A financial data platform that’s engrained with a culture of cost-discipline and contrarian attitudes that has a shot of displacing the existing order.

Could it displace the titans of old? I’m talking about household names like Bloomberg, Moodys, S&P and the like. Maybe that’s not the right question. Maybe the better question is whether it could become an entirely new creature. I don’t know what Youtube was emulating but it’s definitely a beast of a different species from what may have dominated the past. 

It’s tough work trying to quell down my natural sense of optimism and euphoria where I try to see the upside in many cases. Morningstar may be one such scenario. 

Morningstar is, in my life, synonymous with a great financial website for individual investors, a go-to ranking platform for mutual funds, and the only place that has ranking related to economic moats. At least, this was the case when I started out in investing. I rarely use it now having found better/comparable alternatives like QuickFS and Yahoo Finance. 

But once again, my use case probably shouldn’t be the determinant to whether something is a good or bad company. Though, maybe my denial of something may have to be a signal I consider. I thought the iPhone was stupid back in 2008, I thought AirPods for worthless, thought Spotify was a waste of money, that Twitter was a waste of time… and yet… I’ve now come to use all of them… even some a good 10 years after their popularity. A classic tech laggard. 

Before I digress any further, what is Morningstar? Management calls it “The original fintech” and this may be so given that the company was founded in 1984 and had unlimited vacation day policies in the 1990s. But for all intents and purposes, if you had no idea what the company did, it’s a financial data service company with the mission of “Empowering investor success.”

Brief History

Joe Mansueto, current Executive Chairman, founded the company in 1984 from his living in Chicago. Mansueto credits Warren Buffett for the inspiration to start Morningstar as he learned about the Oracle of Omaha from reading John Train’s 1980s book: Money Masters. 

Joe described in past interviews as being an epiphany when he read about Warren Buffett. It seems like this is the case for most people. You either ‘get it’ or you don’t. For Joe, this spurred a curiosity into the market and investing that his business programs failed to achieve. 

But it wasn’t until selling soda out of his dorm room, selling Christmas trees while in his MBA, working at Arby’s for as a night manager to understand the business of fast-food, working as a VC for a couple of years, then becoming a stock analyst… did he finally launch Morningstar… a service to aggregate the mutual fund industry data. Something that others apparently didn’t do. 

"The fact that the mutual-fund industry was growing and that there were few competing publications were additional attractions to this business. The information that did exist went only to the institutions that were running and marketing funds. Fund investors had no affordable sources of information. I was sure that funds had a future and the number of people investing in funds was going to grow. Those people would then need more sophisticated and in-depth information to help them make better investment decisions. So it seemed as if we'd be swimming with a rising tide." - Joe Mansueto in 1999 Inc. Magazine interview

It has since IPO’d in 2005 with Mansueto maintaining 78% ownership. Once again.. 78%! Nowadays, people applaud some 3% ownership by venture-backed CEOs. By golly that is amazing. 

Mansueto transferred the CEO mantle to Kunal Kapoor in 2017. Kapoor joined Morningstar in 1997 as a data analyst straight after university, got his MBA while working at the company and became its leader after 20 years. 

Since beginning as a publishing company for mutual fund information, Morningstar’s evolved to become a data-engine for financial data on companies with various business lines with branches into credit rating (DBRS), private markets (Pitchbook), ESG (Sustainalytics), financial advisors, investment management, public market indexes and other nooks and crannies I’m not too familiar with. The more I dig into it, the more I feel like it has roots embedded in various ways into the financial industry. 

The Attraction at First Sight. 

Once again, the attraction started with Mansueto. His shareholder letters were applauded by a number of investors I respected so this heightened my ears to it. Morningstar also isn’t considered a ‘sexy’ company by the public so that was doubly intriguing. If my trader friends aren’t talking about it, it’s interesting. 

Then I read a few articles depicting Mansueto as this ‘quiet billionaire.’ Yes, he loves Buffett and I do too but there were more things to it than that. The name, Morningstar, was inspired by Thoreau’s Walden. But I’m sure other CEOs have read Thoreau, Emerson and other Transcendentalists as well. 

