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Morningstar, Inc. Reports First Quarter 2005 Financial Results

CHICAGO, May 17, 2005  —  Morningstar, Inc. (NASDAQ: MORN), a leading provider of independent investment research, today announced its first quarter 2005 financial results. The company reported consolidated revenue of $53.2 million in the first quarter of 2005, a 29% increase from revenue of  $41.1 million in the first quarter of 2004. Net income was $4.0 million in the first quarter of 2005, or 9 cents per diluted share, compared with $4.5 million, or 9 cents per diluted share, in the first quarter of 2004. Net income decreased but diluted income per share remained the same because of accounting rules related to the treatment of stock-based compensation in calculating diluted income per share.

“We’re off to a good start in 2005. Our revenue growth reflects strong demand in each of our three business segments – Individual, Advisor, and Institutional – with significant contributions from our independent equity research and Morningstar(R) Advisor WorkstationSM,” said Joe Mansueto, chairman and chief executive officer. “Excluding stock-based compensation expense, our operating income increased 35% in the first quarter of 2005.”

Mansueto added, “In evaluating our income this quarter, it’s helpful to have a brief explanation of our stock-option accounting. We use the liability method of accounting for a portion of our stock option expense, which requires us to ‘mark to market’ the value of our stock options. An increase in the value of our common stock led to a sharp increase in stock-based compensation expense under this method for the quarter. The $1.00 increase in the fair value per share of our common stock to $18.50 as of March 31, 2005, from $17.50 as of Dec. 31, 2004, resulted in $2.8 million of stock-based compensation expense under the liability method in the quarter. Because our May 2005 initial public offering price per share and our March 31, 2005 value per share are the same, we won’t record additional expense under this method in connection with our IPO. This method of expensing stock options is now behind us.”

Our Key Business Drivers
Consolidated Revenue:  Revenue in the Individual segment was $15.5 million in the first quarter of 2005, a 48% increase from $10.5 million in the first quarter of 2004.  Revenue in the Advisor segment was $16.5 million in the first quarter of 2005, a 20% increase compared with $13.7 million in the same period in 2004. Revenue in the Institutional segment was $22.3 million in the first quarter of 2005, a 21% increase from $18.5 million in the first quarter of 2004.

Revenue from international operations increased $1.0 million, or 17%, to $7.0 million in the first quarter of 2005, compared with $6.0 million in the first quarter of 2004. Foreign currency translations contributed $0.3 million; excluding the impact of foreign currency translations, international revenue increased approximately 12% in the first quarter of 2005, compared with the first quarter of 2004.

Results from our International operations were slightly below expectations, but we continue to believe in our long-term prospects and opportunities for growth outside the United States,” Mansueto added.

In January 2005, Morningstar acquired Variable Annuity Research and Data Service (VARDS) from Finetre Corporation for $8.2 million in cash. The acquisition contributed revenue of $0.7 million in the first quarter of 2005. Excluding the impact of foreign currency translations and the VARDS acquisition, consolidated revenue increased approximately 27% in the first quarter of 2005, compared with the first quarter of 2004.

Morningstar has revised its estimate of 2005 walk-in revenue from $129.5 million to $124.9 million. The company defines walk-in revenue as revenue it expects to recognize from licenses or subscriptions in place at the beginning of each year, absent cancellations. Cancellations during the first quarter, the impact of currency translations, and other routine adjustments further reduced this walk-in revenue by $2.4 million, or approximately 2%, to $122.5 million. During the first quarter of 2005, the company closed renewals and brought in new business that will contribute an estimated $36.4 million to 2005 revenue, absent cancellations. Morningstar estimates that 2005 walk-in revenue plus the full-year impact of new and renewal business closed during the first quarter, absent additional cancellations, will total $158.9 million.

Consolidated Operating Income: Consolidated operating income in the first quarter of 2005 was $6.9 million, a 4% increase compared with $6.6 million in the same period a year ago. Excluding stock-based compensation expense, operating income was $11.8 million, an increase of $3.1 million, or 35%, in the first quarter of 2005, compared with $8.7 million in the first quarter of 2004. Operating income before stock-based compensation expense is a measure that is not calculated in accordance with U.S. generally accepted accounting principles (GAAP). A reconciliation to operating income is included in the accompanying financial tables.

Morningstar’s first quarter 2005 operating expenses increased $11.8 million, or 34%, compared with the prior year, including $5.7 million of additional compensation-related expense that reflected salaries, benefits, sales commissions, and bonus expense, and a $2.8 million increase in stock-based compensation expense. The company had approximately 1,000 employees worldwide as of March 31, 2005, compared with approximately 870 as of March 31, 2004. The higher headcount includes additional technical staff for Morningstar’s development center in China, equity analysts in its U.S. operations, and other marketing, product sales, and product support positions.

The company’s operating margin was 12.9% in the first quarter of 2005, compared with 16.1% in the first quarter of 2004. The reduction in operating margin primarily reflects an increase in stock-based compensation expense as a percentage of revenue compared with the first quarter of 2004. Excluding stock-based compensation expense, the company’s operating margin was 22.1% in the first quarter of 2005, compared with 21.2% in the first quarter of 2004. Operating margin before stock-based compensation expense is a non-GAAP measure that is reconciled to operating margin in the accompanying financial tables.

General and administrative expense increased $4.4 million, or 51%, to $13.1 million in the first quarter of 2005 from $8.7 million in the first quarter of 2004. This increase was primarily driven by increases in stock-based compensation expense, other compensation-related expenses, and professional fees.

Consolidated Free Cash Flow: Morningstar reported negative free cash flow of approximately $3.2 million in the first quarter of 2005, reflecting cash used for operating activities of $2.2 million and capital expenditures of $1.0 million. Free cash flow decreased by approximately $4.9 million from a positive free cash flow of $1.7 million in the first quarter of 2004. The decrease reflects a $5.4 million decline in cash provided by operating activities, which was partially offset by a $0.5 million reduction in capital expenditures. Free cash flow is a non-GAAP measure that is reconciled to cash provided by or used for operating activities in the accompanying financial tables. Morningstar defines free cash flow as cash provided by or used for operating activities less capital expenditures.

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