UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

o	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 Incorporation or Organization)		(I.R.S. Employer 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)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common stock, no par value

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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

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

The aggregate market value of shares of common stock held by non-affiliates of the Registrant as of June 30, 2005 was $255,104,055.

As of March 2, 2006, there were 40,371,921 shares of the Registrant’s common stock, no par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Certain parts of the Registrant’s Definitive Proxy Statement for the 2006 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

Growth Strategies

We operate our business in three global segments—Individual, Advisor, and Institutional. Our mission is to create great products that help investors reach their financial goals, and this mission guides all of our operations and product offerings. In keeping with our mission, we are pursuing four key growth strategies, which we describe below. We review our growth strategies on a regular basis and make refinements as necessary to guide our business. Since becoming a public company, we no longer consider strategic acquisitions to be a core growth strategy because we only expect to make acquisitions in support of our other objectives. And, we have added a new growth strategy of becoming a global leader in funds-of-funds investment management, as described in greater detail below.

Enhance our position in each of our three market segments by focusing on our four major Internet-based platforms.

We believe that individual investors, financial advisors, and institutional clients increasingly want integrated solutions as opposed to having to use different research tools for different parts of their portfolios. To help meet the market need for integrated solutions, one of our key strategies is to focus our product offerings on four of our major platforms:

• Morningstar.com for individual investors;

• Morningstar Advisor Workstation for financial advisors;

• Morningstar Direct for institutional investment research professionals; and

• Morningstar Retirement Manager for the retirement market.

These products all include integrated research and portfolio tools, allowing investors to use our proprietary information and advice across multiple security types. We believe we can achieve deeper penetration of our current audiences with each of these platforms, as well as extend their reach to new segments. With Morningstar.com, we’re focusing on expanding beyond our core audience of mutual fund investors by adding more stock investors and continuing to expand our reach with our core audience of experienced and engaged investors. With Advisor Workstation, we’re adding functionality that will help us reach more advisors in the United States and globally. With Morningstar Direct, we’re focusing on expanding functionality and reaching a broader audience. For the Retirement Manager platform, we’re focusing on our managed account offering as more plan providers have been adopting managed accounts. We recently added Advice by Ibbotson to our retirement advice platform following our recent acquisition of Ibbotson Associates.

Become a global leader in funds-of-funds investment management.

The large number of managed investment products available has made assembling them into well-constructed portfolios a difficult task for many investors. Consequently, funds-of-funds offerings have seen strong growth within the mutual fund, variable annuity, and hedge fund industries. We believe assembling and evaluating funds of funds is a natural extension of our expertise in understanding managed investment products.

Our investment management programs combine managed investment vehicles—typically mutual funds—in portfolios designed to help investors and financial advisors meet their specific financial goals. Morningstar Managed Portfolios, which we introduced in 2001, is a fee-based discretionary asset management service that includes a series of mutual fund and exchange-traded fund portfolios tailored to meet specific investment time horizons and risk levels. We also offer a managed account service as part of our Morningstar Retirement Manager platform for the retirement market, which we introduced in 2003. We offer these managed accounts for plan participants who choose to delegate management of their portfolios to Morningstar’s investment professionals, who select investment options and make retirement planning choices for the

participant. We believe that retirement plan participants will continue to adopt managed accounts because of the complexity involved in retirement planning.

In addition to the assets we manage directly, we had a total of $22.1 billion in assets under advisement in our Investment Consulting business as of December 31, 2005. This total includes consulting relationships as well as agreements where we act as a portfolio construction manager for a mutual fund or variable annuity and receive a basis point fee. We see continued potential to expand this part of our business, including in our operations outside the United States.

Expand the range of services we offer investors, financial advisors, and institutional clients.

We plan to expand our product offerings to better meet the needs of investors. We plan to continue building new databases for additional types of investment offerings, including hedge funds, various types of managed investment pools in international markets, and other widely used investment products. We expect to continue expanding our product offerings in two primary areas:

• Expand our stock-research capabilities. Our equity research builds on our approach to mutual fund analysis, which has historically focused on analyzing the individual stocks that make up each fund’s portfolio. In addition to the agreements we have in place with six major investment banks to provide research under the terms of the Global Analyst Research Settlement, we are continuing to pursue opportunities to distribute our equity research in the United States and in major international markets. We also believe that investors’ increasing awareness of the value of independent research will strengthen our business over the long term; and

• Expand our capabilities in hedge fund research. We plan to continue expanding our research and data on hedge funds to help investors analyze this alternative asset class, with the goal of making the hedge fund industry more transparent to investors. Hedge funds worldwide now represent more than $2 trillion in investor assets, according to the December 2005 Hedge Fund Manager/Advent survey of hedge fund administrators. Offering data on hedge funds is a natural extension of our work on other managed investment vehicles. We introduced our hedge fund database in early 2005 and now have comprehensive data on more than 2,600 hedge funds. We plan to add our hedge fund data to additional Morningstar products and begin offering analyst reports on hedge funds during 2006.

Expand our international brand presence, products, and services.

Over the past several years, we have expanded our product offerings internationally. Our international operations generated $29.4 million in revenue in 2005, compared with $25.4 million in 2004. We plan to continue expanding our international operations to meet the increasing demand for wide-ranging, independent investment insight by investors around the globe. Because approximately half of the world’s investable assets are located outside of the United States, we believe there are significant opportunities for us in non-U.S. markets.

Acquisitions

Historically, we have focused primarily on organic growth by introducing new products and services and expanding our marketing efforts for existing products. However, we have made and expect to continue making selective acquisitions that support our four key growth strategies. In reviewing potential acquisitions, we plan to focus on transactions that:

• offer a good strategic fit with our mission of creating great products that help investors reach their financial goals;

• help us build our proprietary investment databases, research capabilities, technical expertise, or customer base faster and more cost effectively than we could if we built them ourselves; and

• offer a good cultural fit with our entrepreneurial spirit and brand leadership.

Ibbotson Associates

On March 1, 2006, we completed our acquisition of Ibbotson Associates, a privately held firm specializing in asset allocation research and services, for approximately $83 million in cash, subject to adjustments for working capital and other items. Ibbotson had $37.2 million in revenue for its fiscal year ended June 30, 2005. Ibbotson’s key products and services include:

• a well-established investment consulting practice that provides asset allocation and fund research to institutions;

• a portfolio and asset management business that constructs actively managed funds-of-funds offerings for financial institutions;

• managed retirement accounts for participants in 401(k) and other defined contribution plans;

• the EnCorr software for investment management and strategic asset allocation;

• asset allocation, forecasting, and optimization software widely used in broker-dealer advisor platforms;

• a long-term database of capital markets returns;

• training and educational services; and

• the Stocks, Bonds, Bills, and Inflation annual reference guides.

