Edgar Filing: Morningstar, Inc.

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number: 000-51280

MORNINGSTAR, INC.

(Exact Name of Registrant as Specified in its Charter)

Illinois		36-3297908
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification Number)

225 West Wacker Drive
Chicago, Illinois
60606-6303

(Address of Principal Executive Offices)

(312) 696-6000

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

Indicate by check mark whether the Registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer ý

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý

As of August 2, 2006, there were 41,390,901 shares of the Company’s common stock, no par value, outstanding.

MORNINGSTAR, INC. AND SUBSIDIARIES

INDEX

PART 1		FINANCIAL INFORMATION

	Item 1.		Unaudited Condensed Consolidated Financial Statements

			Unaudited Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005

			Unaudited Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005

			Unaudited Condensed Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the six months ended June 30, 2006

			Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005

			Notes to Unaudited Condensed Consolidated Financial Statements

	Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations

	Item 3.		Quantitative and Qualitative Disclosure about Market Risk

	Item 4.		Controls and Procedures

PART 2			OTHER INFORMATION

	Item 1.		Legal Proceedings

	Item 1A.		Risk Factors

	Item 4.		Submission of Matters to a Vote of Security Holders

	Item 6.		Exhibits

SIGNATURE

PART 1: FINANCIAL INFORMATION

Item 1: Unaudited Condensed Consolidated Financial Statements

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Operations


	Three Months Ended June 30						Six Months Ended June 30
(in thousands except per share amounts)	2006			2005			2006			2005

Revenue	$	76,257		$	56,243		$	146,317		$	109,447

Operating expense (1):
Cost of goods sold	22,052			15,674			40,725			31,586
Development	7,306			4,593			13,397			9,742
Sales and marketing	11,880			9,845			23,540			19,630
General and administrative	13,793			11,135			25,825			24,219
Depreciation and amortization	3,767			1,852			6,173			4,248
Total operating expense	58,798			43,099			109,660			89,425

Operating income	17,459			13,144			36,657			20,022

Non-operating income:
Interest income, net	858			605			1,917			1,054
Other income (expense), net	(186		)	(200		)	(312		)	60
Non-operating income, net	672			405			1,605			1,114

Income before income taxes, equity in net income of unconsolidated entities, and cumulative effect of accounting change	18,131			13,549			38,262			21,136

Income tax expense	7,624			4,600			15,222			8,660

Equity in net income of unconsolidated entities	658			549			1,305			1,029

Income before cumulative effect of accounting change	11,165			9,498			24,345			13,505

Cumulative effect of accounting change, net of income tax expense of $171	—			—			259			—

Net income	$	11,165		$	9,498		$	24,604		$	13,505

Basic income per share
Income before cumulative effect of accounting change	$	0.27		$	0.24		$	0.60		$	0.35
Cumulative effect of accounting change	—			—			0.01			—
Net income	$	0.27		$	0.24		$	0.61		$	0.35
Diluted income per share
Income before cumulative effect of accounting change	$	0.24		$	0.22		$	0.52		$	0.31
Cumulative effect of accounting change	—			—			0.01			—
Net income	$	0.24		$	0.22		$	0.53		$	0.31

Weighted average shares outstanding:
Basic	40,925			39,064			40,641			38,758
Diluted	46,684			43,742			46,535			42,994


	Three Months Ended June 30				Six Months Ended June 30
	2006		2005		2006		2005
(1) Includes stock-based compensation expense of:
Cost of goods sold	$	285	$	264	$	557	$	928
Development	131		105		245		380
Sales and marketing	137		128		263		453
General and administrative	1,526		1,441		2,948		5,064
Total stock-based compensation expense	$	2,079	$	1,938	$	4,013	$	6,825

See notes to unaudited condensed consolidated financial statements.

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Balance Sheets


(in thousands except share amounts)	June 30 2006			December 31 2005

Assets
Current assets:
Cash and cash equivalents	$	83,259		$	92,367
Investments	38,182			60,823
Accounts receivable, less allowance of $850 and $418, respectively	56,924			47,530
Income tax receivable, net	4,555			—
Other	6,911			5,495
Total current assets	189,831			206,215

Property, equipment, and capitalized software, net of accumulated depreciation of $44,296 and $40,687, respectively	17,040			17,355
Investments in unconsolidated entities	17,238			16,355
Goodwill	64,582			17,500
Intangible assets, net	60,474			7,251
Deferred tax asset, net	8,283			29,729
Other assets	2,330			1,906
Total assets	$	359,778		$	296,311

Liabilities and shareholders’ equity
Current liabilities:
Accounts payable and accrued liabilities	$	17,417		$	13,664
Accrued compensation	22,021			26,463
Income tax payable	—			1,259
Deferred revenue	90,733			71,155
Deferred tax liability, net	711			833
Other	2,487			2,467
Total current liabilities	133,369			115,841

Accrued compensation	3,201			4,458
Other long-term liabilities	3,484			2,298
Total liabilities	140,054			122,597

Shareholders’ equity:
Common stock, no par value, 200,000,000 shares authorized, of which 41,277,019 and 40,284,513 shares were outstanding as of June 30, 2006 and December 31, 2005, respectively	4			4
Treasury stock at cost, 233,334 shares as of June 30, 2006 and December 31, 2005	(3,280		)	(3,280		)
Additional paid-in capital	247,535			226,593
Accumulated deficit	(26,004		)	(50,608		)
Accumulated other comprehensive income:
Currency translation adjustment	1,596			1,130
Unrealized losses on available for sale securities	(127		)	(125		)
Total accumulated other comprehensive income	1,469			1,005
Total shareholders’ equity	219,724			173,714
Total liabilities and shareholders’ equity	$	359,778		$	296,311

See notes to unaudited condensed consolidated financial statements.

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statement of Shareholders’ Equity and Comprehensive Income

For the Six Months Ended June 30, 2006

													Accumulated
	Common Stock						Additional						Other			Total
	Shares	Par		Treasury			Paid-in			Accumulated			Comprehensive			Shareholders’
(in thousands, except share amounts)	Outstanding	Value		Stock			Capital			Deficit			Income			Equity
Balance, December 31, 2005	40,284,513	$	4	$	(3,280	)	$	226,593		$	(50,608	)	$	1,005		$	173,714
Comprehensive income:
Net income		—		—			—			24,604			—			24,604
Unrealized loss on investments, net of income tax benefit		—		—			—			—			(2		)	(2		)
Foreign currency translation adjustment		—		—			—			—			466			466
Total comprehensive income		—		—			—			24,604			464			25,068
Issuance of common stock related to stock option exercises, net	992,506	—		—			10,851			—			—			10,851
Stock-based compensation		—		—			4,013			—			—			4,013
Cumulative effect of accounting change		—		—			(430		)	—			—			(430		)
Tax benefit derived from stock option exercises		—		—			6,508			—			—			6,508
Balance, June 30, 2006	41,277,019	$	4	$	(3,280	)	$	247,535		$	(26,004	)	$	1,469		$	219,724

See notes to unaudited condensed consolidated financial statements.

