Description

Thesis Summary

• PitchBook is undervalued within Morningstar
• “Core” Morningstar is growing mid-single-digits and generates high free cash flow
• Outsider Chairman and 46% owner aligned with shareholders
• Trades at 17.7x ‘21P EBITDA vs. Data Services peers at 18.5x-31x
• 2-yr total return between $250-$290 p.s. (+36%-57%)

Summary

Morningstar offers much more than 5-star mutual-fund ratings. The company sells data services that are sticky, growing and can be perpetually improved as Morningstar adds new data sources. Underlying the stable “core” Morningstar products, PitchBook is growing rapidly and becoming the dominant private market research database. PitchBook’s performance metrics are comparable to those of the most richly valued growth stocks—121% net revenue retention, 37% revenue growth, strong free cash flow, 40% long-term EBITDA margins and 4% penetrated in a growing TAM—suggesting the business is undervalued within Morningstar which trades at a discount to peers. In 3-5 years, PitchBook may be worth nearly as much as Morningstar today.

With PitchBook valued at $100-$113 p.s. (30x-35x ‘23P EBITDA) and “core” Morningstar valued at $130-$147 p.s. (13x-14.5x ‘23P EBITDA) plus over $25 p.s. of FCF and dividends generated over two years, Morningstar’s value will approach $250-$290 p.s. (+36%-57%). PitchBook’s growth path is long and promising so value will continue compounding as the business grows to generate $750m+ of revenue and $320m of EBITDA.

Approach Morningstar’s core business with an open mind: although many associate the company with the retail-facing 5-star and mutual fund ratings, the business trends are not simply tied to the secular decline in actively managed AUM. The company’s main “Data” and “Direct” products have grown at 9% and 10% 3-year CAGRs, respectively, with the growth of outsourced investment advisors (RIAs) and product adoption among insurers, international customers and a diverse set of asset management firms. The platform now includes performance data on over 180K variable annuities, 36K pension funds, 5K 529 college savings plans and a slew of other asset classes, in addition to the firm’s extensive mutual fund and ETF data. The services are sticky, essential to customers’ workflows and grows in value as MORN adds new datasets (ESG, credit, etc.). The highly free cash flow generative core is likely to grow 4-8% annually for years to come and, despite outgrowing most data services peers organically, MORN trades at 4x+ EBITDA multiple discount.

Joe Mansueto, the Founder, Chairman and a 46% shareholder, is 63 and there is some long-term downside protection from the possibility he sells the business. I don’t view this is a near-term catalyst, but it somewhat mitigates the risk of permanent capital loss over a multi-year period.

Product Overview

Morningstar has many produce lines, which I have tried to simplify in the table near the bottom of this write-up. Simplistically, Data, Direct, PitchBook and Sustainalytics are sticky, higher growth products with above average margins; DBRS is tied to origination volumes; and AUM-driven products are supported by growth in HSAs, 401Ks and the increased use of independent financial advisors.

Morningstar segments its products into three categories based on revenue models: license-, asset- and transaction-based. The key take-away is license-based revenue is the largest, fastest growing, and highest margin segment.

• License-based: subscription services including Data, Direct, Workstation, PitchBook, Sustainalytics and premium memberships on Morningstar.com. Licensed-based revenue was $813m in 2019 and is growing over 10% y/y as of Q2 (66% of revenue, 30%+ EBITDA margins).
• Asset-based: fees collected on assets under management in Morningstar’s Investment Management, Workplace Solutions and Index products. Morningstar manages model portfolios and Indexes on behalf of advisors, institutional investors, and corporate benefit plan sponsors. Asset-based revenue was $212m in 2019, growing 6%, and declined modestly in Q2’20 with the market-driven decline in AUM (-1.5% in Q2, ~17% of revenue, high-20% EBITDA margins).
• Transaction-based: primarily credit ratings by the ratings agency, DBRS Morningstar, and a smaller advertising and conference business. Annualizing for the DBRS acquisition closed in July 2019, transaction revenue is ~$220m and should grow 4-7% following a slight decline this year (17% of revenue, mid-20s EBITDA margins).

