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, 2009

 

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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  x

Accelerated filer  o

 

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, 2009 was $848,941,450. As of February 22, 2010, there were 48,786,955 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 2010 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.

Reserved

 

 

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

 

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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 data, software, and research products for individual investors, financial advisors, and institutional clients through our Investment Information segment. We also provide asset management services for advisors, institutions, and retirement plan participants through our Investment Management segment. 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 7.4 million individual investors, 245,000 financial advisors, and 4,200 institutional clients. We have operations in 20 countries and hold minority ownership positions in companies located in two 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 value and insight to the data by applying our core skills of research, technology, and design. As of December 31, 2009, we provided extensive data on more than:

 

·

21,000 mutual fund share classes in the United States;

·

97,000 mutual funds and similar vehicles in international markets;

·

3,400 exchange-traded funds (ETFs);

·

1,800 closed-end funds;

·

28,000 stocks;

·

8,200 hedge funds;

·

7,200 separate accounts and collective investment trusts;

·

109,000 variable annuity/life subaccounts and policies;

·

46,000 insurance, pension, and life funds;

·

12,300 unit investment trusts;

·

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

·

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

·

Extensive cash flow, ownership, and biographical data on directors and officers;

·

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 popular Portfolio X-Ray tool that helps investors reduce risk and understand the key characteristics of their portfolios based on nine different factors.

 

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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.

 

Since 1998, 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.

 

In 2009, we began publishing credit ratings and associated research on corporate debt issuers. We currently provide ratings on approximately 120 companies. We also introduced comprehensive, qualitative research and ratings for mutual funds based in Europe and Asia, a new study comparing the mutual fund investor experience across 16 countries, hedge fund operational risk flags, attribution analysis for equity funds and funds of funds, a new equity fund classification structure, and a new series of specialized, institutional-level investment benchmarks.

 

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.

 

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Growth Strategies

 

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 to reflect changes in our business.

 

GRAPHIC

 

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 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 market updates on the site, including third-party content. We’ve also been focusing on mobile development and social networking, as well as expanding data and functionality to increase the site’s value to both

 

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registered users and Premium members. With Advisor Workstation, we plan to build on our large installed base by expanding our mid- and back-office capabilities, improving the product’s interface and design, and integrating real-time data and other functionality. With Morningstar Direct, we’re pursuing an aggressive development program to provide data and analysis on securities and investments around the world. We’re adding third-party data and content and enhancing our technology to allow the product to function as a purely web-based solution. We also plan to expand into new global markets, enhance our capabilities in portfolio management and accounting, and significantly increase the amount of equity research content and functionality.

 

2.         Become a global leader in fund-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, fund-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 $1.6 trillion in 2009. We believe assembling and evaluating funds of funds is a natural extension of our expertise in understanding managed investment products.

 

Our fund-of-funds 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.

 

In June 2009, we expanded our investment management business by acquiring Intech Pty Ltd, a leading provider of multimanager and investment portfolio solutions in Sydney, Australia. Intech (now doing business as Ibbotson Associates) manages the Intech Investment Trusts, a range of single sector, alternative strategy, and diversified investment portfolios.

 

We had a total of $61.4 billion in assets under advisement in our Investment Consulting business as of December 31, 2009. 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 plan to continue building this business by expanding to reach new markets outside of the United States, expanding our capabilities and products in new areas such as alternative investment strategies, developing more ways to incorporate risk protection and insurance, expanding to reach additional client segments, and focusing on performance and client support.

 

We also offer managed retirement account services through our Retirement Advice platform, which includes Morningstar Retirement Manager and Advice by Ibbotson. We offer these services for retirement plan participants who choose to delegate management of their portfolios to our managed account programs, which are quantitative systems that 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.

 

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. As of December 31, 2009, we had $2.1 billion in assets under management through Morningstar Managed Portfolios and $15.6 billion in assets under management in our managed retirement accounts.

 

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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 producing 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 built an integrated team of locally based fund experts to expand our research coverage in additional markets around the world. As of December 31, 2009, we had about 80 fund analysts globally, including teams in North America, Europe, Asia, and Australia. We currently produce qualitative analyst research on more than 900 funds outside the United States and plan to continue building our coverage of funds based in Europe and Asia.

 

·                  Continue leveraging 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, 2009, we provided analyst research on approximately 2,000 companies.

 

From June 2004 through July 2009, we provided research to six major investment banks under the terms of the Global Analyst Research Settlement, which we describe in more detail on page 27. Although the period covered by the Global Analyst Research Settlement expired in July 2009, and the banks covered by it are no longer required to provide independent investment research to their clients, we remain committed to maintaining the broad, high-quality coverage we’ve become known for as one of the largest providers of independent equity research. For further discussion about this issue, see Item 1A—Risk Factors.

 

We’re working to expand distribution of 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.

 

·                  Build expertise in fixed-income credit research. In 2009, we began publishing research and ratings on corporate credit issuers. During the next year, we plan to produce credit ratings for up to 1,000 companies currently covered by our equity analyst team. We view credit ratings as a natural extension of the equity research we’ve been producing for the past decade. We believe we have a unique viewpoint to offer on company default risk that leverages our cash-flow modeling expertise, proprietary measures like economic moat, and in-depth knowledge of the companies and industries we cover.

 

We’re including this research on our three major software platforms to provide investors with an additional perspective on fixed-income investments. We also plan to monetize the ratings through subscriptions to our institutional equity research clients, who have access to the forecasts, models, and scores underlying the ratings.

 

·                  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 this will lead to a greater need for information and tools focusing on retirement income planning and long-term savings strategies. In 2009, we introduced an advisory service for investors in

 

5



 

retirement through Morningstar Retirement Manager. 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 retired 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.                                   Create a premier global investment database.

 

Our goal is 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.

 

As detailed on page 2, we currently provide extensive data on nearly 400,000 investments globally, including managed investment products, individual securities, capital markets data, real-time stock quotes from nearly all of the world’s major stock exchanges, and 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 prefer  to own the data 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. Our strategy is to continuously expand our databases, focusing on investment products that are widely used by large numbers of investors. In particular, we’re focusing on expanding our fundamental equity data. We also strive to establish our databases as the pre-eminent choice for individual investors, financial advisors, and institutional clients around the world, as well as continuing to invest in world-class data quality, manufacturing, and delivery interfaces.

 

Over the past several years, we’ve developed a series of proprietary indexes based on 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. We’ve significantly expanded the range of indexes we offer and are working to expand our index business globally.

 

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

 

Our operations outside of the United States generated $129.2 million in revenue in 2009 compared with $121.4 million in 2008 and represent an increasing percentage of our consolidated revenue. Our strategy is to expand our non-U.S. operations (either organically or through acquisitions) 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 there. Our strategy is to focus our non-U.S. sales efforts on our major products, including Morningstar Advisor Workstation and Morningstar Direct, as well as opportunities such as real-time data, qualitative investment research and ratings, investment indexes, and consulting. We also plan to explore new regions, such as Latin America, Eastern Europe, and the Middle East; continue expanding our databases to be locally and globally comprehensive; introduce new products in markets where we already have operations; and expand our sales and product support infrastructure around the world.

 

6



 

Acquisitions

 

Historically, the majority of our long-term revenue growth 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 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.

 

We paid approximately $74.2 million for six acquisitions in 2009, as summarized in the table below.

 

Acquisition

 

Description

 

Date Completed

 

Purchase Price*

Global financial filings database business of Global Reports LLC

 

A leading provider of online financial and Corporate and Social Responsibility reports for publicly traded companies around the world

 

April 20, 2009

 

Not separately disclosed

Equity research and data business of C.P.M.S. Computerized Portfolio Management Services Inc.

 

C.P.M.S. tracks fundamental equity data for approximately 4,000 securities in the United States and Canada as well as tracks and provides earnings estimates for Canadian stocks

 

May 1, 2009

 

$13.9 million

Andex Associates, Inc.

 

Andex is known for Andex Charts, which illustrate historical market returns, stock index growth, inflation rates, currency rates, and general economic conditions for the United States dating back to 1926, and for Canada dating back to 1950

 

May 1, 2009

 

Not separately disclosed

Intech Pty Ltd

 

A leading provider of multimanager and investment portfolio solutions in Sydney, Australia, Intech also manages a range of single sector, alternative strategy, and diversified investment portfolios, has one of the leading separately managed account databases in Australia, and offers the Intech Desktop Consultant, a research software product for institutions

 

June 30, 2009

 

Not separately disclosed

Canadian Investment Awards and Gala

 

Canada’s marquee investment awards program, recognizing excellence in products and firms within the financial services industry

 

December 17, 2009

 

Not separately disclosed

Logical Information Machines, Inc.

 

A leading provider of data and analytics for the energy, financial, and agriculture sectors

 

December 31, 2009

 

$53.5 million


*Total purchase price less cash acquired.

 

For information about our previous acquisitions, refer to Note 6 of the Notes to our Consolidated Financial Statements.

 

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Business Segments, Products, and Services

 

We operate our business in two segments:

 

·      Investment Information, which includes all of our data, software, and research products and services. These products are typically sold through subscriptions or license agreements; and

 

·      Investment Management, which includes all of our asset management operations, which operate as registered investment advisors and earn more than half of their revenue from asset-based fees.

 

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

 

 

 

2009

 

2008

 

 

 

2007

 

 

 

Revenue by Segment ($000)

 

Amount

 

%

 

Amount

 

%

 

Amount

 

%

 

Investment Information

 

 

$

386,642

 

80.7%

 

 

$

390,693

 

77.8%

 

 

$

327,372

 

75.2%

 

Investment Management

 

 

92,354

 

19.3

 

 

111,764

 

22.2

 

 

107,735

 

24.8

 

Consolidated revenue

 

 

$

478,996

 

100.0%

 

 

$

502,457

 

100.0%

 

 

$

435,107

 

100.0%

 

 

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

 

Investment Information

 

The largest products in this segment based on revenue are Morningstar Licensed Data, a set of investment data spanning all of our investment databases, including real-time pricing data, and available through electronic data feeds; Morningstar Advisor Workstation, a web-based investment planning system for independent financial advisors as well as advisors affiliated with larger firms; Morningstar.com, which includes both Premium Memberships and Internet advertising sales; Morningstar Direct, a web-based institutional research platform; and Morningstar Principia, our CD-ROM-based investment research and planning software for advisors.

 

The Investment Information 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. In addition, we distribute our research to several other companies that provide our analyst research to their affiliated financial advisors or to individual investors. From June 2004 through July 2009, we distributed our equity research through six major investment banks to meet the requirements for independent research under the Global Analyst Research Settlement, which we describe in more detail on page 27.

