Morningstar: Ready to Rebound

Apr.12.09 | About: Morningstar, Inc. (MORN)

Morningstar (NASDAQ:MORN) provides independent investment research to investors worldwide. It offers a range of Internet, software, and print-based products for individual investors, financial advisors, and institutional clients. It provides asset management services for advisors, institutions, and retirement plan participants. Morningstar sells international versions of its products to investors in Asia, Australia, Canada, Europe, Japan, and South Africa.

Last year MORN introduced hedge fund ratings and Style Boxes, a Morningstar Rating for collective investment trusts, a new series of hedge fund categories and indexes, analyst-driven fair value estimates for exchange traded funds, new glide path data for target-date funds, estimated cash flow and market share data for investments in global markets, and rider descriptions for variable annuities.

Morningstar came public in 2005 and the shares were market darlings rising from $18.51 TO $37.43 between May and December. Earnings grew rapidly in 2006 and 2007 and MORN shares peaked at $85.50 (and 56 times earnings) late in the year.

The first three quarterly comparisons of 2008 were quite positive year-over-year before a Q4 dip to $0.39 versus $0.41 made the full year 2008’s earnings a still excellent $1.88 v. $1.53 /share. MORN’s share price collapsed with the market in October and November last fall hitting $25.78 when the broad market hit bottom around Thanksgiving.

Its sales and earnings are quite sensitive to general market conditions and 2009 estimates now call for their first ever drop in EPS to about $1.63. If the last five weeks upturn in the averages continues, however, I think that estimates may start ratcheting upwards. Here are their per share numbers as reported by Value Line:

Year …..Sales ….. C/F …... EPS ….. B/V ….. Avg. P/E …52-Wk-Price Range
2005 …. 5.64 …… 0.98 ….. 0.70 …. 4.31 …… 42.1x …… $18.51 – $37.43
2006 …. 7.46 …… 1.57 ….. 1.10 …. 6.38 …… 37.3x …… $32.99 – $47.56
2007 …. 9.70 …… 2.12 ….. 1.53 …. 9.11 …… 37.7x …… $44.60 – $85.50
2008 ….10.21 …... 2.23 ….. 1.88 ….11.33 ……27.6x …… $25.78 – $77.81

At Thursday’s close of $32.02 these shares are now at 17x last year’s and < 19.7x the reduced estimates for 2009.

The company is debt free and held $174 MM cash and $124 MM in short term securities against $103 MM in accounts payable at year end 2008. That $195 MM (net cash and equivalents) equals about $4.22 /share making the effective multiple even lower.

I could easily picture these shares returning to a more typical valuation as the markets firm up. The current share price is lower than the lows touched in the full years 2006 and 2007 even though revenues, cash flow, earnings and book value are much higher now.

I see a minimum target price of 22x the conservative $1.63 Zacks estimate or $35.86 /share by year-end. Higher EPS and a larger multiple are certainly possible. The shares were north of $38 this past January.

Here’s a nice play from now through next January:

……………………………………. Cash Outlay……… Cash Inflow
Buy 1000 MORN @ $32.02 …….. $32,020
Sell 10 Jan. $35 calls @ $2.50 ………………….……$2,500
Sell 10 Jan. $30 puts @ $4.20 ………………….…… $4,200
Net Cash Out-of-Pocket ……….... $25,320

If Morningstar shares rise to $35 or higher by the expiration date of January 15, 2010:

  • Your $35 calls will be exercised.
  • You will sell your shares for $35,000.
  • Your $30 puts will expire worthless (a good thing for you as a seller).
  • You will have no further option obligations.

You will hold $35,000 cash for your original $25,320 outlay.

That’s a best case scenario, cash-on-cash return of 38% on a position you held for less than 10 months on shares which only had to go up by 9.3% from trade inception.

If Morningstar shares are unchanged from your starting price on January 15, 2010:

  • Your $35 calls will expire worthless.
  • Your $30 puts will expire worthless.
  • You will still own 1000 shares of MORN worth $32,020.
  • You will have no further option obligations.

You have $32,020 for your original outlay of $25,320.

That’s a total return of 26%, on shares which did not go up, achieved in <10 months.

What’s the risk?

If MORN shares go below $30 before expiration date:

  • Your $35 calls will expire worthless.
  • Your $30 puts will be exercised.
  • You will be forced to buy an additional 1000 shares and to lay out another $30,000 cash.
  • You will now own 2000 shares of MORN.

What’s the break-even on this whole trade?

On the first 1000 shares it’s their $32.02 price less the $2.50 call premium = $29.52 /share.

On the ‘put’ shares it’s the $30 strike price less the $4.20 put premium = $25.80 /share.

Your net break-even price is the average of $29.52 and $25.80 = $27.66 /share.

Thus, Moringstar shares could fall by up to $4.36 /share or (-13.5%) by January 15, 2010 without causing you to suffer a loss from inception of this trade.

Disclosure: Author is long MORN shares and short MORN options.