But it was the overall ethos of the midwestern billionaire that drove a 7-year-old BMW with a $21K book value… his purposeful but unflashy career progression… buying bargain sweaters at GAP as a billionaire….and how he seems to embody the contrarian-isms required to challenge an industry. 

Sure, all the companies boast about no vacation day policies and open office and all the bullshit noise that is used to masquerade a company that doesn’t know what it’s doing these days. It’s easier because other successful companies have done it. But Morningstar was doing this before the 2000s. Outside of Silicon Valley. In an industry that is entrenched in tradition, extrinsic scorecards and everything about fitting in. Mansueto never had an office. 

"I want to have fun at Morningstar, so the environment is casual, with casual dress and free soda, Starbucks coffee, and fish tanks. We have progressive employment policies, like fully paid health care, but no explicit vacation or sick-day policies.” - Joe Mansueto in 1999 Inc. Magazine interview

Oh and he also bought Fast Company and Inc. Magazine in the mid-2000s when digital advertising was attacking print and valuations had fallen from the peak purchase price for such publications. The contrarian track record keeps ongoing. 

A lot of what attracted me, in the beginning, was this kind of cultural element ensuing from who Mansueto is. Even how the management still doesn’t speak with sell-side analysts and when they interact with shareholders is only at their annual meeting. Keeping it all ‘above board’. 

How does it make money?

Here is the revenue breakdown with the various products/business-lines in the three revenue categories. 

Above is 2019 and below is 2018 for some additional context on geography:

About 85%-90% of the business would be considered to have recurring revenue. The license business is primarily annual subscriptions, the asset business is % fees off of the assets under management (AUM) and a portion of the transaction-based business ((DBRS) has a recurring functionality. 

Morningstar has various products but the top 5 (Morningstar Data, Morningstar Direct, PitchBook, DBRS and Morningstar Investment Management) make up ~63% of the total revenue. 

Although there are distinct product areas, it appears as though they are all interrelated in the value they provide. Morningstar Data may provide its institutional clients with a full range of investment data on mutual funds, equity fundamentals, and various real-time market data but I imagine the database will also be valuable to Morningstar Direct where further data and analytics tools on securities are provided on the investment platform for investment managers. I’m guessing this will all cascade into the premium subscription business for individuals, to the Workplace Solution, Advisor Workstation, and even to new product development within acquired entities like PitchBook and DBRS. 

It’s a data company that relies on trust. Trust on the independence of their research, trust in the quality/transparency of data, and all those little elements of trust where you don’t have to ‘think twice’ and are willing to take the word of the provider for. 

Who Do They Serve?

The full gambit of financial players. They service about 40% of the financial advisors in North America, 50% of asset management firms globally, ~5K firms in private markets (i.e. VC/PE), ~286K defined contribution retirement plans, credit issuers (DBRS is #4 in credit ratings) financial data platforms (i.e. Yahoo Finance, Google Finance) and individual investors.

It’s a lot of different entities with the largest customer accounting for less than 2% of consolidated revenue. MORN services large clients like Charles Schwab, JP Morgan, Fidelity, Goldman Sachs, and Bank of America Merrill Lynch so… something I can gather from the small concentration is that they serve a lot of players in the financial ecosystem and that the service is a low operating cost component to many of its clients. If it a material cost function for JP Morgan, I’d imagine the concentration to be much higher given MORN’s revenue with respect to JPM’s expenses. 

Is it Essential? 

Now, the subscriptions for most licensing products are annual and most investment management products don’t have a lock-up period like PE funds. So these aren’t like some 10-year service contracts but I would say the overall retention of the products would easily be in the high 90%.

I would also wager that given how essential the data is to the day-to-day operations of many of its customers, that it’s indeed an essential product. I’d imagine that much of the data is integrated into the daily operations, much like Bloomberg and S&P Cap IQ. 

Market and Competitors:

This leads me to where they compete, opportunity size, and the players. 

MORN has its hands in many cookie jars. Some are more obvious like credit rating. There really are 3 major players there: S&P, Moodys and Fitch. DBRS is 4th… making it ‘arguably’ the Big 4 with many other localized players.

