The Market Fully Reflects Morningstar's Value

Summary

• The fundamentals of the business look good. MORN is growing fast and more importantly, faster than the industry average in its key products.
• The increasing market interest in MORN's products is in my opinion a clear catalyst that will help the company perform well in the future.
• I feel the current valuation is stretched and does not offer any margin of safety.

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Investment Thesis

Financial markets in the United States are the largest and the most liquid in the world. A Gallup survey released in August 2021 found that approximately 56% of individuals in the U.S. invest in the stock market either directly, through mutual funds, or retirement plans. Moreover, the interest in stocks has skyrocketed since the pandemic started and companies such as Morningstar Inc. (NASDAQ:MORN) providing the financial data have benefited and will continue to benefit from this trend. For instance, the stock page view growth for companies like Apple (AAPL) or Coca-Cola (KO) on Morningstar.com has increased by 44% and 121%, respectively in the first two months of 2021. In addition to that, the website has a young audience with more than 50% of users below the age of 44.

Source: Morningstar 2021 Shareholders' Meeting

But MORN is much more than a simple website. The company is one of the largest providers of ESG data through Sustainalytics as well as the 4th largest credit rating agency in the world. Despite the positive tailwinds, I believe the stock is currently overvalued based on my DCF model.

Company Details

Founded in 1984, MORN is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company's core competencies are data and investment research. MORN provides affordable research to both retailers and institutional investors (financial advisors, asset managers, retirement plan providers). MORN is a publicly listed company since May 2005.

Source: Morningstar 2021 Shareholders' Meeting

Source: Morningstar 2021 Shareholders' Meeting

Business Strategy

The company is focused on four strategic priorities:

• to deliver differentiated insights across asset classes to public and private market investors

Shifting investor needs and expectations, innovative investment approaches, technologies, and regulatory environment continue to drive the evolution of the financial services industry. This provides an opportunity for Morningstar to capitalize on. For instance, I think there is a good opportunity to expand the data content beyond traditional markets such as the US. Moreover, the growing regulatory burden on the financial industry provides another opportunity where the company can expand their compliance solutions for the wealth, buy-side, and asset management segments.

• to establish a leading ESG position across each business

The company is very well positioned to benefit from the shift to ESG investing. MORN acquired Sustainalytics back in 2020 which is a leader in the field of sustainability ratings based on ESG metrics. I think there is a good opportunity for the company to continue to grow in this market by developing ESG solutions for wealth managers, advisors, and individual investors.

• to drive operational excellence and scalability to support growth targets

The company has been growing fast in the past six years. The average top-line growth rate stands at 12.15% and in my opinion, there is a high chance the company will be able to maintain such a high growth rate going forward. MORN has gathered a lot of data since its inception and if it can continue to leverage its data collection tools, I think that MORN will continue to deliver strong growth on the back of innovative products and services.

• to build an inclusive culture that drives exceptional talent engagement and development

This last pillar is in line with the general narrative emphasized by most publicly traded companies in the US in recent months. I think it can only be beneficial if the company has an inclusive work environment that attracts top talent.

Turning now to the main sources of income, MORN's revenue comes from three major categories:

1. Licensed-Based: The majority of the company's research, data, and proprietary platforms are accessed via subscription services. Licensed-based revenue represented 67.3% of MORN's 2020 consolidated revenue compared to 68.9% in 2019 and 73.7% in 2018. This includes Morningstar Data, Morningstar Direct, Morningstar Advisor Workstation, PitchBook, and Sustainalytics.
2. Asset-based: Morningstar charges fees for assets under management or advisement. Investment Management, Workplace Solutions, and Morningstar Indexes products all fall under asset-based revenue. Asset-based revenue represented 16.1% of MORN's 2020 consolidated revenue, compared to 17.9% in 2019
3. Transaction-based: Credit ratings and ad sales on Morningstar.com comprise the majority of the products that are transactional, or one-time, in nature. Transaction-based revenue represented 16.6% of MORN's 2020 consolidated revenue compared to 13.1% in 2019 and 6.7% in 2018. It is interesting to note that this category's share of revenue as a percentage of total revenue is growing fast and has more than doubled since 2018.

Digging now deeper into these categories, we can find the top three major products and services MORN is offering:

Morningstar Data: Morningstar Data gives institutions access to a full range of investment data, including equity fundamentals, managed investments, ESG Factors, and market data. MORN also offers other data, including information on investment performance, risk, portfolio, operations data, fees and expenses, financial statement data, and industry statistics. Morningstar Data accounted for 15.5%, 16.7%, and 18.2% of consolidated revenue in 2020, 2019, and 2018, respectively. The main global competitors for Morningstar in mutual fund data are Financial Express and Thomson Reuters. This product is growing at a double digit rate, although not as fast as PitchBook or DBRS.

Source: Morningstar 2021 Shareholders' Meeting

DBRS Morningstar: The DBRS Morningstar is the world's fourth-largest credit rating agency. They provide independent credit ratings for financial institutions, corporate and sovereign entities, and structured finance products and instruments. DBRS Morningstar competes with several other firms, including Fitch, Kroll Bond Ratings, Moody's, and S&P Global Ratings. DBRS is MORN's second-largest product based on revenue and accounted for 14.9%, 10.8%, and 3.6% of total sales in 2020, 2019, and 2018, respectively. The demand for DBRS is pretty impressive. DBRS posted 23.5% organic growth in Q1 FY21, which is far above the 11.1% industry average.

Source: Morningstar 2021 Shareholders' Meeting

PitchBook: PitchBook provides data and research covering the private capital markets, including venture capital, private equity, and M&A. PitchBook is the third-largest product based on revenue and made up 14.5%, 12.6%, and 9.8% of consolidated revenue in 2020, 2019, and 2018, respectively. The main competitors are CB Insights, Dow Jones VentureSource, Preqin, S&P Capital IQ, and Thomson Reuters. This product has been growing very fast. To give you an idea, PitchBook grew at a CAGR of approximately 40% from FY16 until FY20.

Source: MORN's FY20 10-K

Company Valuation

Based on 43.1 million shares outstanding, and a price of $329 per share, the company has a market cap of approximately $14.18 billion. In this part, I have used a discounted free cash flow model to value the business. The following assumptions have been made in the model:

• The estimated free cash flow for FY21 is $352.6 million, which represents a 14.6% increase from FY20.
• A 14.63% growth rate over the next four years until FY25. This growth rate corresponds to the sustainable growth rate calculated based on the Gordon Growth Model assuming a return on equity of 19% and earnings retention rate of 77% going forward.
• A 2% terminal growth rate.
• A discount rate of 9%.

Source: Author's model

Based on my model, the fair value of the stock should be around $183 per share. Despite the high growth rate in free cash flow, the stock is in my opinion overvalued at the current market cap of $14.18 billion. The current price doesn't leave any room for error in execution and if the company is not able to deliver on the high growth expectations, this could turn ugly for MORN investors.

Key Takeaways

In summary, the fundamentals of this company are looking very good. I like the fact that MORN is growing fast and more importantly, faster than the industry average in its top products. The increasing market interest in MORN's products is in my opinion a clear catalyst that will help the company perform well in the future. However, I feel that the market is expecting a lot from MORN at the moment, and this is reflected in the valuation. The stock is currently trading roughly 80% higher than my intrinsic value estimate which makes MORN risky at the moment for me.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.