We believe the Ibbotson acquisition complements our growth strategies in several key areas, including investment consulting, managed retirement accounts, and institutional and advisor software.

Variable Annuity Research and Data Service (VARDS)

In January 2005, we acquired the VARDS unit from Finetre Corporation for $8.2 million in cash. VARDS provides research and data on variable annuities and is used by many firms that offer variable annuities. The service is also used by many brokerage firms for research, due diligence, and suitability determination. We believe this acquisition strengthens our investment database and will enhance our efforts to provide investors with the information they need to make well-informed decisions when investing in variable annuities. The acquisition contributed approximately $2.4 million of revenue in 2005.

We have also made other acquisitions over the past several years. For more information, refer to Note 7 of the Notes to our Consolidated Financial Statements.

Business Segments, Products, and Services

We divide our business operations into three segments:

• Individual, which focuses on products and services for individual investors;

• Advisor, which focuses on products and services for financial advisors; and

• Institutional, which focuses on products and services for institutional clients, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors.

The table below shows our revenue by business segment for each of the past three years:

	2005				2004				2003

Revenue by Segment	$000		%		$000		%		$000		%
Individual	$63,448		27.9	%	$46,996		26.2	%	$35,406		25.4	%
Advisor	72,689		32.0		60,880		33.9		49,161		35.2
Institutional	95,947		42.2		78,402		43.6		59,745		42.8
Elimination of intersegment revenue	(4,970	)	(2.1	)	(6,620	)	(3.7	)	(4,816	)	(3.4	)
Consolidated revenue	$227,114		100.0	%	$179,658		100.0	%	$139,496		100.0	%

For information on segment operating income (loss), refer to Note 5 of the Notes to our Consolidated Financial Statements.

Individual Segment

For individual investors, our largest product is our U.S.-based Web site, Morningstar.com, which includes our Premium Membership service and Internet advertising sales. Morningstar is a leader in broad-based, innovative investment research, and Morningstar.com has consistently received positive reviews from major business publications such as Barron’s, Forbes, and The Wall Street Journal. Our Individual business segment also includes Morningstar Equity Research, which we distribute through several channels. Investors can access our equity research through our Premium Membership service on Morningstar.com. In addition, our independent equity research is currently distributed through six major investment banks to meet the requirement 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 several print and online publications focusing on stocks, mutual funds, personal finance, and other investing topics. We offer free local Web sites for individual investors in Australia, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, Korea, the Netherlands, New Zealand, Norway, People’s Republic of China, Spain, Sweden, Switzerland, and the United Kingdom. Our Web sites and individual investor publications reach more than 4.9 million investors worldwide.

Within the Individual business segment, most of our products target experienced investors who are actively involved in the investing process and want to take charge of their own investment decisions. We also reach individuals who want to learn more about investing and investors who seek out third-party sources to validate the advice they receive from brokers or financial planners. Our client base in this segment consists of more than 230,000 paying customers, including 147,010 Premium members of Morningstar.com and 84,000 subscribers who purchase our investment newsletters designed for individual investors. In addition to this customer base, approximately 4,300 public and private libraries in the United States subscribe to our services. We also offer a series of books and workbooks about investing, as well as formatted printable reports on individual securities.

We promote our individual investor products primarily through traditional direct mail, e-mail, promotions on our 20 investor Web sites worldwide, public relations, and advertising on related Web sites.

Our strategy is to increase the number of investors who sign up for Morningstar.com Premium Membership by continuing to develop and promote Premium content such as analyst reports, Fund Analyst Picks and Pans, and value-added portfolio tools, which we market to registered users and other investors. As a core marketing strategy for Morningstar.com, we use search marketing, which includes working to optimize our site’s ranking in organic search results along with purchasing advertisements on third-party sites such as Yahoo! and Google based on investment-related key words that can bring interested investors to relevant content on Morningstar.com.

In our Individual business segment, we compete with the personal finance Web sites of AOL Money & Finance, CNN Money, MarketWatch, MSN Money, The Motley Fool, SmartMoney.com, The Street.com, The Wall Street Journal Online, and Yahoo! Finance. Our print publications compete with Agora Publishing, Forbes, The Motley Fool, Phillips Investment Resources, and Value Line.

We believe our Individual segment has a modest amount of seasonality. The first quarter tends to show more sales activity for Premium Membership on Morningstar.com and other products such as the Morningstar Stocks 500 and Morningstar Funds 500, which are reference guides that we publish once a year. Sales in our Individual segment tend to be slightly lower over the spring and summer months. However, the impact of this seasonality tends to be moderated by our diversified product base and the fact that we recognize revenue ratably over the term of each subscription.

Our largest customer in the Individual segment made up less than 10% of segment revenue in 2005.

Morningstar.com

Our largest Web site for individual investors is Morningstar.com in the United States. As of December 31, 2005, the free membership services offered through Morningstar.com had more than 4.6 million registered users worldwide, who have access to comprehensive data on individual stocks, mutual funds, and other investments to help them conduct research and track performance. In addition, Morningstar.com features extensive market data, Morningstar articles, proprietary portfolio tools, and educational content to help investors of all levels access timely, relevant investment information. Morningstar.com also includes Portfolio X-Ray, which helps investors reduce risk and understand key characteristics of their portfolios, and a variety of other portfolio tools.

We use our free content as a gateway into paid Premium Membership, which includes access to written analyst reports on more than 1,700 stocks, 2,000 mutual funds, and 100 exchange-traded funds, as well as Analyst Picks and Pans, Stewardship Grades, and Premium Stock and Fund Screeners. We currently offer Premium Membership services only in the United States.

In 2005, we launched the Morningstar Stewardship Grade for stocks on Morningstar.com to help individual investors evaluate a company’s financial transparency, shareholder friendliness, management incentives and ownership, and overall corporate stewardship of investors’ capital. The Morningstar Stewardship Grade for stocks follows a similar grading system for mutual funds that we introduced in 2004.

