MORN_10Q_06.30.2014

Table of Contents

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
 

FORM 10-Q
 
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED June 30, 2014
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from         to
Commission File Number: 000-51280
 

MORNINGSTAR, INC.
(Exact Name of Registrant as Specified in its Charter) 
Illinois
 
36-3297908
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification Number)
 
 
 
22 West Washington Street
 
 
Chicago, Illinois
 
60602
(Address of Principal Executive Offices)
 
(Zip Code)
  (312) 696-6000
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant 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 x No o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer   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
As of July 25, 2014 there were 44,721,637 shares of the Company’s common stock, no par value, outstanding.
 



Table of Contents

MORNINGSTAR, INC. AND SUBSIDIARIES
INDEX
 
 
 
 
 
 
 
 
 
 
 
 
 
Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2014 and 2013
 
 
 
 
 
 
 
 
Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2014 and 2013
 
 
 
 
 
 
 
 
Unaudited Condensed Consolidated Balance Sheets as of June 30, 2014 and December 31, 2013
 
 
 
 
 
 
 
 
Unaudited Condensed Consolidated Statement of Equity for the six months ended June 30, 2014
 
 
 
 
 
 
 
 
Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


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Table of Contents

PART 1.
FINANCIAL INFORMATION
Item 1.
Financial Statements

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Table of Contents

Morningstar, Inc. and Subsidiaries
Unaudited Condensed Consolidated Statements of Operations
 
 
Three months ended June 30
 
Six months ended June 30
(in thousands except per share amounts)
 
2014

 
2013

 
2014

 
2013

 
 
 
 
 
 
 
 
 
Revenue
 
$
189,385

 
$
175,428

 
$
370,550

 
$
344,284

 
 
 
 
 
 
 
 
 
Operating expense (1):
 
 
 
 
 
 
 
 
Cost of revenue
 
81,387

 
64,427

 
157,101

 
126,077

Sales and marketing
 
27,949

 
28,035

 
56,377

 
56,015

General and administrative
 
30,438

 
28,120

 
56,542

 
55,447

Depreciation and amortization
 
13,391

 
11,262

 
25,778

 
22,601

Litigation settlement (2)
 
61,000

 

 
61,000

 

Total operating expense
 
214,165

 
131,844

 
356,798

 
260,140

 
 
 
 
 
 
 
 
 
Operating income (loss)
 
(24,780
)
 
43,584

 
13,752

 
84,144

 
 
 
 
 
 
 
 
 
Non-operating income:
 
 

 
 

 
 
 
 
Interest income, net
 
634

 
664

 
1,219

 
1,405

Gain on sale of investments, reclassified from other comprehensive income
 
371

 
423

 
347

 
1,148

Holding gain upon acquisition of additional ownership of equity and cost method investments
 
5,168

 
3,713

 
5,168

 
3,713

Other income (expense), net
 
(275
)
 
(1,689
)
 
29

 
(2,210
)
Non-operating income, net
 
5,898

 
3,111

 
6,763

 
4,056

 
 
 
 
 
 
 
 
 
Income (loss) before income taxes and equity in net income of unconsolidated entities
 
(18,882
)
 
46,695

 
20,515

 
88,200

 
 
 
 
 
 
 
 
 
Equity in net income of unconsolidated entities
 
497

 
360

 
1,096

 
857

 
 
 
 
 
 
 
 
 
Income tax expense (benefit)
 
(8,611
)
 
15,955

 
5,039

 
28,382

 
 
 
 
 
 
 
 
 
Consolidated net income (loss)
 
(9,774
)
 
31,100

 
16,572

 
60,675

 
 
 
 
 
 
 
 
 
Net loss attributable to the noncontrolling interest
 
5

 
21

 
35

 
64

 
 
 
 
 
 
 
 
 
Net income (loss) attributable to Morningstar, Inc.
 
$
(9,769
)
 
$
31,121

 
$
16,607

 
$
60,739

 
 
 
 
 
 
 
 
 
Net income (loss) per share attributable to Morningstar, Inc.:
 
 

 
 

 
 
 
 
Basic
 
$
(0.22
)
 
$
0.67

 
$
0.37

 
$
1.31

Diluted
 
$
(0.22
)
 
$
0.66

 
$
0.37

 
$
1.30

 
 
 
 
 
 
 
 
 
Dividends per common share:
 
 
 
 
 
 
 
 
Dividends declared per common share
 
$
0.17

 
$
0.13

 
$
0.34

 
$
0.25

Dividends paid per common share
 
$
0.17

 
$
0.13

 
$
0.34

 
$
0.13

 
 
 
 
 
 
 
 
 
Weighted average shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
44,777

 
46,400

 
44,778

 
46,403

Diluted
 
44,777

 
46,853

 
45,039

 
46,756

 
 
 
 
 
 
 
 
 
 
 
Three months ended June 30
 
Six months ended June 30
 
 
2014

 
2013

 
2014

 
2013

(1) Includes stock-based compensation expense of:
 
 

 
 

 
 
 
 
Cost of revenue
 
$
1,890

 
$
1,691

 
$
3,652

 
$
3,392

Sales and marketing
 
530

 
522

 
1,027

 
1,034

General and administrative
 
1,943

 
1,741

 
3,623

 
3,311

Total stock-based compensation expense
 
$
4,363

 
$
3,954

 
$
8,302

 
$
7,737


(2) See Note 11, Contingencies, for additional information.
 
See notes to unaudited condensed consolidated financial statements.


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Table of Contents

Morningstar, Inc. and Subsidiaries
Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)

 
 
Three months ended June 30
 
Six months ended June 30
(in thousands) 
 
2014

 
2013

 
2014

 
2013

 
 
 
 
 
 
 
 
 
Consolidated net income (loss)
 
$
(9,774
)
 
$
31,100

 
$
16,572

 
$
60,675

 
 
 
 
 
 
 
 
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
 
Foreign currency translation adjustment
 
2,861

 
(7,128
)
 
5,333

 
(16,199
)
Unrealized gains on securities, net of tax:
 
 
 
 
 
 
 
 
  Unrealized holding gains (losses) arising during period
 
280

 
(166
)
 
396

 
1,000

  Reclassification of gains included in net income
 
(233
)
 
(271
)
 
(218
)
 
(734
)
Other comprehensive income (loss)
 
2,908

 
(7,565
)
 
5,511

 
(15,933
)
 
 
 
 
 
 
 
 
 
Comprehensive income (loss)
 
(6,866
)
 
23,535

 
22,083

 
44,742

Comprehensive loss attributable to noncontrolling interest
 
10

 
64

 
15

 
206

Comprehensive income (loss) attributable to Morningstar, Inc.
 
$
(6,856
)
 
$
23,599

 
$
22,098

 
$
44,948


See notes to unaudited condensed consolidated financial statements.



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Table of Contents

Morningstar, Inc. and Subsidiaries
Unaudited Condensed Consolidated Balance Sheets
 
 
As of June 30
 
As of December 31
(in thousands except share amounts)
 
2014

 
2013

Assets
 
 

 
 

Current assets:
 
 

 
 

Cash and cash equivalents
 
$
176,254

 
$
168,160

Investments
 
44,696

 
130,407

Accounts receivable, less allowance of $762 and $1,089, respectively
 
135,017

 
114,131

Deferred tax asset, net
 
6,437

 
3,892

Income tax receivable, net
 
18,616

 
3,942

Other current assets
 
21,565

 
26,361

Total current assets
 
402,585

 
446,893

Property, equipment, and capitalized software, less accumulated depreciation and amortization of $119,859 and $106,166, respectively
 
109,900

 
104,986

Investments in unconsolidated entities
 
30,287

 
38,714

Goodwill
 
388,837

 
326,450

Intangible assets, net
 
111,779

 
103,909

Other assets
 
7,835

 
9,716

Total assets
 
$
1,051,223

 
$
1,030,668

 
 
 
 
 
Liabilities and equity
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable and accrued liabilities
 
$
97,251

 
$
42,131

Accrued compensation
 
58,409

 
71,403

Deferred revenue
 
161,921

 
149,225

Other current liabilities
 
4,607

 
6,786

Total current liabilities
 
322,188

 
269,545

Accrued compensation
 
7,512

 
8,193

Deferred tax liability, net
 
19,183

 
23,755

Deferred rent
 
23,158

 
23,938

Other long-term liabilities
 
10,520

 
13,947

Total liabilities
 
382,561

 
339,378

 
 
 
 
 
Equity:
 
 

 
 

Morningstar, Inc. shareholders’ equity:
 
 

 
 

Common stock, no par value, 200,000,000 shares authorized, of which 44,715,637 and 44,967,423 shares were outstanding as of June 30, 2014 and December 31, 2013, respectively
 
5

 
5

Treasury stock at cost, 7,676,092 shares as of June 30, 2014 and 7,202,896 shares as of December 31, 2013
 
(484,560
)
 
(449,054
)
Additional paid-in capital
 
545,624

 
539,507

Retained earnings
 
595,911

 
594,626

Accumulated other comprehensive income:
 
 
 
 
    Currency translation adjustment
 
9,922

 
4,609

    Unrealized gain on available-for-sale investments
 
742

 
564

Total accumulated other comprehensive income
 
10,664

 
5,173

Total Morningstar, Inc. shareholders’ equity
 
667,644

 
690,257

Noncontrolling interests
 
1,018

 
1,033

Total equity
 
668,662

 
691,290

Total liabilities and equity
 
$
1,051,223

 
$
1,030,668

 See notes to unaudited condensed consolidated financial statements.

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Table of Contents

Morningstar, Inc. and Subsidiaries
Unaudited Condensed Consolidated Statement of Equity
For the six months ended June 30, 2014
 
 
 
Morningstar, Inc. Shareholders’ Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Accumulated
Other
Comprehensive
Income
(Loss)

 
 
 
 
 
 
Common Stock
 
 

 
Additional
Paid-in
Capital

 
 
 
 
Non
Controlling
Interests

 
 
(in thousands, except share amounts)
 
Shares
Outstanding

 
Par
Value

 
Treasury
Stock

 
 
Retained
Earnings

 
 
 
Total
Equity

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance as of December 31, 2013
 
44,967,423

 
$
5

 
$
(449,054
)
 
$
539,507

 
$
594,626

 
$
5,173

 
$
1,033

 
$
691,290

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
 
 

 

 

 
16,607

 

 
(35
)
 
16,572

Other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Unrealized gain on available-for-sale investments, net of income tax of $219
 
 
 

 

 

 

 
396

 

 
396

Reclassification of adjustments for gains included in net income, net of income tax of $129
 
 
 

 

 

 

 
(218
)
 

 
(218
)
Foreign currency translation adjustment, net
 
 
 

 

 

 

 
5,313

 
20

 
5,333

Other comprehensive income, net
 
 
 

 

 

 

 
5,491

 
20

 
5,511

Issuance of common stock related to stock-option exercises and vesting of restricted stock units, net
 
238,015

 

 
1,214

 
(4,145
)
 

 

 

 
(2,931
)
Stock-based compensation
 
 
 

 

 
8,302

 

 

 

 
8,302

Excess tax benefit derived from stock-option exercises and vesting of restricted stock units
 
 
 

 

 
1,913

 

 

 

 
1,913

Common shares repurchased
 
(489,801
)
 

 
(36,720
)
 

 

 

 

 
(36,720
)
Dividends declared — common shares outstanding
 
 
 

 

 

 
(15,211
)
 

 

 
(15,211
)
Dividends declared — restricted stock units
 
 
 

 

 
47

 
(111
)
 

 

 
(64
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance as of June 30, 2014
 
44,715,637

 
$
5

 
$
(484,560
)
 
$
545,624

 
$
595,911

 
$
10,664

 
$
1,018

 
$
668,662

 
See notes to unaudited condensed consolidated financial statements.