Morningstar, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows


	Six Months Ended June 30
(in thousands)	2006			2005

Operating activities
Net income	$	24,604		$	13,505
Adjustments to reconcile net income to net cash flows from operating activities:
Cumulative effect of accounting change, net of tax	(259		)	—
Depreciation and amortization	6,173			4,248
Deferred income tax benefit	(717		)	(1,277		)
Stock-based compensation expense	4,013			6,825
Provision for bad debt	328			114
Equity in net income of unconsolidated entities	(1,305		)	(1,029		)
Foreign exchange loss	452			60
Excess tax benefits from stock option exercises	(6,508		)	—
Other, net	36			(48		)
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable	(2,758		)	(6,477		)
Other assets	455			401
Accounts payable and accrued liabilities	(245		)	106
Accrued compensation	(7,174		)	(6,683		)
Income taxes payable	13,467			(1,069		)
Deferred revenue	8,425			4,067
Other liabilities	442			(1,094		)
Cash provided by operating activities	39,429			11,649

Investing activities
Purchases of investments	(37,783		)	(29,941		)
Proceeds from sale of investments	60,454			40,410
Capital expenditures	(2,023		)	(2,327		)
Acquisitions, net of cash acquired	(86,363		)	(8,157		)
Other, net	(294		)	18
Cash (used for) provided by investing activities	(66,009		)	3

Financing activities
Payments of long-term debt and capital lease obligations	—			(18		)
Proceeds from initial public offering	—			18,108
Proceeds from stock options exercises	10,851			1,392
Excess tax benefits from stock option exercises	6,508			—
Other	(4		)	—
Cash provided by financing activities	17,355			19,482

Effect of exchange rate changes on cash	117			(157		)
Net increase (decrease) in cash and cash equivalents	(9,108		)	30,977
Cash and cash equivalents – beginning of period	92,367			35,907
Cash and cash equivalents – end of period	$	83,259		$	66,884

Supplemental disclosure of cash flow information:
Cash paid for taxes	$	2,214		$	10,736
Supplemental information of non-cash investing and financing activities:
Unrealized gain (loss) on available for sale investments	$	(3	)	$	3

See notes to unaudited condensed consolidated financial statements.

MORNINGSTAR, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation of Interim Financial Information

The accompanying unaudited condensed consolidated financial statements of Morningstar, Inc. and subsidiaries (Morningstar, we, our, the Company) included herein have been prepared to conform to the rules and regulations of the Securities and Exchange Commission (SEC). The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue, and expense. Actual results could differ from those estimates. In the opinion of management, the statements reflect all adjustments, which are of a normal recurring nature, necessary to present fairly our financial position, results of operations, stockholders’ equity, and cash flows. These financial statements and notes should be read in conjunction with our Consolidated Financial Statements and Notes thereto as of December 31, 2005 included in our Annual Report on Form 10-K filed with the SEC on March 16, 2006.

In the first quarter of 2006, we changed our segment reporting by allocating stock-based compensation expense to each of our three business segments; before 2006, stock-based compensation expense was recorded as a corporate item. We believe this change gives management a more complete picture of the profitability of each business segment after fully allocating stock-based compensation expense. We have reclassified the 2005 financial results for each segment to reflect this change.

2. Summary of Significant Accounting Policies

We discuss our significant accounting policies in Note 2 of our Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the SEC.

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)), using the modified prospective transition method. Under this method, the provisions of SFAS
No. 123(R) apply to all awards granted after the date of adoption and to any unrecognized expense of awards unvested at the date of adoption based on the fair value as of the date of grant. Prior to this date, we accounted for our stock options in accordance with the fair value provisions of SFAS No. 123, Stock-Based Compensation (SFAS No. 123). Under SFAS No. 123, we accounted for forfeitures of stock options as they occurred. SFAS No. 123(R) requires us to estimate expected forfeitures at the grant date and recognize compensation cost only for those awards expected to vest. Accordingly, in the first quarter of 2006, we recorded a cumulative effect of accounting change, net of tax, of $259,000 to reverse the impact of stock-based compensation expense recorded in prior years related to outstanding stock options that we estimate will not vest. Besides recording this cumulative effect of accounting change, the adoption of SFAS No. 123(R) did not have a significant impact on our financial position or results of operations because we previously recognized stock-based compensation expense in accordance with SFAS No. 123.

Prior to our adoption of SFAS 123(R), we classified tax benefits arising from the exercise of stock options as operating cash flows. SFAS No. 123(R) requires that we classify the cash flows resulting from the tax benefit that arises when the tax deductions exceed the compensation cost recognized for those options (excess tax benefits) as financing cash flows. The excess tax benefits were $6,508,000 in the first six months of 2006, and no comparable amounts were recorded in the first six months of 2005. Refer to Note 8 of the Notes to our Unaudited Condensed Consolidated Financial Statements for more information regarding our adoption of SFAS No. 123(R) and our accounting for stock options and restricted stock units.

3. Acquisitions, Goodwill, and Other Intangible Assets

Ibbotson Associates, Inc.

In March 2006, we acquired Ibbotson Associates, Inc. (Ibbotson), a privately held firm specializing in asset allocation research and services, for $83,000,000 in cash, plus an additional $3,470,000 in cash for working capital and other items, subject to post-closing adjustments. We have included the results of Ibbotson’s operations in our Condensed Consolidated Financial Statements beginning on March 1, 2006. This acquisition fits several of Morningstar’s growth strategies and broadens our reach in the areas of investment consulting, managed retirement accounts, and institutional and advisor software.

In the first quarter of 2006, we performed a preliminary allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed upon acquisition. In the second quarter of 2006, we refined our initial estimates of intangible assets, fixed assets, income tax benefits, and other accrued liabilities. The following table summarizes our current allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

	($000)
Cash	$	103
Accounts receivable	6,629
Income tax benefits, net	12,776
Other current assets	1,530
Fixed assets	1,407
Other assets	166
Intangible assets	55,280
Goodwill	47,018
Deferred revenue	(10,672		)
Accrued liabilities	(4,902		)
Deferred tax liability	(22,108		)
Other non-current liabilities	(761		)
Total purchase price	$	86,466

As part of the purchase price allocation, we recorded an asset of $12,776,000, primarily for the income tax benefit related to payment for the cancellation of Ibbotson’s stock options. This cash income tax benefit will reduce the amount of cash we pay for income taxes in 2006. This cash income tax benefit did not impact our income tax expense or net income in the first six months of 2006.

The purchase price allocation also includes $55,280,000 of acquired intangible assets. These assets include customer-related assets of $34,200,000 that will be amortized over a weighted average period of 9 years; intellectual property (including patents and trade names) of $17,710,000 that will be amortized over a weighted average period of 10 years; technology-based assets of $3,070,000 that will be amortized over a weighted average period of 5 years; and a non-compete agreement of $300,000 that will be amortized over 5 years. Because the amortization expense for these intangible assets is not deductible for U.S. income tax purposes, we recorded a deferred tax liability of $21,971,000 based on these preliminary values.

Based on the purchase price allocation, we recorded $47,018,000 of goodwill. The goodwill we recorded is not deductible for income tax purposes. SFAS No. 109, Accounting for Income Taxes, prohibits recognition of a deferred tax asset or liability for goodwill temporary differences if goodwill is not amortizable and deductible for tax purposes. The goodwill will be tested at least annually for impairment in accordance with SFAS No. 142, Goodwill and Other Intangible Assets.

Based on plans in place at the time of acquisition, we recorded a liability of $614,000 for severance and $761,000 for lease termination costs, net of estimated sub-lease income. As of June 30, 2006, we have made substantially all of the related severance payments. We expect to pay the lease termination costs beginning in March 2008, which is when we plan to vacate the office space.