In 2005, we responded to greater investor demand for information on exchange-traded funds by expanding our coverage on these funds. Our analysts covered more than 100 exchange-traded funds as of December 31, 2005, compared with about 35 as of December 31, 2004. We introduced a new rating for exchange-traded funds in March 2006. To help draw investors deeper into Morningstar.com and highlight the full range of information available on the site, in 2005 we launched a new home page for free and registered users. The new home page highlights more of the most popular content on the site, including articles written by our analyst staff and links to our stock and fund data pages. We developed and introduced a similar home page for Premium members in early 2006.

As of December 31, 2005, we had 147,010 paid Premium subscribers for Morningstar.com in the United States. We currently charge $14.95 for a monthly subscription, $135 for an annual subscription, $225 for a two-year subscription, and $320 for a three-year subscription for Morningstar.com’s Premium service. We also sell advertising space on Morningstar.com.

Morningstar.com is one of our five largest products and was our largest product in the Individual segment in 2005. This product accounted for 11.2%, 11.5%, and 11.7% of our consolidated revenue in 2005, 2004, and 2003, respectively.

Morningstar Equity Research

As of December 31, 2005, we offered independent equity research on more than 1,700 companies. Our approach to stock analysis focuses on long-term fundamentals. Our analysts evaluate companies by assessing each firm’s competitive advantage, analyzing the level of business risk, and completing an in-depth projection of future cash flows. For the companies we cover, we create an analyst-generated fair value estimate, a Morningstar Rating for stocks, a rating for business risk, and an assessment of the company’s economic moat. Economic moat is a concept originally developed by Warren Buffett that describes a company’s competitive advantage relative to other companies. For the remaining 5,400 stocks included in our database, we offer quantitatively generated grades for growth, profitability, and financial health, as well as descriptive text that explains the company’s business operations. We currently deliver our equity research to individual investors as part of our Premium Membership service on Morningstar.com and to six major investment banks under the terms of 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 have significantly expanded our equity research coverage over the past several years. We currently provide analyst reports on more than 99% of the market capitalization of the stocks included in the S&P 500 index. We continue to expand our analyst staff to support these research efforts and had 87 stock analysts in the United States as of December 31, 2005, compared with 73 as of December 31, 2004.

We also introduced a new discounted cash-flow (DCF) model for valuing real estate investment trusts (REITs) in 2005, replacing the net asset value model we previously used. We believe that Morningstar is the first independent research firm to use a DCF approach as a primary tool for valuing REITs.

Pricing for Morningstar Equity Research that we deliver related to the Global Analyst Research Settlement or for other institutional clients varies based on the level of distribution, the number of securities covered, the amount of custom coverage required, and the length of the contract term. Morningstar Equity Research, which primarily consists of research related to the Global Analyst Research Settlement, was the second largest product in the Individual segment based on revenue in 2005, following Morningstar.com.

Morningstar Mutual Funds

Morningstar Mutual Funds is a reference publication that features our signature one-page reports on approximately 1,500 mutual funds. These reports contain historical performance data, portfolio statistics, proprietary measurement tools, and analyst reports. Twice a month, subscribers receive updated reports for approximately 150 of the covered funds, along with news, analyst commentary, industry research, and summary performance data for all 1,500 funds. Subscribers can also access a Web-based version for the most current information. We charge $549 for a one-year subscription to Morningstar Mutual Funds.

Morningstar FundInvestor

Morningstar FundInvestor is a monthly newsletter that provides information and insight on 500 of the most popular mutual funds. It also includes a list of 150 Analyst Picks—hand-selected funds that our analysts think are the most compelling for long-term investors. Each monthly issue contains extensive data, ideas on building better portfolios, news on current developments and changes within the fund industry, and proprietary research and ratings. Morningstar FundInvestor also features three mutual fund portfolios constructed and updated by Morningstar’s senior analyst team. We charge $99 for a one-year subscription to Morningstar FundInvestor.

Morningstar StockInvestor

Morningstar StockInvestor is a monthly newsletter that includes updates on two model portfolios (a Tortoise portfolio designed for conservative investors and a Hare portfolio designed for more risk-tolerant investors), a Red Flags column that cautions investors about stocks to avoid, and the Morningstar Bellwether 50, a watchlist of 50 dominant companies with wide economic moats, or competitive advantages.

Each issue also offers ideas about how investors can improve their stock selection and learn from leading portfolio managers. We charge $109 for a one-year subscription to Morningstar StockInvestor.

In addition to the products mentioned above, we offer several other investment newsletters and a series of books about investing in stocks and mutual funds, which are available directly from us and in bookstores. We launched three new print newsletters in 2005, Morningstar Practical Finance, Morningstar DividendInvestor, and Morningstar GrowthInvestor, as well as a new series of investing workbooks about stocks and mutual funds. In early 2006, we introduced a new annual softcover reference guide on exchange-traded funds, the Morningstar ETFs 100.

Advisor Segment

For financial advisors, our largest products are Morningstar Advisor Workstation, a comprehensive Web-based investment planning system, and Principia, our leading CD-ROM-based investment research and planning software. We also offer Morningstar Managed Portfolios, a fee-based discretionary asset management program distributed exclusively through financial advisors. Our advisor products are integrated into the daily operations and research processes of many financial advisors who use our research and tools to provide guidance for individual investors. According to the most recent report published in June 2003 by the consulting firm Tiburon Strategic Advisors, Morningstar was ranked as the leading provider of investment research and data, financial planning software, and asset allocation software among 1,476 independent financial advisors surveyed. Morningstar has also received the CPA Wealth Provider Financial Planning Award in the Financial Planning Software Vendors category for each of the past three years for Principia and Morningstar Advisor Workstation. This award recognizes companies that have taken the lead through innovation, efficiency, initiative, or growth in the financial planning area.

We sell our advisor-related products both directly to independent financial advisors and through enterprise licenses, which allow financial advisors associated with the licensing enterprise to use our products. Most of our license agreements in the Advisor segment have terms ranging from one to three years. As of December 31, 2005, we had established relationships with more than 130,000 financial advisors in the United States and approximately 55,000 financial advisors in international markets. Approximately 13% of our Advisor segment revenue was from international sales in 2005. In addition to the U.S. versions of our Advisor products, we offer products for financial advisors in a variety of international markets. For example, we have international versions of Advisor Workstation tailored to markets in Asia, Australia, Canada, and Europe, and we offer products similar to Principia in Canada and Australia.