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Table of Contents

Morningstar, Inc. and Subsidiaries
Unaudited Condensed Consolidated Statements of Cash Flows
 
 
Six months ended June 30
(in thousands)
 
2014

 
2013

 
 
 
 
 
Operating activities
 
 

 
 

Consolidated net income
 
$
16,572

 
$
60,675

Adjustments to reconcile consolidated net income to net cash flows from operating activities:
 
 
 
 
Depreciation and amortization
 
25,778

 
22,601

Deferred income taxes
 
(2,638
)
 
(38
)
Stock-based compensation expense
 
8,302

 
7,737

Provision for bad debts
 
(326
)
 
461

Equity in net income of unconsolidated entities
 
(1,096
)
 
(857
)
Excess tax benefits from stock-option exercises and vesting of restricted stock units
 
(1,913
)
 
(3,842
)
Holding gain upon acquisition of additional ownership of equity method investments
 
(5,168
)
 
(3,713
)
Other, net
 
(703
)
 
688

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


 


Accounts receivable
 
(19,340
)
 
524

Other assets
 
163

 
(3,465
)
Accounts payable and accrued liabilities
 
61,196

 
638

Accrued compensation
 
(8,687
)
 
(19,581
)
Income taxes—current
 
(12,169
)
 
13,693

Deferred revenue
 
8,802

 
11,023

Deferred rent
 
(996
)
 
(872
)
Other liabilities
 
(1,089
)
 
(537
)
Cash provided by operating activities
 
66,688

 
85,135

 
 
 
 
 
Investing activities
 
 

 
 

Purchases of investments
 
(7,715
)
 
(82,299
)
Proceeds from maturities and sales of investments
 
95,499

 
96,128

Capital expenditures
 
(30,799
)
 
(18,881
)
Acquisitions, net of cash acquired
 
(64,447
)
 
(11,125
)
Proceeds from sale of a business
 

 
957

Purchases of equity- and cost-method investments
 

 
(909
)
Other, net
 
259

 
436

Cash used for investing activities
 
(7,203
)
 
(15,693
)
 
 
 
 
 
Financing activities
 
 

 
 

Proceeds from stock-option exercises
 
2,072

 
2,810

Employee taxes withheld for restricted stock units
 
(5,003
)
 
(5,157
)
Excess tax benefits from stock-option exercises and vesting of restricted stock units
 
1,913

 
3,842

Common shares repurchased
 
(36,720
)
 
(53,937
)
Dividends paid
 
(15,309
)
 
(5,889
)
Other, net
 
14

 
(50
)
Cash used for financing activities
 
(53,033
)
 
(58,381
)
 
 
 
 
 
Effect of exchange rate changes on cash and cash equivalents
 
1,642

 
(5,140
)
Net increase in cash and cash equivalents
 
8,094

 
5,921

Cash and cash equivalents—beginning of period
 
168,160

 
163,889

Cash and cash equivalents—end of period
 
$
176,254

 
$
169,810

 
 
 
 
 
Supplemental disclosure of cash flow information:
 
 

 
 

Cash paid for income taxes
 
$
19,891

 
$
14,511

Supplemental information of non-cash investing and financing activities:
 
 
 
 
Unrealized gain on available-for-sale investments
 
$
270

 
$
418

Equipment obtained under long-term financing arrangement
 
$

 
$
4,860

 
See notes to unaudited condensed consolidated financial statements.

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Table of Contents

MORNINGSTAR, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
1. Basis of Presentation of Interim Financial Information
 
The accompanying condensed consolidated financial statements of Morningstar, Inc. and subsidiaries (Morningstar, we, our, the Company) have been prepared to conform to the rules and regulations of the Securities and Exchange Commission (SEC). The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue, and expenses. Actual results could differ from those estimates. In the opinion of management, the statements reflect all adjustments, which are of a normal recurring nature, necessary to present fairly our financial position, results of operations, equity, and cash flows. These financial statements and notes are unaudited and should be read in conjunction with our Audited Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on February 28, 2014.

Certain prior period amounts have been reclassified to conform to our current period's presentation. We now include development expense in the cost of revenue category. We have reclassified development expense to include it in cost of revenue for all periods presented. We previously reported development expense as a separate operating expense category.

Separately, as a result of our recent reorganization (including new positions created, changes in focus for some existing roles, and the refinement of employee cost categorizations as we moved to a more centralized structure), approximately 180 net positions shifted from the general and administrative and sales and marketing categories to cost of revenue. For the first six months of 2014 as compared with the same period in 2013, changes related to our more centralized organizational structure added $14 million of compensation expense to cost of revenue, and reduced the compensation expense in our sales and marketing and general and administrative expense categories by $8 million and $6 million, respectively. These changes did not affect our total operating expense or operating income for any of the periods presented.

The acronyms that appear in the Notes to our Unaudited Condensed Consolidated Financial Statements refer to the following:
 
ASC: Accounting Standards Codification
ASU: Accounting Standards Update
FASB: Financial Accounting Standards Board
 
2. Correction

In 2014, we identified and corrected an immaterial classification error related to the current and long-term balance for deferred rent included on our Consolidated Balance Sheets as of December 31, 2013. The correcting entries had the effect of decreasing accounts payable and accrued liabilities by $10.7 million and increasing deferred rent (long-term) by the same amount. The financial statements have been corrected to reduce the current balance and increase the long-term balance as shown in the table below:
 
 
As of December 31, 2013
($000)
 
Previously Reported

 
Correction

 
As Corrected

Accounts payable and accrued liabilities
 
$
52,877

 
$
(10,746
)
 
$
42,131

Deferred rent
 
$
13,192

 
$
10,746

 
$
23,938



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Table of Contents

3. Summary of Significant Accounting Policies

We discuss our significant accounting policies in Note 2 of our Audited Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on February 28, 2014.

In addition, effective January 1, 2014, we adopted FASB ASU No. 2013-05, Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or an Investment in a Foreign Entity (a consensus of the FASB Emerging Issues Task Force). ASU No. 2013-05 specifies that when a reporting entity (parent) ceases to have a controlling financial interest in a subsidiary or group of assets that is a business within a foreign entity, the parent is required to apply the guidance in Subtopic 830-30 to release any related cumulative translation adjustment into net income. Accordingly, the cumulative translation adjustment should be released into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. Additionally, the amendments in this update clarify that the sale of an investment in a foreign entity includes both (1) events that result in the loss of a controlling financial interest in a foreign entity and (2) events that results in an acquirer obtaining control of an acquiree in which it held an equity interest immediately before the acquisition date (sometimes referred to as a step acquisition). The currency translation adjustment should be released into net income upon the occurrence of those events. The adoption of ASU No. 2013-05 did not have a material effect on our consolidated financial statements.

We also adopted FASB ASU No. 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (a consensus of the FASB Emerging Issues Task Force), effective January 1, 2014. This update requires an entity to present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss (NOL) carryforward, or similar tax loss or tax credit carryforward, rather than as a liability when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) the entity intends to use the deferred tax asset for that purpose. The update does not require new recurring disclosures. The adoption of ASU No. 2013-11 did not have a material effect on our consolidated financial statements.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for us on January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. We are evaluating the effect that ASU 2014-09 will have on our consolidated financial statements and related disclosures. We have not yet selected a transition method nor have we determined the effect of the standard on our ongoing financial reporting.


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Table of Contents

4. Acquisitions, Goodwill and Other Intangible Assets

Acquisitions

Increased Ownership Interest in HelloWallet Holdings, Inc.

In June 2014, we acquired an additional 81.3% interest in HelloWallet Holdings, Inc. (HelloWallet), increasing our ownership to 100% from 18.7%. HelloWallet combines behavioral economics and the psychology of decision-making with sophisticated technology to provide personalized, unbiased financial guidance to U.S. workers and their families through their employer benefit plans. We began consolidating the financial results of this acquisition in our Consolidated Financial Statements on June 3, 2014.

HelloWallet's total preliminary estimated fair value of $54,006,000 includes $40,525,000 in cash paid to acquire the remaining 81.3% interest in HelloWallet and pay off HelloWallet's indebtedness as well as $13,481,000 related to the 18.7% of HelloWallet we previously held. We recorded a preliminary non-cash holding gain of $5,168,000 for the difference between the fair value and the book value of our previously held investment. The gain is included in non-operating income in our Unaudited Condensed Consolidated Statement of Income.

The preliminary allocation of the purchase price will be finalized upon the completion of the fair value analysis of the acquired assets and liabilities, including the preliminary intangible assets. We have not yet obtained all of the information related to the fair value of the acquired assets and liabilities related to the acquisition to finalize the purchase price allocation. The primary areas of the preliminary purchase price allocation that are not yet finalized relate to the valuation of the identifiable intangible assets and income taxes.

The following table summarizes our preliminary allocation of the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, all of which are preliminary pending receipt of the final valuation:
 
 
($000)

Cash and cash equivalents
 
$
3,739

Accounts receivable and other current assets
 
150

Other current and non-current assets
 
318

Deferred tax asset
 
7,340

Intangible assets
 
9,460

Goodwill
 
40,472

Deferred revenue
 
(2,897
)
Deferred tax liability
 
(3,595
)
Other current and non-current liabilities
 
(981
)
Total fair value of HelloWallet
 
$
54,006


The preliminary allocation includes $9,460,000 of acquired intangible assets, as follows:
 
 
($000)

 
Weighted Average Useful Life (years)
Technology based assets
 
6,670

 
5
Intellectual property (trademarks and trade names)
 
169

 
3
Non-competition agreement
 
2,621

 
5
Total intangible assets
 
$
9,460

 
5

We recognized a preliminary deferred tax liability of $3,595,000 mainly because the amortization expense related to certain intangible assets is not deductible for income tax purposes. The fair value of the acquired intangible assets and the deferred tax liability are preliminary pending receipt of the final valuation for these intangible assets.

We recognized a preliminary deferred tax asset of $7,340,000 mainly because of net operating losses of HelloWallet which will become available to Morningstar.


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Preliminary goodwill of $40,472,000 represents the premium over the fair value of the net tangible and intangible assets acquired with this acquisition. We paid this premium for a number of reasons, including the opportunity to bring together HelloWallet's comprehensive financial wellness expertise with Morningstar's independent, research-based retirement advice to create a holistic retirement savings and advice offering.

ByAllAccounts, Inc.

In April 2014, we acquired ByAllAccounts, Inc. (ByAllAccounts), a provider of innovative data aggregation technology for financial applications, for $27,949,000 in cash. ByAllAccounts uses a knowledge-based process, including patented artificial intelligence technology, to collect, consolidate, and enrich financial account data and deliver it to virtually any platform. We began including the financial results of this acquisition in our Consolidated Financial Statements on April 1, 2014.

The preliminary allocation of the purchase price will be finalized upon the completion of the fair value analysis of the acquired assets and liabilities, including the preliminary intangible assets. We have not yet obtained all of the information related to the fair value of the acquired assets and liabilities related to the acquisition to finalize the purchase price allocation. The primary areas of the preliminary purchase price allocation that are not yet finalized relate to the valuation of the identifiable intangible assets and income taxes.

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

 
 
($000)

Cash and cash equivalents
 
$
287

Accounts receivable and other current assets
 
152

Deferred tax asset
 
3,685

Other non-current assets
 
257

Intangible assets
 
8,681

Goodwill
 
18,778

Deferred revenue
 
(79
)
Deferred tax liability
 
(3,299
)
Other current and non-current liabilities
 
(513
)
Total purchase price
 
$
27,949


The preliminary allocation includes $8,681,000 of acquired intangible assets, as follows:

 
 
($000)

 
Weighted Average Useful Life (years)
Customer-related assets
 
$
5,506

 
24
Technology-based assets
 
3,020

 
4.5
Intellectual property (trademarks and trade names)
 
47

 
1
Non-competition agreement
 
108

 
3
Total intangible assets
 
$
8,681

 
19

We recognized a preliminary deferred tax liability of $3,299,000 mainly because the amortization expense related to certain intangible assets is not deductible for income tax purposes. The fair value of the acquired intangible assets and the deferred tax liability are preliminary pending receipt of the final valuation for these intangible assets.

We recognized a preliminary deferred tax asset of $3,685,000 mainly because of net operating losses of ByAllAccounts which will become available to Morningstar.



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Preliminary goodwill value of $18,778,000 represents the premium we paid over the fair value of the acquired net tangible and intangible assets. We paid this premium for a number of reasons, including the opportunity to integrate the service into our offerings as well as expand and develop ByAllAccounts' third-party distribution relationships.

Goodwill
 
The following table shows the changes in our goodwill balances from December 31, 2013 to June 30, 2014:
 
 
 
($000)

Balance as of December 31, 2013
 
$
326,450

Acquisitions of HelloWallet and ByAllAccounts
 
59,250

Foreign currency translation
 
3,137

Balance as of June 30, 2014
 
$
388,837


We did not record any impairment losses in the first six months of 2014 or 2013. We perform our annual impairment reviews in the fourth quarter.

Intangible Assets

The following table summarizes our intangible assets: 
 
 
As of June 30, 2014
 
As of December 31, 2013
($000)
 
Gross

 
Accumulated
Amortization

 
Net

 
Weighted
Average
Useful  Life
(years)
 
Gross

 
Accumulated
Amortization

 
Net

 
Weighted
Average
Useful  Life
(years)
Intellectual property
 
$
30,177

 
$
(24,741
)
 
$
5,436

 
9
 
$
29,477

 
$
(23,128
)
 
$
6,349

 
9
Customer-related assets
 
148,000

 
(80,782
)
 
67,218

 
12
 
141,833

 
(74,311
)
 
67,522

 
12
Supplier relationships
 
240

 
(114
)
 
126

 
20
 
240

 
(108
)
 
132

 
20
Technology-based assets
 
90,979

 
(54,729
)
 
36,250

 
9
 
80,489

 
(50,673
)
 
29,816

 
9
Non-competition agreement
 
4,428

 
(1,679
)
 
2,749

 
5
 
1,661

 
(1,571
)
 
90

 
4
Total intangible assets
 
$
273,824

 
$
(162,045
)
 
$
111,779

 
11
 
$
253,700

 
$
(149,791
)
 
$
103,909

 
10
 
The following table summarizes our amortization expense related to intangible assets:
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Amortization expense
 
$
5,501

 
$
5,337

 
$
10,643

 
$
10,962

 
We amortize intangible assets using the straight-line method over their expected economic useful lives.