Thesis Points

(1) PitchBook is an undervalued, high growth asset with growing competitive advantages. 

 Hypothetically, what value would the market ascribe to a subscription service with the following characteristics?

• 121% net revenue retention (only ~15 SaaS comps had 120%+ net revenue retention in Q2).
• 53% y/y user growth, license additions accelerating.
• 4% penetrated in a $4 Bn, growing global TAM.
• 60%+ “Rule of 40” (36% revenue growth + 30% FCF margin, note: my estimates).
• 70%+ gross margins, 40% long-term EBITDA margins
• Existing cohort growth, new customer growth and early penetration in new industry verticals.

These metrics put PitchBook in the top quartile of subscription businesses: growth, margins, Rule of 40 are all top quartile and net dollar retention, ARR growth and quarterly payback period are all in the second quartile relative to 70 SaaS comps. The median EV/’21P Revenue multiples for comps with similar characteristics range from 16x to 29x, which, if applied to PitchBook would value the business at $4 Bn-$7.4 Bn ($92-$171 per MORN share). I don’t expect PitchBook’s value to rerate to 16x-29x revenue, but the company’s strong performance would likely warrant a higher standalone valuation. The upside potential is still attractive underwriting much less aggressive valuation assumptions: I assume value appreciates to $5 Bn over the next few years (a 9x forward revenue multiple and 20x forward EBITDA multiple at that time).

Ignoring high relative valuations, PitchBook intrinsically warrants a high valuation given its strong and improving competitive position in a growing market. The core product—providing data on private market companies, transactions and the people involved—was built over the last decade and now contains a wealth of details that will be difficult, if not impossible, to replicate. The database contains all of the generic, scraped private and public company data from public filings and news sources, but what differentiates PitchBook’s database is a wealth of data provided directly from VC/PE/legal/banking personnel involved with specific companies and transactions. For a variety of reasons, VC/PE funds may want to broadcast certain metrics to other users on the platform, including to capital allocators (high returns, attractive exits/entries, trend signalling). As a result, PitchBook contains and continues accumulating proprietary cap table, valuation, and investor data that will be impossible to duplicate. The unique data has made PitchBook the authoritative source on PE/VC deals, which attracts users to the platform, further encouraging private market participants to provide information to the platform, further deepening the platform’s data advantage.

PitchBook’s data is packaged in a user-friendly, feature-rich UI making it increasingly essential to VC/PE/investment banking workflows and attracting new customer groups that will sustain growth. Among the newer user groups are credit investors, internal corporate M&A and IR teams and recruiting firms. I spoke to a representative of Heidrick & Struggles who lauded the platform’s ability to help find executive talent; the executive search use case is still in the early innings and presents an opportunity for new revenue models. Near-term, growth from new and existing PE/VC funds and investment banks globally will be the main growth driver (as evidenced by the company’s 121% net revenue retention), but the platform’s ability to connect asset allocators, startups, investment firms, transaction advisors, recruiters and a host of service providers is increasingly valuable. The company also has a long international growth runway and has been adding data on Chinese-VC deals to ensure it maintains a global data advantage (the company is also rapidly adding public company data that could make the product competitive with CapIQ and Factset).

Morningstar does not disclose segment level margins so we don’t know PitchBook’s exact margin profile or FCF characteristics, but in November 2019 the company disclosed that PitchBook was EBITDA positive and generating strong free cash flow and would reach margins similar to the rest of rest of Morningstar’s license-based services (30%+ EBITDA margins). Incremental margins are high as the research resources required to maintain the company’s data advantages are scalable and a large portion of user growth comes from existing customers, requiring little associated sales and marketing expense. At maturity, PitchBook’s EBITDA margins will likely be 40%+, much higher than Morningstar’s blended margins. Ultimately, PitchBook could be a $750m+ revenue business generating over $320m of EBITDA.