The following unaudited pro forma information presents a summary of our consolidated statements of operations for the three and six months ended June 30, 2006 and 2005 as if we had acquired Ibbotson as of January 1, 2006 and 2005, respectively. In calculating the pro forma information below, we made an adjustment to eliminate stock-based compensation expense previously recorded by Ibbotson based on the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. We also made an adjustment to record stock-based compensation expense for an estimated value of stock options assumed to be granted to Ibbotson employees. This adjustment assumes the stock option awards were made in May 2005, consistent with the timing of our annual equity grant, and vest over a four-year period. In 2005, we recorded stock-based compensation expense based on the recognition and measurement principles of SFAS No. 123, Accounting for Stock-Based Compensation.

	Three Months Ended June 30				Six Months ended June 30
($000)	2006		2005		2006		2005
Revenue	$	76,257	$	68,829	$	153,708	$	133,308
Operating income	17,459		13,717		36,998		20,958
Income before cumulative effect of accounting change	11,165		9,483		24,320		13,335
Net income	11,165		9,483		24,579		13,335

Basic income per share:
Income before cumulative effect of accounting change	$	0.27	$	0.24	$	0.60	$	0.34
Net income	$	0.27	$	0.24	$	0.60	$	0.34

Diluted income per share:
Income before cumulative effect of accounting change	$	0.24	$	0.22	$	0.52	$	0.31
Net income	$	0.24	$	0.22	$	0.53	$	0.31

Variable Annuity Research and Data Service

In January 2005, we acquired Variable Annuity Research and Data Service (VARDS) from Finetre Corporation for $8,192,000 in cash, including costs directly related to the acquisition. The results of VARDS’ operations have been included in our Condensed Consolidated Financial Statements beginning in January 2005.

The following table summarizes the allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:

	($000)
Accounts receivable	$	639
Other assets	57
Intangible assets	6,370
Goodwill	3,084
Liabilities, primarily deferred revenue	(1,958		)
Total purchase price	$	8,192

The acquired intangible assets include $5,700,000 of customer-related assets, consisting primarily of acquired customer contracts; $430,000 for technology-based assets, consisting of a database and developed software; and $240,000 related to supplier relationships. Both the acquired intangible assets and the acquired goodwill are deductible for U.S. income tax purposes.

Goodwill

The following table shows the changes in our goodwill balance from January 1, 2005 to June 30, 2006:

	($000)
Balance as of January 1, 2005	$	14,408
Goodwill acquired related to VARDS	3,084
Other, primarily currency translation adjustment	8
Balance as of December 31, 2005	$	17,500
Goodwill acquired related to Ibbotson	47,018
Other, primarily currency translation adjustment	64
Balance as of June 30, 2006	$	64,582

We did not record any impairment losses in the quarter or year-to-date periods ended June 30, 2006 or 2005, respectively.

Intangible Assets

We amortize intangible assets using the straight-line method over their expected economic useful lives. The following table summarizes our intangible assets:

	As of June 30, 2006								As of December 31, 2005
($000)	Gross		Accumulated Amortization			Net		Weighted Average Useful Life (years)	Gross		Accumulated Amortization			Net		Weighted Average Useful Life (years)
Intellectual property	$	18,842	$	(1,070	)	$	17,772	10	$	1,132	$	(405	)	$	727	7
Customer-related assets	40,771		(2,046		)	38,725		11	6,571		(597		)	5,974		18
Supplier relationships	240		(19		)	221		20	240		(12		)	228		20
Technology-based assets	3,896		(420		)	3,476		5	430		(108		)	322		4
Non-competition agreement	300		(20		)	280		5	—		—			—		—
Total intangible assets	$	64,049	$	(3,575	)	$	60,474	10	$	8,373	$	(1,122	)	$	7,251	16

Amortization expense was $2,454,000 and $346,000 for the six months ended June 30, 2006 and 2005, respectively.

As of June 30, 2006, we estimate that aggregate amortization expense for intangible assets will be $5,979,000 in 2006; $7,051,000 in 2007; $6,994,000 in 2008; $6,867,000 in 2009; $6,300,000 in 2010; and $5,816,000 in 2011.

4. Income Per Share

The numerator for both basic and diluted income per share is net income. The denominator for basic income per share is the weighted-average number of common shares outstanding during the period. The dilutive effect of outstanding employee stock options and restricted stock units is reflected in the denominator for diluted income per share using the treasury stock method.

The following table shows how we reconcile the net income and the number of shares used in computing basic and diluted income per share:

	Three Months Ended June 30				Six Months Ended June 30
(in thousands, except per share amounts)	2006		2005		2006		2005

Basic income per share:
Income before cumulative effect of accounting change	$	11,165	$	9,498	$	24,345	$	13,505
Cumulative effect of accounting change, net of tax	—		—		259		—
Net income	$	11,165	$	9,498	$	24,604	$	13,505
Weighted average common shares outstanding	40,925		39,064		40,641		38,758

Income before cumulative effect of accounting change	$	0.27	$	0.24	$	0.60	$	0.35
Cumulative effect of accounting change, net of tax	—		—		0.01		—
Net income	$	0.27	$	0.24	$	0.61	$	0.35

Diluted income per share:
Income before cumulative effect of accounting change	$	11,165	$	9,498	$	24,345	$	13,505
Cumulative effect of accounting change, net of tax	—		—		259		—
Net income	$	11,165	$	9,498	$	24,604	$	13,505

Weighted average common shares outstanding	40,925		39,064		40,641		38,758
Net effect of dilutive stock options and restricted stock units	5,759		4,678		5,894		4,236
Weighted average common shares outstanding for computing diluted income per share	46,684		43,742		46,535		42,994

Income before cumulative effect of accounting change	$	0.24	$	0.22	$	0.52	$	0.31
Cumulative effect of accounting change, net of tax	—		—		0.01		—
Net income	$	0.24	$	0.22	$	0.53	$	0.31

5. Segment and Geographical Area Information

We organize our operations based on products and services sold in three primary business segments: Individual, Advisor, and Institutional.

• Individual segment. Our Individual segment provides products and services for individual investors. The largest product in this segment is our U.S.-based Web site, Morningstar.com, which includes both paid Premium Membership service and sales of advertising space. Our Individual segment also includes Morningstar Equity Research, which we distribute through several channels. Investors can access our equity research through our Premium Membership offering on Morningstar.com. In addition, our equity research is currently distributed through six major investment banks to meet the requirements for independent research under the Global Analyst Research Settlement, as well as to several other companies who provide our research to their affiliated financial advisors or to individual investors. We also offer a variety of print publications on stocks and mutual funds, including our monthly newsletters, Morningstar FundInvestor and Morningstar StockInvestor, and our twice-monthly publication, Morningstar Mutual Funds. We sell several annual reference guides, including the Morningstar Funds 500, the Morningstar Stocks 500, the Morningstar ETFs 100, and the newly acquired Ibbotson Stocks, Bonds, Bills, and Inflation Yearbook.

• Advisor segment. Our Advisor segment focuses on products and services for financial advisors. Key products in this segment are Morningstar Advisor Workstation and Principia. Advisor Workstation is a Web-based investment planning system that provides financial advisors with a comprehensive set of tools for conducting their core business – including investment research, planning, and presentation tools. Advisor Workstation is available in two editions: the Office Edition for independent financial advisors and the Enterprise Edition for financial advisors affiliated with larger firms. Principia is our CD-ROM-based investment research and planning software for financial planners. In addition, we offer Morningstar Managed Portfolios, a fee-based discretionary asset management service that includes a series of mutual fund and exchange-traded fund portfolios tailored to meet a range of investment time horizons and risk levels that financial advisors can use for their clients’ taxable and tax-deferred accounts. Through our acquisition of Ibbotson, we also offer a series of NASD-reviewed Financial Communications materials that advisors can use to educate clients about asset allocation and demonstrate other key investment concepts, as well as data and graphs that financial advisors can license to use in published materials.