 

We also offer a variety of financial communications materials, real-time data, other investment software, and investment indexes, as well as several print and online publications focusing on stocks, mutual funds, personal finance, and other investing topics. In 2009, we developed a beta version of Morningstar QuoteSpeed, a new web-based solution that delivers real-time market data through a simplified desktop application. In addition to real-time market information, QuoteSpeed provides users with access to Morningstar’s fundamental data, news, analysis, and more. QuoteSpeed will be available as a stand-alone application or as a module through platforms such as Morningstar.com, Direct, Office, and Advisor Workstation. We also created a

 

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new Enterprise Data Management business that helps institutions outsource certain business operations to Morningstar, including creating investment profiles, aggregating account data, performance reporting, and consolidating and managing data feeds from multiple sources.

 

With our purchase of Logical Information Machines, Inc. (LIM) at the end of 2009, we added a new analytical software application, which delivers a comprehensive, real-time solution for research, analysis, and trading for institutional clients. LIM is an analytical software service that aggregates financial and energy data from a large number of sources. LIM’s software lets clients query these multiple data sets simultaneously. The majority of LIM’s clients are in the energy and commodities industries.

 

In 2009, about 31.6% of Investment Information segment revenue was from outside of the United States.

 

Most of our products for individual investors 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.

 

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. Our institutional clients include banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan sponsors and providers. 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.

 

We believe the Investment Information segment has a modest amount of seasonality. We’ve historically had higher revenue in the second quarter because we hold an investment conference then. Sales for other products, such as Morningstar.com, tend to be slightly lower over the spring and summer months. Other products in this segment generally have not shown marked seasonality.

 

Our largest customer in the Investment Information segment made up approximately 3% of segment revenue in 2009.

 

Licensed Data

 

Our Licensed Data service gives institutions access to a full range of proprietary investment data spanning numerous investment databases, including real-time pricing 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 websites, 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 2009, we introduced a new browser-based interface that allows clients who license proprietary data for their marketing materials to access Morningstar’s proprietary statistics and images in a format easily used by designers and web developers. We also added interfaces that allow clients to view, search, and sort data on their desktops, or export the data to their own applications. We launched an alert feed that highlights relevant changes in a fund’s status and proprietary statistics, as well as additional descriptive data on separate accounts. We introduced a series of manager benchmarks based on our new institutional categories, as well as other specialized

 

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investment groupings and client-customizable benchmarks. We continued to expand our fundamental data on stocks around the world.

 

We rebranded Tenfore Systems Limited (acquired in December 2008) as Morningstar Real-Time Data and integrated many of Morningstar’s data sets, including fundamental equity data and research. We also began providing 24-hour support to our Real-Time Data clients.

 

We introduced a new Ownership Database toward the end of the year, which provides security ownership information and position changes on individual stocks. Following our acquisition of Fundamental Data Limited in 2008, in 2009 we created a new Traded Funds Center, which includes all global data on closed-end and exchange-traded funds. We also launched the Morningstar Pension and Endowment Center, which provides insight into the largest pensions and endowments and the underlying investments used in these types of plans.

 

For Licensed Data, our primary competitors are Bloomberg, FactSet Research Systems, Interactive Data Corporation, Standard & Poor’s, and Thomson Reuters.

 

Licensed Data was our largest product in 2009 and accounted for 19.1%, 15.6%, and 13.6% of our consolidated revenue in 2009, 2008, and 2007, respectively.

 

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, closed-end funds, 529 plans, offshore funds, and pension and life funds.

 

As of December 31, 2009, about 149,000 advisors in the United States were licensed to use Advisor Workstation, which is available in two versions: Morningstar Office (formerly Advisor Workstation Office Edition) for independent financial advisors and a configurable enterprise version for financial advisors affiliated with larger firms. Morningstar Advisor Workstation includes four core modules:  Clients & Portfolios, Research, Sales/Hypotheticals, and Planning. We also offer a variety of other applications, including tools for defined contribution plans; Morningstar Retirement Income Strategist, a financial planning application that helps advisors create retirement income plans for their clients; Morningstar Portfolio Builder, which helps advisors quickly produce sound client portfolios; Morningstar Annuity Analyzer, which helps advisors screen and analyze variable annuity contracts and subaccounts; and Morningstar Hypothetical Illustrator. These applications can be purchased as stand-alone products or combined as part of a full Workstation license.

 

Pricing for Morningstar Advisor Workstation 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 Morningstar Advisor Workstation, 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 $5,400 per user for an annual license for Morningstar Office.

 

In 2009, we upgraded our defined contribution module and alert capabilities, created a newer and more flexible version of Hypothetical Illustrator, and launched a new version of Annuity Analyzer.

 

We incorporated additional functionality and content, including Target-Date Fund Series Reports, a new version of the Analyst Research Center, and a Roth IRA calculator. We also expanded our sales efforts for Portfolio Builder in several markets outside the United States. With Morningstar

 

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Office, we introduced an enhanced client web portal, added more investment data, and expanded back-office services that handle daily importing and reconciliation of client accounts.

 

Major competitors for Morningstar Advisor Workstation and Morningstar Office include Advanced Sales, Advent Software, ASI, Junxure, MoneyGuide Pro, SunGard, and Thomson Reuters.

 

Morningstar Advisor Workstation is our second-largest product based on revenue and made up 13.7%, 12.8%, and 12.5% of our consolidated revenue in 2009, 2008, and 2007, respectively.

 

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Morningstar.com

 

Our largest website for individual investors is Morningstar.com in the United States, which includes both Premium Membership revenue and Internet advertising sales. As of December 31, 2009, the free membership services offered through Morningstar.com had more than 7.3 million registered users worldwide, who have access to comprehensive data on stocks, mutual funds, exchange-traded funds, hedge funds, commodities, options, bonds, and other investments to help them conduct research and track performance. In addition, Morningstar.com features extensive market data, 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 websites for investors in 35 countries around the world, including new sites launched in Estonia, India, Iceland, Ireland, Latvia, Lithuania, and Thailand in 2009.

 

We use our free content as a gateway into paid Premium Membership, which includes access to written analyst reports on more than 1,700 stocks, 1,700 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 2009, we re-launched our site for individual investors in Australia supported by a significant branding campaign. The product integrates Your Money Weekly content with managed funds data and research. With the new site, we now offer qualitative research that was previously available only to professionals to individual investors in this market.

 

For Morningstar.com in the United States, in 2009 we added real-time stock and ETF quotes, as well as expanded market data. During the year we also doubled the number of free articles published to about 40 per week and introduced a new mobile application for the iPhone. In its December 2009 issue, Kiplinger’s Personal Finance magazine named Morningstar.com as one of two best investing websites.

 

In early 2010, we acquired the Footnoted.org website and the Footnoted Pro service, which provide insight and analysis gathered from corporate SEC filings. We plan to make some content from Footnoted.org available on Morningstar.com.

 

Morningstar.com competes with the personal finance websites of AOL Money & Finance, Google Finance, The Motley Fool, MSN Money, Seeking Alpha, The Street.com, Yahoo! Finance, and The Wall Street Journal Online.

 

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As of December 31, 2009, we had 150,473 paid Premium subscribers for Morningstar.com in the United States plus an additional 16,000 paid Premium subscribers in Australia, the United Kingdom, and China. We currently charge $19.95 for a monthly subscription, $179 for an annual subscription, $299 for a two-year subscription, and $399 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 (including local language versions outside of the United States) is one of our five largest products based on revenue and accounted for 8.2% of our consolidated revenue in 2009, compared with 9.1% of our consolidated revenue in 2008 and 9.0% in 2007.

 

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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 2009, we made several key enhancements to Morningstar Direct, including a new Presentation Studio that allows clients to create reusable templates of customized presentations, reports, and fact sheets; improved capabilities for performance attribution; and expanded performance reporting, importing, and batch scheduling. We also added new data on fund flows; descriptive text on separate accounts; Target Date Fund Series Reports; more specialized fund categories; qualitative analyst reports and ratings; and data on unit investment trusts. We introduced local language versions of Morningstar Direct in China and Italy in 2009 and plan to launch additional versions in Spain, France, and Germany in 2010.

 

For Morningstar Direct, our primary competitors are eVestment Alliance, FactSet Research Systems, Markov Processes International, Strategic Insight, Thomson Reuters, and Zephyr Associates in the United States, and Europerformance, Feri, FinEx, Mercer, MoneyMate, and Style Research in non-U.S. markets.

 

Morningstar Direct had 3,524 licensed users worldwide as of December 31, 2009.

 

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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Morningstar Principia

 

Principia is our CD-ROM-based investment research and planning software for financial planners and had 35,844 subscriptions as of December 31, 2009. 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

 

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National Association of Securities Dealers for financial advisors to distribute and review with their clients.

 

In 2009, we began offering electronic delivery for Principia, which allows us to deliver data to customers faster and at lower cost. We introduced a new CAMS (Client Account Manager Service) module that incorporates the portfolio accounting and performance reporting functionality we acquired through our purchase of Financial Computer Support, Inc. in 2008. We also introduced new functionality for point-in-time historical analysis, portfolio comparisons, and investment policy statements.

 

Principia prices generally range from approximately $710 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 $7,535 for all investment universes plus additional modules for asset allocation, defined contribution plans, and portfolio management.

 

Major competitors for Principia include Standards & Poor’s and Thomson Reuters.

 

Morningstar Site Builder and Licensed Tools

 

We offer an extensive set of online tools and editorial content that institutional clients can license to use in their websites and software products. Within the United States, we offer Morningstar Site Builder, a set of integrated tools, content, and reports that investment firms can easily add to their existing advisor websites. Outside of the United States, we offer Licensed Tools, which can be customized to meet the needs of international audiences. Clients can select from more than 30 customizable investment tools for retail and advisor websites or purchase modules focusing on screening and performance tools, editorial commentary and educational articles, and goal planning and portfolio analysis. Site Builder and Licensed Tools can be customized to analyze a set of investments, focus on client-defined data points, or perform calculations required by specific products or services. We also offer licenses for investment research and portfolio analysis tools. Morningstar Site Builder and Licensed Tools can be integrated with a client’s existing website and allow users to drill down into the underlying data when researching a potential investment.

 

In 2009, we added several new tools to the Site Builder suite, including Portfolio Planner, Retirement Analyzer, Watchlist, News, Ticker Tape, and IRA Calculators as well as a new administrative tool. We have also launched new charting capabilities, market monitoring tools, and real-time market data.