We expect intangible amortization expense for 2014 and subsequent years as follows:
 
 
($000)

2014
 
$
22,493

2015
 
22,669

2016
 
18,071

2017
 
13,406

2018
 
11,190

Thereafter
 
34,593

 

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Our estimates of future amortization expense for intangible assets may be affected by additional acquisitions, divestitures, changes in the estimated average useful life, and currency translations.

14


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5. Income Per Share 

The following table shows how we reconcile our net income and the number of shares used in computing basic and diluted income per share:

 
 
Three months ended June 30
 
Six months ended June 30
(in thousands, except per share amounts)
 
2014

 
2013

 
2014

 
2013

 
 
 
 
 
 
 
 
 
Basic net income (loss) per share attributable to Morningstar, Inc.:
 
 

 
 

 
 
 
 
Net income (loss) attributable to Morningstar, Inc.:
 
$
(9,769
)
 
$
31,121

 
$
16,607

 
$
60,739

Less: Distributed earnings available to participating securities
 
(1
)
 
(2
)
 
(4
)
 
(5
)
Less: Undistributed earnings available to participating securities
 
3

 
(9
)
 

 
(18
)
Numerator for basic net income (loss) per share — undistributed and distributed earnings available to common shareholders
 
$
(9,767
)
 
$
31,110

 
$
16,603

 
$
60,716

 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding
 
44,777

 
46,400

 
44,778

 
46,403

 
 
 
 
 
 
 
 
 
Basic net income (loss) per share attributable to Morningstar, Inc.
 
$
(0.22
)
 
$
0.67

 
$
0.37

 
$
1.31

 
 
 
 
 
 
 
 
 
Diluted net income (loss) per share attributable to Morningstar, Inc.:
 
 
 
 
 
 
 
 
Numerator for basic net income (loss) per share — undistributed and distributed earnings available to common shareholders
 
$
(9,767
)
 
$
31,110

 
$
16,603

 
$
60,716

Add: Undistributed earnings allocated to participating securities
 
(3
)
 
9

 

 
18

Less: Undistributed earnings reallocated to participating securities
 
3

 
(9
)
 

 
(17
)
Numerator for diluted net income per share — undistributed and distributed earnings available to common shareholders
 
$
(9,767
)
 
$
31,110

 
$
16,603

 
$
60,717

 
 


 


 


 


Weighted average common shares outstanding
 
44,777

 
46,400

 
44,778

 
46,403

Net effect of dilutive stock options and restricted stock units
 

 
453

 
261

 
353

Weighted average common shares outstanding for computing diluted income per share
 
44,777

 
46,853

 
45,039

 
46,756

 
 


 


 


 


Diluted net income (loss) per share attributable to Morningstar, Inc.
 
$
(0.22
)
 
$
0.66

 
$
0.37

 
$
1.30


Because of our net loss for the quarter ended June 30, 2014, the assumed exercise of stock options and vesting of restricted stock units outstanding would have had an anti-dilutive effect and were therefore excluded from the computation of diluted net loss per share.

The following table shows the number of weighted average stock options, restricted stock units, performance share awards, and restricted stock excluded from our calculation of diluted earnings per share because their inclusion would have been anti-dilutive:

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Table of Contents

 
 
Three months ended June 30
 
Six months ended June 30
(in thousands)
 
2014

 
2013

 
2014

 
2013

Weighted average stock options
 
160

 

 

 

Weighted average restricted stock units
 
108

 
2

 
18

 
22

Weighted average performance share awards
 
10

 

 

 

Weighted average restricted stock
 
3

 

 
6

 

Total
 
281

 
2

 
24

 
22


These stock options, restricted stock units and performance share awards could be included in the calculation in the future.

6. Segment, Enterprise-Wide, and Geographical Area Information
 
Segment Information

Beginning with the third quarter of 2013, we revised our segment structure to reflect our shift to a more centralized organizational structure. We now report our results in a single reportable segment, which reflects how our chief operating decision maker allocates resources and evaluates our financial results.

Because we have one reportable segment, all required financial segment information can be found directly in the Unaudited Condensed Consolidated Financial Statements.

The accounting policies for our single reportable segment are the same as those described in “Note 2. Summary of Significant Accounting Policies” included in our Annual Report on Form 10-K for the year ended December 31, 2013. We evaluate the performance of our reporting segment based on revenue and operating income.

Products and Services Information

We derive revenue from two product groups. The investment information product group includes all of our data, software, and research products and services. These products are typically sold through subscriptions or license agreements. The investment management product group includes all of our asset management operations, which earn the majority of their revenue from asset-based fees. The table below summarizes our revenue by product group:

External revenue by product group
 
 
 
 
 
 
 
 
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

 
Investment information
 
$
149,527

 
$
140,031

 
$
290,797

 
$
275,116

 
Investment management
 
39,858

 
35,397

 
79,753

 
69,168

 
Consolidated revenue
 
$
189,385

 
$
175,428

 
$
370,550

 
$
344,284

 


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Geographical Area Information

The tables below summarize our revenue and long-lived assets by geographical area:

External revenue by geographical area
 
 
 
 
 
 
 
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

United States
 
$
136,453

 
$
126,335

 
$
266,405

 
$
247,748

 
 
 
 
 
 
 
 
 
United Kingdom
 
15,544

 
14,015

 
30,882

 
27,168

Continental Europe
 
15,921

 
13,993

 
31,547

 
27,160

Australia
 
9,233

 
9,176

 
17,401

 
18,528

Canada
 
7,542

 
7,812

 
15,209

 
15,548

Asia
 
3,888

 
3,449

 
7,597

 
6,873

Other
 
804

 
648

 
1,509

 
1,259

Total International
 
52,932

 
49,093

 
104,145

 
96,536

 
 
 
 
 
 
 
 
 
Consolidated revenue
 
$
189,385

 
$
175,428

 
$
370,550

 
$
344,284


Long-lived assets by geographical area
 
 
 
 
 
 
As of June 30
 
As of December 31
($000)
 
2014

 
2013

United States
 
$
90,924

 
$
84,321

 
 
 
 
 
United Kingdom
 
6,720

 
6,873

Continental Europe
 
1,591

 
1,873

Australia
 
977

 
1,051

Canada
 
1,041

 
1,275

Asia
 
8,548

 
9,479

Other
 
99

 
114

Total International
 
18,976

 
20,665

 
 
 
 
 
Consolidated property, equipment, and capitalized software, net
 
$
109,900

 
$
104,986


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7. Investments and Fair Value Measurements
 
We account for our investments in accordance with FASB ASC 320, Investments—Debt and Equity Securities. We classify our investments in three categories: available-for-sale, held-to-maturity, and trading. We monitor the concentration, diversification, maturity, and liquidity of our investment portfolio, which is primarily invested in fixed-income securities, and classify our investment portfolio as shown below:
 
 
 
As of June 30
 
As of December 31
($000)
 
2014

 
2013

Available-for-sale
 
$
16,015

 
$
91,461

Held-to-maturity
 
20,422

 
31,214

Trading securities
 
8,259

 
7,732

Total
 
$
44,696

 
$
130,407



The following table shows the cost, unrealized gains (losses), and fair values related to investments classified as available-for-sale and held-to-maturity:
 
 
 
As of June 30, 2014
 
As of December 31, 2013
($000)
 
Cost

 
Unrealized
Gain

 
Unrealized
Loss

 
Fair
Value

 
Cost

 
Unrealized
Gain

 
Unrealized
Loss

 
Fair
Value

Available-for-sale:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Government obligations
 
$
3,396

 
$
2

 
$

 
$
3,398

 
$
19,693

 
$
8

 
$
(3
)
 
$
19,698

Corporate bonds
 

 

 

 

 
49,913

 
22

 
(124
)
 
49,811

Foreign obligations
 

 

 

 

 
505

 

 
(2
)
 
503

Commercial paper
 

 

 

 

 
9,482

 
7

 

 
9,489

Equity securities and exchange-traded funds
 
9,311

 
1,100

 
(118
)
 
10,293

 
8,872

 
1,011

 
(141
)
 
9,742

Mutual funds
 
2,137

 
276

 
(89
)
 
2,324

 
2,095

 
221

 
(98
)
 
2,218

Total
 
$
14,844

 
$
1,378

 
$
(207
)
 
$
16,015

 
$
90,560

 
$
1,269

 
$
(368
)
 
$
91,461

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Held-to-maturity:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Certificates of deposit
 
$
20,422

 
$

 
$

 
$
20,422

 
$
31,214

 
$

 
$

 
$
31,214

 
As of June 30, 2014 and December 31, 2013, investments with unrealized losses for greater than a 12-month period were not material to the Condensed Consolidated Balance Sheets and were not deemed to have other than temporary declines in value.


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The table below shows the cost and fair value of investments classified as available-for-sale and held-to-maturity based on their contractual maturities as of June 30, 2014 and December 31, 2013. The expected maturities of certain fixed-income securities may differ from their contractual maturities because some of these holdings have call features that allow the issuers the right to prepay obligations without penalties.
 
 
 
As of June 30, 2014
 
As of December 31, 2013
($000)
 
Cost

 
Fair Value

 
Cost

 
Fair Value

Available-for-sale:
 
 

 
 

 
 

 
 

Due in one year or less
 
$
3,396

 
$
3,398

 
$
45,486

 
$
45,402

Due in one to two years
 

 

 
34,107

 
34,099

Equity securities, exchange-traded funds, and mutual funds
 
11,448

 
12,617

 
10,967

 
11,960

    Total
 
$
14,844

 
$
16,015

 
$
90,560

 
$
91,461

 
 
 
 
 
 
 
 
 
Held-to-maturity:
 
 

 
 

 
 

 
 

Due in one year or less
 
$
20,417

 
$
20,417

 
$
31,210

 
$
31,210

Due in one to three years
 
5

 
5

 
4

 
4

Total
 
$
20,422

 
$
20,422

 
$
31,214

 
$
31,214

 
As of June 30, 2014 and December 31, 2013, held-to-maturity investments included a $1,500,000 certificate of deposit held primarily as collateral against bank guarantees for our office leases, primarily in Australia.

The following table shows the realized gains and losses arising from sales of our investments classified as available-for-sale recorded in our Condensed Consolidated Statements of Income: 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Realized gains
 
$
417

 
$
662

 
$
578

 
$
2,226

Realized losses
 
(46
)
 
(239
)
 
(231
)
 
(1,078
)
Realized gains, net
 
$
371

 
$
423

 
$
347

 
$
1,148

 
We determine realized gains and losses using the specific identification method.

The following table shows the net unrealized gains (losses) on trading securities as recorded in our Condensed Consolidated Statements of Income:
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Unrealized gains (losses), net
 
$
(224
)
 
$
(45
)
 
$
(155
)
 
$
273



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The fair value of our assets subject to fair value measurements and that are measured at fair value on a recurring basis using the fair value hierarchy and the necessary disclosures under FASB ASC 820, Fair Value Measurement, are as follows:
 
 
 
Fair Value
 
Fair Value Measurements as of June 30, 2014
 
 
as of
 
Using Fair Value Hierarchy
($000)
 
June 30, 2014
 
Level 1

 
Level 2

 
Level 3

Available-for-sale investments:
 
 

 
 

 
 

 
 

Government obligations
 
$
3,398

 
$

 
$
3,398

 
$

Corporate bonds
 

 

 

 

Foreign obligations
 

 

 

 

Commercial paper
 

 

 

 

Equity securities and exchange-traded funds
 
10,293

 
10,293

 

 

Mutual funds
 
2,324

 
2,324

 

 

Trading securities
 
8,259

 
8,259

 

 

Cash equivalents
 
2,691

 
2,691

 

 

Total
 
$
26,965

 
$
23,567

 
$
3,398

 
$

 
 
 
Fair Value
 
Fair Value Measurements as of December 31, 2013
 
 
as of
 
Using Fair Value Hierarchy
($000)
 
December 31, 2013
 
Level 1

 
Level 2

 
Level 3

Available-for-sale investments:
 
 

 
 

 
 

 
 

Government obligations
 
$
19,698

 
$

 
$
19,698

 
$

Corporate bonds
 
49,811

 

 
49,811

 

Foreign obligations
 
503

 

 
503

 

Commercial paper
 
9,489

 

 
9,489

 

Equity securities and exchange-traded funds
 
9,742

 
9,742

 

 

Mutual funds
 
2,218

 
2,218

 

 

Trading securities
 
7,732

 
7,732

 

 

Cash equivalents
 
925

 
925

 

 

Total
 
$
100,118

 
$
20,617

 
$
79,501

 
$

 
Level 1:
Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access.
Level 2:
Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Level 3:
Valuations based on inputs that are unobservable and significant to the overall fair value measurement.

Based on our analysis of the nature and risks of our investments in equity securities and mutual funds, we have determined that presenting each of these investment categories in the aggregate is appropriate.

We measure the fair value of money market funds, mutual funds, equity securities, and exchange-traded funds based on quoted prices in active markets for identical assets or liabilities. All other financial instruments were valued either based on recent trades of securities in inactive markets or based on quoted market prices of similar instruments and other significant inputs derived from observable market data. We did not hold any securities categorized as Level 3 as of June 30, 2014 and December 31, 2013.