On private data there is CB Insights, S&P, Thomson Reuters but this also transitions over to public data and the index business with Thomson Reuters, S&P, MSCI, FactSet competing in more than one of MORN’s product lines. The growing robo-advisors like Wealthfront and Wealthsimple are competitors in the investment management landscape too.

These are all big industries with big incumbents and many new entrants with cheap VC money. 

However, unlike tobacco or sugarly beverages, these are all industries that will probably grow faster than inflation. Some will continue to outpace the US GDP growth too. 

There will probably be more companies in the future (private + public combined). There will probably be more wealthier individuals with the standard of living improving as frictional cost of everyday essentials declines. I mean, if we look back 50 years ago… there were more people/countries in poverty… communication cost more, entertainment cost more, travelling cost more, food cost more… all generally speaking, the world’s gotten more prosperous. People don’t have to spend 16 hours a day working on fields to just survive (at least for a larger portion of the world now than before). I imagine this trend will continue. More economic prosperity = more financial data. 

Moats.. Is it Widening? 

MORN’s popularized the metrics of economic moat as their own proprietary data point. They define it as 5 attributes:

• Network Effects

• Intangible Assets

• Cost Advantage

• Switching Costs

• Efficient Scale

Many investors will use the above 5 in tandem with Porter’s 5 forces as a kind of ‘moat checklist’. 

If I thought about MORN’s moats using their own attributes, it would be a mix of network effects, intangible assets and switching costs. 

Now, before I get there… one way to test the existence of a moat is by whether the business is generating high returns on invested capital and ample free cash flow. With 10-year median gross margins and FCF margins at ~59% and ~20% and avg 5-year ROIC 15%+ it seems fair to say that the business has been generating a solid return over time. It’s last 5 years is below from their annual reports: 

Credit rating moat is obvious. There is a regulatory hurdle where it’s pretty difficult to become a credit rating agency. There are high barriers to entry with the regulators that are in tandem with the trust that needs to be built from rating lots of debt for many years. Also, the more people that use your rating, the more credible it becomes. 

I think data alone can be hard felt to be an intangible moat. In the early years of MORN, Mansueto noted how building a large financial database and brand name would be an effective moat. As the industry evolved and technology lowered barriers to entry in gathering data, Mansueto admitted to how that has weakened MORN’s moat in the mid-2000s. MORN’s continued to innovate around widening the moat by creating more proprietary measures (i.e. Star-ratings, investment-style boxes, indexes) and differentiating their information with analytics and acquisitions (i.e. Pitchbook, Sustainalytics). 

It’s the ‘what you do’ with the data. Which forms into intangible assets that only become valuable the more people use it (network effects). As more of their proprietary measures become commonplace vernacular and are used to build foundations of new Fintech companies, the stronger it gets. 

"I think one of the things that maybe is less well-appreciated outside Morningstar is that we have a pretty significant channel with, what we call, redistributors as well. So, when you see a lot of FinTech firms starting up or when you see others building solutions for advisors for instance, you'll often see that Morningstar is the intelligence inside” - Kunal Kapoor in 2018

This plays in with switching costs. The more ingrained MORN’s data is to the operations of investment funds, financial news sites and various service providers, it gets harder to switch out. The extreme example being how Bloomberg practically customizes for each individual user to tailor for their individual needs or how funds may have to take out a lot of brain power rebuilding all their automated excel models that link to CAP IQ. 

The cost is also not a major function of most of these organizations (most operating costs are probably in human capital) and it’s not an exclusive product in most cases. Exclusivity maybe the case for investment management or possible financial advisor tools but as far as the data platforms and credit ratings are concerned, clients will probably use multiple providers. 

It’s one of those irrational insecurities with data. People would opt to have the maximum amount of data in the hopes it makes a difference. Just like how tobacco or alcohol companies prey on addiction, I’d say data companies in one part play to the insecurity of people who make a livelihood trying to predict the future. 