• Institutional segment. Our Institutional segment focuses on products and services for institutions, including banks, insurance companies, mutual fund companies, brokerage firms, media outlets, and retirement plan providers and sponsors. Key products and services in this segment include Licensed Data, a set of investment data spanning eight core databases, available through electronic data feeds; Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities; retirement advice, including the Morningstar Retirement Manager and Advice by Ibbotson platforms; Licensed Tools and Content, a set of online tools and editorial designed for institutions to use in their Web sites and software; Investment Profiles and Guides, which are designed for institutions to use in communicating investment information to individual investors; Morningstar Direct, a Web-based institutional research platform that provides advanced research and tools on the complete range of securities in Morningstar’s global database; and Encorr, an asset allocation software package (acquired with Ibbotson).

We measure the operating results of these segments based on operating income (loss), including an allocation of corporate costs. We include intersegment revenue and expenses in segment information. We sell services and products between segments at predetermined rates primarily based on cost. The recovery of intersegment cost is shown as “Intersegment revenue.”

In the first quarter of 2006, we changed our segment reporting by allocating stock-based compensation expense to each of our three business segments; before 2006, stock-based compensation expense was recorded as a corporate item. This change gives management a more complete picture of the profitability of each business segment after fully allocating stock-based compensation expense. The 2005 financial results for each segment have been reclassified to reflect this change.

Our segment accounting policies are the same as those described in Note 2 to our Consolidated Financial Statements as of December 31, 2005 included in our Annual Report on Form 10-K as of December 31, 2005, except for the capitalization and amortization of internal product development costs and amortization of intangible assets. We exclude these items from our operating segment results to provide our chief operating decision maker with a better indication of each segment’s ability to generate cash flow. This information is one of the criteria used by our chief operating decision maker in determining how to allocate resources to each segment. We include the capitalization and amortization of internal product development costs and amortization of intangible assets, as well as the elimination of intersegment revenue and expense, in the Corporate Items and Eliminations category to arrive at the consolidated financial information. Our segment disclosures include the business segment information provided to our chief operating decision maker on a recurring basis, and, therefore, we do not present balance sheet information, including goodwill or other intangibles, by segment.

The following tables show selected segment data for the three and six months ended June 30, 2006 and 2005:

	Three months ended June 30, 2006
($000)	Individual		Advisor		Institutional		Corporate Items & Eliminations			Total
Revenue:
External customers	$	18,379	$	24,320	$	33,558	$	—		$	76,257
Intersegment	996		1		738		(1,735		)	—
Total revenue	19,375		24,321		34,296		(1,735		)	76,257
Operating expense, excluding stock-based compensation expense, depreciation, and amortization	12,240		16,901		25,540		(1,729		)	52,952
Stock-based compensation expense	608		633		838		—			2,079
Depreciation and amortization	305		392		600		2,470			3,767
Operating income (loss)	$	6,222	$	6,395	$	7,318	$	(2,476	)	$	17,459

Capital expenditures	$	79	$	98	$	352	$	635		$	1,164

U.S. revenue										$	66,724
Non-U.S. revenue										$	9,533

	Three months ended June 30, 2005
($000)	Individual		Advisor		Institutional		Corporate Items & Eliminations			Total
Revenue:
External customers	$	14,982	$	18,784	$	22,477	$	—		$	56,243
Intersegment	646		—		550		(1,196		)	—
Total revenue	15,628		18,784		23,027		(1,196		)	56,243
Operating expense, excluding stock-based compensation expense, depreciation, and amortization	10,229		13,573		16,869		(1,362		)	39,309
Stock-based compensation expense	562		614		762		—			1,938
Depreciation and amortization	287		361		475		729			1,852
Operating income (loss)	$	4,550	$	4,236	$	4,921	$	(563	)	$	13,144

Capital expenditures	$	107	$	217	$	419	$	563		$	1,306

U.S. revenue										$	49,117
Non-U.S. revenue										$	7,126

	Six months ended June 30, 2006
($000)	Individual		Advisor		Institutional		Corporate Items & Eliminations			Total
Revenue:
External customers	$	36,717	$	46,068	$	63,532	$	—		$	146,317
Intersegment	1,786		3		1,336		(3,125		)	—
Total revenue	38,503		46,071		64,868		(3,125		)	146,317
Operating expense, excluding stock-based compensation expense, depreciation, and amortization	25,025		31,557		46,199		(3,307		)	99,474
Stock-based compensation expense	1,183		1,204		1,626		—			4,013
Depreciation and amortization	511		833		1,030		3,799			6,173
Operating income (loss)	$	11,784	$	12,477	$	16,013	$	(3,617	)	$	36,657

Capital expenditures	$	120	$	180	$	660	$	1,063		$	2,023

U.S. revenue										$	128,362
Non-U.S. revenue										$	17,955

										June 30, 2006
U.S. long-lived assets										$	13,198
Non-U.S. long-lived assets										$	3,842

	Six months ended June 30, 2005
($000)	Individual		Advisor		Institutional		Corporate Items & Eliminations			Total
Revenue:
External customers	$	29,888	$	35,275	$	44,284	$	—		$	109,447
Intersegment	1,248		—		1,049		(2,297		)	—
Total revenue	31,136		35,275		45,333		(2,297		)	109,447
Operating expense, excluding stock-based compensation expense, depreciation, and amortization	21,442		25,690		33,713		(2,493		)	78,352
Stock-based compensation expense	2,144		2,044		2,637		—			6,825
Depreciation and amortization	575		719		962		1,992			4,248
Operating income (loss)	$	6,975	$	6,822	$	8,021	$	(1,796	)	$	20,022

Capital expenditures	$	165	$	327	$	651	$	1,184		$	2,327

U.S. revenue										$	95,348
Non-U.S. revenue										$	14,099

										June 30, 2005
U.S. long-lived assets										$	14,142
Non-U.S. long-lived assets										$	1,709

6. Investments

We monitor the concentration, diversification, maturity, and liquidity of our investment portfolio, which is primarily invested in fixed-income securities. We classify our investment portfolio as follows:

($000)	June 30, 2006		December 31, 2005
Available for sale	$	35,705	$	58,761
Held to maturity	796		420
Trading securities	1,681		1,642
Total	$	38,182	$	60,823

7. Investments In Unconsolidated Entities

Morningstar Japan K.K. In April 1998, we entered into an agreement with Softbank Corporation to form a joint venture, Morningstar Japan K.K. (MJKK), which develops and markets products and services customized for the Japanese market. In June 2000, MJKK became a public company, and its shares are traded on the Osaka Stock Exchange, “Hercules Market,” using the ticker number 4765. Subsequent to MJKK’s initial public offering, the joint venture agreement between us and Softbank Corporation was terminated, but we continued to hold shares of MJKK stock. As of June 30, 2006 and December 31, 2005, we owned approximately 35% of MJKK. We account for our investment in MJKK using the equity method. Our investment in MJKK totaled $15,608,000 and $14,884,000 as of June 30, 2006 and December 31, 2005, respectively. MJKK’s market value was approximately Japanese Yen 27.7 billion (approximately U.S. $238,440,000) as of June 30, 2006 and Japanese Yen 27.8 billion (approximately U.S. $235,625,000) as of December 31, 2005.