 

We also added several new tools to our Licensed Tools offerings outside the United States, including Portfolio Planner, Asset Allocator, real-time market data, and new equity tools, including Stock Quickrank and Stock Reports.

 

Major competitors for Morningstar Site Builder and Licensed Tools include Interactive Data Corporation, QuoteMedia, Thomson Reuters, and Wall Street On Demand.

 

Pricing for Morningstar Site Builder and Licensed Tools depends on the audience, the level of distribution, and the scope of information and functionality licensed.

 

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

 

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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 and personal finance, which are available directly from us and in bookstores.

 

Our Investment Information 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.

 

In 2009, we created companion websites for two of our publications. We also moved Your Money Weekly in Australia to an online format that integrates content from the magazine with data and research on managed investment funds.

 

Our print publications compete with Agora Publishing, Forbes, InvestorPlace Media, The Motley Fool, and Value Line in the United States and Intelligent Investor, InvestSmart, and The Rivkin Report in Australia.

 

Morningstar Equity Research

 

As of December 31, 2009, we offered independent equity research on approximately 2,000 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, as well as to several other companies who provide our research to their affiliated financial advisors or to individual investors.

 

From June 2004 through July 2009, we also provided independent equity research to six major investment banks under the terms of the Global Analyst Research Settlement. For further discussion about this issue, see Item 1A — Risk Factors.

 

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 major indexes. We had approximately 108 stock analysts around the world as of December 31, 2009, compared with 128 as of December 31, 2008.

 

In 2009, we entered into an agreement with the NASDAQ OMX Group, Inc. to provide equity research profile reports on more than 3,600 NASDAQ OMX-listed companies. In January 2010, we announced an expanded agreement with NASDAQ OMX that gives NASDAQ-listed companies the option of contracting with NASDAQ OMX for comprehensive analyst research reports provided by Morningstar.

 

We also began publishing credit ratings on 100 of the largest corporate issuers in 2009. In 2010, we plan to produce credit ratings for up to 1,000 companies currently covered by our equity analyst team. The ratings are available on Morningstar.com, and we offer forecasts and scores underlying the ratings to our institutional equity research clients.

 

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Our Equity Research services compete with The Applied Finance Group, Credit Suisse HOLT, Renaissance Capital, Standard & Poor’s, Value Line, Zacks Investment Research, and several smaller research firms. Competitors for our fixed-income credit research include Credit Sights, Egan-Jones, Fitch, Gimme Credit, Moody’s, and Standard & Poor’s.

 

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 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 most attractive 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 that offer exchange-traded funds or exchange-traded notes based on the indexes, including Barclays Global Investors, First Trust, and Merrill Lynch.

 

In 2009, we introduced a family of asset allocation indexes that serve as benchmarks for target-date and target-risk investments and expanded our family of commodity- and managed futures- based 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.

 

Investment Management Segment

 

The largest products and services in this segment based on revenue are Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities; Retirement Advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms; and Morningstar Managed Portfolios, a fee-based discretionary asset management service that includes a series of mutual fund, exchange-traded  fund, and stock portfolios tailored to meet a range of investment time horizons and risk levels that financial advisors can use for their clients’ taxable and tax-deferred accounts.

 

Our client base in this segment includes banks, brokerage firms, insurance companies, mutual fund companies, and retirement plan sponsors and providers. We currently offer investment management services in the United States, Europe, Japan, and Australia. Our license agreements in the Investment Management segment have an average contract term of approximately three years, although some of our agreements allow for early termination.

 

About 7.7% of Investment Management segment revenue was from outside the United States in 2009.

 

Many of our largest customers are insurance companies, including variable annuity providers, followed by mutual fund companies and other asset management firms, retirement plan sponsors and providers, broker-dealers, and banks. We plan to develop additional distribution channels to reach other client types, including foundations and endowments, defined contribution plans, defined benefit plans, and wealth management firms. We also expect to continue expanding our Investment Management business outside the United States.

 

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For Morningstar Managed Portfolios, our target audience consists of home offices of insurance companies, broker-dealers, and registered investment advisors, as well as independent financial advisors.

 

We market our Investment Management services almost exclusively through our institutional sales team, including both strategic account managers and sales representatives within each business unit. We employ a consultative sales approach and often tailor customized solutions to meet the needs of larger institutions. We have a regional sales team responsible for expanding relationships for Morningstar Managed Portfolios.

 

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. We also reach approximately 1,900 financial advisors through our Managed Portfolios platform.

 

The Investment Management segment has not historically shown seasonal business trends; however, business results for this segment are typically more variable because of our emphasis on asset-based fees, which change along with market movements and other factors.

 

Our largest customer in the Investment Management segment made up approximately 9% of segment revenue in 2009.

 

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 through Morningstar Associates, LLC, Morningstar Associates Europe, Ltd,  Ibbotson Associates, Inc., Ibbotson Advisors, LLC, and Intech Pty Ltd, which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. 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, focusing on customized solutions that improve the investor experience and help our clients build 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.

 

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In 2009, Morningstar Associates introduced several new multimanager portfolios, including one incorporating a risk management overlay and one using managed futures and foreign exchange managers for distribution to accredited investors. We also developed a technology solution that enables advisors or plan sponsors to create time, risk, or hybrid models to select funds for defined contribution plan lineups.

 

In early 2010, Morningstar Associates announced an agreement with Pax World Funds to create and manage a series of four asset allocation portfolios featuring investment managers who incorporate environment, social, and governance issues in their investment process.

 

Pax World is the investment advisor to these portfolios, and Morningstar Associates is charged with manager selection, asset allocation, and portfolio construction and monitoring. We invested $8 million as seed money in the portfolios in 2009.

 

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 subadvisor. 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 fund-of-funds subadvisory services, as well as tailored model portfolios, fund classification schemes, and questionnaire design.

 

In 2009, Ibbotson Associates added capabilities for forecasting and modeling the glide paths of target-maturity funds; launched a lifetime financial advice solution that combines insurance and annuities as part of investors’ portfolios over time; expanded its target-maturity portfolio construction services to large plan sponsors; began specifically incorporating an analysis of statistically unlikely (aka “fat tail”) events in its portfolio construction process for some clients; and introduced alternative investment strategy portfolios for clients in the United States.

 

Ibbotson is also developing active investment management capabilities based on founder Roger Ibbotson’s liquidity methodology. We launched two seed portfolios in October 2009 with an investment of $2 million to begin establishing a track record for this methodology.

 

As discussed on page 7, in June 2009 we acquired Intech Pty Ltd, a leading provider of multimanager and investment portfolio solutions in Sydney, Australia, from IOOF Holdings Limited. Intech manages the Intech Investment Trusts, a range of single sector, alternative strategy, and diversified investment portfolios. In 2009, Intech launched several additional unit trusts, including five multimanager solutions and two trusts emphasizing different levels of growth and income. We rebranded Intech under the Ibbotson name in February 2010.

 

Our Investment Consulting business competes primarily with Mercer, Mesirow Financial, Russell Investments, Watson Wyatt, and Wilshire Associates, as well as some smaller firms in the retirement consulting business and various in-house providers of investment advisory services.

 

Pricing for the consulting services we provide through 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.

 

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Investment Consulting was our third-largest product based on revenue in 2009 and accounted for 13.3%, 15.5%, and 17.4% of our consolidated revenue in 2009, 2008, and 2007, respectively.

 

Retirement Advice

 

We have two Retirement Advice offerings that help retirement plan participants plan and invest for retirement: Morningstar Retirement Manager (offered by Morningstar Associates) and Advice by Ibbotson (offered by Ibbotson Associates).

 

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 2009, we introduced a new advisory service for individuals in retirement that provides recommendations for drawing down their portfolios to create sustainable income and managing their remaining assets. We also created a custom models platform that enables retirement plan sponsors and advisors to develop custom retirement date, lifestyle, or blended portfolios using the plans investment lineup.

 

As of December 31, 2009, approximately 11.2 million plan participants had access to Morningstar Retirement Manager through approximately 83,000 plan sponsors and 16 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.

 

In 2009, we launched our proprietary Advice by Ibbotson technology platform serving defined contribution plan providers; expanded the services available in Advice by Ibbotson to provide financial advice to retirement plan participants through all stages of their lives (including wealth accumulation, transition, and retirement); began incorporating simulations of statistically unlikely (aka “fat tail”) events in Advice by Ibbotson’s wealth-forecasting process for defined contribution plans; and enhanced our reporting capabilities for retirement-plan sponsors and plan participants.

 

As of December 31, 2009, approximately 9.5 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.

 

In the retirement advice market, we compete primarily with Financial Engines, Guided Choice, and ProManage.

 

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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 $2.1 billion in assets under management with about 1,900 financial advisors using the service as of December 31, 2009. 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 30 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 2009, Morningstar Investment Services introduced a series of Lifetime Wealth Portfolios in partnership with Ibbotson Associates and a large insurance company. The Lifetime Wealth Portfolios incorporate insurance as an integral part of an asset allocation. The solution builds on Ibbotson’s “Human Capital” concept, which models the value and risk of an individual’s human capital and recommends a face value of life insurance (or an annuity) to hedge that capital. As a first-of-its-kind solution, the portfolios help to define and contextualize an investor’s insurance needs within a holistic financial plan.

 

For Morningstar Managed Portfolios, our primary competitors are Brinker Capital, Curian Capital, Envestnet PMC, FundQuest, and SEI Investments.

 

The Morningstar Managed Portfolios program is offered through Morningstar Investment Services, Inc., a registered investment advisor, registered broker-dealer, member of the Financial Industry Regulatory Authority, Inc. (FINRA), and wholly owned subsidiary of Morningstar, Inc.

 

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 and forecasting sales and other tasks to support our sales team. Across our business, 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 400 sales and marketing professionals on staff as of December 31, 2009.

 

International Operations

 

We conduct our business operations outside of the United States, which have been increasing as a percentage of our consolidated revenue, through wholly owned or majority-owned operating subsidiaries doing business in each of the following countries: Australia, Canada, France, Germany, India, Italy, Japan, Korea, 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

 

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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, and Sweden. As of December 31, 2009, we owned approximately 34% of the outstanding shares in Morningstar Japan K.K. (Morningstar Japan) and our share had a market value of approximately $28.5 million. Morningstar Japan is publicly traded under ticker 4765 on the Osaka Stock Exchange “Hercules Market.” See Note 7 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.

 

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.