This all plays with the intangible asset of ‘brand’. The brand that gives ease of mind to ‘trust’ and I think this stems from the culture of the organization. Especially when the businesses’ data product has evolved from merely selling a commodity to the analysis of the data, the integrity of the ratings with data etc… When you are selling an independent perspective, independence, integrity, and transparency needs to be reflected in the culture of the organization. 

Culture

Periodically throughout this article I referenced elements to MORN’s culture through the words of Mansueto. When examining how management described the culture of the organization, I couldn’t ignore the continued emphasis on independence and the need to be contrarian. 

The need for independence and being contrarian would be essential if you were in the business of selling your analysis/judgment. As Manuseto has said in reference to MORN’s culture: “….doing things the right way. Everything we do is in an independent fashion. We've never had a problem speaking out against a bad investment idea and that's a big deal"

Or maybe it’s what keeps management up at night: "I’m often asked what keeps me up at night, and I always answer that it’s ensuring that the next person to walk our halls commits to our mission and values in the way we all do."

MORN has demonstrated that it is not afraid to look different than its ‘older + established’ competitors and the ability to continuously change and innovate will be key to thriving in the future. This is something the new head of DBRS, Detlef Scholz, said in the 2019 meeting when he was comparing MORN to Moody’s, his previous employer. 

The fact that MORN doesn’t take sell-side analyst meetings, doesn’t provide financial guidance, expenses stock options in their financial statement for accuracy continues to present signs of a thoughtful and transparent management team. I can only imagine that it will have a trickle down effect. 

They also capitalize software into their balance sheet as part of “PP&E&Software”.

As far as the management’s view on building a financial service organization, it’s definitely unique when compared to its peers. However, I had a hard time finding further signals in regards to how the company was ‘decentralized’ or how it instilled its values further down to all parts of the business. 

A Glassdoor rating of 3.9/5 didn’t scream any alarms but also didn’t signal something possible amazing hidden underneath. Nothing abnormal for the 7000 person company with operations in 27 countries. 

In the early years of MORN, Mansueto noted: "At Morningstar we share information widely throughout the company in a way that is rare for private companies. By sharing information and communicating honestly, we develop an unusual degree of trust that's an important part of the Morningstar culture." Is this still the case? If we were to take the financial success of the company to this point, maybe. 

Though there have been hints… like in 2018 when Kapoor referred to the importance of culture in capital allocation decision making: "I'm always happy to look at all sources of growth but we've got to have a very convicted reason for making acquisitions, not just because the financial part of it the cultural part of it is pretty important right. To the company like Morningstar, we don't want to bring in a culture that’s not going to gel well and I spend a lot of time think about that”

Capital Allocation

How management thinks about deploying capital can possibly shed light to not only their cost discipline but their stewardship that can be reflected into the culture of the business. 

In 2019, MORN’s capital looked as such:

Management noted that the preference for capital allocation would be to invest internally for organic expansion, then lock to repurchase shares, then look at dividends, then debt repayment and then M&A. 

MORN has consistently paid a dividend in recent years and that may be because Mansueto would like to get some money out of his business and it’s an immaterial enough amount that I don’t really care. Rather, it’s something I could see myself doing too.

Though the $660M DBRS acquisition was a large part of the capital allocation in 2019, this was MORN’s largest acquisition to date and they don’t have a history of high M&A like you’d see in roll-ups. I rather see management’s choice to not optimize their operating margin as an indication of continued prioritization of investing in organic expansion of the business. 

"We want to manage the business in a prudent fashion. And sometimes that prudence means being particularly aggressive when others are heading for the exit….. So, whether you look at when we got into Investment Management fully particularly Managed Portfolios, or when we got into the Credit Ratings business it was right during the financial crisis, because we thought the Big 3 had done a particularly poor job with their work. So, we tend to be opportunistic in those types of things, although as I've learnt over time, no one ever wants to sell their business for a value price.” - Kapoor in 2018

If their capital allocation were to spell something else, it does indicate that management may be the “...patient and long-term investors and business builders." they describe themselves to be. It’s such contrarian betting that will be required for the business to thrive. 