Morningstar Korea, Ltd. In June 2000, we entered into a joint venture agreement with Shinheung Securities Co., Ltd. and SOFTBANK Finance Corporation to establish a Korean limited liability company named Morningstar Korea Ltd. (Morningstar Korea). Morningstar Korea develops, markets, and sells products and services to assist in the analysis of financial portfolios and provides financial information and services for investors in South Korea. Our ownership interest and profit and loss sharing interest in Morningstar Korea was 40% as of June 30, 2006 and December 31, 2005. We account for this investment using the equity method. Our investment totaled $1,203,000 and $1,129,000 as of June 30, 2006 and December 31, 2005, respectively.

Other Investments in Unconsolidated Entities. As of June 30, 2006 and December 31, 2005, the book value of our other investments in unconsolidated entities totaled $427,000 and $342,000, respectively, and consist primarily of our investments in Morningstar Danmark A/S (Morningstar Denmark) and Morningstar Sweden AB (Morningstar Sweden). In August 2001, we entered into a joint venture agreement with Phosphorus A/S to establish Morningstar Denmark, which develops and markets products and services customized for the Danish market. In April 2001, we entered into a joint venture agreement with Stadsporten Citygate AB to establish Morningstar Sweden, which develops and markets products and services customized for the Swedish market. Our ownership interest in both Morningstar Denmark and Morningstar Sweden was approximately 25% as of June 30, 2006 and December 31, 2005. We account for our investments in Morningstar Denmark and Morningstar Sweden using the equity method.

The following table shows condensed combined unaudited financial information for our investments in unconsolidated entities:

	Three months ended June 30					Six months ended June 30
($000)		2006		2005		2006		2005
Revenue		$	4,876	$	3,709	$	9,720	$	7,004
Operating income		$	1,473	$	840	$	2,885	$	1,483
Net income		$	1,581	$	1,321	$	3,119	$	1,695

8. Stock-Based Compensation

Stock-Based Compensation Plans

Prior to November 2004, we granted stock options under various plans including the 1993 Stock Option Plan (the 1993 Plan), the 2000 Morningstar Stock Option Plan (the 2000 Plan), and the 2001 Morningstar Stock Option Plan (the 2001 Plan). In general, options granted under the 1993 Plan vest ratably over a five-year period and options granted under the 2000 Plan and the 2001 Plan vest ratably over a four-year period; options under all three plans expire 10 years after the date of grant.

In November 2004, we adopted the 2004 Stock Incentive Plan. The 2004 Stock Incentive Plan amends and restates the 1993 Plan, the 2000 Plan, and the 2001 Plan (collectively, the Prior Plans). Under the 2004 Stock Incentive Plan, we will not grant any additional

options under any of the Prior Plans, and any shares subject to an award under any of the Prior Plans that are forfeited, canceled, settled, or otherwise terminated without a distribution of shares, or withheld by us in connection with the exercise of options or in payment of any required income tax withholding, will not be available for awards under the 2004 Stock Incentive Plan. The 2004 Stock Incentive Plan provides for grants of options, stock appreciation rights, restricted stock, restricted stock units, and performance shares. All of our employees are eligible for awards under the 2004 Stock Incentive Plan. Our non-employee directors are also eligible for awards under the 2004 Stock Incentive Plan. Joe Mansueto, our chairman and chief executive officer, does not participate in the 2004 Stock Incentive Plan or the Prior Plans.

Since the adoption of the 2004 Stock Incentive Plan, we have granted stock options and, beginning in 2006, restricted stock units. Stock options granted under the 2004 Stock Incentive Plan vest ratably over a four-year period and expire 10 years after the date of grant. Almost all of the options granted under the 2004 Stock Incentive Plan have a premium feature in which the exercise price increases over the term of the option at a rate equal to the 10-year Treasury bond yield as of the date of grant. Restricted stock units represent the right to receive a share of Morningstar common stock when that unit vests. Restricted stock units granted under the 2004 plan vest ratably over a four-year period. The number of shares available for future grants under our 2004 Plan, which include both stock options and restricted stock units, as of June 30, 2006 and December 31, 2005 was 2,791,860 and 2,989,322, respectively.

In February 1999, we entered into an Incentive Stock Option Agreement and a Nonqualified Stock Option Agreement under the 1999 Incentive Stock Option Plan (the 1999 Plan) with Don Phillips, an officer of Morningstar. Under these agreements, we granted Don options to purchase 1,500,000 shares of common stock at an exercise price of $2.77 per share, equal to the fair value at the grant date. These options are fully vested and expire in February 2009. On the date of grant, 1,138,560 options were fully exercisable and an additional 36,144 shares became and continue to become exercisable each year from 1999 through 2008. As of June 30, 2006 and December 31, 2005, there were 849,174 and 869,174 options remaining to be exercised, respectively.

Accounting for Stock-Based Compensation Awards

Effective January 1, 2006, we adopted SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123(R)), using the modified prospective transition method. Prior to this date, we accounted for our equity plans in accordance with the fair value provisions of SFAS No. 123, Stock-Based Compensation (SFAS No. 123). Under SFAS No. 123, we accounted for forfeitures of stock options as they occurred. SFAS No. 123(R) requires us to estimate expected forfeitures at the grant date and recognize compensation cost only for those awards expected to vest. Accordingly, in the first quarter of 2006, we recorded a cumulative effect of accounting change, net of tax, of $259,000 to reverse the impact of stock-based compensation expense recorded in prior years related to outstanding stock options that we estimate will not vest. Other than recording this cumulative effect of accounting change, the adoption of SFAS No. 123(R) did not have a significant impact on our financial position or results of operations because we previously recognized stock-based compensation expense in accordance with SFAS No. 123.

Prior to our adoption of SFAS 123(R), we presented the tax benefit of deductions arising from the exercise of stock options as operating cash flows in our Condensed Consolidated Statement of Cash Flows. SFAS No. 123(R) requires that we classify the cash flows resulting from the tax benefit that arises when the tax deductions exceed the compensation cost recognized for those options (excess tax benefits) as financing cash flows. The excess tax benefits classified as financing cash flows were $6,508,000 in the first six months of 2006.

Prior to our initial public offering in May 2005, we accounted for stock options granted under the 1993 Plan and the 1999 Plan using the liability method in accordance with SFAS No. 123, reflecting the terms of the respective stock option plans which allowed for cash settlement at the option holder’s election subject to certain conditions. Under the liability method, we accounted for options as a liability that was measured each period using the fair value per share of our common stock. We recorded changes in the liability resulting from changes in the fair value of our common stock in our Consolidated Statements of Operations. As a result of our initial public offering, we are no longer required to settle options under the 1993 Plan and the 1999 Plan in cash. Upon our initial public offering, we valued the liability using a fair value of $18.50 per share, which was equivalent to the fair value of our common stock at the time of our initial public offering. We reclassified stock options accounted for as current liabilities of $16,707,000 and long-term liabilities of $24,882,000 to additional paid-in capital. In addition, because all of the options previously accounted for under the liability method were fully vested by March 31, 2005, we have not recorded any additional expense for these options in subsequent periods.

