Is Morningstar a Good Addition to Your Portfolio?

As one of the world’s most reliable providers of investment analysis covering everything from equities to mutual funds, Morningstar, Inc. (NASDAQ:MORN) is truly a finance geek’s best friend. The company, originally conceived by Chicagoan Joe Mansueto with a mere $80,000 in starting capital, has grown into a multi-billion dollar behemoth since its inception in 1984.

Morningstar, Inc. (NASDAQ:MORN)

Over the past two and a half decades, Morningstar has introduced a number of innovative concepts into the investment research industry, including its patented Style Box, The Mutual Fund Sourcebook, and its recognizable five-star rating system. In addition to these developments, Mansueto has also demonstrated a certain “entrepreneurial swagger” in an industry that is sorely devoid of such behavior, and has acquired a range of impressive businesses since his company’s IPO in 2005. The Morningstar founder’s most notable acquisitions include: a $35 million purchase of the Fast Company and Inc. publications, a bargain-bin buy of 10-K Wizard worth a mere $11 million, and a purchase of Standard & Poor’s Fund Data Business for a little over $50 million. The company also holds a 20% minority stake in the ever-useful YCharts platform.

Outside of the company’s investment research division, Morningstar also offers investment management services through its registered investment advisory business, which manages over $180 billion in assets throughout North America, Europe, Asia, and Australia. Perhaps its best growth-driver going forward, the company introduced its corporate credit rating service in late 2009, with a methodology that is decidedly different than industry stalwarts Moody’s Corporation (NYSE:MCO) and The McGraw-Hill Companies, Inc. (NYSE:MHP). Morningstar’s credit ratings have a forward-looking focus, using fresh metrics like cash-flow cushion, economic moat, and solvency score.

The company generated $166 million in revenues during its most recent quarter (Q2), which was a 3.1% increase from the $161 million it reported at the same time last year. As briefly mentioned above, Morningstar has a bevy of business segments, which are broken down into two parts: Investment Information and Investment Management.

The former segment accounts for a little over four-fifths of Morningstar’s total top line, as many of the company’s top products are here, most notably: Morningstar’s subscription-based data feeds, the Morningstar Direct software platform, its Advisor Workstation, Morningstar.com, and Morningstar Principa. While all of these names seem rather unimaginative, it really doesn’t matter; the segment as a whole has grown its revenues by 5.2% over the past year. Morningstar Direct was the largest contributor to this expansion, as it accounted for nearly one-third of the company’s total organic revenue growth. The service saw its licenses increase by 24.4% over the past year.

On the other side of the coin, Morningstar’s Investment Management segment accounts for less than 20% of the company’s overall revenues, and actually shrank slightly over the past calendar year. This segment includes its Investment Advisory Services, Retirement Solutions, and its bevy of active and passively managed portfolios. The company’s retirement services had the most drastic effect on the segment’s revenue declines, which fell by 5.1% over the past year.

In comparison to Morningstar’s 3.1% year-over-year growth in total revenue, Moody’s most recent quarter reported results that nearly doubled this rate of expansion, and McGraw-Hill actually saw its top line decline by 0.6% in the past year. Other, more media-focused peers like TheStreet, Inc. (NASDAQ:TST) and Thomson Reuters Corporation (NYSE:TRI) have also endured slight revenue declination over this time frame.

These results make Morningstar’s modest growth even more impressive, as the company’s niche industry as a whole has a mixed outlook over the next few years. In 2011, improving advertising trends stalled rather abruptly, as the typical culprits – worse than expected unemployment, Eurozone fears, and a generally sluggish economic recovery – were to blame, at least from a macroeconomic standpoint.

Going forward, however, S&P Capital IQ projects double-digit growth in online advertising to continue in the intermediate term, with accelerated growth in online video advertising. Companies with at least a portion of their content in streaming video form – which includes Morningstar – have a distinct advantage over their text-based competitors. Consequently, analysts are expecting Morningstar to average a 15.0% annual earnings growth over the next half-decade, which outpaces competitors like Moody’s (14.1%), McGraw-Hill (11.3%), and Thomson Reuters (7.7%). Only TheStreet (21.0%) has a more impressive EPS forecast.

Even if these estimates hold, however, it appears that shares of Morningstar may be overbought at current levels. The stock trades at a PEG ratio of 2.16; typically any figure above 2.0 signals an overvaluation. More importantly, this is also above each of the company’s aforementioned competitors, none of which sport a PEG ratio higher than 1.89. From a book, sales, and cash flow standpoint, Morningstar also trades at a premium to its industry’s average – 81% to be exact. This valuation differential is larger than those of media-related peers like TheStreet (-84%) and Thomson Reuters (-22%), but far below Moody’s (+194%) and McGraw-Hill (+91%).

In the hedge fund industry, a few of the most notable Morningstar bulls include Jim Simons, D.E. Shaw, Ken Griffin, and Steven Cohen. Chuck Royce of Royce & Associates has the largest position in the investment research company, worth a value of more than $125 million. It appears that these money managers have noticed Morningstar’s above-average top and bottom line growth prospects, and believe that its shares can still provide some value at current price levels. For a complete look at the hedge fund industry’s sentiment towards this stock, continue reading here.

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