Our products for advisors are sold primarily through our sales force and direct mail, with promotional support from online and print advertising, public relations, and conference exhibits. We also use the annual Morningstar Investment Conference to promote our offerings for advisors. We believe that there are substantial opportunities to increase Advisor Workstation sales by attracting additional brokerage firms and investment advisors to sign up as clients. We also expect to expand our offerings to financial advisors in international markets. Our primary competitors in the Advisor segment include Standard & Poor’s, SunGard, and Thomson Financial Services. For Morningstar Managed Portfolios, our primary competitors are AssetMark, Brinker Capital, Envestnet PMC, SEI Investments, and Standard & Poor’s.

In the Advisor segment, sequential revenue growth tends to be higher in the second quarter because our annual investment conference is held once per year in June. Other products in this segment generally have not shown marked seasonality.

Our largest customer in this segment accounted for less than 10% of segment revenue in 2005.

Morningstar Advisor Workstation

Morningstar Advisor Workstation, a Web-based investment planning system, provides financial advisors with a comprehensive set of tools for conducting their core business—including investment research, planning, and presentation tools. It also allows advisors to build and maintain a client portfolio database that can be fully integrated with the firm’s back-office technology and resources. Moreover, it helps advisors create customized reports for client portfolios that combine mutual funds, stocks, separate accounts, variable annuity/life subaccounts, exchange-traded funds, and closed-end funds. As of December 31, 2005, more than 113,000 advisors in the United States were licensed to use Advisor Workstation, which is available in two editions: the Office Edition for independent financial advisors and the Enterprise Edition for financial advisors affiliated with larger firms. We generally charge $5,000 per year for the Office Edition. Pricing for the Enterprise Edition varies based on the number of users, as well as the level of functionality offered and generally ranges between $80 and $2,500 per licensed user.

In 2005, we added a series of Advisor Compliance Tools to the Enterprise Edition of Advisor Workstation, including our Compliance Data Digest to help institutions manage compliance issues related to point-of-sale requirements for financial advisors. The Compliance Data Digest tool allows advisors to view information about mutual fund breakpoints, rights of accumulation linkage rules, and letter of intent policies commonly contained in the mutual fund prospectus or Statement of Additional Information. We also introduced a new Share Class Analyzer report that helps advisors select the most appropriate, cost-effective share class and present a comprehensive cost analysis to their clients. We created a Virtual Training Center to allow users to participate in self-directed tutorials on all Advisor Workstation functionality. In addition, we expanded the range of data universes covered by our hypothetical illustrator and other reporting tools. We also made a number of improvements to the account management and reporting functionality included in Advisor Workstation Office Edition. For example, we now offer a batch reporting feature that allows advisors to automatically generate professional-quality reports for an entire practice.

Morningstar Advisor Workstation is one of our five largest products and made up 12.9%, 10.8%, and 7.7% of our consolidated revenue in 2005, 2004, and 2003, respectively.

Morningstar Principia

Principia is our CD-ROM-based investment research and planning software for financial planners and had 49,728 subscriptions as of December 31, 2005. The modules offered in Principia provide data on mutual funds, stocks, hedge funds, separate accounts, variable annuity/life subaccounts, and closed-end funds. Each module is available separately or together in a CD-ROM format and features searching, screening, and ranking tools. Principia allows advisors to create integrated portfolios for clients and offers three-page Portfolio Snapshot reports that provide a comprehensive picture of the client’s portfolio. The Snapshot report shows overall style and sector weightings as well as the cumulative exposure to individual stocks. The Snapshot report is among those approved by the National Association of Securities Dealers for financial advisors to distribute and review with their clients. Principia prices generally range from approximately $635 per year for monthly updates on one investment database to $2,725 per year for monthly updates on the complete package spanning all investment universes. Pricing for Principia Enterprise licenses varies based on the investment universes selected, level of functionality, and number of users and generally starts at about $635 per user.

During 2005, we added a Defined Contribution Plans module to Principia, which is designed to help financial advisors evaluate an organization’s 401(k) or 403(b) plan lineup and build a recommended list of investment selections. It allows advisors to analyze 401(k) and 403(b) plans by highlighting several characteristics of mutual funds offered through a given plan, including diversification across asset classes, styles, and regions; quality of the investment options; and fees associated with the plan and its investment options. This module is designed to be used in tandem with the other mutual fund modules offered through Principia. The price for the new module is $1,990 per year.

Principia is one of our five largest products and accounted for 12.7%, 16.3%, and 20.7% of our consolidated revenue in 2005, 2004, and 2003, respectively.

Morningstar Managed Portfolios

Morningstar Managed Portfolios is a fee-based discretionary asset management service that includes a series of mutual fund and exchange-traded fund portfolios tailored to meet specific investment time horizons and risk levels. This program is only available through financial advisors. Our team of investment professionals uses a disciplined process for asset allocation, fund selection, and portfolio construction. They actively monitor the portfolios and make adjustments as needed. We complement these asset management services with online client-management functions such as risk profiling and access to client statements, transaction capabilities, and performance reports.

We introduced the Morningstar Managed Portfolios program in 2001 and had approximately $1.4 billion in assets under management as of December 31, 2005. We charge asset-based fees for Morningstar Managed Portfolios. The management fee is based on a tiered schedule that depends on the client’s average daily portfolio balance and generally ranges from 0.20% to 0.40% of assets.

The Morningstar Managed Portfolios program is offered through Morningstar Investment Services, Inc., a registered investment advisor, registered broker-dealer, NASD member, and wholly owned subsidiary of Morningstar.

Institutional Segment

For institutional clients, our key products and services include Licensed Data, a set of investment data spanning eight core databases, available through electronic data feeds; Investment Profiles & 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; Investment Consulting, which focuses on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities; and Morningstar Retirement Manager, a suite of advice and guidance services for retirement plan participants.

As of December 31, 2005, we served approximately 750 clients through our Institutional segment, including banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan sponsors and providers. We believe our institutional clients value our independence, breadth of information, and customized services; in addition, we believe our research, tools, and advice reach many individual investors through this channel. Across the Institutional segment, we’ve established relationships with many of the largest companies in the financial services industry, including Fidelity, MetLife, Nationwide, and Prudential. Approximately 21% of our institutional sales are to clients located outside of the United States—primarily in Australia, Canada, and various countries in Europe. We typically sell our institutional products based on a contract term of one to three years.

We market our products for institutional clients almost exclusively through our sales team. We provide marketing support for our sales team in the form of online and print advertising, public relations, direct mail, and conference exhibits. We also have data reselling agreements with third-party providers of investment tools and applications, allowing us to increase the distribution of our data with minimal additional cost.