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8. Investments in Unconsolidated Entities
 
Our investments in unconsolidated entities consist primarily of the following:
 
 
As of June 30


As of December 31

($000)
 
2014


2013

Investment in MJKK
 
$
22,173

 
$
21,782

Other equity method investments
 
5,788

 
6,166

Investments accounted for using the cost method
 
2,326

 
10,766

Total investments in unconsolidated entities
 
$
30,287

 
$
38,714

 
Morningstar Japan K.K. Morningstar Japan K.K. (MJKK) develops and markets products and services customized for the Japanese market. MJKK’s shares are traded on the Tokyo Stock Exchange under the ticker 47650. We account for our investment in MJKK using the equity method. The following table summarizes our ownership percentage in MJKK and the market value of this investment based on MJKK’s publicly quoted share price: 
 
 
As of June 30

 
As of December 31

 
 
2014

 
2013

Morningstar’s approximate ownership of MJKK
 
34
%
 
34
%
 
 
 
 
 
Approximate market value of Morningstar’s ownership in MJKK:
 
 

 
 

Japanese yen (¥000)
 
¥
7,567,560

 
¥
9,824,068

Equivalent U.S. dollars ($000)
 
$
74,616

 
$
94,999


Other Equity Method Investments. As of June 30, 2014 and December 31, 2013, other equity method investments consist of our investment in Inquiry Financial Europe AB (Inquiry Financial) and YCharts, Inc. (YCharts). Inquiry Financial is a provider of sell-side consensus estimate data. Our ownership interest in Inquiry Financial was approximately 34% as of June 30, 2014 and December 31, 2013. YCharts is a technology company that provides stock research and analysis. Our ownership interest in YCharts was approximately 22% as of June 30, 2014 and December 31, 2013.

We did not record any impairment losses on our equity method investments in the first six months of 2014 or 2013.
 
Cost Method Investments. As of June 30, 2014 and December 31, 2013, our cost method investments consist of a minority investment in Pitchbook Data, Inc. (Pitchbook). Pitchbook offers detailed data and information about private equity transactions, investors, companies, limited partners, and service providers.

As of December 31, 2013, our cost method investments also included a minority investment in HelloWallet LLC (HelloWallet). In June 2014, we purchased the remaining interest in HelloWallet. See Note 4 for additional information concerning our acquisition of HelloWallet.

We did not record any impairment losses on our cost method investments in the first six months of 2014 or 2013.

9. Stock-Based Compensation
 
Stock-Based Compensation Plans
 
Our shareholders approved the Morningstar 2011 Stock Incentive Plan (the 2011 Plan) on May 17, 2011. As of that date, we stopped granting awards under the Morningstar 2004 Stock Incentive Plan (the 2004 Plan). The 2004 Plan amended and restated the Morningstar 1993 Stock Option Plan, the Morningstar 2000 Stock Option Plan, and the Morningstar 2001 Stock Option Plan.

The 2011 Plan provides for a variety of stock-based awards, including, among other things, stock options, performance share awards, restricted stock units, and restricted stock. We granted stock options, restricted stock units, and restricted stock under the 2004 Plan.

All of our employees and our non-employee directors are eligible for awards under the 2011 Plan.

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Table of Contents


Grants awarded under the 2011 Plan or the 2004 Plan that are forfeited, canceled, settled, or otherwise terminated without a distribution of shares, or shares withheld by us in connection with the exercise of options, will be available for awards under the 2011 Plan. Any shares subject to awards under the 2011 Plan, but not under the 2004 Plan, that are withheld by us in connection with the payment of any required income tax withholding will be available for awards under the 2011 Plan.

The following table summarizes the number of shares available for future grants under our 2011 Plan:
 
 
 
As of June 30

(in thousands)
 
2014

Shares available for future grants
 
4,248

 
Accounting for Stock-Based Compensation Awards
 
The following table summarizes our stock-based compensation expense and the related income tax benefit we recorded:
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Restricted stock units
 
$
3,983

 
$
3,734

 
$
7,675

 
$
7,297

Restricted stock
 
97

 
97

 
194

 
194

Performance share awards
 
173

 

 
200

 

Stock options
 
110

 
123

 
233

 
246

Total stock-based compensation expense
 
$
4,363

 
$
3,954

 
$
8,302

 
$
7,737

 
 


 


 


 


Income tax benefit related to the stock-based compensation expense
 
$
1,283

 
$
1,068

 
$
2,362

 
$
2,098

 
The following table summarizes the amount of unrecognized stock-based compensation expense as of June 30, 2014 and the expected number of months over which the expense will be recognized:
 
 
Unrecognized stock-based compensation expense ($000)

 
Expected amortization period (months)
Restricted stock units
 
$
39,567

 
36
Restricted stock
 
323

 
10
Performance share awards
 
1,716

 
30
Stock options
 
353

 
11
Total unrecognized stock-based compensation expense
 
$
41,959

 
35

In accordance with FASB ASC 718, Compensation—Stock Compensation, we estimate forfeitures of employee stock-based awards and recognize compensation cost only for those awards expected to vest. Our largest annual equity grants typically have vesting dates in the second quarter. We adjust the stock-based compensation expense annually in the third quarter to reflect those awards that ultimately vested and update our estimate of the forfeiture rate that will be applied to awards not yet vested.
 
Restricted Stock Units
 
Restricted stock units represent the right to receive a share of Morningstar common stock when that unit vests. Restricted stock units to employees vest ratably over a four-year period. Restricted stock units granted to non-employee directors vest ratably over a three-year period. For restricted stock units granted through December 31, 2008, employees could elect to defer receipt of the Morningstar common stock issued upon vesting of the restricted stock unit.


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We measure the fair value of our restricted stock units on the date of grant based on the closing market price of the underlying common stock on the day prior to the grant. We amortize that value to stock-based compensation expense, net of estimated forfeitures, ratably over the vesting period.

The following table summarizes restricted stock unit activity during the first six months of 2014:
Restricted Stock Units (RSUs)
 
Unvested

 
Vested but
Deferred

 
Total

 
Weighted
Average
Grant Date Value
per RSU

RSUs outstanding—December 31, 2013
 
680,002

 
16,682

 
696,684

 
$
62.02

Granted
 
245,350

 

 
245,350

 
73.11

Dividend equivalents
 
1,528

 
76

 
1,604

 
57.50

Vested
 
(231,500
)
 

 
(231,500
)
 
57.48

Issued
 

 
(2,054
)
 
(2,054
)
 
53.54

Forfeited
 
(17,874
)
 

 
(17,874
)
 
57.22

RSUs Outstanding - June 30, 2014
 
677,506

 
14,704

 
692,210

 
$
67.37

 
Restricted Stock
 
In conjunction with our acquisition of Realpoint LLC in May 2010, we issued 199,174 shares of restricted stock to the selling employee-shareholders under the 2004 Stock Incentive Plan. The restricted stock vests ratably over a five-year period from the acquisition date and may be subject to forfeiture if the holder terminates his or her employment during the vesting period.

Because of the terms of the restricted stock agreements prepared in conjunction with the Realpoint acquisition, we account for the grant of restricted stock as stock-based compensation expense and not as part of the acquisition consideration.

We measured the fair value of the restricted stock on the date of grant based on the closing market price of our common stock on the day prior to the grant. We amortize the fair value of $9,363,000 to stock-based compensation expense over the vesting period. We have assumed that all of the remaining restricted stock will ultimately vest, and therefore have not incorporated a forfeiture rate for purposes of determining the stock-based compensation expense.
 
Performance Share Awards

In 2014, executive officers, other than Joe Mansueto, were granted performance share awards pursuant to which each executive becomes entitled to a number of shares of Morningstar common stock equal to the number of notional performance shares that become vested. Each award specifies a number of performance shares that will vest if pre-established target performance goals are attained. The number of performance shares that actually vest may be more or less than the specified number of performance shares to the extent Morningstar exceeds or fails to achieve, respectively, the target performance goals over a three-year performance period.

The performance conditions are not considered in the determination of the grant date fair value for these awards. We measure the fair value of our performance share awards on the date of grant based on the closing market price of the underlying common stock on the day prior to the grant date. We amortize that value to stock-based compensation expense, based on the satisfaction of the performance condition that is most likely to be satisfied over the three-year service period ratably over the vesting period.

Information as of June 30, 2014 regarding the Company's target performance share awards granted and shares that would be issued at current performance levels for performance share awards granted during the first six months of 2014 is as follows:

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Table of Contents

 
 
As of June 30, 2014

Target performance share awards granted
 
23,685

Fair value (1)
 
$
80.91

Number of shares that would be issued based on current performance levels
 
23,685

Unamortized expense, based on current performance levels
 
$
1,716,000


(1) Represents the closing market price of Morningstar's stock on March 14, 2014, which is the last closing price prior to the grant date.

Stock Options

Stock options granted to employees vest ratably over a four-year period. Grants to our non-employee directors vest ratably over a three-year period. All grants expire 10 years after the date of grant. Almost all of the options granted under the 2004 Stock Incentive Plan have a premium feature in which the exercise price increases over the term of the option at a rate equal to the 10-year Treasury bond yield as of the date of grant. Options granted under the 2011 Plan have an exercise price equal to the fair market value on the grant date.

The following tables summarize stock option activity in the first six months of 2014 for our various stock option grants. The first table includes activity for options granted at an exercise price below the fair value per share of our common stock on the grant date; the second table includes activity for all other option grants. 
Options Granted At an Exercise Price Below the Fair Value Per Share on the Grant Date
 
Underlying
Shares

 
Weighted
Average
Exercise
Price

Options outstanding—December 31, 2013
 
179,559

 
$
21.47

Granted
 

 

Canceled
 

 

Exercised
 
(26,420
)
 
21.67

Options outstanding—June 30, 2014
 
153,139

 
21.91

 
 
 
 
 
Options exercisable—June 30, 2014
 
153,139

 
$
21.91

 
All Other Option Grants, Excluding Activity Shown Above
 
Underlying
Shares

 
Weighted
Average
Exercise
Price

Options outstanding—December 31, 2013
 
253,972

 
$
36.48

Granted
 

 

Canceled
 

 

Exercised
 
(47,898
)
 
30.58

Options outstanding—June 30, 2014
 
206,074

 
38.27

 
 
 
 
 
Options exercisable—June 30, 2014
 
189,604

 
$
36.58

 

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The following table summarizes the total intrinsic value (difference between the market value of our stock on the date of exercise and the exercise price of the option) of options exercised:
 
 
 
Six months ended June 30
($000)
 
2014

 
2013

Intrinsic value of options exercised
 
$
3,760

 
$
8,170

 

The table below shows additional information for options outstanding and exercisable as of June 30, 2014:
 
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number of  Options

 
Weighted
Average
Remaining
Contractual
Life (years)
 
Weighted
Average
Exercise
Price

 
Aggregate
Intrinsic
Value
($000)

 
Exercisable Shares

 
Weighted Average Remaining Contractual Life (years)
 
Weighted Average Exercise Price

 
Aggregate Intrinsic Value ($000)

$21.61 - $26.96
 
280,732

 
0.62
 
$
24.20

 
$
13,364

 
280,732

 
0.62
 
$
24.20

 
$
13,364

$39.68 - $49.92
 
6,806

 
1.43
 
48.18

 
161

 
6,806

 
1.43
 
48.18

 
161

$57.28 - $59.35
 
71,675

 
7.02
 
57.46

 
1,029

 
55,205

 
7.02
 
57.39

 
758

$21.61 - $59.35
 
359,213

 
1.91
 
$
31.29

 
$
14,554

 
342,743

 
1.67
 
$
30.03

 
$
14,283

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Vested or Expected to Vest
 
 
 
 
 
 
 
 
 
 
 
 
 
$21.61 - $59.35
 
359,213

 
1.91
 
$
31.29

 
$
14,554

 
 
 
 
 
 
 
 
 
The aggregate intrinsic value in the table above represents the total pretax intrinsic value all option holders would have received if they had exercised all outstanding options on June 30, 2014. The intrinsic value is based on our closing stock price of $71.81 on that date.

Excess Tax Benefits Related to Stock-Based Compensation
 
FASB ASC 718, Compensation—Stock Compensation, requires that we classify the cash flows that result from excess tax benefits as financing cash flows. Excess tax benefits correspond to the portion of the tax deduction taken on our income tax return that exceeds the amount of tax benefit related to the compensation cost recognized in our Condensed Consolidated Statements of Operations. The following table summarizes our excess tax benefits:
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Excess tax benefits related to stock-based compensation
 
$
1,340

 
$
2,255

 
$
1,913

 
$
3,842




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Table of Contents

10. Income Taxes

Effective Tax Rate

The following table shows our effective income tax rate for the three and six months ended June 30, 2014 and June 30, 2013:
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Income (loss) before income taxes and equity in net income of unconsolidated entities
 
$
(18,882
)
 
$
46,695

 
$
20,515

 
$
88,200

Equity in net income of unconsolidated entities
 
497

 
360

 
1,096

 
857

Net loss attributable to the noncontrolling interest
 
5

 
21

 
35

 
64

Total
 
$
(18,380
)
 
$
47,076

 
$
21,646

 
$
89,121

Income tax expense (benefit)
 
$
(8,611
)
 
$
15,955

 
$
5,039

 
$
28,382

Effective tax rate
 
46.8
%
 
33.9
%
 
23.3
%
 
31.8
%
 
Our effective tax rate in the second quarter of 2014 was 46.8%, an increase of 12.9 percentage points compared with the prior-year period. During the second quarter of 2014, we reported a loss before income taxes and equity in net income of unconsolidated entities of $18.9 million, which included a litigation settlement expense of $61.0 million that is deductible for tax purposes. In the same period, we realized a $5.2 million non-taxable gain in connection with the purchase of the remaining ownership interest in HelloWallet. Because of these two items, we reported an income tax benefit of $8.6 million, which is equivalent to a 46.8% effective tax rate.