 

“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 Associates®

 

Morningstar Market BarometerSM

Ibbotson ®  SBBI ®

 

Morningstar ®  Mutual Funds TM

Morningstar ®  Advisor Workstation SM

 

Morningstar OfficeSM

Morningstar ®  Advisor Workstation SM  Enterprise Edition

 

Morningstar ®  Ownership Zone SM

Morningstar ®  Analyst Research Center

 

Morningstar® Pension & Endowment CenterSM

Morningstar® Annuity AnalyzerSM

 

Morningstar ®  Portfolio Builder SM

Morningstar® Back Office ServicesSM

 

Morningstar ®  Portfolio X-Ray ®

Morningstar Direct SM

 

Morningstar ®  Principia ®

Morningstar® Enterprise Data Management

 

Morningstar Qualitative Rating™

Morningstar ®  Equity Research Services SM

 

Morningstar Rating TM

Morningstar ®  Essentials TM

 

Morningstar® Real-Time Data

Morningstar ®  ETFInvestor TM

 

Morningstar ®  Retirement Income Strategist SM

Morningstar ®  FundInvestor TM

 

Morningstar ®  Retirement Manager SM

Morningstar ®  Global Document Library SM

 

Morningstar ®  Site Builder SM

Morningstar® Hypothetical IllustratorSM

 

Morningstar ®  Stewardship Grade SM

Morningstar® Institutional Equity Research ServicesSM

 

Morningstar ®  StockInvestor TM

Morningstar® Investment Guide

 

Morningstar Style Box TM

Morningstar ®  Investment Profiles TM

 

Morningstar® Traded Fund CenterSM

Morningstar ®  Licensed Data SM

 

Morningstar ®  Wide Moat Focus SM  Index

Morningstar ®  Licensed Tools and Content

 

Morningstar.com ®

 

In addition to trademarks, we currently hold several patents in the United States, United Kingdom, and 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.

 

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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.

 

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.

 

We believe market movements generally have more influence on our performance than seasonality. 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.

 

Largest Customer

 

In 2009, 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

 

21



 

have financial resources that are significantly greater than ours. We also have a number of smaller competitors in our two business segments, which we discuss in Business Segments, Products, and Services above.

 

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.

 

Major 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

 

·

 

 

 

 

 

 

 

 

 

 

News Corporation*

 

 

 

 

 

 

 

·

 

 

 

 

Standard & Poor’s

 

·

 

 

 

·

 

 

 

·

 

 

Thomson Reuters**

 

·

 

 

 

·

 

 

 

·

 

·

Wilshire Associates

 

 

 

·

 

 

 

 

 

 

 

·

Yahoo!

 

 

 

 

 

 

 

·

 

 

 

 

Zephyr Associates

 

 

 

 

 

 

 

 

 

 

 

·

 

*    News Corporation includes Dow Jones, MarketWatch, and SmartMoney

**  Thomson Reuters includes Lipper

 

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 websites and build our own software 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, 2009, our technology team consisted of approximately 500 programmers and technology and infrastructure professionals.

 

In 2009, 2008, and 2007, our development expense represented 8.0%, 8.0%, and 8.1%, 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

 

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responsible for enforcing the federal securities laws and oversees federally registered investment advisors and broker-dealers.

 

As of December 31, 2009, 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 each other and 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.

 

Australia

 

Our subsidiaries that provide financial information services in Australia, Morningstar Australasia Pty Limited and Intech Fiduciaries Limited, must hold an Australian Financial Services License and submit to the jurisdiction of the Australian Securities and Investments Commission (ASIC). This license requires them 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.

 

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.

 

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

 

23



 

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.

 

Employees

 

We had approximately 2,600 employees as of December 31, 2009, including approximately 480 data analysts, 75 designers, 290 investment analysts (including consulting and quantitative research analysts), 490 programmers and technology staff, and 400 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 February 26, 2010, we had 13 executive officers. The table below summarizes information about each of these officers.

 

Name

 

Age

 

Position

Joe Mansueto

 

53

 

Chairman, Chief Executive Officer, and Director

Chris Boruff

 

44

 

President, Advisor Software

Peng Chen

 

39

 

President, Ibbotson Associates, Inc.

Scott Cooley

 

41

 

Chief Financial Officer

Bevin Desmond

 

43

 

President, International Division and Institutional Software

Catherine Gillis Odelbo

 

47

 

President, Equity Research

Tao Huang

 

47

 

Chief Operating Officer

Kunal Kapoor

 

34

 

President, Individual Investor Software

Elizabeth Kirscher

 

45

 

President, Data Services

Don Phillips

 

47

 

President, Fund Research and Managing Director

Patrick Reinkemeyer

 

44

 

President, Morningstar Associates LLC

Richard Robbins

 

47

 

General Counsel and Corporate Secretary

David W. Williams

 

49

 

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. He is a member of the board of directors for Trans Union LLC.

 

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

 

24



 

bachelor’s degree in industrial management engineering from Harbin Institute of Technology and 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.

 

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 was president of our Individual segment from 2000 through 2008 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.

 

25



 

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 websites. 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, as well as our corporate communications area. 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 from the University of Texas and a master’s degree 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 Advice 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.

 

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 website 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 website 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.

 

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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.

 

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 2009, our five largest products based on revenue (Licensed Data, Morningstar Advisor Workstation, Investment Consulting, Morningstar.com, and Morningstar Direct) accounted for approximately 61% 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 and 2009, two of our Investment Consulting clients did not renew their contracts. Combined, these contracts represented about $17 million in annual revenue in 2008.

 

From June 2004 through July 2009, we also had significant revenue from the independent equity research we provided under the terms of the Global Analyst Research Settlement. 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 was designated for independent research over a period of five years, with the independent research provided by companies that are not engaged in the investment banking industry.

 

The period during which investment banks were required to provide independent equity research to their clients expired in July 2009. As a result, our Equity Research revenue has declined significantly; the loss of revenue associated with the Global Analyst Research Settlement accounting for approximately $9.4 million of the decline in our consolidated revenue in 2009.

 

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.

 

27



 

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.

 

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.

 

Failing to differentiate our products and continuously create innovative, proprietary research tools may negatively impact our competitive position and business results.

 

We attribute much of our company’s success over the past 25 years to our ability to develop innovative, proprietary research tools. We cannot guarantee that we will continue to successfully develop new product features and tools that differentiate our product offerings from those of our competitors. If tools similar to Morningstar’s proprietary tools become more broadly available through other channels, our competitive position and business results may suffer.

 

If we do not maintain and increase the number and contract value of our 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. Subscription 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, as well as the price they’re willing to pay. 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.

 

Consolidation among our clients may adversely impact our competitive position, our relationships with our clients, and business results.

 

Industry consolidation in the financial services sector has accelerated over the past several years. 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.

 

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 clients have generated a significant percentage of our consolidated revenue in recent years. 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

 

28



 

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 recent 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 $61.4 billion in assets as of December 31, 2009, 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 acquisitions of Ibbotson Associates in 2006 and Intech Pty Ltd in 2009 substantially increased our business in this area. We’ve also expanded the investment advisory services we offer outside the United States through Morningstar Associates Europe and other subsidiaries. The securities laws and other laws that govern our activities as a registered investment advisor in the United States are complex. The activities of our investment advisory operations are primarily subject to provisions of the 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.

 

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

 

Our operations outside of the United States have expanded to $129.2 million in revenue in 2009 from $89.7 million in 2007. Several of our recent acquisitions have added to our business operations in Europe, Australia, and other areas outside the United States. 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; potential tax exposure related to

 

29



 

transfer pricing and other issues; heightened risk of fraud and noncompliance; 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.

 

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.

 

The increasing concentration of data and development work carried out at our offshore facilities may have a negative impact on our business operations, products, and services.

 

We now have approximately 600 employees working in our data and technology development center in Shenzhen, China, or about one-fourth of our total workforce. 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 150 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.

 

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 declared bankruptcy, were acquired, accepted funding from the U.S. government, or otherwise restructured their operations.

 

In response to these events, the global financial markets showed unusually high levels of volatility in 2007 and 2008. Although conditions improved in 2009, we believe the disruption in the financial markets continues to cause investor uncertainty and pressure on consumer discretionary spending. The market downturn also led to spending cutbacks among asset management firms and other financial services companies, which make up a large percentage of our client base. Following the financial crisis in 2007 and 2008, many institutional clients became more cautious and price-sensitive. Some of them also implemented additional review processes for new contracts or began 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 experience negative performance and volatility, demand for our products and services may decline, and our revenue, operating income, and other financial results could suffer. Our business results may also be impacted by negative trends in Internet advertising sales. 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.

 

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Our revenue from asset-based fees may be impacted by market declines as well as the impact of cash outflows.

 

Our fee-based asset management business has become more important to our financial results. In 2009, revenue from asset-based fees made up approximately 12% 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. Revenue from asset-based fees made up 12% of consolidated revenue in 2009, compared with 13% in 2008 and 16% in 2007. 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, but suffered along with the market downturn in 2008 and early 2009. Global mutual fund assets declined to about $22.3 trillion as of September 30, 2009, down from a peak of $26.1 trillion in 2007. Continued downturns or volatility in the financial markets, increased investor interest in other investment vehicles, or a lack of investor confidence could reduce investor interest and investment activity in this area. A slower growth rate or downturn in mutual fund assets could decrease demand for our products.

 

Failing to successfully integrate acquisitions could harm our business.

 

We’ve completed numerous acquisitions over the past three years, including six acquisitions in 2009. 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, particularly if numerous acquisitions are in process at the same time. 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.

 

We may be unable to generate adequate returns on our cash and investment balance if we cannot identify attractive investment opportunities.

 

We held a total of $342.6 million in cash and investments as of December 31, 2009. Because of generally low prevailing interest rates on high-quality fixed-income securities, the rate of return we can generate with our cash and investment balance is relatively low. We have used portions of our cash and investment balance to finance acquisitions over the past several years. We cannot guarantee that we will be able to find suitable acquisition opportunities in the future. As mentioned above, we may also fail to generate enough revenue or profits from an acquisition to earn a return on the associated purchase price.

 

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

 

As we originally disclosed in 2004, the New York Attorney General’s Office is conducting an investigation 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.

 

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 website provides real-time access to SEC filings, including annual, semi-annual, and quarterly reports. Financial information and data is also widely available in XBRL (eXtensible Business Reporting Language), and many brokerage firms 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.

 

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.

 

32



 

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 websites. 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, including our research and ratings on corporate credit issuers. 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 website through links to other websites. 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.

 

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.

 

33



 

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.

 

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

 

As of December 31, 2009, Joe Mansueto, our chairman and chief executive officer, owned approximately 53% 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, office leases, and other infrastructure spending, which generally cannot 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.