For Licensed Data and Investment Profiles & Guides, our primary competitors are Bowne, FactSet Research Systems, Lipper, and Standard & Poor’s. For Morningstar Direct, our primary competitors are Informa, Lipper, Markov, Mobius Data Subscriptions, Strategic Insight, and Zephyr Management. Our Investment Consulting business competes primarily with Lipper, Standard & Poor’s, and Wilshire, as well as some smaller competitors in the retirement consulting business. In the retirement advice market, we compete primarily with Financial Engines and Promanage.

Most products within our Institutional segment have not shown pronounced seasonality over the past three years.

Our largest customer in the Institutional segment accounted for less than 10% of segment revenue in 2005.

Licensed Data

Our Licensed Data service offers a set of investment data spanning eight core databases, available through electronic data feeds. Available data packages include proprietary statistics such as the Morningstar Style Box and Morningstar Rating and a wide range of other data, including information on investment performance, portfolio composition, operations data, fees and expenses, cash flows, and ownership. Institutions can use Licensed Data in a variety of investor communications, including Web sites, print publications, and marketing fact sheets, as well as for internal research and product development. We deliver Licensed Data as an electronic data feed using XML technology for rapid transmission and ease of use. Pricing for Licensed Data is based on the number of funds or other securities covered, the amount of information provided for each security, and the level of distribution.

Licensed Data is one of our five largest products and accounted for 14.3%, 15.1%, and 16.1% of our consolidated revenue in 2005, 2004, and 2003, respectively.

Investment Consulting

Our Investment Consulting services focus on investment monitoring and asset allocation for funds of funds, including mutual funds and variable annuities. Our investment professionals evaluate portfolios, recommend strategies, help set investment policies, design asset allocations, and monitor ongoing performance. We offer these consulting services to clients in the United States, Asia, Australia, Canada, and Europe, including insurance companies, investment management companies, mutual fund companies, and broker-dealers. We also provide services for retirement plan sponsors and providers, including developing plan lineups, creating investment policy statements, and monitoring investment performance.

Our team of investment consultants draws on both quantitative research tools and qualitative expertise to assess investment vehicles, provide detailed analysis of performance and portfolio characteristics, and make comprehensive recommendations for improvement. We also offer investment manager search services. Our staff combines the depth of Morningstar’s historical fundamental databases with detailed investment knowledge and investment experience to recommend qualified candidates for subadvisory firms, mutual fund managers, variable insurance trust managers, and separate account managers. Our investment monitoring services include analyst reports, customizable board reports, select lists, watchlists, and in-depth attribution analysis. Pricing for our consulting services is based on the scope of work and the level of service required. For agreements where we act as a portfolio construction manager for a mutual fund or variable annuity, we receive asset-based fees.

We offer our Investment Consulting services through Morningstar Associates, LLC, a registered investment advisor and wholly owned subsidiary of Morningstar. Investment Consulting is one of our five largest products and accounted for 9.6%, 7.7%, and 6.5% of our consolidated revenue in 2005, 2004, and 2003, respectively.

Morningstar Retirement Manager

Morningstar Retirement Manager is a suite of advice and guidance services that helps retirement plan participants plan and invest for retirement. It gives clear guidance explaining whether participants’ suggested plans are on target to meet their retirement goals. As part of this service, we also offer specific suggestions for contribution rates, asset mix, investment style, and sector exposure to help participants maximize their retirement portfolios, as well as specific recommendations for funds to invest in. Morningstar Retirement Manager includes a managed account service designed for plan participants who choose to delegate management of their portfolios to Morningstar’s investment professionals. We offer these services primarily through retirement plan providers—typically third-party asset management companies or companies that offer administrative services to retirement plans. These providers often supply investment offerings to retirement plan sponsors and their participants. As of December 31, 2005, more than 9 million plan participants had

access to Morningstar Retirement Manager through approximately 69,000 plan sponsors and 30 plan providers. Pricing for Morningstar Retirement Manager depends on the number of participants, as well as the level of service we provide.

Morningstar Retirement Manager is offered through Morningstar Associates, LLC, a registered investment advisor and wholly owned subsidiary of Morningstar.

Licensed Tools and Content

We offer an extensive set of online tools and editorial content that institutional clients can license to use in their Web sites and software products. Clients can select from among more than 40 different tools and content offerings or purchase modular packages focusing on screening and performance tools, editorial commentary and educational articles, as well as goal planning and portfolio analysis. Our online tools and content can be customized to meet the needs of international audiences, and can also be modified to analyze a set of investments, focus on client-defined data points, or perform calculations required by specific products or services. We also offer a fully integrated set of tools and applications to provide portfolio answers and analysis in context. Pricing for Licensed Tools and Content depends on the audience, the level of distribution, and the scope of information and functionality licensed.

Investment Profiles & Guides

Our Investment Profiles & Guides are designed for institutions to use as an alternative to creating their own materials for use in communicating with clients, or for companies to use in communicating with retirement plan participants. Investment Profiles are single-page reports that combine key elements from our data, design, and editorial content to clearly present the essential facts about an investment. They cover mutual funds, stocks, exchange-traded funds, hedge funds, variable annuity/life subaccounts, separate accounts, custom funds, offshore funds, pension and life funds, and Section 529 College Savings Plans. We also offer Investment Guides, which are a collection of Investment Profiles combined with summary information and educational articles. Morningstar handles all of the document production, including data collection, design, and delivery. Pricing for Investment Profiles and Investment Guides is based on the number of securities covered, the amount of information we provide, and the level of distribution.

Morningstar Direct

Morningstar Direct is a Web-based institutional research platform that provides advanced research on the complete range of securities in Morningstar’s global database. This comprehensive research platform allows research and marketing professionals to conduct advanced performance comparisons and in-depth analyses of a portfolio’s underlying investment style. Morningstar Direct includes access to numerous investment universes, including U.S. mutual funds; European and offshore funds; funds based in Australia, Canada, China, and Hong Kong; stocks; separate accounts; global hedge funds; closed-end funds; exchange-traded funds; Section 529 College Savings Plans; and market indexes. Pricing for Morningstar Direct is based on the number of licenses purchased: $15,000 for the first user, $10,000 for the second user, and $7,500 for each additional user.

During 2005, we launched the next generation of Morningstar Direct, expanding the range of data universes to allow institutions to conduct research across global markets and adding the full range of Morningstar’s available data on stocks, hedge funds, and Section 529 College Savings Plans. We also expanded our sales efforts outside the United States.