Our effective tax rate for the first six months of 2014 was 23.3%, which is lower than the statutory rate mainly because of the non-taxable gain of $5.2 million recorded in connection with purchasing the remaining ownership interest in HelloWallet.

Unrecognized Tax Benefits

The table below provides information concerning our gross unrecognized tax benefits as of June 30, 2014 and December 31, 2013. The table also provides the effect these gross unrecognized tax benefits would have on our income tax expense, if they were recognized.
 
 
As of June 30
 
As of December 31
($000)
 
2014

 
2013

Gross unrecognized tax benefits
 
$
11,476

 
$
12,958

Gross unrecognized tax benefits that would affect income tax expense
 
$
11,476

 
$
10,557

Decrease in income tax expense upon recognition of gross unrecognized tax benefits
 
$
9,961

 
$
9,262


Our Condensed Consolidated Balance Sheets include the following liabilities for unrecognized tax benefits. These amounts include interest and penalties, less any associated tax benefits.

 
 
As of June 30
 
As of December 31
Liabilities for Unrecognized Tax Benefits ($000)
 
2014

 
2013

Current liability
 
$
4,490

 
$
6,211

Non-current liability
 
6,712

 
6,012

Total liability for unrecognized tax benefits
 
$
11,202

 
$
12,223


We conduct business globally and, as a result, we file income tax returns in U.S. federal, state, local, and foreign jurisdictions. We are currently under audit by federal and various state and local tax authorities in the United States,

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Table of Contents

as well as tax authorities in certain non-U.S. jurisdictions. It is possible, though not likely, that the examination phase of some of these audits will conclude in 2014. It is not possible to estimate the effect of current audits on previously recorded unrecognized tax benefits.


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Table of Contents

We have not provided federal and state income taxes on accumulated undistributed earnings of certain foreign subsidiaries because these earnings have been permanently reinvested. Approximately 69% of our cash, cash equivalents, and investments as of June 30, 2014 was held by our operations outside of the United States. As such, we believe that our cash balances and investments in the United States, along with cash generated from our U.S. operations, will be sufficient to meet our U.S. operating and cash needs for the foreseeable future, without requiring us to repatriate earnings from these foreign subsidiaries. It is not reasonably practical to determine the amount of the unrecognized deferred tax liability related to the undistributed earnings.
 
Certain of our non-U.S. operations have incurred net operating losses (NOLs) which may become deductible to the extent these operations become profitable. For each of our operations, we evaluate whether it is more likely than not that the tax benefits related to NOLs will be realized. As part of this evaluation, we consider evidence such as tax planning strategies, historical operating results, forecasted taxable income, and recent financial performance. In the year that certain non-U.S. operations record a loss, we do not recognize a corresponding tax benefit, thus increasing our effective tax rate. Upon determining that it is more likely than not that the NOLs will be realized, we reduce the tax valuation allowances related to these NOLs, which results in a reduction to our income tax expense and our effective tax rate in the period.


11. Contingencies

Life's Good S.T.A.B.L. Hedge Fund

In September 2011, three individual investors in Life's Good S.T.A.B.L. Mortgage hedge fund (LG), Marta Klass, Gregory Martin, and Richard Roellig, filed a complaint in the United States District Court for the Eastern District of Pennsylvania against LG, its principal Robert Stinson, and several other parties, including Morningstar, Inc. (the Klass Matter). The plaintiffs claim that Morningstar committed fraud and aided and abetted the other defendants' breach of fiduciary duty through the 5-star rating LG obtained from Morningstar. The plaintiffs seek unspecified damages. Hedge fund managers self-report their performance data to Morningstar. More than a year before the Klass Matter, in June 2010, the SEC filed suit against LG and other entities claiming they were part of a Ponzi scheme operated by Stinson. As a result, LG and the other entities were placed in court-appointed receivership. Morningstar was not part of the SEC suit or receivership. Since that time, the Receiver, as part of his duties, has been investigating whether to assert claims against third parties. Morningstar is aware of 14 lawsuits filed by the Receiver seeking to recover money for the fund.

In November 2011, Morningstar filed a motion to dismiss the Klass Matter. On behalf of the entities in receivership, the Receiver filed a motion to stay the proceedings because the Receivership Order does not permit suits against the entities in receivership without court permission. The court granted the Receiver's motion and stayed the Klass Matter. In April 2012, the Receiver filed a complaint against Morningstar, in which the Receiver claims that Morningstar is liable for contribution and aiding and abetting Stinson's breach of fiduciary duty and fraud through the 5-star rating LG obtained from Morningstar. The same day the Receiver filed his complaint, Morningstar sought leave from the court to file a countersuit against Stinson and two of his entities-Keystone State Capital Corporation and LG for, among other things, fraud, misrepresentation, and breach of user agreements. In June 2012, the court denied Morningstar's motion for leave to file suit. The court took no position on the merits of Morningstar's claims, and did not preclude us from renewing our motion to file a complaint at a later time, but deferred to the Receiver's request not to subject the receivership estate to additional litigation at this early point in the receivership. A bench trial related to the Receiver’s claims against Morningstar was held between January 13 and January 28, 2014. At trial, the Receiver claimed that Morningstar is liable under a contribution theory for all or part of a $14.5 million disgorgement judgment that the SEC obtained against the entities and individuals in receivership. Morningstar contested liability and damages at trial and believes it is not liable for any amount. The parties filed post-trial proposed findings of fact and conclusions of law on March 14, 2014. It is not known when the court will issue its decision.

We believe the allegations against Morningstar by the Klass plaintiffs and the Receiver have no legal or factual basis, and we plan to continue to vigorously contest the claims. We also intend to refile our affirmative claims against Stinson, Keystone, and LG at a later time consistent with the court's order. We cannot predict the outcome of the proceedings.

We have not provided an estimate of loss or range of loss in connection with this matter because no such estimate can reasonably be made.

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Table of Contents


Business Logic Holding Corporation

In November 2009, Business Logic Holding Corporation (Business Logic) filed a complaint in the Circuit Court of Cook County, Illinois against Ibbotson Associates, Inc., one of our wholly owned subsidiaries, and Morningstar, Inc. relating to Ibbotson's prior commercial relationship with Business Logic. Business Logic alleged breach of contract and trade secret misappropriation in connection with Ibbotson's development of a proprietary web-service software and user interface that connects plan participant data with the Ibbotson Wealth Forecasting Engine. Ibbotson and Morningstar answered the complaint, and Ibbotson asserted a counterclaim against Business Logic alleging trade secret misappropriation and breach of contract, also seeking damages and injunctive relief.

On July 17, 2014, Morningstar and Ibbotson entered into a settlement agreement with Business Logic relating to this litigation (the Settlement Agreement). Pursuant to the Settlement Agreement, among other things, Morningstar or Ibbotson will pay Business Logic $61.0 million and Business Logic (i) will dismiss with prejudice all claims asserted in the Litigation; (ii) grants releases to Morningstar, Ibbotson, and their clients; and (iii) grants to Morningstar, its affiliates, Ibbotson and their clients an irrevocable license to use the intellectual property at issue in the litigation. In late July 2014, Morningstar paid $15.0 million of the amount owed to Business Logic under the Settlement Agreement and the case was dismissed with prejudice. The Settlement Agreement provides that the remaining $46.0 million be paid on or before August 17, 2014.

Other Proceedings

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 position.

12. Share Repurchase Program
 
We have an ongoing authorization, originally approved by our board of directors in September 2010, and subsequently amended, to repurchase up to $700 million in shares of our outstanding common stock. The authorization expires on December 31, 2015. We may repurchase shares from time to time at prevailing market prices on the open market or in private transactions in amounts that we deem appropriate.

As of June 30, 2014, we had repurchased a total of 7,557,807 shares for $486.5 million under this authorization.

13. Subsequent Events

On July 17, 2014, Morningstar and Ibbotson entered into a settlement agreement with Business Logic Holding Corporation (Business Logic). Pursuant to the settlement agreement, Morningstar will pay Business Logic $61.0 million. In July 2014, Morningstar paid $15.0 million of the amount owed to Business Logic under the settlement agreement and the case was dismissed with prejudice. This obligation was accrued as of June 30, 2014 and the corresponding expense is reported as "Litigation settlement" in our Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2014. See Note 11, Contingencies, for additional information.
Separately, in July 2014, we established a $75 million single-bank revolving credit facility. The line of credit allows for borrowings from time to time of up to $75 million for general corporate purposes.


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Table of Contents



Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The discussion included in this section, as well as other sections of this Quarterly Report on Form 10-Q, contains forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995. These statements are based on our current expectations about future events or future financial performance. Forward-looking statements by their nature address matters that are, to different degrees, uncertain, and often contain words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue.” These statements involve known and unknown risks and uncertainties that may cause the events we discuss not to occur or to differ significantly from what we expect. For us, these risks and uncertainties include, among others:

liability for any losses that result from an actual or claimed breach of our fiduciary duties;
failing to differentiate our products and continuously create innovative, proprietary research tools;
failing to respond to technological change, keep pace with new technology developments, or adopt a successful technology strategy
a prolonged outage of our database and network facilities;
any failures or disruptions in our electronic delivery systems and the Internet;
liability and/or damage to our reputation as a result of some of our pending litigation;
liability related to the storage of personal information about our users;
general industry conditions and competition, including global financial uncertainty, trends in the mutual fund industry, and continued growth in passively managed investment vehicles;
the effect of market volatility on revenue from asset-based fees;
failing to maintain and protect our brand, independence, and reputation;
changes in laws applicable to our investment advisory or credit rating operations, compliance failures, or regulatory action; and
challenges faced by our operations outside the United States, including the concentration of development work at our offshore facilities in China and India.

A more complete description of these risks and uncertainties can be found in our other filings with the Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K for the year ended December 31, 2013. If any of these risks and uncertainties materialize, our actual future results may vary significantly from what we expect. 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 previous year unless otherwise stated. 

Understanding our Company
 
Our Business

Our mission is to create great products that help investors reach their financial goals. We offer an extensive line of products and services for financial advisors, asset managers, retirement plan providers and sponsors, and individual investors. Many of our products are sold through subscriptions or license agreements. As a result, we typically generate recurring revenue.

In the third quarter of 2013, we revised our segment structure to reflect our shift to a more centralized organization. We now report our results in a single segment, which is consistent with how management allocates resources and evaluates our financial results.

Industry Overview
 
We monitor developments in the economic and financial information industry to help inform our company strategy, product development plans, and marketing initiatives.
 
After a strong rally in 2013, equity markets continued to generate gains in the second quarter of 2014. The Morningstar U.S. Market Index, a broad market benchmark, gained 5.0% in the quarter, while the Global Ex-U.S. Index finished the quarter with a total return of 5.2%.
 
U.S. mutual fund assets stood at $15.7 trillion as of June 30, 2014, based on data from the Investment Company Institute (ICI), compared with $13.6 trillion as of June 30, 2013. Based on Morningstar's estimated asset flow data, investors added about $200 billion to long-term open-end funds during the first six months of 2014 and pulled $147 billion from money market funds. Both equity and fixed-income funds had positive net inflows for the first half of 2014.
 
Assets in exchange-traded funds (ETFs) rose to $1.8 trillion as of June 30, 2014, compared with $1.4 trillion as of June 30, 2013, based on data from the ICI.
Despite generally positive market trends, we believe the business environment for the financial services industry remains challenging. Asset management firms have been facing increasing regulatory burdens, which are leading to higher costs and more cautious spending in other areas. Further, the historically low interest rate environment has put pressure on the margins of many firms, most notably those in the variable annuity space. As a result, we expect there will be further pressure on revenue from clients in this area.




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Table of Contents

Supplemental Operating Metrics

The tables below summarize our key product metrics and other supplemental data.
 
 
 
As of June 30
 
 
 
2014

 
2013

 
Change
 
Our business
 
 
 
 
 
 
 
Morningstar.com Premium Membership subscriptions (U.S.)
 
122,736

 
123,881

 
(0.9
)%
 
Registered users for Morningstar.com (U.S.)
 