Stock-Based Compensation Expense

The following table summarizes stock-based compensation expense (including expense for both stock options and restricted stock units) recorded in our Consolidated Statements of Operations:

	Three months ended June 30				Six months ended June 30
($000)	2006		2005		2006		2005
Stock-based compensation expense under the liability method	$	—	$	—	$	—	$	2,810
Stock-based compensation expense under the equity method	2,079		1,938		4,013		4,015
Total stock-based compensation expense	$	2,079	$	1,938	$	4,013	$	6,825

The deferred tax benefit related to the stock-based compensation expense above was $643,000 and $631,000 for the three months ended June 30, 2006 and 2005, respectively, and $1,390,000 and $1,459,000 for the six months ended June 30, 2006 and 2005, respectively.

We estimate forfeitures of all employee stock-based awards and recognize compensation cost only for those awards expected to vest. We determine forfeiture rates based on historical experience. Estimated forfeitures are adjusted to actual forfeiture experience as needed; there were no such adjustments recorded during the first six months of 2006.

Restricted Stock Units

We measure the fair value of our restricted stock units on the date of grant based on the market price of the underlying common stock as of the close of trading on the day prior to grant and amortize that value to stock-based compensation expense, net of estimated

forfeitures, ratably over the vesting period. We granted restricted stock units for the first time in May 2006; the fair value of the restricted stock units granted was $44.47 per restricted stock unit, for a total value of approximately $10,759,000.

The following table summarizes restricted stock unit activity for the first six months of 2006:

	Six months ended June 30, 2006
Restricted Stock Units	Shares	Weighted Average Grant Date Fair Value
Nonvested shares—January 1, 2006	—	—
Granted	241,945	$44.47
Vested	—	—
Forfeited	(513)	$44.47
Nonvested shares—June 30, 2006	241,432	$44.47

As of June 30, 2006, the total amount of unrecognized stock-based compensation expense related to nonvested restricted stock units was approximately $8,893,000, which is expected to be recognized over a period of approximately 47 months.

Stock Option Fair Value

We estimate the fair value of our stock options on the date of grant using a Black-Scholes option-pricing model and amortize that value to stock-based compensation expense ratably over the option’s vesting period. The fair value of options granted during the first six months of 2006 and 2005 using this model was $14.16 per share and $9.16 per share, respectively. We estimated the fair value of the options granted in the first six months of 2006 and 2005 on the date of grant using the following weighted-average assumptions in our Black-Scholes option-pricing model:

	2006		2005
Expected life (years)	6.25		7.0
Expected volatility (%)	43.0	%	50.0	%
Dividend yield (%)	—		—
Interest rate (%)	4.33	%	4.03	%
Expected exercise price	$45.31		$24.91

Expected life. The expected term represents the period over which the stock options are expected to be outstanding. Because we have limited historical information regarding stock option exercises since becoming a public company in May 2005, we have determined the expected life using the “shortcut method” described in Staff Accounting Bulletin Topic 14.D.2, which is based on a calculation to arrive at the midpoint between the vesting date and the end of the contractual term.

Expected volatility. The volatility factor used in our assumptions is based on an average of the historical stock prices of a group of our peers over the most recent period commensurate with the expected term of the stock option award. As a newly public company with limited historical data on the price of our stock, we do not base our volatility assumption on our own stock price.

Dividend yield. We do not intend to pay dividends on our common stock for the foreseeable future. Accordingly, we use a dividend yield of zero in our assumptions.

Interest rate. We base the risk-free interest rate used in our assumptions on the implied yield available on U.S. Treasury zero-coupon issues with a remaining term that approximates the stock option award’s expected term.

Expected exercise price. Options granted in 2006 have initial exercise prices that will increase over the term of the options at a rate equal to the 10-year Treasury bond rate as of the date of grant. The expected exercise price included in the option pricing models for these options was calculated using an estimated life of 6.25 years and the applicable 10-year Treasury bond rate.

Stock Option Activity

The following tables summarize stock option activity for our various stock option grants. The first table includes activity for options granted at an exercise price below the fair value per share of our common stock on the grant date; the second table includes activity for all other option grants.

	Six months ended June 30, 2006
Options Granted At an Exercise Price Below the Fair Value Per Share on the Grant Date	Underlying Shares	Weighted Average Exercise Price
Options outstanding—January 1, 2006	3,338,959	$10.50
Canceled	(56,228)	15.40
Exercised	(98,718)	12.83
Options outstanding—June 30, 2006	3,184,013	$10.44

Options exercisable—June 30, 2006	2,378,085	$9.10

	Six months ended June 30, 2006
All Other Option Grants, Excluding Activity Shown Above	Underlying Shares	Weighted Average Exercise Price
Options outstanding—January 1, 2006	7,795,848	$11.96
Canceled	(42,590)	18.38
Exercised	(893,160)	10.73
Granted	46,451	34.64
Options outstanding—June 30, 2006	6,906,549	$12.30

Options exercisable—June 30, 2006	5,886,598	$11.11

The total intrinsic value (difference between the market value of our stock on the date of exercise and the exercise price of the option) of options exercised in the six months ended June 30, 2006 and 2005 was $31,153,000 and $2,648,000, respectively.

Stock Options Outstanding and Exercisable

The table below shows additional information for options outstanding and options exercisable as of June 30, 2006:

Options Outstanding							Options Exercisable
Range of Exercise Prices	Outstanding Shares	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Aggregate Intrinsic Value ($000)		Exercisable Shares	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Aggregate Intrinsic Value ($000)
$2.00 - $2.77	2,146,549	2.19	$	2.53	$	83,608	2,066,688	2.17	$	2.52	$	80,512
$8.57 - $14.70	5,555,966	4.57	12.53		160,838		5,364,786	4.49	12.67		154,578
$15.71 - $35.39	2,388,047	8.63	18.11		55,808		833,209	8.53	16.72		20,629
$2.00 - $35.39	10,090,562	5.02	$	11.72	$	300,254	8,264,683	4.32	$	10.54	$	255,719
Vested or Expected to Vest
$2.00 - $35.39	9,951,935	4.97	$	11.61	$	297,288

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on our closing stock price of $41.48 on June 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date.

As of June 30, 2006, the total amount of unrecognized stock-based compensation expense related to nonvested stock options was approximately $14,805,000, which is expected to be recognized over a weighted average period of approximately 28 months.

9. Related Party Transactions

In 1989, under our 1989 Nonqualified Stock Option Plan (the 1989 Plan), we granted options to purchase 1,500,000 shares of common stock at an exercise price of $0.075 per share, equal to the fair value at date of issue, to Don Phillips, an officer of Morningstar. These options were not exercised and expired in February 1999. In February 1999, in conjunction with the expiration of options granted under the 1989 Plan, we entered into a Deferred Compensation Agreement (the Agreement) with Don. Under the terms of the Agreement, on any date that he exercises the right to purchase shares under the 1999 Plan, we shall pay to him $2.69 per share in the form of cash or, at our election, shares of common stock. If on the date of purchase the fair value of Morningstar’s stock is below $2.77 per share, the amount paid per share will be reduced based on the terms of the Agreement. Our obligation to pay deferred

compensation will not be increased by any imputed interest or earnings amount. In May 2006, Don entered into a Rule 10b5-1 sales plan contemplating the sale of up to 450,000 shares to be acquired through stock option exercises during 2006 and 2007. Upon exercise of these stock options, we will make payments to him, as prescribed by the Agreement, which, if all 450,000 stock options are exercised, would total approximately $1,200,000. These payments would reduce the liability associated with the Agreement. In the second quarter of 2006, Don exercised 20,000 options and we made corresponding payments to him in accordance with the Agreement. As of June 30, 2006 and December 31, 2005, a liability of $2,313,000 and $2,340,000, respectively, for the Agreement is recorded in our Consolidated Balance Sheets, primarily classified as other current liabilities.