Morningstar Indexes

Based on the same methodology as the Morningstar Style Box, our 16 real-time indexes track the U.S. equity market by capitalization and investment style. They include a broad market index, three capitalization-based indexes, three composite style indexes, and nine indexes based on both investment style and market capitalization. The Morningstar Indexes cover approximately 97% of the market capitalization of

the U.S. equity market. We charge licensing fees for the Morningstar Indexes, with fee levels generally customized by client.

Barclays Global Investors is licensing our 16 style-based indexes and has introduced nine exchange-traded funds (ETFs) based on the Morningstar Indexes.

During 2005, we introduced the Morningstar China Index Series, a series of 10 market indexes tracking China’s entire stock market since its inception. In early 2006, we created the Morningstar Dividend Leaders Index, a broadly diversified portfolio of 100 stocks that have strong potential for sustaining and increasing dividend payouts. First Trust Advisors L.P. is licensing the Dividend Leaders Index from Morningstar and introduced an exchange-traded fund based on this index in February 2006.

Marketing and Sales

We promote our print, software, Web-based products and services, and consulting services with a staff of sales and marketing professionals, as well as public relations. Our marketing staff includes both product specialists and a corporate marketing group that manages company initiatives. As part of these groups, we have several strategic account managers who oversee all aspects of our largest institutional client relationships. We also have a sales operations staff, which focuses on tracking revenue, forecasting sales, and other tasks to support our sales team. Across all three of our segments, we emphasize high levels of product support to help our customers use our products effectively and provide our product managers with feedback from customers. We had approximately 170 sales and marketing professionals on staff as of December 31, 2005.

International Operations

We conduct our business operations outside of the United States through a variety of subsidiaries and other operating companies. We have wholly owned or majority-owned operating subsidiaries doing business in each of the following markets: Australia, Canada, France, Germany, Italy, the Netherlands, New Zealand, Norway, People’s Republic of China (both Hong Kong and the mainland), Spain, and the United Kingdom. See Note 5 of the Notes to our Consolidated Financial Statements for additional information concerning revenue from customers and long-lived assets from our business operations outside the United States. See Note 17 of the Notes to our Consolidated Financial Statements for information on a legal proceeding that may, if decided adversely to us, affect our ownership of our Australian and New Zealand subsidiaries.

In addition, we hold minority ownership positions in operating companies based in Denmark, Japan, Korea, and Sweden. Our ownership in these companies is either held directly by us or indirectly through separate non-U.S. subsidiaries that we control. As of December 31, 2005, we owned approximately 35% of the outstanding shares in Morningstar Japan K.K. (Morningstar Japan); our share had a market value of approximately $82.1 million. Morningstar Japan is publicly traded under ticker 4765 on the Osaka Stock Exchange “Hercules Market.” See Note 8 of the Notes to our Consolidated Financial Statements for information on investments in unconsolidated entities.

To enable these companies to do business in their designated territories, we provide them with the rights to the Morningstar name and logo and with access to certain of our products and technology. Each company operating within a particular country is responsible for developing marketing plans tailored to meet the specific needs of investors within its own market and working with Morningstar’s data collection and development centers to create and maintain databases, develop new products, and enhance existing products.

See Item 1A—Risk Factors for a discussion of the risks related to our business operations outside of the United States.

Intellectual Property and Other Proprietary Rights

We treat our brand, product names and logos, software, technology, databases, and other products as proprietary. We try to protect this property by using trademark, copyright, patent and trade secrets laws,

licensing and nondisclosure arrangements, and other security measures. For example, in the normal course of business, we only provide our intellectual property to third parties through standard licensing agreements. The purposes of these agreements are to both define the extent and duration of any third party usage rights and to provide for our continued ownership in any intellectual property furnished.

Because of the value of our brand name and logo, we have tried to register one or both of them in all of the relevant international classes under the trademark laws of most of the jurisdictions in which we do business. As we move into new markets, we are continuing to effect these registrations and, in some jurisdictions, the registration of certain product identifiers as well. To date, we have registered our name and/or logo in 12 countries and the European Union and have applied for registrations in several other countries.

We currently hold two U.S. patents, one U.K. patent, and one Canadian patent. We do not rely on our patents and do not believe patents are important to our business.

From time to time, we encounter jurisdictions in which one or more third parties have a pre-existing trademark registration in certain relevant international classes that may prevent us from registering our own marks in those jurisdictions. It is possible that our continued ability to use the “Morningstar” name or logo, either on a stand-alone basis or in association with certain products or services, could be compromised in such jurisdictions because of these pre-existing registrations. Similarly, from time to time, we encounter situations in certain jurisdictions where one or more third parties are already using the Morningstar name, either as part of a registered corporate name, a registered domain name or otherwise. It is possible that our ability to continue to effectively market certain of our products and/or services could be adversely affected by these usages.

“Morningstar” and the Morningstar logo are registered marks of Morningstar in the United States and in certain other jurisdictions. The following are also trademarks or service marks of our company:

Morningstar^® Advisor Workstation^SM		Morningstar^® Mutual Funds^TM
Morningstar.com^®		Morningstar^® Ownership Zone^SM
Morningstar Direct^SM		Morningstar^® Principia^®
Morningstar^® FundInvestor^TM		Morningstar Rating^TM
Morningstar^® Indexes^SM		Morningstar^® Retirement Manager^SM
Morningstar^® Investment Guides^TM		Morningstar^® Stewardship Grade^SM
Morningstar^® Investment Profiles^TM		Morningstar^® StockInvestor^TM
Morningstar^® Licensed Data^SM		Morningstar Style Box^TM
Morningstar^® Managed Portfolios^SM		Portfolio X-Ray^®

License Agreements

In the majority of our licensing agreements, we license our products and/or other intellectual property to our customers for a fee. We generally use our own standard agreements, whether in paper or electronic form, and we do not provide our products and services to customers or other users without having an agreement in place.

We also maintain licensing agreements with each of our joint venture companies and with Morningstar Japan. We put these agreements in place so these companies can use our intellectual property, such as our products and trademarks, to develop and market similar products under our name in their operating territories.

Competitive Landscape

The economic and financial information market has been marked by increased consolidation over the past five years, with the strongest players generally gaining market share at the expense of smaller competitors. Our largest competitors are Lipper, Standard & Poor’s, and Thomson Financial Services. These companies have financial resources that are significantly greater than ours. We also have a number of smaller competitors in each of our three business segments; for more information, refer to the discussion in Business Segments, Products, and Services above. Most of our competitors compete with individual products or segments of our business; we are not aware of any company that offers substantially similar product solutions in all three of our segments.