8,021,734

 
7,690,300

 
4.3
 %
 
U.S. Advisor Workstation Clients (1)
 
170

 
151

 
12.6
 %
 
U.S. Morningstar Office Licenses (1)
 
4,201

 
3,985

 
5.4
 %
 
Principia subscriptions
 
14,805

 
22,464

 
(34.1
)%
 
Morningstar Direct licenses
 
9,222

 
7,960

(2)
15.9
 %
 
Assets under advisement and management (approximate) ($bil)
 
 
 
 
 
 
 
 
Investment Advisory services (3)
 
$
82.7

 
$
101.4

 
(18.4
)%
 
 
Retirement Solutions
 
 
 
 
 
 
 
 
     Managed Retirement Accounts (4)
 
$
36.8

 
$
27.9

 
31.9
 %
 
 
     Other assets
 
37.6

 
28.0

 
34.3
 %
 
 
Total Retirement Solutions
 
$
74.4

 
$
55.9

 
33.1
 %
 
 
Morningstar Managed Portfolios
 
$
8.6

 
$
5.9

 
45.8
 %
 
 
Ibbotson Australia
 
$
3.3

 
$
2.9

 
13.8
 %
 
 
 
 
 
 
 
 
 
 
Our employees (approximate)
 
 
 
 
 
 
 
Worldwide headcount
 
3,800

 
3,425

 
10.9
 %
 
Number of worldwide equity and credit analysts
 
175

 
150

 
16.7
 %
 
Number of worldwide fund analysts
 
100

 
105

 
(4.8
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
Three months ended June 30
 
 
 
 
2014

 
2013

 
Change
 
Average assets under management and advisement ($bil)
 
166.3

 
161.6

 
2.9
 %
 
Number of new commercial mortgage-backed securities (CMBS) new-issue ratings completed
 
9

 
8

 
12.5
 %
 
Rated balance for CMBS new-issue ratings ($bil)
 
$
4.7

 
$
6.8

 
(30.9
)%
 

(1) Beginning in the second quarter of 2014, we changed our reporting to show the number of enterprise clients for Morningstar Advisor Workstation instead of the number of individual licenses. We believe this is a more meaningful indicator of underlying business trends because per-user pricing varies significantly depending on the scope of the license. We also began disclosing the number of licenses for Morningstar Office as a separate line item.

(2) Revised to reflect a minor calculation change.

(3) The decline in assets under advisement as of June 30, 2014 reflects difficult market conditions for companies that offer variable annuities. Some of our clients have been managing their funds-of-funds portfolios in-house instead of using outside subadvisors. Because of this trend, assets under advisement as of June 30, 2014 were $18.7 billion lower versus the same date in 2013.

The asset totals include relationships for which we receive basis-point fees, including consulting arrangements and other agreements where we act as a portfolio construction manager for a mutual fund or variable annuity. We also provide Investment Advisory services for some assets for which we receive a flat fee; we do not include these assets in the total reported above.
 
Excluding changes related to new contracts and cancellations, changes in the value of assets under advisement can come from two primary sources: gains or losses related to overall trends in market performance, and net inflows or outflows caused when investors add to or redeem shares from these portfolios.


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Table of Contents

We cannot separately quantify cash inflows and outflows for these portfolios because we do not have custody of the assets in the majority of our investment management businesses. The information we receive from many of our clients does not separately identify the effect of cash inflows and outflows on asset balances for each period. We also cannot precisely quantify the effect of market appreciation or depreciation because the majority of our clients have discretionary authority to implement their own portfolio allocations.

(4) We cannot separately quantify the factors affecting assets under management and advisement for our managed retirement accounts. These factors primarily consist of employer and employee contributions, plan administrative fees, market movements, and participant loans and hardship withdrawals. We cannot quantify the effect of these other factors because the information we receive from the plan providers does not separately identify these transactions or the changes in balances caused by market movement.


Three and Six Months Ended June 30, 2014 vs. Three and Six Months Ended June 30, 2013
 
Consolidated Results
 
 
 
Three months ended June 30
 
Six months ended June 30
 
Key Metrics ($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Revenue
 
$
189,385

 
$
175,428

 
8.0
 %
 
$
370,550

 
$
344,284

 
7.6
 %
 
Operating income (loss)
 
$
(24,780
)
 
$
43,584

 
(156.9
)%
 
$
13,752

 
$
84,144

 
(83.7
)%
 
Operating margin
 
(13.1
)%
 
24.8
%
 
(37.9
)
pp
3.7
%
 
24.4
%
 
(20.7
)
pp
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash used for investing activities
 
$
(58,685
)
 
$
(64,925
)
 
(9.6
)%
 
$
(7,203
)
 
$
(15,693
)
 
(54.1
)%
 
Cash used for financing activities
 
$
(25,531
)
 
$
(46,731
)
 
(45.4
)%
 
$
(53,033
)
 
$
(58,381
)
 
(9.2
)%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash provided by operating activities
 
$
54,804

 
$
58,462

 
(6.3
)%
 
$
66,688

 
$
85,135

 
(21.7
)%
 
Capital expenditures
 
(10,006
)
 
(9,763
)
 
2.5
 %
 
(30,799
)
 
(18,881
)
 
63.1
 %
 
Free cash flow
 
$
44,798

 
$
48,699

 
(8.0
)%
 
$
35,889

 
$
66,254

 
(45.8
)%
 
 
____________________________________________________________________________________________
pp — percentage points
 
To supplement our consolidated financial statements presented in accordance with U.S. Generally Accepted Accounting Principles (GAAP), we use the following measures considered as non-GAAP by the U.S. Securities and Exchange Commission: consolidated revenue excluding acquisitions and foreign currency translations (organic revenue), consolidated operating income excluding the litigation settlement (adjusted operating income), consolidated operating margin excluding the litigation settlement (adjusted operating margin), and free cash flow. These non-GAAP measures may not be comparable to similarly titled measures reported by other companies.

We present consolidated revenue excluding acquisitions and foreign currency translations (organic revenue) because the company believes this non-GAAP measure helps investors better compare period-over-period results.

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

Overview of Consolidated Results

Our consolidated revenue increased by about 8% for both the second quarter and first six months of 2014. During the second quarter of 2014, we recorded an expense of $61.0 million—approximately $38.2 million after taxes, or 85 cents per share—related to a previously announced litigation settlement with Business Logic Holding Corp. As a

32


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result, we reported a consolidated operating loss of $24.8 million in the second quarter of 2014, compared with operating income of $43.6 million in the same period a year ago. For the first six months of 2014, we reported operating income of $13.8 million, compared with $84.1 million in the first six months of 2013.

Excluding the litigation settlement, our adjusted operating income declined in both the second quarter and first six months of 2014, mainly because of higher compensation expense from additional headcount, reflecting new hires as well as acquisitions. We discuss these trends in more detail in the Consolidated Operating Expense section that follows. 



Consolidated Revenue
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

Investment information
 
$
149,527

 
$
140,031

 
6.8
%
 
$
290,797

 
$
275,116

 
5.7
%
Investment management
 
39,858

 
35,397

 
12.6
%
 
79,753

 
69,168

 
15.3
%
Consolidated revenue
 
$
189,385

 
$
175,428

 
8.0
%
 
$
370,550

 
$
344,284

 
7.6
%

In the second quarter of 2014, our consolidated revenue increased 8.0% to $189.4 million, compared with $175.4 million in the second quarter of 2013. Some of the main contributors to the increase were Morningstar Direct, Morningstar Retirement Solutions, and Morningstar Data. Positive results for these products were partially offset by a $2.4 million decline for Principia. We have been migrating some Principia clients to Morningstar Advisor Workstation and other products. Revenue for Investment Advisory services was down $1.5 million, reflecting the ongoing effect of clients moving to in-house management for fund-of-funds portfolios in the variable annuity industry.

For the first six months of 2014, our consolidated revenue was up 7.6% to $370.6 million, compared with $344.3 million in the same period of 2013. Morningstar Direct, Morningstar Retirement Solutions and Morningstar Data were the main positive contributors, partially offset by lower revenue for Principia and, to a lesser extent, Investment Advisory services.

Investment information revenue

Investment information revenue, which makes up about 80% of our consolidated revenue, increased $9.5 million, or 6.8%, in the second quarter of 2014. Morningstar Direct revenue rose $3.4 million, and Morningstar Data was up $2.6 million. Revenue for Morningstar Advisor Workstation (including Morningstar Office) rose $2.0 million, which was offset by a $2.4 million drop in revenue for Principia.

For the first six months of 2014, investment information revenue increased $15.7 million, or 5.7%, mainly because of higher revenue for Morningstar Direct and Morningstar Data. Revenue for Morningstar Advisor Workstation (including Morningstar Office) also increased, but was offset by lower revenue for Principia.

Investment management revenue

Investment management revenue, which makes up about 20% of consolidated revenue, was up $4.5 million, or 12.6%, in the second quarter of 2014, driven by higher revenue for Retirement Solutions and Morningstar Managed Portfolios. Assets under management and advisement for Retirement Solutions rose 33.1% year over year, while assets under management for Morningstar Managed Portfolios rose 45.8%. These increases reflect positive market returns over the past 12 months as well as additional net inflows.

Companies that offer variable annuities have continued to face difficult market conditions, which has prompted some of our clients to begin managing their fund-of-funds portfolios in-house instead of using outside subadvisors. Because of this trend, assets under advisement for our Investment Advisory services as of June 30, 2014 were $18.7 billion lower versus the same date in 2013.


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Table of Contents

For the first six months of 2014, investment management revenue increased $10.6 million, or 15.3%, with growth driven mainly by Morningstar Retirement Solutions and Morningstar Managed Portfolios. In addition, we recognized an additional $1.7 million of revenue in the first quarter of 2014 because of a change in accounting estimates involving revenue recognition for certain investment management contracts with minimum fee features.

Revenue from asset-based fees made up about 12% of total consolidated revenue in the second quarter and first six months of both of 2014 and 2013.
 
Organic revenue

To allow for more meaningful comparisons of our results in different periods, we provide information about organic revenue, which reflects our underlying business excluding acquisitions, divestitures, and the effect of foreign currency translations. We had $2.6 million of incremental revenue in the second quarter of 2014 from acquisitions, primarily from ByAllAccounts, as well as a slight benefit from foreign currency translations. Excluding these two factors, organic revenue rose 6.0% in the second quarter of 2014.

For the first six months of 2014, we had $4.1 million of incremental revenue from acquisitions, primarily from ByAllAccounts and purchasing the remaining ownership interest in Morningstar Sweden. Currency translations had close to no effect, and organic revenue increased about 6.4% for the six-month period.

The table below reconciles consolidated revenue with organic revenue (revenue excluding acquisitions, divestitures, and the effect of foreign currency translations):
 
 
 
Three months ended June 30
Six months ended June 30
($000)
 
2014

 
2013

 
Change

2014

 
2013

 
Change

Consolidated revenue
 
$
189,385

 
$
175,428

 
8.0
%
$
370,550

 
$
344,284

 
7.6
%
Less: acquisitions
 
(2,594
)
 

 
NMF

(4,071
)
 

 
NMF

Less: divestitures
 

 

 
NMF


 

 
NMF

Effect of foreign currency translations
 
(885
)
 

 
NMF

(79
)
 

 
NMF

Organic revenue
 
$
185,906

 
$
175,428

 
6.0
%
$
366,400

 
$
344,284

 
6.4
%
 ___________________________________________________________________________________________
NMF - not meaningful

Organic revenue (revenue excluding acquisitions, divestitures, and the effect 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.

Revenue by region
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

United States
 
$
136,453

 
$
126,335

 
8.0
 %
 
$
266,405

 
$
247,748

 
7.5
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
United Kingdom
 
15,544

 
14,015

 
10.9
 %
 
30,882

 
27,168

 
13.7
 %
Continental Europe
 
15,921

 
13,993

 
13.8
 %
 
31,547

 
27,160

 
16.2
 %
Australia
 
9,233

 
9,176

 
0.6
 %
 
17,401

 
18,528

 
(6.1
)%
Canada
 
7,542

 
7,812

 
(3.5
)%
 
15,209

 
15,548

 
(2.2
)%
Asia
 
3,888

 
3,449

 
12.7
 %
 
7,597

 
6,873

 
10.5
 %
Other
 
804

 
648

 
24.1
 %
 
1,509

 
1,259

 
19.9
 %
Total International
 
52,932

 
49,093

 
7.8
 %
 
104,145

 
96,536

 
7.9
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated revenue
 
$
189,385

 
$
175,428

 
8.0
 %
 
$
370,550

 
$
344,284

 
7.6
 %

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Table of Contents


International revenue made up about 28% of our consolidated revenue in the first six months of both 2014 and 2013. About 60% of this amount is from Continental Europe and the United Kingdom; we also generate significant international revenue from Australia and Canada.

Revenue from international operations rose $3.8 million, or 7.8%, in the second quarter. Excluding acquisitions and foreign currency translations, revenue from international operations increased 5.1%. Our operations in Continental Europe and Australia were the main contributors to the increase.

For the first six months of 2014, revenue from international operations was up $7.6 million, or 7.9%. Excluding acquisitions and the negative effect of foreign currency translations, revenue from international operations increased 5.8%. Our operations in the United Kingdom and Continental Europe were the main contributors to the increase, followed by Canada and Australia.