 

34



 

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, 2009, our employees and non-employee directors held options to acquire 2,677,577 shares of common stock, 2,668,034 of which were exercisable at a weighted average price of approximately $16.54 per share and 9,543 were not exercisable. As of December 31, 2009, there were 721,019 restricted stock units outstanding, which have an average remaining vesting period of 32 months. Generally speaking, the company issues a share of stock 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 realized. Because of this uncertainty, there may be additional volatility in our cash flows from financing activities.

 

35



 

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, 2009, we lease approximately 310,000 square feet of office space for our U.S. operations, primarily for our office located in Chicago, Illinois. We also lease approximately 260,000 square feet of office space in 19 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

 

Business Logic

 

In November 2009, Business Logic Holding Corporation filed a complaint in the Circuit Court of Cook County, Illinois against Ibbotson Associates, Inc. and Morningstar, Inc. relating to Ibbotson’s prior commercial relationship with Business Logic. Business Logic is alleging that Ibbotson Associates and Morningstar violated Business Logic’s rights by using its trade secrets to develop a proprietary web-service software and user interface that connects plan participant data with the Ibbotson Wealth Forecasting Engine. Business Logic seeks, among other things, injunctive relief and unspecified damages. While Morningstar and Ibbotson Associates are vigorously contesting the claims against them, we cannot predict the outcome of the proceeding.

 

Online News Link LLC

 

In October 2009, Online News Link LLC filed a complaint in the United States District Court for the Eastern District of Texas against Morningstar, Inc. and several other providers of online information alleging that each defendant infringes U.S. Patent No. 7,508,789, which relates to ways for delivering online information. Online News Link seeks, among other things, unspecified damages and costs incurred by Online News Link because of defendants’ infringing activities. The complaint does not include specific allegations against Morningstar. Morningstar is evaluating the lawsuit but cannot predict the outcome of the proceeding.

 

NewRiver, Inc.

 

In January 2009, NewRiver, Inc. filed a lawsuit in the Superior Court of the Commonwealth of Massachusetts against Morningstar, Inc. alleging that Morningstar inappropriately accessed its data in order to build a competing product to deliver SEC-filed mutual fund disclosure documents online. In February 2009, the case was removed to the United States District Court for the District of Massachusetts. In September 2009, Morningstar and NewRiver resolved the litigation. Morningstar has agreed not to engage in the conduct that NewRiver alleges prompted it to file suit, and NewRiver has agreed to dismiss its lawsuit. The settlement does not include any payments by either party, and Morningstar maintains its denial of NewRiver’s allegations. All other settlement terms are confidential.

 

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

 

·                  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.

 

36



 

·                  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 was conducting. The Department of Labor subpoena was substantially similar in scope to the SEC subpoena.

 

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.

 

In September 2009, the Department of Labor 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 and Department of Labor subpoenas 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.

 

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.

 

37



 

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:

 

 

 

 

 

 

 

 

 

 

 

 

2009

 

2008

 

 

 

High

 

Low

 

High

 

Low

 

First Quarter

 

$

38.60

 

$

26.70

 

$

77.81

 

$

58.00

 

Second Quarter

 

45.69

 

30.37

 

76.95

 

53.67

 

Third Quarter

 

48.56

 

35.61

 

71.54

 

52.51

 

Fourth Quarter

 

54.75

 

46.00

 

61.86

 

25.78

 

 

As of February 22, 2010, the last reported price on the Nasdaq Global Select Market for our common stock was $44.33 per share and there were approximately 1,500 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. 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 February 15, 2010:

 

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
February 15,
2010

 

Projected
Beneficial
Ownership (1)

Joe Mansueto

Chairman and Chief

Executive Officer

 

08/04/09

 

12/31/10

 

1,034,050

 

Shares to be sold ratably over the course of the plan

 

106,964

 

24,740,510

Chris Boruff

President,

Advisor Software

 

08/25/09

 

05/01/10

 

15,000

 

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

 

 

144,180

Cheryl Francis

Director

 

08/11/09

 

12/17/10

 

12,000

 

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

 

4,500

 

28,354

Steve Kaplan

Director

 

08/05/09

 

05/31/10

 

725

 

Shares to be sold under the plan on a specified date

 

 

67,776

Liz Kirscher

President,

Data Services

 

11/23/09

 

12/31/10

 

25,000

 

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

 

 

107,876

Cathy Odelbo

President,

Equity Research

 

08/13/08

 

12/31/10

 

100,000

 

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

 

 

76,165

Richard Robbins

General Counsel and

Corporate Secretary

 

11/11/09

 

12/31/10

 

5,000

 

Biweekly increments of up to 500 shares

 

 

23,801

Paul Sturm

Director

 

08/28/09

 

12/31/10

 

25,000

 

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

 

4,000

 

104,438

David Williams

Managing

Director,

Design

 

09/10/08

 

12/31/10

 

20,000

 

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

 

 

84,640


(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, 2009, and includes shares of our common stock subject to options that were then exercisable or that will have become exercisable by March 1, 2010 and restricted stock units that will vest by March 1, 2010. The estimates do not reflect any changes to beneficial ownership that may have occurred since December 31, 2009. 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.

 

38



 

 

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, 2009, 2008, and 2007 and Consolidated Balance Sheet Data as of December 31, 2009 and 2008 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, 2006 and 2005 and Consolidated Balance Sheet Data as of December 31, 2007, 2006, and 2005 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)

 

2005

 

2006

 

2007

 

2008

 

2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

227,114

 

$

315,175

 

$

435,107

 

$

502,457

 

$

478,996

 

Operating expense

 

180,634

 

237,648

 

317,853

 

363,338

 

353,676

 

Operating income

 

46,480

 

77,527

 

117,254

 

139,119

 

125,320

 

Non-operating income, net

 

3,199

 

4,164

 

6,229

 

4,252

 

2,934

 

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

 

49,679

 

81,691

 

123,483

 

143,371

 

128,254

 

Income tax expense

 

20,224

 

32,975

 

51,255

 

51,763

 

47,095

 

Equity in net income of unconsolidated entities

 

1,662

 

2,787

 

1,694

 

1,321

 

1,165

 

Consolidated income before cumulative effect of accounting change

 

31,117

 

51,503

 

73,922

 

92,929

 

82,324

 

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

 

 

259

 

 

 

 

Consolidated net income

 

31,117

 

51,762

 

73,922

 

92,929

 

82,324

 

Net (income) loss attributable to noncontrolling interests

 

 

 

 

(397

)

132

 

Net income attributable to Morningstar, Inc.

 

$

31,117

 

$

51,762

 

$

73,922

 

$

92,532

 

$

82,456

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income per share attributable to Morningstar, Inc.:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.79

 

$

1.26

 

$

1.71

 

$

2.01

 

$

1.71

 

Diluted

 

$

0.70

 

$

1.11

 

$

1.53

 

$

1.88

 

$

1.66

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

39,392

 

41,176

 

43,216

 

46,139

 

48,112

 

Diluted

 

44,459

 

46,723

 

48,165

 

49,213

 

49,793

 

 

Other Consolidated Financial Data ($000)

 

2005

 

2006

 

2007

 

2008

 

2009

 

Consolidated revenue

 

$

227,114

 

$

315,175

 

$

435,107

 

$

502,457

 

$

478,996

 

Revenue from acquisitions

 

(2,443

)

(36,434

)

(44,226

)

(27,125

)

(29,590

)

Unfavorable (favorable) impact of foreign currency translations

 

(694

)

(793

)

(3,808

)

(1,850

)

8,987

 

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

 

$

223,977

 

$

277,948

 

$

387,073

 

$

473,482

 

$

458,393

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense (2):

 

 

 

 

 

 

 

 

 

 

 

Stock options (liability method)

 

$

2,810

 

$

 

$

 

$

 

$

 

Stock options (equity method)

 

8,085

 

7,169

 

6,475

 

3,710

 

1,002

 

Restricted stock units (equity method)

 

 

1,406

 

4,503

 

7,571

 

10,591

 

Total stock-based compensation expense

 

$

10,895

 

$

8,575

 

$

10,978

 

$

11,281

 

$

11,593

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash used for investing activities (3)

 

$

(16,913

)

$

(129,002

)

$

(102,838

)

$

(179,124

)

$

(174,675

)

Cash provided by financing activities (4) (8)

 

$

25,256

 

$

33,983

 

$

52,465

 

$

47,630

 

$

30,394

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

48,445

 

$

98,677

 

$

112,368

 

$

152,446

 

$

96,182

 

Capital expenditures

 

(7,451

)

(4,722

)

(11,346

)

(48,519

)

(12,372

)

Free cash flow (5)

 

$

40,994

 

$

93,955

 

$

101,022

 

$

103,927

 

$

83,810

 

 

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

 

2005

 

2006

 

2007

 

2008

 

2009

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents, and investments

 

$

153,190

 

$

163,751

 

$

258,588

 

$

297,577

 

$

342,553

 

Working capital

 

90,374

 

70,021

 

149,723

 

180,295

 

237,218

 

Total assets

 

296,311

 

447,838

 

649,307

 

803,940

 

919,583

 

Deferred revenue (6)

 

71,155

 

100,525

 

129,302

 

130,270

 

127,114

 

Long-term liabilities (7)

 

6,756

 

10,952

 

23,166

 

34,570

 

35,830

 

Total equity (7) (8)

 

173,714

 

269,423

 

408,303

 

535,929

 

676,874

 

 

39



 


(1)

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)

Prior to our initial public offering in May 2005, in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Stock-Based Compensation, 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 and as a result, all of options are accounted for under the equity method.

 

Effective January 1, 2006, we adopted SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)). 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.

 

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.

 

Refer to Note 10 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. 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, 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.

 

40



 

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 current global financial uncertainty; 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 data, software, and research 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.

 

Morningstar has two operating segments: Investment Information and Investment Management. The Investment Information segment includes all of our data, software, and research products and services. These products and services are typically sold through subscriptions or license agreements. The Investment Management segment includes our asset management operations, which operate as registered investment advisors and earn more than half of their revenue from asset-based fees. We emphasize a decentralized approach to running our business to empower our managers and to create a culture of responsibility and accountability.

 

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 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 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 websites 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

 

41



 

Advice by Ibbotson that we calculate as a percentage of assets under management. Overall, revenue tied to asset-based fees accounted for about 12% of our consolidated revenue in 2009.

 

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 $127.1 million as of December 31, 2009 and $130.3 million as of December 31, 2008. We expect to recognize this deferred revenue in future periods as we fulfill the 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. In general, our businesses have high fixed costs, and we expect our revenue to increase or decrease more quickly than our expenses. 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.

