Three Reasons to Wake Up to Morningstar

I am not going to lie; I became as giddy as a teeny bopper buying the new Justin Timberlake album when I read and analyzed the business of Morningstar (MORN). The company possesses almost every aspect that I look for when evaluating an investable business. Great cash flows, excellent management and superior competitive advantages are all essential when I evaluate a business. Below are some additional reasons why I purchased shares of Morningstar (in no particular order)

Superior Free Cash Flow Generation

Much has been written recently about the importance of a company generating adequate free cash flow (click here for a more detailed explanation of Free Cash Flow). All the attention is much warranted. Having the ability to generate excess cash is beneficial as it can be used in many different ways to increase shareholder value. Ways to increase shareholder value include stock buybacks, dividend payments, and even the ability to acquire companies without adding any additional debt.

Think about free cash flow from a personal aspect; wouldn’t it be nice to have extra cash per month from your paycheck after paying all your bills and living costs like groceries? All that excess cash can be used to purchase a new TV or enhance your DVD collection. Historically, many companies don’t have superior Free Cash Flow because they need to invest any cash earned back in the business. Auto makers are a good example. They make a ton of cash but require a lot of cash right back into the business (think factories, engineering.)

Over the past few years, Morningstar has been able to grow and expand its FCF at a nice clip. In 2004, the company reported FCF of $25 million and $93 million in the most recently reported 2006 results. Management has decided to use this excess cash to make a variety of acquisitions that boosted their Investing Consulting business and International presence; both which are keys to future growth. Going forward, it appears the company could grow FCF an annual growth rate of about 15% for the next five years. Odds are the Company will probably use the free cash to fund more acquisitions, especially from an international presence, and buy back some stock.

Strong Business Model

The Company’s main weapon is its vast databases of information on mutual funds, stocks and other investments which it sells to its customers as the basis of its business. Morningstar is the first database business model I have examined. I never realized how strong using databases as the basis of a company’s business model can be. If you think about, creating a database has significant upfront and fixed costs. However, the beauty of the Morningstar model is that once the upfront costs are incurred, adding any additional customers is dirt cheap because they are able to cross sell the heck out of the databases. Without spoiling the last topic of discussion below, the company has been able to successfully cross sell database information into viable specific business segments to increase growth.

For the near future, MORN’s profitability should be relatively high because the company incurred most of the upfront costs of creating their databases already. So adding the additional customers of the past few quarters has been relatively cheap. This trend should continue in the near future, as the company shouldn’t require a great deal of investment in their already strong database. However, don’t expect exploding growth because the company will potentially require investments into the international equities and hedge fund databases.

Strong Business Segments

Prior to researching MORN as a potential investment, my impression of the company was probably similar to many others; the company sells its mutual fund “star ratings” to businesses like Yahoo (YHOO) and MSN (MSFT) to use on their finance branded sites. After further research I noticed that, while this segment was a large part of the company’s revenue, MORN has many other business lines. More specifically, I was impressed with how the company used its dominant position in mutual fund ratings to expand into many different products and business segments. The business segment expansion evidenced in the past gives me confidence that Management will continue to find additional revenue streams in the future. Below is a listing of segment revenue and percentages:

Top Five Products (Segment) 2006*
Investment Consulting (Institutional) $ 46,597 - 14.8 %
Advisor Workstation (Advisor) $43,140 - 13.7%
Licensed Data (Institutional) $37,730 - 12.0%
Morningstar.com (Individual) $31,311 - 9.9%
Principia (Advisor) $28,735 - 9.1%

*Below is a quick overview of each (segment) obtained from 2006 10-K

Individual - which focuses on products and services for individual investors;
Advisor - which focuses on products and services for financial advisors; and
Institutional - which focuses on products and services for institutional clients, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors.

The notes above are just a few reasons why I purchased a position in MORN. In reality, there are a number of additional reasons why I purchased shares. I would recommend performing additional analysis to determine if the investment is appropriate for your portfolio.

Disclosure: I own shares Morningstar.

MORN 1-yr chart

Comments

[DavidJackson]

I wonder whether Morningstar is at risk in any way from the growth of ETFs.