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

 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

International revenue
 
$
52,932

 
$
49,093

 
7.8
%
 
$
104,145

 
$
96,536

 
7.9
%
Less: acquisitions
 
(472
)
 

 
NMF

 
(1,949
)
 

 
NMF

Less: divestitures
 

 

 
NMF

 

 

 
NMF

Favorable effect of foreign currency translations
 
(885
)
 

 
NMF

 
(79
)
 

 
NMF

International organic revenue
 
$
51,575

 
$
49,093

 
5.1
%
 
$
102,117

 
$
96,536

 
5.8
%

International organic revenue (international revenue excluding acquisitions, divestitures, and the effect of foreign currency translations) is considered a non-GAAP financial measure. The definition we use for this measure 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.

Consolidated Operating Expense
  
 
 
Three months ended June 30
 
Six months ended June 30
 
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Cost of revenue (1)
 
$
81,387

 
$
64,427

 
26.3
 %
 
$
157,101

 
$
126,077

 
24.6
%
 
  % of revenue
 
43.0
%
 
36.7
%
 
6.3

pp
42.4
%
 
36.6
%
 
5.8

pp
Sales and marketing
 
27,949

 
28,035

 
(0.3
)%
 
56,377

 
56,015

 
0.6
%
 
  % of revenue
 
14.8
%
 
16.0
%
 
(1.2
)
pp
15.2
%
 
16.3
%
 
(1.1
)
pp
General and administrative
 
30,438

 
28,120

 
8.2
 %
 
56,542

 
55,447

 
2.0
%
 
  % of revenue
 
16.1
%
 
16.0
%
 
0.1

pp
15.3
%
 
16.1
%
 
(0.8
)
pp
Depreciation and amortization
 
13,391

 
11,262

 
18.9
 %
 
25,778

 
22,601

 
14.1
%
 
  % of revenue
 
7.1
%
 
6.4
%
 
0.7

pp
7.0
%
 
6.6
%
 
0.4

pp
Litigation settlement
 
61,000

 

 

 
61,000

 

 

 
  % of revenue
 
32.2
%
 
%
 
32.2

pp
16.5
%
 
%
 
16.5

pp
Total operating expense (2) (3)
 
$
214,165

 
$
131,844

 
62.4
 %
 
$
356,798

 
$
260,140

 
37.2
%
 
  % of revenue
 
113.1
%
 
75.2
%
 
37.9

pp
96.3
%
 
75.6
%
 
20.7

pp
 
(1) We now include development expense in the cost of revenue category, which we previously referred to as cost of goods sold. We have reclassified development expense to include it in cost of revenue for all periods presented. We previously reported development expense as a separate operating expense category.

Separately, as a result of moving to a more centralized structure in 2013 (including new positions created, changes in focus for some existing roles, and the refinement of employee cost categorizations), approximately 180 net positions shifted from the

35


Table of Contents

general and administrative and sales and marketing categories to cost of revenue. For the second quarter of 2014 compared with the same period in 2013, changes related to our more centralized organizational structure added approximately $7 million of compensation expense to cost of revenue, and reduced the compensation expense in our sales and marketing and general and administrative expense categories by approximately $4 million and $3 million, respectively. These changes did not affect our total operating expense or operating income for any of the periods presented.

(2) Includes stock-based compensation expense of:
 
 
Three months ended June 30
 
Six months ended June 30
 
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Stock-based compensation expense
 
$
4,363

 
$
3,954

 
10.3
%
 
$
8,302

 
$
7,737

 
7.3
%
 
  % of revenue
 
2.3
%
 
2.3
%
 

pp
2.2
%
 
2.2
%
 

pp

(3) Includes bonus expense of:
 
 
Three months ended June 30
 
Six months ended June 30
 
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Bonus expense
 
$
13,037

 
$
9,628

 
35.4
%
 
$
25,519

 
$
20,154

 
26.6
%
 
  % of revenue
 
6.9
%
 
5.5
%
 
1.4

pp
6.9
%
 
5.9
%
 
1.0

pp

Consolidated operating expense increased $82.3 million, or 62.4%, in the second quarter of 2014, and $96.7 million, or 37.2%, in the first six months of the year. The $61.0 million litigation settlement expense recorded in connection with our agreement with Business Logic Holding Corporation (the "litigation settlement") contributed the majority of the change in operating expense for both periods.

Higher compensation expense (including salaries, bonus, and other company-sponsored benefits) also contributed to expense growth in both periods. We had approximately 3,800 employees worldwide as of June 30, 2014, compared with 3,425 as of June 30, 2013. We hired about 275 additional employees year over year, including for product and technology roles in the United States as well as data analysts based in India to support our existing business and new initiatives. Headcount also increased because of the ByAllAccounts and HelloWallet acquisitions, which accounted for about 100 additional employees combined.

Commission expense rose $2.1 million in the second quarter and $5.0 million in the first half of 2014, mainly because we changed to a new sales commission structure that requires a different accounting treatment. We now expense commissions as incurred instead of amortizing them over the term of the underlying contracts. However, we are continuing to amortize the prepaid commission balance from our previous commission plan. We expect to incur additional commission expense for the next several quarters because of this change.

Professional fees were up $1.6 million in the second quarter and $3.6 million in the first half of 2014, mainly because of higher legal expense and consulting costs.

The expense growth in both periods was partially offset by a step up in capitalized software development, which reduced operating expense. In the second quarter of 2014, we capitalized $2.2 million of software development costs related to ongoing enhancements for some of our key platforms, including Morningstar Direct, Morningstar Advisor Workstation, and Morningstar.com, as well as an additional $2.2 million of expense for new development of special projects. For the first six months of 2014, we capitalized $8.5 million of software development expense, including $4.3 million for ongoing enhancements of key platforms and an additional $4.2 million for new development of special projects.

Cost of revenue
 
Cost of revenue is our largest category of operating expense, representing about one-half of our total operating expense. Our business relies heavily on human capital, and cost of revenue includes the compensation expense for employees who produce our products and services. Compensation expense for approximately 80% of our employees is included in this category. We now include development expense in this category. We have reclassified development expense to include it in cost of revenue for all periods presented.
 
Cost of revenue increased $17.0 million in the second quarter of 2014. Higher salary expense of $11.4 million was the primary contributor to the increase (including an increase of approximately $7 million from the shift in expense

36


Table of Contents

categories as a result of our recent reorganization). Higher expense for bonus, other compensation, and employee benefits driven by higher headcount also contributed to the change in this category.

For the first six months of 2014, cost of revenue was up $31.0 million. Higher salary expense of $21.1 million was the primary contributor to the increase (including an increase of approximately $14 million from the shift in expense categories as a result of our recent reorganization). Higher expense for bonus, other compensation, and production driven by higher headcount also contributed to the change in this category.

Partially offsetting these increases was an increase in capitalized software development, which reduced cost of revenue in both periods compared to prior periods. We capitalized $4.4 million of compensation associated with software development activities in the second quarter of 2014 and $8.5 million in the first six months of 2014. For comparison, we capitalized $2.2 million of expense in the second quarter of 2013 and $3.8 million in the first six months of 2013.

As a percentage of revenue, cost of revenue increased by about six percentage points in both the second quarter and first six months of 2014, mainly because of additional employees included in this category as a result of our reorganization as well as new hires.

Sales and marketing
  
Sales and marketing expense decreased slightly in the second quarter of 2014. While sales commission expense increased (mainly because of the change in sales commission plan discussed above), this was offset by lower salary expense included in this category as well as a reduction in costs for travel, training, telephone, and conferences.

For the first six months of 2014, sales and marketing was up about $0.4 million, as higher sales commission expense was almost entirely offset by lower salary expense included in this category as well as lower costs for travel, training, telephone, and conferences.

As a percentage of revenue, sales and marketing expense decreased by about one percentage point in both periods.

General and administrative
 
General and administrative (G&A) expense increased $2.3 million in the second quarter of 2014. Benefit costs and professional fees both increased, but that was partially offset by a $0.7 million reduction in salary expense from the shift in expense categories as a result of our recent reorganization.

For the first six months of 2014, general and administrative expense was up $1.1 million. The increase mainly reflects higher costs for professional fees, which was partially offset by lower salary costs included in this category. In addition, we recorded a credit of $1.5 million for damages received in connection with a litigation settlement in the first quarter of 2014, which partially offset increases in legal and other professional fees.

As a percentage of revenue, G&A expense increased slightly in the second quarter of 2014 and decreased by 0.8 percentage points in the first six months of the year, mainly because of the shift in expense categories.

Depreciation and amortization
 
Intangible amortization expense increased slightly in the second quarter of 2014, as additional amortization expense for the intangible assets of HelloWallet and ByAllAccounts was largely offset by the completed amortization of certain intangible assets from some of our earlier acquisitions. However, depreciation expense rose $2.0 million in the quarter, primarily driven by higher capital expenditures for computer software and incremental capitalized software development costs for our operations in the United States.

For the first six months of 2014, intangible amortization expense was down about $0.3 million, as certain intangible assets from some of our earlier acquisitions are now fully amortized. Depreciation expense increased by $3.5 million, largely driven by the same factors that contributed to growth in depreciation in the second quarter of 2014.
 

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Table of Contents

We expect that amortization of intangible assets will be an ongoing cost for the remaining lives of the assets. We estimate that aggregate amortization expense for intangible assets will be approximately $22.5 million in 2014 and $22.7 million in 2015. Our estimates of future amortization expense for intangible assets may be affected by additional acquisitions, dispositions, changes in the estimated average useful lives, and currency translations.
 
As a percentage of revenue, depreciation and amortization expense increased slightly in both the second quarter and first six months of 2014.

Litigation settlement

As mentioned above, we recorded a $61.0 million litigation settlement in the second quarter of 2014 related to the agreement with Business Logic.

The litigation settlement contributed the majority of the increase in operating expense for both the second quarter and first six months of 2014.

Consolidated Operating Income (Loss)
 
 
 
Three months ended June 30
 
Six months ended June 30
 
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Operating income (loss)
 
$
(24,780
)
 
$
43,584

 
(156.9
)%
 
$
13,752

 
$
84,144

 
(83.7
)%
 
% of revenue
 
(13.1
)%
 
24.8
%
 
(37.9
)
pp
3.7
%
 
24.4
%
 
(20.7
)
pp
 
Consolidated operating income (loss) decreased $68.4 million in the second quarter of 2014 as revenue increased $14.0 million and operating expense increased $82.3 million. Operating margin was (13.1)%, down 37.9 percentage points compared with the second quarter of 2013.

Consolidated operating income decreased $70.4 million in the first six months of 2014 as revenue increased $26.3 million and operating expense increased $96.7 million. Operating margin was 3.7%, down 20.7 percentage points compared with the first half of 2013.

The $61.0 million litigation settlement was the primary contributor to the decline in operating income and operating margin in both the second quarter and first six months of 2014. We also had higher salary and other compensation-related expense from additional headcount, reflecting both new hires and employees added through the ByAllAccounts and HelloWallet acquisitions.

Excluding the litigation settlement, we reported adjusted operating income of $36.2 million in the second quarter of 2014, a decrease of 16.9%, and $74.8 million for the first six months of 2014, a decrease of 11.2%. Adjusted operating income is a non-GAAP measure; the table below shows a reconciliation to the comparable GAAP measure.

We present adjusted operating income (operating income excluding the litigation settlement) to show the effect of this charge, better reflect period-over-period comparisons, and improve overall understanding of our current and future financial performance.

 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

Operating income (loss)
 
$
(24,780
)
 
$
43,584

 
(156.9
)%
 
$
13,752

 
$
84,144

 
(83.7
)%
Less: litigation settlement
 
61,000

 

 

 
61,000

 

 

Adjusted operating income
 
$
36,220

 
$
43,584

 
(16.9
)%
 
$
74,752

 
$
84,144

 
(11.2
)%

Excluding the litigation settlement, we reported an adjusted operating margin of 19.1% in the second quarter of 2014, a decrease of 5.7 percentage points, and 20.2% for the first six months of 2014, a decrease of 4.2 percentage points. Adjusted operating margin is a non-GAAP measure; the table below shows a reconciliation to the comparable GAAP measure.


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Table of Contents

We present adjusted operating margin (operating margin excluding the litigation settlement) to show the effect of this charge, better reflect period-over-period comparisons, and improve overall understanding of our current and future financial performance.


 
 
Three months ended June 30
 
Six months ended June 30
 
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

 
Operating margin
 
(13.1
)%
 
24.8
%
 
(37.9
)
pp
3.7
%
 
24.4
%
 
(20.7
)
pp
Less: litigation settlement
 
32.2
 %
 
%
 
32.2

pp
16.5
%
 
%
 
16.5

pp
Adjusted operating margin
 
19.1
 %
 
24.8
%
 
(5.7
)
pp
20.2
%
 
24.4
%
 
(4.2
)
pp
 

Equity in Net Income of Unconsolidated Entities, Non-Operating Income (Expense), and Income Tax Expense (Benefit)
 
Equity in net income of unconsolidated entities
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Equity in net income of unconsolidated entities
 
$
497

 
$
360

 
$
1,096

 
$
857

 
Equity in net income of unconsolidated entities includes our portion of the net income (loss) of Morningstar Japan K.K. (MJKK), YCharts, Inc., and Inquiry Financial Europe AB. In the first four months of 2013, this category also included our portion of the net income (loss) of Morningstar Sweden. In May 2013, we acquired an additional 76% interest in Morningstar Sweden, increasing our ownership interest to 100% to become sole owner. Because Morningstar Sweden is now a wholly owned subsidiary, we no longer account for our investment using the equity method.

