CurrentOfferings.com Story:

Will sunshine lessen Morningstar�s glow?

By Rick Miller, Investment News, May 15, 2004

Morningstar Inc.�s plans to go public will put added scrutiny on conflicts of interest that could sully its squeaky-clean reputation.

A private company�s arrangements with mutual fund companies may be kept secret; Morningstar, in its regulatory filings as a public company, may shed light on relationships that, at a minimum, could be perceived as conflicts.

If apparent conflicts are deemed serious by invest-ors, the company�s stock could take a hit.

�If people look at this [initial public offering] and say � �They seem to have been growing more recently in this area that could take them into an area of greater conflict as it grows,� then I am not so sure that they�ve made a good trade-off,� said Timothy Schlindwein, managing principal at Schlindwein Associates LLC in Chicago, which has about $100 million under management.

�They will definitely be more scrutinized,� added Bernard R. Horn, president of Boston-based Polaris Capital Management Inc. and manager of the Polaris Global Value Fund. �As a private company, they can probably cut more deals with fund companies then they will be able to do as a public company.�

Morningstar, which is in its quiet period, declined to comment on the issue, but it is aware of the problem. In its IPO filing with the Securities and Ex-change Commission two weeks ago, the company acknowledged that it could be harmed by the perception that its research is tainted.

�The fact that fund companies and other financial institutions pay us for certain products and services may create the perception that our ratings, research and recommendations are not impartial,� it said.

�The perception that we may be subject to a conflict of interest may undermine the confidence of our customers and potential customers in our reputation as a provider of independent research.�

Morningstar, best known for its star ratings of funds, is hardly the first company to have to walk that line.

Standard & Poor�s, owned by The McGraw-Hill Cos. in New York and competing with Morningstar, gets revenue from public companies to produce reports on their businesses. New York�s Lipper Inc., owned by Reuters Group PLC in London and catering mainly to institutional clients, is also in the business of rating mutual funds.

Morningstar is not going to �compromise [its] stellar reputation for a few quick bucks,� said Joel Bruckenstein, president of Global Financial Advisors Inc. in Miramar, Fla.

�During the current mutual fund scandal, they didn�t back off from naming names, certainly to the possible detriment of advertising revenues in the short term,� he added. �I don�t see any reason why that would change.�

Tom Taulli, co-founder of Current Offerings Inc., an IPO research firm in Newport Beach, Calif., agrees.

�Independent research and being a trusted source of information � that�s the heart of their business, and they have to protect that at all costs,� he said. �If that starts to weaken, their business starts to weaken.�

Still, Morningstar�s �stellar reputation� is not beyond reproach.

The company found itself in the hot seat last year when it collected a fee from Fidelity Investments to put together Fidelity Fund Favorites, a list of 20 to 30 top funds from the Boston-based company.

To some, the deal smacked of conflict.

Morningstar�s chairman and chief executive, Joe Mansueto, said at the time that Fidelity had asked for merely a more robust screening of Fidelity�s lineup. �Our endorsement is not for sale,� he wrote in one letter to the editor.

Nevertheless, Fidelity cut the program short.

�I think they already have huge conflicts,� Scott Leonard, a certified financial planner in El Segundo, Calif., said of Morningstar. His firm, Leonard Wealth Management Inc., has $100 million under management.

�Once they go public, all their forms of compensation are going to be available for people to review and analyze, and that actually might help deal with some of the potential conflicts that they might have,� Mr. Leonard said.

The IPO filing sheds light on where Morningstar�s money comes from, although not in the detail that future SEC filings may provide.

Morningstar�s institutional unit is the largest of its three lines of business in terms of revenue. The unit provides web-based investment software, electronic data feeds, retirement planning tools and consulting services to fund companies, banks, brokerage houses, insurers and other financial services companies.

In this area, Morningstar serves about 500 clients.

The filing lists established relationships with companies such as American Express Co. in New York, Nationwide Financial Services Inc. in Columbus, Ohio, Prudential Financial Inc. in Newark, N.J., MetLife Inc. in New York and Fidelity.

Morningstar�s other two lines of business cater to financial advisers and individual investors.

A growing source of revenue comes from licensing of its data. For instance, fund groups pay for permission to advertise their star ratings and a wide variety of other information.

In 2003, licensed data was its second-biggest-selling product, with $22.4 million in sales, or 16.1% of revenue, right behind sales of Principia software, which generated $28.8 million, or 20.7% of revenue. Morningstar.com was the No. 3 revenue-generating product, with $16.3 million, or 11.7%, part of which comes from web advertisements.

LOFTY GOALS

For all the talk about conflicts of interest, Morningstar appears intent on positioning itself as a model public company. For starters, it will put in place a completely independent board of directors that goes beyond regulatory standards.

In addition, Mr. Mansueto will maintain his 78.1% stake in the company, limiting the amount of influence of outside stockholders.

�If all the shares were floating out there, and maybe Janus decided to load up on the stock, or Fidelity,� that would raise flags, said Global Financial�s Mr. Bruckenstein. �I don�t see the negatives right now.