For all this, Morningstar paid ~$200m (excluding earnouts paid in MORN stock): $4m for 20% ownership through a Series A in 2009 and $195m for the remainder in 2016. PitchBook’s management team just signed a new 3-year, $30m incentive comp package so they should remain motivated to grow the business. Today, PitchBook only contributes about 15% of MORN’s revenue and 10% of EBITDA (my estimate), but over the next few years that contribution should grow to 25% of revenue and 30% of EBITDA.

A few quotes about the PitchBook product from the company:

• On sourcing proprietary data: “The research team communicates directly with people involved in deals to gather and validate hard-to-find information.”
• Data differentiation versus CB Insights and S&P CapitalIQ: “PitchBook’s strengths are based on depth and breadth of hard-to-find private market data including capitalization tables, pre-money valuations and deal multiples, fund-level data and contact information for 1.8 million deal professionals…we've been heavily investing in public market coverage and are now tracking more than 81,000 publicly-traded companies…CB Insights’ coverage is limited to top-level information on the venture financing space. In contrast, PitchBook publishes detailed, proprietary cap tables information including series terms, authorized shares, liquidation preferences, stock prices, voting rights, and percentage ownership. Our private transactions also include deal multiples and calculated pre-money valuations. CB Insights does not include important personnel information, like lead investors, that can be found on PitchBook.”

   

• Margin profile: “PitchBook’s margin profile is lower than our corporate average, it has a positive underlying contribution to our operating profit and generates strong free cash flow. Over time, we believe PitchBook will reach a similar operating margin profile as the rest of Morningstar.”

(2) Core Morningstar is misperceived and benefits from growth outside of the secularly declining active management industry.

“Each year we add more data to the pot we have and we add our research IP on top of it…each year we try to add new IP on top of what we’re delivering to our clients and slowly and surely it all gets worked into their workflows. We have the pipes set up to our clients and we send them more things through those pipes every year and that shows up in the wonderful, steady performance of our Data business year in, year out.”

- Kunal Kapoor, CEO, 2020 Annual Meeting:

Morningstar’s core businesses are growing, high margin, essential services built on Morningstar’s unique database of return, performance, and holdings data on a wide range of asset classes. The two main “data” products, Morningstar Data and Morningstar Direct, help mutual funds, insurers, investment advisors and institutional investors benchmark performance, market their funds, develop new investing strategies and create portfolios based on specialized investment mandates. Speaking to current customers in the RIA and institutional investment advisory segments, it is clear that Morningstar’s products are sticky and, at the retail level, are often requested by name (the benefit of the company’s retail-facing 5-star ratings). The platform offers much more than mutual fund data and the depth and breadth of capital markets coverage has driven adoption by growth segments within the investment management industry including among RIAs, insurers (annuities and for broader asset allocation) and other low-fee advisory providers.

The data products are sold on annual, recurring licenses. Data is used by larger, institutional asset managers and is an “all-you-can-eat”, regularly updated pipe of capital markets data used for benchmarking, holdings analysis, fund flows analysis and portfolio creation. Direct and Workstation are user-friendly platforms that package Morningstar’s data in an easy to use interface used by RIAs, wealth advisors and marketing teams to benchmark, create investment strategies and stress test hypothetical portfolios. Net revenue retention is 104%, 99% and 96% for Data, Direct and Workstation, respectively, and while the products lack organic pricing power, Morningstar continually adds new datasets that drive upsell opportunities. ESG has been an area of focus and the recent acquisition of Sustainalytics, one of two ESG research tools used by most ESG funds, will boost licensed revenue growth going forward. Adding data for new investment strategies and asset-classes is an evergreen opportunity for Morningstar.

