)

 

2008

 

2007

 

2006

 

Bonus expense

 

$

49,912

 

$

52,014

<