I have to say, it feels good to be a Morningstar (NASDAQ:MORN) shareholder this week. Ever since the mutual fund-meister reported Q2 earnings on Thursday, the stock has been on a tear -- up, at last report, a whopping 28% from its pre-earnings close.
And after the heartbreak of seeing one of my other favorite Fool competitors, TheStreet.com (NASDAQ:TSCM), head the other way, I must admit that it's gratifying to see Mr. Market nod his head in agreement with my investment thesis for a change. That said, the last time I checked my valuations on these two firms, they were both looking pretty equally attractive to me. So with last week's news now in hand, I'm wondering if it might be time to sell off some Morningstar and put the profits in a now-deflated TheStreet.com. Would that be a good trade? Let's find out.
First, the highlights
As I've already covered TheStreet.com's earnings report in detail, let's begin today's column with equal time for Morningstar. Here's what Q2 brought us:
• 44% revenue growth to $109.7 million, 27% of which was organic growth
• 300 basis points' worth of operating margin improvement, to 25.9%
• 58% growth in profits to $0.38 per share
• $32.2 million in free cash flow, which was 76% better than net profits reported under GAAP.
Incidentally, that last point brings free cash flow for the first half of the year up to $38.6 million, makes trailing free cash flow $95.6 million, and gives us a run rate for the year of approximately $77 million. In working a valuation on the firm, though, I'll be using the higher trailing-12-month number as a base -- not because it looks better, but because Q1 has historically always been a weak quarter for Morningstar, free cash flow-wise. It's the quarter in which Morningstar pays the bulk of its bonuses to employees, which saps cash from the coffers. The upside to this is that because we know H1 results are depressed by Q1's free cash flow, we know H2 will be the stronger half, and we know better than to extrapolate run rates for this firm.
The comparison
Side by side, here are how the two firms, Morningstar and TheStreet.com, look:
|
Market Cap |
Free Cash Flow |
Price-to-Free | |
|---|---|---|---|
|
Morningstar |
$2.65 billion |
$95.6 million |
28 |
|
TheStreet.com |
$321 million |
$12.6 million* |
25 |
The ringers
Before getting to my decision, let me complicate things just a bit more by adding a few more names to the mix, and another chart:
|
Market Cap |
Free Cash Flow |
Price-to-Free |
Growth Rate | |
|---|---|---|---|---|
|
Value Line
|
$516 million |
$25.2 million |
20 |
N/A |
|
Thomson Corp |
$26.35 billion |
$1.43 billion |
18 |
15% |
|
McGraw-Hill |
$19.57 billion |
$1.43 billion |
14 |
12% |
Each of the three companies listed above can arguably be called a competitor to both TheStreet.com and Morningstar. In fact, Morningstar itself names both Thomson and McGraw-Hill as its primary competition. As you can see, all three of these "ringers" sport significantly cheaper price-to-free cash flow ratios than our two contenders today. They also bring with them something that our contenders lack -- more staid, predictable businesses that presumably make growth rates easier to calculate.
The growth rate
This is important to our decision for two reasons: First, on its face, the valuation being accorded to both TheStreet.com and Morningstar appears unreasonable in light of a broader S&P 500 that sports only an 18 price-to-free cash flow ratio. Second, to justify paying such "unreasonable" prices, both companies must significantly outgrow the market going forward.
Unfortunately, growth estimates for our two contenders are exceedingly hard to come by. No analyst publicly states a growth estimate for Morningstar. And while TheStreet.com has several analysts bandying numbers about, they're widely in flux. A few months ago, Yahoo! Finance had TheStreet.com pegged for 20% annual growth over the next five years. Post-earnings, that estimate has been slashed to 16%.
Meanwhile, we've seen that over the four years since Morningstar first reported generating positive free cash flow, it increased FCF at an annualized rate of 73% (through the end of fiscal 2006.) TheStreet.com, which itself only turned FCF-positive two years ago, compounded its cash profits at 150% per year through the end of fiscal 2006.
I personally don't believe these rates of growth are sustainable, but I also find the analysts' postulated 16% growth (for TheStreet.com) too conservative. Asset-light business models such as Morningstar and TheStreet.com both boast are capable of much faster growth, as their low fixed costs permit growing revenues to drop rapidly to the bottom line. So while I suspect both firms' rate of free cash flow growth to decelerate, I still believe that their current multiples in the mid-to-upper 20s look fairly valued.
Bonus paragraph
Did you know that one of the stocks mentioned in today's column was just tapped to join the Motley Fool Stock Advisor portfolio? The recommendation came out too recently for me to reveal the name just yet (we have a 30-day holding period before publicizing our picks), but you can get an early glimpse at who the lucky winner is when you claim a free, 30-day trial subscription to Stock Advisor. Click here to get the inside scoop.
Fool contributor Rich Smith owns shares of both Morningstar and TheStreet.com. The Motley Fool's disclosure policy is always a "buy."