 

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 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 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. We amortize intangible assets using the straight-line method over their estimated economic useful lives, which range from one to 25 years.

 

42



 

International Operations

 

We have majority-owned operations in 19 countries outside of the United States and include these in our consolidated financial statements. We account for our minority-owned investments in Japan, Denmark, and Sweden using the equity method.

 

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 (including organic revenue);

·                  Operating income (loss); and

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

 

Organic revenue is considered a non-GAAP financial measure under Securities and Exchange Commission (SEC) regulations. We define organic revenue as consolidated revenue excluding acquisitions and foreign currency translations. We present organic revenue because we believe it helps investors better compare our period-to-period results, and our management team uses this measure to evaluate the performance of our business.

 

Free cash flow is also considered a non-GAAP financial measure. 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, 2010.

 

The Year 2009 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.

 

Following the severe market downturn in 2008, the U.S. market rebounded sharply by the end of 2009. Despite continued negative performance in the first quarter of 2009, the equity market gained 28.5% for the year as measured by Morningstar’s U.S. Market Index, a broad market index. Global markets also rallied, as did most fixed-income investments.

 

Total U.S. mutual fund assets rose to $11.1 trillion as of December 31, 2009, compared with $9.6 trillion as of December 31, 2008, based on data from the Investment Company Institute (ICI). Although aggregate cash flows to mutual funds were strong for the year, investors continued to show caution by heavily favoring fixed-income funds rather than equity funds. U.S. stock funds had negative net cash flows for the year, although less so than in 2008. Global mutual fund assets showed a similar trend, with total assets rising after 2008’s decline, but asset flows weighted toward fixed-income portfolios.

 

43



 

The downturn in 2008 also led to contraction in the number of funds. The number of mutual funds in the United States fell to about 7,700 in 2009 (excluding multiple share classes) from 8,000 in 2008, based on data from the ICI. Global mutual funds also contracted, with the number of funds totaling 66,000 as of September 30, 2009, compared with more than 69,000 as of September 30, 2008, based on ICI data.

 

Despite strong market performance in 2009, we estimate that hedge funds included in Morningstar’s database had about $55 billion in net outflows through December 31, 2009, compared with about $57 billion for the same period in 2008. However, many hedge-fund categories had positive inflows later in the year.

 

Exchange-traded funds continued to increase in popularity relative to traditional mutual funds. The U.S. ETF industry closed out 2009 with $784.9 billion in assets under management based on Morningstar’s data, up from $533.4 billion at the end of 2008.

 

Based on data from Nielsen/Net Ratings, aggregate page views and the number of unique users for financial and investment sites in 2009 both declined by about 5% to 10% compared with 2008, while the amount of time spent per visit was down more. We attribute these trends to the unusual level of market volatility in 2008, which increased investor interest in financial and investment sites in the year-ago period. Although unique users and page views for Morningstar.com also declined during 2009, the site continued to perform well based on metrics such as pages viewed per visit and time spent per visit.

 

Economic uncertainty continued to weigh on the global advertising market. Magna, a division of Interpublic Group, estimates that industry-wide revenue for online advertising was down about 3% in 2009. Although online advertising has held up better than other areas as advertisers have continued to shift spending from traditional media to the Internet, we believe that spending in the financial services area remains under pressure. Following 2009’s downturn in advertising sales, several surveys conducted by the American Marketing Association and other organizations have projected moderate increases in overall ad spending for 2010.

 

Asset managers and other financial services firms continued to consolidate in the wake of the global financial crisis. If one of our clients is acquired, we may lose business if we’re not able to continue providing services or expand our business with the combined organization.

 

The financial crisis of 2009 and 2008 caused sharp cutbacks in investment research spending by institutional clients and financial advisors, many of whom had staff layoffs or other reductions in spending. We believe individual investors also reduced discretionary spending because of the weak economic environment in 2009.

 

Despite spending pressures, we believe our clients continue to find value in our services. Some of our products allow clients to streamline the number of third-party applications they use and save money. We’ve also created a new Enterprise Data Management business that offers back-office service bureau and performance reporting operations to financial advisors. By outsourcing these services, clients can leverage our infrastructure and capabilities to offload non-core tasks and save money.

 

The global financial crisis has led to increased regulatory scrutiny of financial services around the world. In Germany and France, for example, independent financial advisors have been under pressure to provide more written evidence for their advice to clients. Hong Kong regulators recently implemented increased regulatory requirements for risk disclosure to retail clients.

 

The United Kingdom’s Retail Distribution Review (RDR), which emphasizes increased regulation of advisory fees, higher professional standards for financial advisors, and an emphasis on “whole of market” investment solutions, is scheduled to come into effect at the end of 2012. Because advisors will be obligated to give clients a choice of all investment vehicles (including funds, ETFs, and structured products) and demonstrate that they consider different investment options without bias, we believe it may increase the business need for investment information on multiple investment types, which we offer through products such as Morningstar Direct and Morningstar Advisor Workstation.

 

The Obama administration has proposed numerous financial regulatory reforms. We don’t believe the majority of these reforms would have a direct impact on our business, although they will likely impact many of our clients. Several proposed regulations may also impact investment advice and retirement plans, including additional regulations on asset custody, privacy, and other investor protection issues. We continue to monitor the potential impact of these proposed regulations on our business.

 

44



 

Overall, we remain cautious because of the difficult market environment, which persisted in the wake of the financial crisis that began in 2007. Despite the recent upturn in the U.S. equity market, we believe asset management firms and other financial services companies continue to carefully scrutinize their spending levels, creating additional pricing pressure and increasing the time required to close new business and renewals. On the positive side, however, we believe some of the uncertainty in the financial services sector began easing during 2009, with business trends improving toward the end of the year. As discussed in more detail in the Consolidated Operating Income section below, in early 2010 we began phasing in some of the benefits and other compensation-related expenses we previously reduced.

 

Performance Summary

 

The list below summarizes the key accomplishments and challenges that our management team has highlighted related to our 2009 performance:

 

Accomplishments

 

·      We completed six acquisitions, four of which were outside the United States. These acquisitions represent approximately $38 million in annual revenue. We increased our ownership interest in Morningstar Korea, making it one of our majority-owned operations. We also integrated many capabilities from previous acquisitions.

·      We continued investing in our three key web-based platforms, Morningstar.com, Morningstar Advisor Workstation, and Morningstar Direct. Licensed Data had strong renewal rates and ranks as our largest product by revenue. Morningstar Direct continued its strong growth and now ranks as our fifth-largest product by revenue.

·      We expanded our research offerings, including the launch of corporate credit ratings on 100 public companies; basic profile reports for NASDAQ-listed companies; target-date fund series ratings and research reports for 20 of the largest fund series; qualitative research and ratings for more than 830 European and Asian funds; and a Global Fund Investor Experience study across 16 countries.

·      In our Investment Management segment, we continued our work in custom target-date funds and lifetime financial advice and expanded our consulting services internationally.

·      We added database coverage of more than 75,000 securities and expanded our fundamental data on global stocks and exchange-traded funds.

·      We created a new Enterprise Data Management business that offers back-office service bureau and performance reporting operations to financial advisors.

 

Challenges

 

·      Despite an upturn in the market, revenue declined for the second time in our history, and operating income fell 10%. Many of our clients were cutting budgets, reducing staff, and experiencing the effects of industry consolidation, all of which had a direct impact on our business.

·      We had lower revenue for Investment Consulting because one client did not renew its contract in the fourth quarter of 2008 and another client did not renew its contract in May 2009.

·      The independent equity research we provided to six banks under the terms of the Global Analyst Research Settlement ended in July 2009. As a result, equity research revenue was $9.4 million lower in 2009 versus 2008.

·      Internet advertising sales were down sharply, Premium Membership subscriptions for Morningstar.com fell 15%, and revenue for Morningstar Principia was down for the year.

·      Our 2009 results include a total of $9.5 million in operating expense related to two unanticipated matters. We recorded a $6.1 million operating expense related to adjusting the tax treatment of some stock options that were originally considered incentive stock options, and we incurred $3.4 million in operating expense for penalties related to the timing of deposits for taxes withheld on stock option exercises from 2006 through 2009.

 

Consolidated Results

 

($000)

 

2009

 

2008

 

2007

 

2009 Change

 

2008 Change

 

Revenue

 

$

478,996

 

$

502,457

 

$

435,107

 

(4.7)%

 

15.5%

 

Operating income

 

125,320

 

139,119

 

117,254

 

(9.9)%

 

18.6%

 

Operating margin

 

26.2%

 

27.7%

 

26.9%

 

(1.5)pp

 

0.8pp

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash used for investing activities

 

$

(174,675

)

$

(179,124

)

$

(102,838

)

(2.5)%

 

74.2%

 

Cash provided by financing activities

 

30,394

 

47,630

 

52,465

 

(36.2)%

 

(9.2)%

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash provided by operating activities

 

$

96,182

 

$

152,446

 

$

112,368

 

(36.9)%

 

35.7%

 

Capital expenditures

 

(12,372

)

(48,519

)

(11,346

)

(74.5)%

 

327.6%

 

Free cash flow

 

$

83,810

 

$

103,927

 

$

101,022

 

(19.4)%

 

2.9%

 

 

 

 

 

 

 

 

 

 

 

 

 

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. Please refer to the discussion on page 43 for more detail.

 

Because we’ve made several acquisitions in recent years, comparing our financial results from year to year is complex. To make it easier for investors to compare our results in different periods, we provide information on both revenue from acquisitions and organic revenue, which reflects our underlying business excluding revenue from acquisitions and the impact of foreign currency translations. 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.

 

45



 

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

 

GRAPHIC

 

Consolidated Revenue

 

In 2009, our consolidated revenue decreased 4.7% to $479.0 million. We had about $29.6 million in incremental revenue from acquisitions during the year, mainly reflecting additional revenue from Tenfore Systems Limited (Tenfore), as well as 10-K Wizard Technology, LLC (10-K Wizard), the equity research and data business from C.P.M.S. (CPMS), Intech Pty Limited (Intech), Fundamental Data Limited (Fundamental Data), and others. However, this was more than offset by lower organic revenue, largely reflecting a drop in revenue from Investment Consulting as well as lower Equity Research revenue related to the Global Analyst Research Settlement. Investment Consulting revenue declined because two clients did not renew their contracts, one in October 2008 and the other in May 2009. The Global Analyst Research Settlement period expired in July 2009.