Equity in net income of unconsolidated entities is primarily from our position in MJKK.
 
Non-operating income (expense)
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Interest income
 
$
715

 
$
750

 
$
1,363

 
$
1,508

Interest expense
 
(81
)
 
(86
)
 
(144
)
 
(103
)
Gain (loss) on sale of investments, net
 
371

 
423

 
347

 
1,148

Holding gain upon acquisition of additional ownership of equity and cost method investments
 
5,168

 
3,713

 
5,168

 
3,713

Other income (expense), net
 
(275
)
 
(1,689
)
 
29

 
(2,210
)
Non-operating income, net
 
$
5,898

 
$
3,111

 
$
6,763

 
$
4,056

 
Interest income mainly reflects interest from our investment portfolio.

Non-operating income for both the second quarter and first six months of 2014 reflects the $5.2 million gain we recorded in connection with our purchase of the remaining ownership interest in HelloWallet, which was previously a minority investment. Non-operating income for both the second quarter and first six months of 2013 reflects the $3.7 million gain we recorded in connection with our purchase of the remaining ownership interest in Morningstar Sweden, which was previously a minority investment.

Other income (expense), net also includes foreign currency exchange gains and losses arising from the ordinary course of business related to our U.S. and non-U.S. operations and royalty income from MJKK.

Income tax expense (benefit)
 
The following table shows our effective tax rate:

39


Table of Contents

 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
2014

 
2013

Income (loss) before income taxes and equity in net income of unconsolidated entities
 
$
(18,882
)
 
$
46,695

 
$
20,515

 
$
88,200

Equity in net income of unconsolidated entities
 
497

 
360

 
1,096

 
857

Net loss attributable to the noncontrolling interest
 
5

 
21

 
35

 
64

Total
 
$
(18,380
)
 
$
47,076

 
$
21,646

 
$
89,121

Income tax expense (benefit)
 
$
(8,611
)
 
$
15,955

 
$
5,039

 
$
28,382

Effective tax rate
 
46.8
%
 
33.9
%
 
23.3
%
 
31.8
%
 
During the second quarter of 2014, we reported a loss before income taxes and equity in net income of unconsolidated entities of $18.9 million, which included litigation settlement expense of $61.0 million that is deductible for tax purposes. In the same period, we realized a $5.2 million non-taxable gain in connection with the purchase of the remaining ownership interest in HelloWallet. Because of these two items, we reported an income tax benefit of $8.6 million, which is equivalent to a 46.8% effective tax rate.

Our effective tax rate for the first six months of 2014 was 23.3%, which is lower than the statutory rate mainly because of the non-taxable gain of $5.2 million recorded in connection with purchasing the remaining ownership interest in HelloWallet.


Liquidity and Capital Resources
 
We believe our available cash balances and investments, along with cash generated from operations, will be sufficient to meet our operating and cash needs for at least the next 12 months. We invest our cash reserves in cash equivalents and investments, consisting primarily of fixed-income securities. We maintain a conservative investment policy for our investments and invest a portion of these assets in government obligations and corporate bonds with high-quality stand-alone credit ratings. Investments in our portfolio have a maximum maturity of two years; the weighted average maturity is approximately one year. We also invest a portion of our investments balance (approximately $21.6 million, or 48% of our total investments balance as of June 30, 2014) in proprietary Morningstar portfolios, exchange-traded funds that seek to track the performance of certain Morningstar proprietary indexes, and various mutual funds. These portfolios may consist of stocks, bonds, options, mutual funds, or exchange-traded funds.

Approximately 31% of our cash, cash equivalents, and investments as of June 30, 2014 was held by our operations in the United States, down from about 51% as of December 31, 2013. We do not expect to repatriate earnings from our foreign subsidiaries in the foreseeable future. We have not recognized deferred tax liabilities for the portion of the outside basis differences (including unremitted earnings) relating to foreign subsidiaries because the investment in these subsidiaries is considered to be permanent in duration. Quantification of the deferred tax liability associated with these outside basis differences is not practicable.
 
We intend to use our cash, cash equivalents, and investments for general corporate purposes, including working capital and funding future growth.

In July 2014, we established a $75 million single-bank revolving credit facility in the United States, which we intend to use for general corporate purposes.

In the first six months of 2014, we paid dividends of $15.3 million. In May 2014, our board of directors approved a payment of a regular quarterly dividend of 17.0 cents per share payable on July 31, 2014 to shareholders of record as of July 11, 2014. We expect to make a recurring quarterly dividend payment of 17.0 cents per share in 2014.

In December 2013, our board approved a $200 million increase to our share repurchase program, bringing the total amount authorized under the program to $700 million. We may repurchase shares from time to time at prevailing market prices on the open market or in private transactions in amounts that we deem appropriate. In the first six months of 2014, we repurchased a total of 0.5 million shares for $36.7 million. As of June 30, 2014, we have

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repurchased a total of 7.6 million shares for $486.5 million since we announced the share repurchase program in September 2010.

Cash provided by operating activities is our main source of cash. In the first six months of 2014, cash provided by operating activities was $66.7 million, driven by $38.8 million of net income, adjusted for non-cash items, partially offset by $27.9 million in changes from our net operating assets and liabilities.

As of June 30, 2014, we had cash, cash equivalents, and investments of $221.0 million, a decrease of $77.6 million compared with $298.6 million as of December 31, 2013. The decrease reflects $36.7 million used to repurchase common stock through our share repurchase program, bonus payments of $39.8 million made during the first quarter of 2014 related to the 2013 bonus, $64.4 million used for the acquisitions of ByAllAccounts and HelloWallet, and $30.8 million of capital expenditures. These outflows were partially offset by cash provided by operating activities.

We expect to continue making capital expenditures in 2014, primarily for internally developed software, leasehold improvements for new and existing office locations, and computer hardware and software.

Our cash flows during the third quarter of 2014 will reflect the $61.0 million payment to Business Logic as part of the July 2014 settlement agreement reached in connection with this litigation matter.


Consolidated Free Cash Flow
 
As described in more detail above, we define free cash flow as cash provided by or used for operating activities less capital expenditures.
 
 
 
Three months ended June 30
 
Six months ended June 30
($000)
 
2014

 
2013

 
Change

 
2014

 
2013

 
Change

Cash provided by operating activities
 
$
54,804

 
$
58,462

 
(6.3
)%
 
$
66,688

 
$
85,135

 
(21.7
)%
Capital expenditures
 
(10,006
)
 
(9,763
)
 
2.5
 %
 
(30,799
)
 
(18,881
)
 
63.1
 %
Free cash flow
 
$
44,798

 
$
48,699

 
(8.0
)%
 
$
35,889

 
$
66,254

 
(45.8
)%
 
We generated free cash flow of $44.8 million in the second quarter of 2014, a decrease of $3.9 million compared with free cash flow of $48.7 million in the second quarter of 2013. The change reflects a $3.7 million decline in cash provided by operating activities, as well as an $0.2 million increase in capital expenditures.

In the first six months of 2014, we generated free cash flow of $35.9 million, a decrease of $30.4 million compared with free cash flow of $66.3 million in the same period of 2013. The decrease reflects an $18.4 million decline in cash provided by operating activities, as well as an $11.9 million increase in capital expenditures.

Application of Critical Accounting Policies and Estimates
 
We discuss our critical accounting policies and estimates in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in our Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the SEC on February 28, 2014. We also discuss our significant accounting policies in Note 2 of our Audited Consolidated Financial Statements included in our Annual Report.



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Rule 10b5-1 Sales 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 July 15, 2014:
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 July 15, 2014

 
Projected
Beneficial
Ownership (1)

Cheryl Francis, Director
 
5/15/2014
 
12/31/2014
 
6,220

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

 
17,023

Steve Kaplan, Director
 
2/26/2014
 
12/10/2014
 
4,000

 
Shares to be sold under the plan on specified dates
 

 
49,345

Jack Noonan, Director
 
11/15/2012
 
5/2/2015
 
24,000

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

 
18,000

 
60,523

David Williams, Head of Design and Marketing
 
11/25/2013
 
4/1/2015
 
7,500

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

 
4,500

 
38,277


During the second quarter of 2014, the previously disclosed Rule 10b5-1 sales plan for Richard Robbins completed in accordance with its terms.
_______________________________
(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 June 30, 2014, and includes shares of our common stock subject to options that were then exercisable or that will have become exercisable by August 29, 2014 and restricted stock units that will vest by August 29, 2014. The estimates do not reflect any changes to beneficial ownership that may have occurred since June 30, 2014. 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.

Item 3.
Quantitative and Qualitative Disclosures about Market Risk
 
Our investment portfolio is actively managed and may suffer losses from fluctuating interest rates, market prices, or adverse security selection. We invest our investment portfolio mainly in high-quality fixed-income securities. As of June 30, 2014, our cash, cash equivalents, and investments balance was $221.0 million. Based on our estimates, a 100 basis-point change in interest rates would change the fair value of our investment portfolio by approximately $0.01 million.

As our non-U.S. revenue increases as a percentage of our consolidated revenue, fluctuations in foreign currencies present a greater potential risk. Our European operations are subject to currency risk related to the euro. 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 results could suffer if certain foreign currencies decline relative to the U.S. dollar. In addition, because we use the local currency of our subsidiaries as the functional currency, we are affected by the translation of foreign currencies into U.S. dollars.
 
Item 4.
Controls and Procedures
 
(a)
Evaluation and Disclosure Controls and Procedures
 
Disclosure controls and procedures are designed to reasonably assure that information required to be disclosed in the reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation,

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controls and procedures designed to reasonably assure that information required to be disclosed in the reports filed under the Exchange Act is accumulated and communicated to management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
 
We carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as of June 30, 2014. Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported as and when required and is accumulated and communicated to management, including the chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.
 
(b)
Changes in Internal Control Over Financial Reporting
 
There were no changes in our internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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PART 2.
OTHER INFORMATION
 
Item 1.
Legal Proceedings
 
We incorporate by reference the information regarding legal proceedings set forth in Note 11, Contingencies, of the Notes to our Unaudited Condensed Consolidated Financial Statements contained in Part 1, Item 1 of this Quarterly Report on Form 10-Q.
 
Item 1A.
Risk Factors
 
There have been no material changes to the risk factors disclosed in Item 1A—Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2013.


Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
Issuer Purchases of Equity Securities*
 
The following table presents information related to repurchases of common stock we made during the three months ended June 30, 2014:
 
Period:
 
Total number
of shares
purchased

 
Average
price paid
per share

 
Total number
of shares
purchased as
part of publicly
announced
programs (1)

 
Approximate
dollar value of
shares that
may yet be
purchased
under the
programs (1)

Cumulative through March 31, 2014
 
7,350,313

 
$
64.13

 
7,350,313

 
$
228,519,472

April 1, 2014 – April 30, 2014
 

 

 

 
$
228,519,472

May 1, 2014 – May 31, 2014
 

 

 

 
$
228,519,472

June 1, 2014 – June 30, 2014
 
207,494

 
72.40

 
207,494

 
$
213,495,903

Total
 
7,557,807

 
$
64.36

 
7,557,807

 



 _________________________________________________
* Subject to applicable law, we may repurchase shares at prevailing market prices directly on the open market or in privately negotiated transactions in amounts that we deem appropriate.
 
(1)
We have an ongoing authorization, originally approved by our board of directors in September 2010, and subsequently amended, to repurchase up to $700 million in shares of our outstanding common stock. The authorization expires on December 31, 2015.


Item 6.
Exhibits
 
Incorporated by reference to Exhibit Index included herewith.


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SIGNATURE
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
MORNINGSTAR, INC.
 
 
 
Date: July 31, 2014
By:
/s/ Stéphane Biehler
 
 
Stéphane Biehler
 
 
Chief Financial Officer
 
 
 
 

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EXHIBIT INDEX
 
Exhibit No
 
Description of Exhibit
10.1
 
Settlement Agreement dated as of July 17, 2014 between Morningstar, Ibbotson Associates and Business Logic is incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K that we filed with the SEC on July 17, 2014
 
 
 
31.1†
 
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended
 
 
 
31.2†
 
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as amended
 
 
 
32.1†
 
Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
32.2†
 
Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101†
 
The following financial information from Morningstar Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, filed with the SEC on July 31, 2014 formatted in XBRL: (i) Condensed Consolidated Statements of Income, (ii) Condensed Consolidated Statements of Comprehensive Income (iii) Condensed Consolidated Balance Sheets, (iv) Condensed Consolidated Statement of Equity, (v) Condensed Consolidated Statements of Cash Flows and (vi) the Notes to Unaudited Condensed Consolidated Financial Statements
 ______________________________________

† Filed herewith.


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