10. Income Taxes

The following table shows our effective income tax expense rate for the three and six months ended June 30, 2006 and 2005:

	Three months ended June 30						Six months ended June 30
($000)	2006			2005			2006			2005
Income before income taxes, equity in net income of unconsolidated entities, and cumulative effect of accounting change	$	18,131		$	13,549		$	38,262		$	21,136
Equity in net income of unconsolidated entities	658			549			1,305			1,029
Total	$	18,789		$	14,098		$	39,567		$	22,165
Income tax expense	$	7,624		$	4,600		$	15,222		$	8,660
Effective income tax expense rate	40.6		%	32.6		%	38.5		%	39.1		%

In the second quarter of 2006, our effective income tax expense rate increased compared with the same period in 2005. In the second quarter of 2005 we recorded a deferred income tax benefit of $668,000 related to research and development expenses due to a change in U.S. tax regulations, which resulted in a one-time reduction of our effective income tax expense rate. In the second quarter of 2006, we recorded additional income tax expense related to certain operations outside of the United States.

In the first six months of 2006, our effective income tax expense rate decreased compared with the prior-year period, primarily because of a reduction in the tax impact related to incentive stock options. In the first quarter of 2005, we recorded stock-based compensation expense related to incentive stock options but we did not record a corresponding tax benefit. This had the impact of increasing our effective income tax rate above the U.S. Federal rate of 35%. Because the incentive stock options were fully vested by March 31, 2005 and because we no longer account for options under the liability method subsequent to our initial public offering, we did not record any stock based compensation expense related to incentive stock options in the first six months of 2006.

In 2006, our effective tax rate in both the quarter and year-to-date periods also reflects an increase in the benefit we receive related to disqualifying dispositions related to incentive stock options. The value of disqualifying dispositions increased compared with the same periods in 2005. A disqualifying disposition occurs when the option holder sells shares within one year of exercising an incentive stock option. We receive a tax benefit in the period that the disqualifying disposition occurs.

In both 2006 and 2005, our effective income tax expense rate reflects the fact that we are not recording an income tax benefit related to losses recorded by certain of our non-U.S. operations. In the year the non-U.S. entity records a loss, we do not record a corresponding tax benefit, thus increasing our effective tax rate. The foreign net operating losses may become deductible in certain international tax jurisdictions to the extent these international operations become profitable. For each of our operations, we evaluate whether it is more likely than not that the tax benefits related to net operating losses will be realized. As part of this evaluation, we consider evidence such as tax planning strategies, historical operating results, forecasted taxable income, and recent financial performance.

11. Contingencies

Morningstar Australia

In 2001, Mr. Graham Rich, the then managing director and chief executive officer of Morningstar Research Pty Limited (Morningstar Australia), and one of two companies controlled by Mr. Rich, filed a suit in the Supreme Court of New South Wales, Australia against Morningstar and certain of its officers and nominee directors on the board of Morningstar Australia. Mr. Rich was also a beneficial owner of shares in Morningstar Australia. Mr. Rich and his company originally sought an injunction which, if granted, would have precluded Morningstar Australia from terminating the services of Mr. Rich and from issuing additional shares to Morningstar in exchange for the provision of further funding by Morningstar to Morningstar Australia. Further, Mr. Rich and his company sought an order that a provisional liquidator be appointed for Morningstar Australia. The court rejected this injunction application, observing that Morningstar Australia would be insolvent without financial backing from Morningstar. The application for the appointment of a provisional liquidator also failed. The services of Mr. Rich were terminated in November 2001. Mr. Rich and his company were ordered to pay Morningstar’s costs of the injunction proceedings.

Mr. Rich and the two companies noted above have additional pending claims, alleging, among other things, breaches by Morningstar of contracts and statutory and general law duties, misleading, deceptive, and unconscionable conduct by Morningstar, oppression by Morningstar and its nominee directors, claims under the Industrial Relations Act of New South Wales, breaches of directors’ duties by Morningstar’s nominee directors, and conflict of interest. The claims seek various forms of relief, including monetary damages in the amount of Australian $25,000,000, the setting aside of transactions which resulted in Morningstar obtaining control of Morningstar Australia, and an order either setting aside Morningstar’s acquisition of the shares formerly beneficially owned by Mr. Rich and his companies or determining a different price for this acquisition. In the alternative, Mr. Rich and his companies seek an order that they be entitled to purchase the shares in Morningstar Australia at a price to be determined by the court or book value (as defined in the Morningstar Australia shareholders agreement). Morningstar has denied the claims and filed counter-claims against Mr. Rich and certain of his companies, alleging breaches of statutory, general law, and contractual duties.

In July 2004, the court decided Morningstar’s application for security for its potential additional costs in the litigation by ordering the two companies controlled by Mr. Rich to provide approximately Australian $925,000 to the court as security for these potential costs. Morningstar has been paid some of its costs and will be entitled to be paid costs in the future only if the court makes a determination to that effect. The court stayed the proceedings pending its receipt of the security and indicated that it would entertain an application by Morningstar for additional security at a later time in the proceedings.

In May 2005, Mr. Rich obtained conditional leave of the court to begin a proceeding in the name of Morningstar Australia against Morningstar and its nominee directors. The leave was, however, subject to the following conditions: (i) Mr. Rich must pay and bear, and indemnify Morningstar Australia against, all costs, charges, and expenses of and incidental to the bringing and continuation of the proceeding (except as the court may otherwise direct or allow) and may not seek contribution or indemnity from Morningstar Australia for any of these costs, charges, or expenses; (ii) Morningstar Australia, or Mr. Rich on its behalf, together with the two companies controlled by Mr. Rich were required to provide to the court, as security for Morningstar’s costs, approximately Australian $925,000 as described in the preceding paragraph; and (iii) approximately Australian $100,000 in costs owed by Mr. Rich and one of his companies to Morningstar in respect of the 2001 injunction proceedings was required to be paid to Morningstar. These conditions have been satisfied.

On September 20, 2005, Mr. Rich and his companies filed a Second Further Amended Statement of Claim, consolidating the claims. Morningstar filed a Defence to that pleading and an Amended Cross-Claim against Mr. Rich, both his companies, and a third Australian company controlled by Mr. Rich.

The parties have discussed settling the claims but have been unable to reach an agreement. In the fourth quarter of 2003, Morningstar offered to settle all claims for Australian $1,250,000, which then approximated U.S. $942,000, and, in accordance with SFAS No. 5, Accounting for Contingencies (SFAS No. 5), Morningstar recorded a reserve in this amount. In December 2005, Morningstar increased its offer to settle all claims to approximately Australian $2,500,000, which approximates U.S. $1,800,000, and, in accordance with SFAS No. 5, Morningstar recorded a reserve in this amount. While Morningstar is vigorously contesting the claims against it, we cannot predict the outcome of the proceeding.