 

Our 2009 results also suffered because of the continuing effects of the severe market downturn in 2008, which put pressure on client budgets and led to consolidation among some of our clients. Our organic growth rate decelerated during 2008 because of these adverse market conditions and continued deteriorating during the first half of 2009. While our organic revenue was down for the year, we believe the trend in the second half is encouraging. Our organic revenue fell 10.2% in the third quarter of 2009, but only 6.6% in the fourth quarter.

 

46



 

GRAPHIC

 

Our consolidated revenue increased 15.5% to $502.5 million in 2008, reflecting positive organic growth for the year as well as new revenue from acquisitions, with the majority driven by the Hemscott businesses we acquired in January 2008. Acquired operations contributed $27.1 million of revenue and represented 6 percentage points of our consolidated revenue growth in 2008.

 

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

 

2009 vs. 2008 ($000)

 

2009

 

2008

 

Change

 

Consolidated revenue

 

$

478,996

 

$

502,457

 

(4.7)%

 

Revenue from acquisitions

 

(29,590

)

 

NMF

 

Unfavorable impact of foreign currency translations

 

8,987

 

 

NMF

 

Organic revenue

 

$

458,393

 

$

502,457

 

(8.8)%

 

 

2008 vs. 2007 ($000)

 

2008

 

2007

 

Change

 

Consolidated revenue

 

$

502,457

 

$

435,107

 

15.5%

 

Revenue from acquisitions

 

(27,125

)

 

NMF

 

Favorable 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%

 

Revenue from acquisitions

 

(44,226

)

 

NMF

 

Favorable impact of foreign currency translations

 

(3,808

)

 

NMF

 

Organic revenue

 

$

387,073

 

$

315,175

 

22.8%

 

 

While organic revenue and acquisitions had the most significant impact on revenue in 2009 and 2008, 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. As a result, foreign currency translations reduced revenue by nearly $9.0 million in 2009.

 

GRAPHIC

 

Revenue for our Investment Information segment, which accounts for about 81% of company-wide revenue, declined by 1% in 2009, as the lower revenue across various product lines was partially offset by revenue from acquisitions. Acquisitions contributed $25.9 million to segment revenue in 2009.

 

Investment Management segment revenue was down 17.4% in 2009, driven by the two Investment Consulting non-renewals mentioned above. Combined, these contracts represented about $17 million of revenue in 2008. Acquisitions contributed $3.7 million to segment revenue in 2009.

 

In 2008, Investment Information segment revenue rose 19.3%. Acquisitions contributed $27.1 million to segment revenue for the year. Software products, including Morningstar Advisor Workstation and Morningstar Direct, were the largest drivers behind the revenue increase. Licensed Data was another significant contributor to revenue growth, and investment research revenue also rose for the year.

 

Investment Management segment revenue rose 3.7% in 2008. Total assets under advisement for Investment Consulting declined approximately 32%, partly driven by the market downturn as well as the impact of one client not renewing its contract. New client wins for Ibbotson Associates partly offset the impact of these factors.

 

 

 

 

GRAPHIC

 

Revenue from international operations increased as a percentage of total revenue in 2009 and 2008. Our non-U.S. revenue increased to 27.0% of consolidated revenue in 2009, compared with 24.2% in 2008 and 20.6% in 2007. Several of our recent acquisitions have extensive operations outside the United States. The majority of our international revenue is from Europe, Australia, and Canada. Acquisitions contributed $23.4 million to international revenue in 2009 and $19.4 million in 2008.

 

47



 

Foreign currency translations reduced revenue by approximately $9.0 million in 2009, reversing the trend from 2008, when foreign currency translations had a positive impact of $1.9 million. Excluding acquisitions and the impact of foreign currency translations, our non-U.S. revenue declined 5.5% in 2009 and increased 11.7% in 2008.

 

GRAPHIC

 

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:

 

2009 vs. 2008 ($000)

 

2009

 

2008

 

Change

 

International revenue

 

$

129,160

 

$

121,436

 

6.4%

 

Revenue from acquisitions

 

(23,371

)

 

NMF

 

Unfavorable impact of foreign currency translations

 

8,987

 

 

NMF

 

International organic revenue

 

$

114,776

 

$

121,436

 

(5.5)%

 

 

2008 vs. 2007 ($000)

 

2008

 

2007

 

Change

 

International revenue

 

$

121,436

 

$

89,680

 

35.4%

 

Revenue from acquisitions

 

(19,426

)

 

NMF

 

Favorable 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%

 

Revenue from acquisitions

 

(31,690

)

 

NMF

 

Favorable impact of foreign currency translations

 

(3,808

)

 

NMF

 

International organic revenue

 

$

54,182

 

$

44,276

 

22.4%

 

 

Our five largest products based on revenue—Licensed Data, Investment Consulting, Morningstar Advisor Workstation, Morningstar.com, and Morningstar Direct—made up about 61% of consolidated revenue in 2009. 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. Licensed Data became our largest product in 2008 and continued increasing as a percentage of revenue in 2009, partly because of incremental revenue from Tenfore, 10-K Wizard, and Fundamental Data. Investment Consulting moved down to become the third-largest product in 2009, while Morningstar Direct moved up to become the fifth-largest product because of continued license growth.

 

In 2009, as a part of the changes to our organizational structure with a focus on our global product lines, we no longer include Morningstar Site Builder as part of Morningstar Advisor Workstation. Site Builder consists of a set of integrated tools, content, and reports that investment firms can seamlessly add to their existing advisor websites. In addition, we’re continuing to globalize the Premium subscriptions and advertising revenue generated by Morningstar.com websites, which operate in a variety of markets. As a result, we now include advertising revenue for all non-U.S. sites as part of Morningstar.com and have reclassified prior-year product revenue for consistency with current-year presentation. These reclassifications did not have any impact on the order of our top five products in 2008 or 2007.

 

48



 

Top Five Products (Segment) 2009

 

Revenue
($000)

 

% of
Consolidated
Revenue

 

Licensed Data (Investment Information)

 

$

91,524

 

19.1%

 

Morningstar Advisor Workstation (Investment Information)

 

65,673

 

13.7%

 

Investment Consulting (Investment Management)

 

63,748

 

13.3%

 

Morningstar.com (Investment Information)

 

39,454

 

8.2%

 

Morningstar Direct (Investment Information)

 

29,968

 

6.3%

 

 

Top Five Products (Segment) 2008

 

Revenue
($000)

 

% of
Consolidated
Revenue

 

Licensed Data (Investment Information)

 

$

78,329

 

15.6%

 

Investment Consulting (Investment Management)

 

77,757

 

15.5%

 

Morningstar Advisor Workstation (Investment Information)

 

64,222

 

12.8%

 

Morningstar.com (Investment Information)

 

45,684

 

9.1%

 

Principia (Investment Information)

 

27,791

 

5.5%

 

 

Top Five Products (Segment) 2007

 

Revenue
($000)

 

% of
Consolidated
Revenue

 

Investment Consulting (Investment Management)

 

$

75,595

 

17.4%

 

Licensed Data (Investment Information)

 

59,207

 

13.6%

 

Morningstar Advisor Workstation (Investment Information)

 

53,755

 

12.4%

 

Morningstar.com (Investment Information)

 

39,367

 

9.0%

 

Principia (Investment Information)

 

28,760

 

6.6%

 

 

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 five years:

 

GRAPHIC

 

In 2009, we estimate that our retention rate for subscription-based products, such as Principia, Morningstar.com Premium Membership service, and print and online newsletters, was on the higher end of the range between 55% and 60%, down from 60% to 65% in 2008. For contract-based products and services, we estimate that our weighted average renewal rate was on the low end of the range between 80% and 85% and was down about 9.5 percentage points from our renewal rate in 2008. The decline in renewal rates in 2009 was largely driven by the end of the Global Analyst Research Settlement period. Excluding this factor, the 2009 renewal rate declined about 3 percentage points from 2008. This decline reflects lower renewal rates for several product lines, including Investment Consulting, institutional software, and advisor software. Many of our clients were cutting budgets, reducing staff, and experiencing the effects of industry consolidation during 2009. 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.

 

Consolidated Operating Expense

 

($000)

 

2009

 

2008

 

2007

 

Operating expense

 

$

353,676

 

$

363,338

 

$

317,853

 

% change

 

(2.7)%

 

14.3%

 

33.7%

 

 

 

 

 

 

 

 

 

% of revenue

 

73.8%

 

72.3%

 

73.1%

 

Change

 

1.5pp

 

(0.8)pp

 

(2.3)pp

 

 

Our consolidated operating expense decreased $9.6 million, or 2.7%, in 2009. To better align operating expense with revenue in a challenging business environment, we took a number of steps to reduce costs beginning in 2008, with the largest cutbacks effective January 1, 2009. We changed our bonus plan in 2009 to reduce bonus expense, our single largest discretionary cost. As a result, bonus expense was down about $28.9 million in 2009. The significant reduction in bonus expense also reflects a slowdown in our financial performance in 2009 compared with 2008.

 

49



 

We also suspended matching contributions to our 401(k) program in the United States, which reduced operating expense by about $6.6 million. In addition, we reduced discretionary spending in travel, advertising, and marketing. Travel costs were about $4.5 million lower in 2009. Advertising and marketing costs declined by $4.3 million in 2009. We’ve been carefully evaluating spending in this area and cutting back on programs with lower returns. In addition, we discontinued three publications previously published, which contributed to lower marketing expense in 2009.

 

The positive impact of these cost reductions was partially offset by incremental costs from acquisitions. We completed six acquisitions in 2009 and six in 2008. Because of the timing of these acquisitions, our 2009 results include operating expense that did not exist in 2008. Headcount and salary expense increased year over year, partly because of incremental employees added through acquisitions. We had approximately 2,605 employees worldwide as of December 31, 2009, a 9.7% increase, from 2,375 employees as of December 31, 2008. We added approximately 170 employees through acquisitions over the 12 months ending December 31, 2009. The remainder of the increase in headcount reflects continued hiring for our development center in China.

 

The cost reductions were further offset by a total of $9.5 million of operating expense for two separate matters. First, we recorded a $6.1 million operating expense related to adjusting the tax treatment of certain stock options that were originally considered incentive stock options (ISOs). In 1998, 1999, and 2000, we granted ISOs to many employees. Upon exercise, ISOs typically have a favorable tax treatment for the employee relative to the tax treatment for non-qualified stock options (NQSOs). In 2009, we determined that certain ISOs granted to one former and two current executives should have been treated as NQSOs for the executives’ and our income tax purposes. As a result, Morningstar will pay these individuals a total of $4.9 million to compensate for the difference in tax treatment. We also recorded $1.2 million, primarily for potential penalties related to this matter. This $6.1 million expense is included in our operating expenses as a general and administrative expense.