Morningstar has used its database to build an asset management business in which it creates or helps clients create customized portfolios and invests assets on its clients’ behalf. The primary “asset-based” revenue drivers are Managed Portfolios and Workplace Solutions. Managed Portfolios are multi-asset strategies built using mutual funds, ETFs and individual securities tailored to meet specific investment time horizons, risk levels and outcomes to meet investors’ goals. A customer like Charles Schwab uses MORN’s portfolios to gain access to low fee target-date funds and other multi-asset strategies as well as white-labelled customer service functions: proposal building, client reporting and retirement planning (fees are Workplace Solutions, retirement plan sponsors offer MORN’s prepackaged investment lineups to plan participants and use MORN’s administrative and record-keeping services (fees are low—5 bps on AUM). Morningstar recently launched a “Managed Retirement Accounts” platform that will provide RIAs and plan participants greater discretion over 401(k) asset allocation and should drive share gains. Finally, Morningstar offers ETFs built around its moat-based, ESG and other custom strategies. Ron Bundy, the former COO of Russell, joined in January 2020 and Morningstar may try to disrupt the current benchmark licensing-fee system; a rapidly growing expense for investment managers. Asset-based fees are likely to face downward pressure and Morningstar has competition in these segments, but the broader trend to low fee, outsourced investment advice should continue driving mid-to-high single digit growth in Managed Portfolios and Workplace Solutions.

DBRS (~17% of revenue) and the ratings agency model is an area of focus for the company. MORN recently added Steve Joynt, the former CEO of Fitch, to the board and I would not be surprised to see the company acquire another player in the space to secure a lead in most ABS and high-yield categories. DBRS is the ratings leader in Canada and #2-3 in many ABS products in the U.S. and should grow through international expansion and the introduction of additional product verticals (there are always new products to rate—DBRS recently issued ratings on “buy-now-pay-later” securitizations). In addition to the inherent merits of the rating agency business model, increasing MORN’s access to the credit industry will broaden its fixed income dataset.

The “Core” excluding PitchBook should grow mid-single-digits annually over the next few years, generating $375m-$432m of annual EBITDA along the way. The business does not warrant a discounted multiple based on recent trends, but I value it at a 4x+ discount to peers given the secular headwinds faced by many of its customers.

(3) Outsider Chairman, clean balance sheet and ample free cash flow

Joe is still very much involved in directing Morningstar’s overarching strategy, including capital allocation decisions. He founded Morningstar to provide retail investors with insight into the performance of the mutual fund industry in the 1980s and places an emphasis on “levelling the playing field” between retail and institutional investors. As a result, the company takes an untraditional approach to shareholder communications by eschewing earnings calls and limiting most investor interaction to the Annual Shareholder Meeting. Morningstar does, however, provide a regularly updated Q&A addressing investors’ questions which provides an audited record of comments on products, strategy, margin structure and growth. In many ways, the information is superior to what most companies provide on earnings calls, to sellside analysts and in the MD&A (the Q&A can be found here: https://bit.ly/2EVfyDS). Morningstar does have a head of Investor Relations who takes investor calls.

M&A is an important strategic focus: MORN earns ~$270m-$300m of FCF after the dividend and has low leverage so there will be ample capital to deploy. Joe and the current CEO, Kunal Kapoor, have made astute early-stage investments and acquisitions over the years. I’ve already pointed-out the attractive all-in cost of PitchBook ( ~$200m) and the more recent acquisition of Sustainalytics is promising as well.

Sustainalytics is the #1/#2 ESG research platform along with MSCI’s ESG product. The business is small today but is likely growing 20%-25% annually and should exceed $100m in revenue soon, particularly with upcoming regulatory growth drivers in Europe in 2021. Amendments to MiFID aim to put ESG considerations at the heart of the EU’s financial system and will require firms providing investment advice to consider clients’ ESG preferences. The new obligations should drive adoption of Sustainalytics’ products as well as Morningstar’s Managed Portfolios. Morningstar will also use aspects of Sustainalytics’ data to drive add-on sales to existing customers of MORN’s other products. The ~$90m paid for Sustainalytics since 2017 (not including undisclosed ‘21/’22 earnouts) will prove to have been a bargain. 

The DBRS acquisition, the largest in the company’s history at $669m, is less than a year old so the verdict is still out on the deal, but the strategic rationale for growing MORN’s credit market database makes sense given the growth in private credit since the financial crisis. Other acquisitions have not been clear home runs—Logical Information Machines ($50m in 2011), ByAllAccounts ($28m in 2014), HelloWallet ($24m in 2017)—but they are generally small and always add features, data or technology the company uses on an on-going basis. Overall, the M&A strategy has created significant shareholder value and should continue to be value accretive going forward.