It’s tricky evaluating whether MORN’s investment for internal expansion has been effective. The way I went about looking at is is calculating my own version of return on invested capital that accounts for human capital. 

As MORN capitalizes software costs and depreciated it over 3 years, I thought about capitalizing 3 years of human capital costs that make up its cost of revenue. This also meant adding back the personnel cost to FCF to make it a proxy for the continued reinvestment required for the business to continue to generate products for its customers. This came out to between 30-40% ROIC over the last 3 years. 

With the current enterprise value in May of 2020 at ~$6.3bn, I’m seeing a yield of ~10%. 

Management

I can’t ignore management here. Going back down the culture angle stemming from the top, the insiders own ~50% of the company. Mansueto owns ~49%, down from 74% when MORN IPO’d in 2005. Though he is the Chairman, I can only imagine that Mansueto’s involvement with the company has declined materially. If his Mansueto Ventures, owning a soccer team and building a beautiful mansion in downtown Chicago signalling anything, it shows a desire to diversify interests. 

These are situations I have a harder time evaluating because the ownership is still maintained by the founder but the business is essentially operated by a hired CEO. Though, with 23 years of experience inside the business, Kapoor may be considered an ‘owner-operator’ as well. 

Though I covered various parts of the business that make management unique, a major factor that bothers me is how management is compensated. For a management team that seems focused on being ‘shareholder-oriented’, long-term investors and business builders… I was rather disappointed to not see any ‘return on capital’ metric as part of the compensation measurement. 

For all the talk of increasing intrinsic value, the performance equity compensation (referred to as market share units) are based on Total Shareholder Return (TSR) over a three year period. It’s not a flat TSR target and there is an element to incentivize a higher share price with stock vesting fluctuating as such: 

Short term bonus is measured on adj. Revenue and EBITDA targets "adjusted to exclude the impact of certain items, such as expected incentive compensation costs, foreign currency fluctuations, capitalized software development costs, acquisitions and divestitures, and associated costs, and certain investments in the business"..... So it doesn’t do anything to penalize inflating numbers with acquisitions. 

Overall, Kapoor is receiving some $500K in salaries with the long term equity being about $6M with only about 50% being performance-based. Turns out, I’m not the only one critical of this and MORN has an awesome Q&A function on their IR page and on August 3, 2017, an investor inquired on this very concern about compensation not seeming to aligned with shareholders and the prompt answer was.

It just left a bitter taste in my mouth and I guess this means they’ll probably take issue with my criticism. 

What Now?

The compensation/incentive scheme isn’t ideal. But I like what I’ve read about Mansueto thus far… I just wish he was still actively involved in the business. It’s just a different trust level I have when I see the majority owner and founder actively leading the business. But maybe leading the hungrier young guns take the reign will spur on growth… though the poor incentive scheme is concerning. 

MORN has assets that I like. The credit rating acquisition paired with MORN’s culture brings forth the imagination that it could displace the ‘big 3’ in the future. The fast growth of Pitchbook and how MORN is integrating all their business lines to cross-sell and create a data giant is appealing as well. In its current form, it’s a weaker S&P Global. However, I think the leadership and culture is distinctly different and I think they are better suited to create a different business that can compete and capitalize on the changing financial landscape. 

Unlike the established giants, I think MORN is continuously reinvesting and generating fast-growing products to combat the decline of its legacy business lines and think their capacity to execute is dependent on the management and building on the culture Mansueto created in the beginning.

So What’s look like in 2025?

I’m not sure. I could imagine Pitchbook to be a reasonably larger portion of the overall revenue. I could see MORN to acquire more alternative data companies like Sustinalytics. They could become the dominant leader in ESG data along with MSCI. DBRS could become a debatable ‘big 3’ of credit rating.

Due to my lack of insight, I can reasonably see MORN becoming a bigger version of it’s current self but not some game-changing form. Though, as the only company that seems to actually embrace independence, trust and transparency.. compared to its older competition… I have belief MORN will be able to navigate and capitalize the changing finance landscape better than its larger peers can.

Disclaimer: Not investment advice. My opinions, observations and thoughts. Heed at your own risk.