 

Second, we recorded an operating expense of $3.4 million for penalties related to the timing of deposits for taxes withheld on stock option exercises. The expense impacted each of our operating expense categories, with approximately half recorded as general and administrative expense. For some companies, including Morningstar, it is common practice for taxes withheld on stock-based compensation to be paid with the company’s regularly scheduled payroll deposit. This approach, however, does not technically comply with Internal Revenue Service (IRS) guidelines concerning deposits of taxes withheld in connection with stock-based compensation, which generally require that if a company’s cumulative deposit liability for all compensation exceeds $100,000, the tax withholding must be deposited by the following business day. Transactions related to stock-based compensation frequently cause companies to exceed this threshold outside of their regularly scheduled payroll cycles, thus triggering the accelerated deposit rules. The subject of tax deposit penalties was part of an IRS audit that began in 2009 and concluded in early 2010. We have concluded the matter with the IRS and have increased the frequency of deposits for taxes withheld on stock option exercises.

 

Our operating expense in 2009 also includes additional rent expense of $2.7 million to increase a liability related to vacant office space, primarily for the former Ibbotson headquarters. We increased the liability because we anticipate receiving lower sublease income and expect it will take more time than previously estimated to identify a tenant.

 

Despite significant reductions to bonus expense, operating expense as a percentage of revenue increased 1.5 percentage points in 2009, mainly driven by the $9.5 million of incremental operating expenses described above and other expense increases.

 

In 2008, our consolidated operating expense increased $45.4 million, or 14.3%. 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 these increases. 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.

 

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.

 

50



 

Cost of Goods Sold

 

($000)

 

2009

 

2008

 

2007

 

Cost of goods sold

 

$

128,616

 

$

130,085

 

$

113,777

 

% change

 

(1.1)%

 

14.3%

 

30.8%

 

 

 

 

 

 

 

 

 

% of revenue

 

26.9%

 

25.9%

 

26.1%

 

Change

 

1.0pp

 

(0.2)pp

 

(1.5)pp

 

 

 

 

 

 

 

 

 

Gross profit

 

$

350,380

 

$

372,372

 

$

321,330

 

% change

 

(5.9)%

 

15.9%

 

40.8%

 

 

 

 

 

 

 

 

 

Gross margin

 

73.1%

 

74.1%

 

73.9%

 

Change

 

(1.0)pp

 

0.2pp

 

1.5pp

 

 

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 decreased $1.5 million in 2009, with the majority of the decline driven by lower bonus expense and lower fulfillment expense, partially offset by incremental costs from acquisitions.

 

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.

 

Gross margin declined by about one percentage point in 2009, reversing the trend in the two previous years.

 

Development Expense

 

($000)

 

2009

 

2008

 

2007

 

Development expense

 

$

38,378

 

$

40,340

 

$

35,116

 

% change

 

(4.9)%

 

14.9%

 

19.1%

 

 

 

 

 

 

 

 

 

% of revenue

 

8.0%

 

8.0%

 

8.1%

 

Change

 

 

(0.1)pp

 

(1.3)pp

 

 

Development expense decreased $1.9 million in 2009, mainly because of lower bonus expense, which was partially offset by incremental compensation costs from acquisitions. Development expense as a percentage of revenue in 2009 was consistent with 2008 and 2007.

 

Sales and Marketing Expense

 

($000)

 

2009

 

2008

 

2007

 

Sales and marketing expense

 

$

71,772

 

$

81,651

 

$

68,835

 

% change

 

(12.1)%

 

18.6%

 

36.0%

 

 

 

 

 

 

 

 

 

% of revenue

 

15.0%

 

16.3%

 

15.8%

 

Change

 

(1.3)pp

 

0.5pp

 

(0.3)pp

 

 

Sales and marketing expense decreased $9.9 million in 2009. Lower bonus expense and advertising and marketing were the two largest factors driving this change, with each contributing about 40% of the decline. We reduced advertising and marketing from higher levels in 2008 because of the challenging business environment. In 2009, we also discontinued three of the publications we previously published in the first quarter of each year—Morningstar Funds 500, Morningstar Stocks 500, and Morningstar ETFs 150—and therefore didn’t incur costs to promote these publications. Reduced spending on travel, training, and conferences also contributed to the decrease, but to a lesser extent.

 

51



 

Sales and marketing expense increased $12.9 million in 2008. Higher compensation expense, including sales commissions, was the main contributor to the change. 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 decreased about 1 percentage point in 2009, following a slight increase in 2008.

 

General and Administrative Expense

 

($000)

 

2009

 

2008

 

2007

 

General and administrative expense

 

$

82,949

 

$

85,266

 

$

78,868

 

% change

 

(2.7)%

 

8.1%

 

41.9%

 

 

 

 

 

 

 

 

 

% of revenue

 

17.3%

 

17.0%

 

18.1%

 

Change

 

0.3pp

 

(1.1)pp

 

0.5pp

 

 

General and administrative (G&A) expense decreased $2.3 million in 2009. Most of the decline reflects lower bonus expense included in this category. Decreases in travel, training, and conferences also contributed to lower expense in this area, but to a lesser extent.

 

These cost reductions were partially offset by the $6.1 million operating expense related to adjusting the tax treatment of certain stock options originally considered incentive stock options as well as an operating expense for the deposit penalty, which contributed $1.8 million to general and administrative expense in 2009. We discuss both of these matters in more detail in the Consolidated Operating Expense section, on page 50.

 

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 Chicago headquarters as well as for the office space we occupied until December 2008. Compensation expense also increased, but was offset by the favorable impact of lower bonus expense. 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 increased 0.3 percentage points in 2009.

 

Depreciation and Amortization Expense

 

($000)

 

2009

 

2008

 

2007

 

Depreciation expense

 

$

12,998

 

$

9,348

 

$

8,488

 

Amortization expense

 

18,963

 

16,648

 

12,769

 

Total depreciation and amortization expense

 

$

31,961

 

$

25,996

 

$

21,257

 

% change

 

22.9%

 

22.3%

 

41.9%

 

 

 

 

 

 

 

 

 

% of revenue

 

6.7%

 

5.2%

 

4.9%

 

Change

 

1.5pp

 

0.3pp

 

0.1pp

 

 

Deprecation expense rose $3.7 million in 2009, primarily from higher depreciation expense associated with our new corporate headquarters. Amortization expense increased $2.3 million in 2009 and $3.8 million in 2008, reflecting amortization of intangible assets related to acquisitions.

 

As a percentage of revenue, depreciation and amortization increased 1.5 percentage points in 2009.

 

We expect that amortization of intangible assets will be an ongoing cost for the remaining life of the assets. Based on acquisitions completed through December 31, 2009, we estimate that aggregate amortization expense for intangible assets will be $23.4 million in 2010. Our estimates of future amortization expense for intangible assets may be affected by changes to the preliminary purchase price allocations associated with our 2009 acquisitions.

 

52



 

Stock-Based Compensation Expense

 

Stock-based compensation expense is included in each of our operating expense categories, as shown below:

 

($000)

 

2009

 

2008

 

2007

 

Cost of goods sold

 

$

2,666

 

$

2,058

 

$

1,706

 

Development

 

1,570

 

1,402

 

1,256

 

Sales and marketing

 

1,587

 

1,449

 

1,397

 

General and administrative

 

5,770

 

6,372

 

6,619

 

Stock-based compensation expense

 

$

11,593

 

$

11,281

 

$

10,978

 

% change

 

2.8%

 

2.8%

 

28.0%

 

 

 

 

 

 

 

 

 

% of revenue

 

2.4%

 

2.2%

 

2.5%

 

Change

 

0.2pp

 

(0.3)pp

 

(0.2)pp

 

 

Our stock based compensation expense mainly relates to grants of restricted stock units, and to a lesser extent, to stock options granted in previous years:

 

($000)

 

2009

 

2008

 

2007

 

Restricted stock units

 

$

10,591

 

$

7,571

 

$

4,503

 

Stock options

 

1,002

 

3,710

 

6,475

 

Stock-based compensation expense

 

$

11,593

 

$

11,281

 

$

10,978

 

 

We began granting restricted stock units (RSUs) in May 2006 and made additional grants in 2007, 2008, and 2009, typically in the second quarter of each year. We recognize the expense related to RSUs over the vesting period, which is generally four years. We estimate forfeitures of all stock-based awards and typically adjust the estimated forfeitures to actual forfeiture experience in the second quarter, which is when most of our larger equity grants typically vest. In the second quarters of 2009, 2008, and 2007, we recorded approximately $0.2 million, $0.2 million, and $0.8 million, respectively, of additional stock-based compensation expense as a result of these adjustments.

 

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 2009 and 2008, a small grant in 2007, and that stock options granted prior to 2007 were fully expensed by 2009.

 

As discussed above, in 2009 we adjusted the tax treatment of certain stock options that were originally considered incentive stock options. This change did not impact the amount of stock-based compensation expense we recorded related to these stock options.

 

Based on grants made through December 31, 2009, we anticipate that stock-based compensation expense will be $10.3 million in 2010. This amount is subject to change based on additional equity grants or changes in our estimated forfeiture rate related to these grants.

 

Bonus Expense

 

($000)

 

2009

 

2008

 

2007

 

Bonus expense

 

$

21,019

 

$

49,912

 

$

52,014

 

% change

 

(57.9)%

 

(4.0)%

 

35.7%

 

 

 

 

 

 

 

 

 

% of revenue

 

4.4%

 

9.9%

 

12.0%

 

Change

 

(5.5)pp

 

(2.1)pp

 

(0.2)pp

 

 

Bonus expense, which we include in each of our operating expense categories, declined $28.9 million in 2009. This reduction reflects changes we made to our bonus program for 2009 as part of our efforts to better align our cost structure with revenue in the challenging business environment. The significant reduction in bonus expense also reflects a slowdown in our financial performance in 2009 compared with 2008. Overall, bonus expense as a percentage of revenue declined about 5.5 percentage points in 2009.

 

In 2008, bonus expense declined about $2.1 million, or 4.0%. Bonus expense declined to 9.9% of revenue in 2008, compared with 12.0% in 2007, reflecting the lower operating income growth in 2008 compared with 2007.

 

53



 

The amount of bonus expense is not a fixed cost. Instead, the size of the bonus pool varies each year based on a number of items, including changes in full-year operating income relative to the previous year and other factors. We review and update our estimates and the bonus pool size quarterly. We record bonus expense throughout the year and pay out annual bonuses to employees in the first quarter of the following year.