Valuation

Valuing PitchBook and “Core” Morningstar separately drives a ~$250 total return (+36%) through 2021 and $285 through 2022 (+57%). At $250 at YE 2021, the forward EBITDA multiple would be ~18x-20x, which is in-line with Factset and Gartner’s multiples between 19x-23x.

In a downside scenario, with all of Morningstar valued at 13x EBITDA, the price over the next year or two would still approach $190. At close to trough, 2009 multiples of 11x, the stock could trade close to $160 over the next two years.

There could be additional upside as DBRS and Sustainalytics scale and organic growth resumes at DBRS. Both businesses should arguably be valued at higher multiples than where I value the “core” today.

Links and Resources

• Investor Q&A: https://shareholders.morningstar.com/investor-relations/investor-qa/default.asp 
• The 10K has a more detailed discussion of each Morningstar product: https://bit.ly/3jhp03p
• 2020 Annual Shareholder Meeting Presentation: https://bit.ly/30tezlG 
• PitchBook acquisition presentation (10/14/16): https://bit.ly/3cU4d3p 
• Sustainalytics acquisition presentation (4/21/20): https://bit.ly/3neZSwg 

Risks

Growth of Passive Investing: Mutual funds and other active public equity investment managers are large Morningstar customers and Morningstar’s mutual fund data is core to the value of its products. As passive investment strategies continue gaining share, Morningstar’s data services will face headwinds as the user base shrinks and demand for active management data decreases. I expect this to be a sustained headwind. Despite the clear fund flows into passive (ETF) strategies and out of active strategies over the last two decades, MORN has grown the core business at an attractive high-single-digit CAGR with new customer adoption and the growth of outsourced investment advisory services. Continued growth in RIAs, SMAs and other wealth management products should continue driving demand for MORN’s products. MORN will also continue integrating data on new investment products, which will contribute to revenue growth.

Fee pressure will likely be a headwind offsetting

Lacks a clear corporate identity and strategy: One of the criticisms I have heard is that Morningstar lacks a clear corporate strategy, hence why it has been acquiring assets in new verticals over the last decade (PitchBook, DBRS). The company has failed to gain traction with a few new products in its Data/ Direct/ Workstation segments and has likely ceded lucrative opportunities to competitors that have become key software platforms to the wealth advisory industry.

On the other hand, Joe Mansueto intentionally created a decentralized structure to better incentivize and provide greater autonomy to unit heads. The core strategy is clear—add data to fuel new use cases and upsell existing data customers—so management integrates what is needed to enhance the data products and otherwise allows the business segments to operate independently. He is also an astute acquirer with skin in the game ($3.7 Bn in stock) so acquired or added products should create value over time.

Note: Joe sells stock steadily on the open market. The regularity of his sales suggests he is selling for tax planning or working capital purposes and not necessarily due to a fundamental view on the stock’s valuation.

M&A: past performance is no guarantee of future results. Joe is aligned with shareholders and is unlikely to do any transaction that materially impairs shareholder value.

Regulatory: the financial services industry faces regulatory regime changes on occasion and more stringent fiduciary requirements, or regulation on fund/401(k)/HSA fees could increase costs or harm Morningstar’s end-customers. However, the trend toward greater advisor fiduciary responsibility has generally been a tailwind for Morningstar. MORN can better justify investment allocations given its position as the ratings standard for many investment products and can, therefore, help investment advisors meet their fiduciary requirements under policies like the SECURE Act and Regulation Best Interest. I have discussed previously how changes in MiFID will drive demand for ESG-related products and services.

Product Overview

Financial Summary

PitchBook Financials and KPIs

Valuation

Public Comps

SaaS Benchmarking

Note: most of the metrics are from publiccomps.com

Catalyst

- Continued growth of PitchBook

- Sustained growth of Morningstar's core business