Our international operations compete with a variety of other companies not named above, including Brain Power, IWL Limited, MoneyMate, and vanEyk Research.

We believe the most important competitive factors in our industry are brand and reputation, data quality and comprehensiveness, quality of investment analysis and analytics, design, reliability, product support capabilities, and value of the products and services provided.

Research and Development

A key aspect of our growth strategy is to expand our investment research capabilities and enhance our existing products and services. We strive to rapidly adopt new technology that can improve the products and services we deliver to our customers. We have also built a flexible technology platform that allows our products to work together across a full range of investment databases, delivery formats, and market segments. As a general practice, we manage our own Web sites and build our own software applications rather than relying on outside vendors. This allows us to control our development and better manage costs, enabling us to respond quickly to market changes and to meet customer needs efficiently. As of December 31, 2005, our technology team consisted of approximately 300 programmers and technology and infrastructure professionals.

In 2005, 2004, and 2003 our development expense represented 8.7%, 9.0%, and 10.5%, respectively, of our revenue. We expect that development expense will continue to represent a meaningful percentage of our revenue in the future.

Government Regulation

United States

Our investment advisory and broker-dealer businesses are subject to extensive regulation in the United States at both the federal and state level, as well as by self-regulatory organizations. Financial services companies are among the nation’s most extensively regulated. The Securities and Exchange Commission (SEC) is responsible for enforcing the federal securities laws and serves as a supervisory body for all federally registered investment advisors and broker-dealers.

As of December 31, 2005, three of our subsidiaries, Morningstar Investment Services, Inc., Morningstar Associates, LLC, and mPower Advisors, LLC are registered as investment advisors with the SEC under the Investment Advisers Act of 1940 (Advisers Act). As registered investment advisors, these companies are subject to the requirements and regulations of the Advisers Act. Such requirements relate to, among other things, record-keeping and reporting requirements, disclosure requirements, and limitations on principal transactions between an advisor and advisory clients, as well as general anti-fraud prohibitions.

Because Morningstar Associates provides investment advisory services to retirement plans and their participants, it may be acting as a fiduciary under the Employee Retirement and Investment Security Act of 1974 (ERISA). As a fiduciary under ERISA, Morningstar Associates has duties of loyalty and prudence, as well as duties to diversify investments and to follow plan documents to the extent that they comply with ERISA.

We provide each of our investment advisor companies with financial and operational support. However, each of them operates independently from other areas of Morningstar, using separate personnel and making independent investment decisions.

Executive Officers

As of December 31, 2005, we had 14 executive officers. The information below summarizes certain information about each of these officers.

Name	Age	Position
Joe Mansueto	49	Chairman, Chief Executive Officer, and Director
Tim Armour	57	Managing Director
Chris Boruff	40	President, Advisor Business
Bevin Desmond	39	President, International Business
Martha Dustin Boudos	39	Chief Financial Officer
Catherine Gillis Odelbo	43	President, Individual Business
Tao Huang	43	Chief Operating Officer
Elizabeth Kirscher	41	President, Data Services Business
Art Lutschaunig	47	President and Chief Investment Officer, Morningstar Investment Services
Don Phillips	43	Managing Director and Director
Patrick Reinkemeyer	40	President, Morningstar Associates
John Rekenthaler	45	Vice President, Research and New Product Development
Richard E. Robbins	43	General Counsel and Corporate Secretary
David W. Williams	45	Managing Director, Design

Joe Mansueto

Joe Mansueto founded Morningstar in 1984. He has served as our chairman since our inception, and as our chief executive officer from inception to 1996 and from 2000 to the present. He holds a bachelor’s degree in business administration from The University of Chicago and a master’s degree in business administration from The University of Chicago Graduate School of Business.

Tim Armour

Tim Armour has been one of our managing directors since 2000. He is responsible for strategic relationships and business development. He joined us in 1998 as our chief operating officer and from 1999 to 2000 served as our president. He holds a bachelor’s degree in business administration from Gettysburg College and a master’s degree in business administration from the Columbia Business School at Columbia University.

Chris Boruff

Chris Boruff has been the president of our advisor business since 2000. He is responsible for overseeing strategy, development, and marketing associated with our products for financial advisors. He joined us in 1996 as product manager for Principia, and from 1997 to 1998, he served as senior product manager of advisor products. From 1999 to 2000, he served as vice president of advisor products, where he was responsible for all marketing related to financial advisors. He holds a bachelor’s degree in economics and psychology from Northwestern University.

Bevin Desmond

Bevin Desmond has been president of our international business since 2000. She is responsible for identifying and developing new markets, managing and directing operations, and launching new products. She joined us in 1993 and was one of three employees who started our international business. From 1998 to 2000, she served as manager of all international ventures. She holds a bachelor’s degree in psychology from St. Mary’s College.

Martha Dustin Boudos

Martha Dustin Boudos has been our chief financial officer since 2001. She oversees our finance, human resources, and accounting operations. She joined us in 1992 as a marketing manager. She also played a key role in the creation of our Web site for individual investors, Morningstar.com. From 1998 to 2000, she was responsible for our retirement advice service. During 2001, she served as our vice president of human resources. She holds a bachelor’s degree in political science from Wellesley College and a master’s degree in business administration from the Kellogg School of Management at Northwestern University.

Catherine Gillis Odelbo

Catherine Gillis Odelbo has been president of our Individual segment since 2000. She joined us in 1988 as a mutual fund analyst and from 1999 to 2000 served as senior vice president of content development for the company, as well as publisher and editor of our stock and closed-end fund research. She holds a bachelor’s degree in American history from The University of Chicago and a master’s degree in business administration from The University of Chicago Graduate School of Business.

Tao Huang

Tao Huang has been our chief operating officer since 2000. He is responsible for corporate strategy, oversight of all business units, and directing our day-to-day operations. He joined us in 1990 as a software developer and from 1996 to 1998 served as chief technology officer. From 1998 to 2000, he served as senior vice president of business development and head of international operations. He holds a bachelor’s degree in computer science from Hunan University in China, a master’s degree in computer science from Marquette University, and a master’s degree in business administration from The University of Chicago Graduate School of Business.

Elizabeth Kirscher

Elizabeth Kirscher has been president of our data services business since 2000. She is responsible for managing our investment databases and related products. She joined us in 1995 as a major accounts manager in our institutional sales area. From 1998 to 1999, she served as international product manager and worked on the launch of Morningstar Japan. From 1999 to 2000, she was director of sales and business development for Morningstar.com and marketed Morningstar.com data and tools to other Web sites. She holds a bachelor’s degree from Vassar College and a master’s degree in business administration from the Columbia Business School at Columbia University.

