MORN - Morningstar: An Impressive Recovery Leaves Shares Pricey

2023-12-08 01:40:22 ET

Summary

• Morningstar's organic growth rate and margins have improved, leading to a significant recovery in its share price.
• The company has diversified its business through M&A deals and expansion into areas like ESG and venture capital.
• Despite positive operating performance, the high valuation and potential impact of AI make shares look unattractively valued here.

In April, I saw continued headwinds in the case of Morningstar ( MORN ) as the business started 2023 on a soft note. Topline growth stabilized, with the positive contribution of long term growth engines being offset by lower activity levels in key markets.

This made me very cautious as earnings power was trending at just over $2 per share, making me a patient waiter for a further pullback in the share price. Since April, the business has seen a big improvement in the organic growth rate of the business, but moreover saw a big recovery in margins, which is really comforting. Unfortunately, this has been more than priced in already following a big recovery in the share price.

On Morningstar

In the 2010s, Morningstar has made a string of M&A deals to grow the business to become a diversified $1.7 billion information power house by 2021, posting earnings in excess of $6 per share at the time. A $100 stock in 2017 has risen to about $150 pre-pandemic, as the real momentum only started thereafter.

On top of the pure "plain-vanilla" information provision, the company has moved into secular growth areas like ESG, through its Sustainalytics platform as well as its strong brand PitchBook its Venture Capital platform. These and other focus areas created quite a diversified information business.

The strong growth prospects made that shares peaked at $350 in the aftermath of the pandemic, at its peak granting the business a $15 billion equity valuation, with shares trading at over 9 times sales and 50 times adjusted earnings, both being huge multiples of course.

Slowing Down

Momentum reversed as shares fell to the $200 mark in February of this year, as investors were fearful about a combination of slower growth and higher interest rates, with the business furthermore being hurt by a stronger dollar at that time as well. Furthermore, there were softening conditions in certain end markets being observed.

On top of the recurring and sticky revenues from the information-based services, the business was hurt by lower transaction activity, mostly induced by higher interest rates on mortgage and bond markets, as notably interest rate sensitive operations saw lower revenues.

This was evident as sales for the fourth quarter of 2022 grew by just 2%, while full year sales still rose some 10% to $1.9 billion. The issue is that full year earnings were down 39% to $3.87 per share, with profit declines being more pronounced in the second half of the year, due to the lower activity in transaction-based revenue streams, the most lucrative part of the business.

Due to M&A activity and share buybacks, Morningstar incurred about $700 million in net debt, pushing up leverage ratios quite a bit, as the buybacks at higher levels actually made that the impact on earnings per share was dilutive.

A Big Disappointment

By April, shares of Morningstar have fallen to the $170 mark, having been cut in half from its highs. This came as first quarter revenues rose by just 5% to $480 million, with organic growth reported at 3%.

The more moderate pace of growth was all the good news, as margins took a huge beating, with the company even posting net losses of $0.18 per share. Adjusted earnings were down sixty cents to $0.56 per share, all while net debt ticked up to $779 million. With earnings power trending at just over $2 per share, it was hard to find fundamental support of course with shares trading in the $170s.

Under normal conditions, I believed that Morningstar should be able to post sales of around $2 billion, on which it could post margins of 20%. In such a scenario, I pegged after-tax profits around $300 million after accounting for modest taxes and interest rates, working down to an earnings number of around $7 per share. Even in such a rosy scenario, valuations were demanding at 24 times earnings, as such a scenario required real and substantial execution of course.

While I did not want to be too cautious, I noted that Morningstar was already a $150 stock pre-pandemic already, making me cautious to buy the dip just yet at the time.

A Huge Recovery

Since April, shares of Morningstar have seen a huge boom, having risen two-thirds to $285 per share at the moment of writing, levels last seen early in 2022.

In July, Morningstar reported a 7% increase in second quarter sales to $505 million, with organic growth reported at 5%. On top of the higher growth, the business benefits from less pressure on margins, with adjusted earnings up 11% to $1.30 per share, which was looking a lot better already.

Third quarter revenues rose as much as 1% to $515 million, with organic growth reported at 9%. Adjusted earnings rose as much as 66% to $1.28 per share, with adjusted earnings trending at around $5 per share here. Net debt was pretty stable at three quarters of a billion, although this includes just over a hundred million in investments in unconsolidated entities.

The 43 million shares of the company now trade at $285, granting the company a $12.2 billion equity valuation, or $13 billion if we factor in net debt. This values the operations at about 6.5 times sales, but of course a very demanding earnings multiple at over 50 times earnings here.

Inspired the by the better operating performance, the company hiked the dividend by three pennies to $0.405 per share (on a quarterly basis). The annual payout of $1.62 per share translates into a very modest dividend yield, of course.

Too Rich To Get Involved

Right here I must admit that I have been too cautious in April, although I am not too regretful about it. The business has seen a solid acceleration of organic growth and relative margin recovery here, both comforting, and to a certain extent impressive (although the comparables were easier).

In fact, current organic growth rates come in close to the numbers required to maintain the growth track record, which allowed the business to triple sales over the past decade.

That said, shares have risen a huge deal, in fact so much that executives recently announced substantial insider sales. Moreover, I wonder about the impact of AI and other players on the business, as Morningstar traditionally has been regarded as top quality.

Given all of this, I find it very easy to avoid getting involved with the shares here.

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