Morningstar Associates, LLC Subpoenas from New York Attorney General’s Office, Securities and Exchange Commission, and Department of Labor

In December 2004, Morningstar Associates, LLC, a wholly owned subsidiary of Morningstar, Inc., received a request in the form of a subpoena from the New York Attorney General’s office, seeking information and documents from Morningstar Associates related to an investigation the New York Attorney General’s office is conducting. While the subpoena is very broad, it specifically asks for information and documents about the investment consulting services Morningstar Associates offers to retirement plan providers, including fund lineup recommendations for retirement plan sponsors. On December 16, 2004, shortly after the New York Attorney General’s office issued the subpoena, the SEC notified Morningstar Associates and Morningstar Investment Services, Inc. that it had begun an examination. In February 2005, the SEC issued a request to Morningstar Associates for the voluntary production of documents. The request is similar in scope to the New York Attorney General’s subpoena. In May 2005, Morningstar Associates received a request in the form of a subpoena from the United States Department of Labor, seeking information and documents from Morningstar Associates related to an investigation the Department of Labor is conducting. While the Department of Labor subpoena is very broad, it is substantially similar in scope to the New York Attorney General subpoena and the SEC request. In July 2005, the SEC issued a subpoena to Morningstar Associates. The subpoena is virtually identical to the SEC’s February 2005 request. We have been fully cooperating with the New York Attorney General’s office, the SEC, and the Department of Labor. Although we believe the focus of these investigations is on Morningstar Associates, information and documents pertaining to Morningstar, Inc. and Morningstar Investment Services have also been requested. We cannot predict the scope, timing, or outcome of these matters, which may include the institution of administrative, civil injunctive, or criminal proceedings, the imposition of fines and penalties, and other remedies and sanctions, any of which could lead to an adverse impact on our stock price, the inability to attract or retain key

employees, and the loss of customers. We also cannot predict what impact, if any, these matters may have on our business, operating results, or financial condition.

In addition to these proceedings, we are involved in legal proceedings and litigation that have arisen in the normal course of our business. Although the outcome of a particular proceeding can never be predicted, we do not believe that the result of any of these matters will have a material adverse effect on our business, operating results, or financial condition.

12. Recently Issued Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48), which prescribes the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, and disclosure for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006; therefore, we will adopt FIN 48 in the first quarter of 2007. We are in the process of determining the effect, if any, the adoption of FIN 48 will have on our financial statements.

In June 2006, the Emerging Issues Task Force (EITF) ratified EITF Issue No. 06-2, Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, “Accounting for Compensation Absence” (EITF No. 06-2), which requires that a liability for employees’ sabbatical benefits be accrued over the period required for employees to earn the right to sabbatical leave. EITF No. 06-2 is effective for fiscal years beginning after December 15, 2006; therefore, we will adopt EITF No. 06-2 in the first quarter of 2007. We are in the process of determining the effect the adoption of EITF No. 06-2 will have on our financial statements.

In June 2006, the EITF ratified EITF Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (EITF No. 06-3), which concludes that companies have the option to report taxes that are externally imposed on a revenue producing transaction between a seller and a customer either gross within revenue or net. This is, it may include charges to customers for taxes within revenues and the charge for taxes from the taxing authority within cost of sales, or alternatively, it may net the charge to the customer and the charge from the taxing authority. In addition, if these taxes are significant, disclosure of the accounting policy used is required. EITF No. 06-3 is effective for fiscal years beginning after December 15, 2006; therefore, we will adopt EITF No. 06-3 in the first quarter of 2007. We do not anticipate that EITF No. 06-3 will have an impact on our financial statements.

13. Subsequent Events

On July 25, 2006, we acquired Aspect Huntley Pty Limited, a leading provider of equity information, research, and financial trade publishing in Australia, for Australian $30,000,000 (approximately U.S. $23,000,000) in cash, of which Australian $2,000,000 will be paid in 2007 subject to post-closing adjustments. This acquisition fits with our growth strategy to expand our products and services internationally. The key benefit of this acquisition is the combination of Morningstar’s expertise in fund research and information with Aspect Huntley’s equity research, information, and financial media expertise in Australia. We believe this acquisition will significantly expand the breadth and quality of services we can deliver to individuals, advisors, and institutions and will offer Australian investors one place to obtain all their investment information and research needs.

On August 1, 2006, we acquired the institutional hedge fund and separate account database division of InvestorForce, Inc., a financial software and data integration company based in Wayne, Pennsylvania, for $10,000,000 in cash. This acquisition includes both the Altvest database, one of the first and largest databases covering hedge funds, managers, and data, along with InvestorForce’s extensive institutional separate account database. It also includes several online software applications for manager search, research, and reporting. We believe that this acquisition combined with Morningstar’s existing mutual fund, stock, variable annuity, hedge fund, and separate account data, will allow us to offer one of the largest, most comprehensive proprietary investment databases for our three market segments.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The discussion included in this section, as well as other sections of this Quarterly Report on Form 10-Q, contains forward-looking statements. These statements relate to future events or to our future financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by these forward-looking statements. In some cases, you can identify forward-looking statements by the use of words such as “may,” “could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue” or the negative of these terms or other comparable terminology. You should not place undue reliance on forward-looking statements because they involve known and unknown risks, uncertainties, and other factors that are, in some cases, beyond our control and that could materially affect actual results, levels of activity, performance, or achievements.

Other factors that could materially affect actual results, levels of activity, performance, or achievements can be found in our other filings with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2005. If any of these risks or uncertainties materialize, or if our underlying assumptions prove to be incorrect, actual results may vary significantly from what we projected. Any forward-looking statement you read in this Quarterly Report on Form 10-Q reflects our current views with respect to future events and is subject to these and other risks, uncertainties, and assumptions relating to our operations, results of operations, growth strategy, and liquidity. We assume no obligation to publicly update or revise these forward-looking statements for any reason, whether as a result of new information, future events, or otherwise.

Understanding our Company

Our Business

Our mission is to create great products that help investors reach their financial goals. We offer an extensive line of Internet, software, and print-based products for individual investors, financial advisors, and institutional clients. We also offer asset management services for advisors and institutional clients. We have historically generated recurring revenue because many of our products are sold through subscriptions or license agreements. We believe that while the investments in our business are significant, the variable cost of adding customers is considerably lower, particularly as our products and services focus more on Internet-based platforms and assets under management. We strive to realize this operating leverage by selling a wide variety of products and services to multiple investor segments, through multiple media, and in many geographic markets.

Our decentralized structure includes three global business segments: Individual, Advisor, and Institutional. In all three of these segments, we believe our work helps individual investors make better investment decisions. We consolidate the results of our majority-owned operations. We account for our minority-owned investments in Japan, Korea, Denmark, and Sweden using the equity method.

Industry Overview

We monitor developments in the economic and financial information industry on an ongoing basis and use these insights to help inform our company strategy, product development plans, and marketing initiatives.

Investment Landscape and Database Areas

Performance in the U.S. equity markets dipped lower in the second quarter of 2006, with Morningstar’s U.S. Market Index, a broad market benchmark, posting a total return of -1.8% for the quarter. Following the market downturn, total U.S. mutual fund assets declined slightly to about $9.33 trillion as of June 30, 2006 based on data from the Investment Company Institute, compared with about $9.36 trillion as of March 31, 2006. The number of mutual funds remained stable during the quarter.

Debate about pricing models for securities research continued in the second quarter of 2006. Following similar moves by other firms in the first quarter, brokerage firm Thomas Weisel disclosed in May that it made an agreement to unbundle its research and trading fees with Fidelity. These moves are a shift from longtime Wall Street practice of bundling costs for research in the same fees paid for trading commissions. Several large brokerage firms have taken a different tack by arguing in favor of commission sharing, which involves using separate firms for brokerage and research, with the research firm paid through credits from the trading broker.