Art Lutschaunig

Art Lutschaunig has been president and chief investment officer for Morningstar Investment Services since August 2001. He is responsible for managing the investment services business, including oversight of the group’s investment research and portfolio management. Before joining us in May 2001, he was an independent consultant. From 2000 to 2001, he served as president of Giving Capital, Inc. He holds a bachelor’s degree in marketing from Villanova University.

Don Phillips

Don Phillips has been one of our managing directors since 2000. He is responsible for corporate strategy, research, and corporate communications. He joined us in 1986 as our first analyst. He served as our vice president and publisher from 1991 to 1996, as our president from 1996 to 1998, and as our chief executive officer from 1998 to 2000. He has served on our board of directors since August 1999. He also serves on the board of directors for Morningstar Japan. He holds a bachelor’s degree in English from the University of Texas and a master’s degree in American literature from The University of Chicago.

Patrick Reinkemeyer

Patrick Reinkemeyer has been president of Morningstar Associates since October 2004. He is responsible for Morningstar’s investment consulting and retirement businesses. From 2001 until October 2004, he served as president of Morningstar’s institutional investment consulting business. He joined us in 1996. From 1996 to 1997, he directed our print and software variable annuity/life products. He holds a bachelor’s degree in history from Middlebury College and a master’s degree in business administration from The University of Chicago Graduate School of Business.

John Rekenthaler

John Rekenthaler has been vice president of new product development since October 2004. In April 2005, he took on additional responsibilities as vice president of research. From 2001 until October 2004, he served as president of Morningstar Associates and head of the company’s retirement advice business. He joined us in 1988 as an assistant editor and from 1998 to 2000 he served as our director of research. From 1991 to 1995, he served as editor of Morningstar Mutual Funds and Morningstar FundInvestor. He holds a bachelor’s degree in English from the University of Pennsylvania and a master’s degree in business administration from The University of Chicago Graduate School of Business.

Richard E. Robbins

Richard E. Robbins has been our general counsel and corporate secretary since August 2005. He is responsible for directing Morningstar’s legal department and managing its relationships with outside counsel. From May 1999 until he joined Morningstar, he was a partner at Sidley Austin Brown & Wood LLP, which he joined as an associate in August 1991. He holds bachelor’s and master’s degrees in computer science and electrical engineering from the Massachusetts Institute of Technology and a juris doctor degree from The University of Chicago Law School.

David W. Williams

David W. Williams has been one of our managing directors since 2000. He is in charge of design and its application to brand identity, products, communications, and the workplace. He joined us in 1993 and has been instrumental in establishing design as one of our recognized core capabilities. He holds a bachelor’s degree in industrial design from The Ohio State University and a master’s degree in fine arts from the Yale University School of Art.

Company Information

We were incorporated in Illinois on May 16, 1984. Our corporate headquarters and U.S. operations are located at 225 West Wacker Drive, Chicago, Illinois, 60606.

We maintain a Web site at http://corporate.morningstar.com. Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to any of these documents are available free of charge on this site as soon as reasonably practicable after the reports are filed with or furnished to the Securities and Exchange Commission. We also post quarterly press releases on our financial results and other documents containing additional information related to our company on this site. Our Web site and the information contained in or connected to our Web site are for informational purposes only and are not part of this Annual Report on Form 10-K.

Item 1A. Risk Factors

You should carefully consider the risks described below and all of the other information included in this Form 10-K when deciding whether to invest in our common stock or otherwise evaluating our business. If any of the following risks actually occur, our business, financial condition, or operating results could suffer. In this case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Competition could reduce our share of the investment research market and hurt our financial performance.

We operate in a highly competitive market, with many investment research providers competing for business from individual investors, financial advisors, and institutional clients. We compete with many different types of companies that vary in size, product scope, and media focus including large and well-established distributors of financial information, such as Lipper, a division of Reuters, The McGraw-Hill Companies, through its Standard & Poor’s division, and Thomson Corporation, through its Thomson Financial Services division. In addition to these key competitors, we compete with a variety of other companies in different areas of our business, which we discuss in greater detail in the Business Segments, Products, and Services section in Item 1—Business above.

Many of our competitors have larger customer bases and significantly greater resources than we do. This may allow these competitors to respond more quickly to new technologies and changes in market demand, to devote greater resources to developing and promoting their services, and to make more attractive offers to potential clients, subscribers, and strategic partners. Industry consolidation may also lead to more intense competition. Increased competition could result in price reductions, reduced gross margins, or loss of market share, any of which could hurt our business, operating results, or financial condition.

If we do not maintain and increase the number of subscriptions and license agreements, our operating results could suffer.

A substantial portion of our revenue is generated from subscriptions and license agreements. In 2005, “walk-in” revenue, which we define as revenue from licenses or subscriptions that were in place at the beginning of the year adjusted for cancellations, currency translations, and other routine adjustments during the year, accounted for 53.8% of our revenue, and renewal revenue, which we define as revenue from renewals of licenses or subscriptions, accounted for 29.0% of our revenue. In general, our subscriptions are paid in advance, but may be canceled by the customer at any time. We may be obligated to refund a portion of prepaid subscription fees when a customer cancels. Cancellations may have a negative impact on our revenue and cash position. Our license agreements, which typically do not allow for cancellation, have terms ranging from one to three years. As of January 1, 2006, we had subscriptions and license agreements in place that were expected to generate $138.8 million of revenue in 2006. In 2005 and 2004, cancellations reduced “walk-in” revenue by between 2% and 4%. Our future success depends on our maintaining (through renewals) and increasing (through new subscriptions and license agreements) the number of customers who pay for our investment research and services. Further, if the market for our services develops more slowly than we expect, or declines, and the number of customers who pay for our services does not increase, or declines, our business, operating results, or financial condition could suffer.

The availability of free or low-cost investment information could lead to lower demand for our products and adversely affect our financial results.

Investment research and information relating to publicly traded companies and mutual funds is widely available for little or no cost from various sources, including the Internet and public libraries. Investors can also access information directly from publicly traded companies and mutual funds. The EDGAR database available through the Securities and Exchange Commission (SEC) Web site provides real-time access to SEC filings, including annual, semi-annual, and quarterly reports. Many brokerage firms also provide financial and investment research to their clients. The widespread availability of free or low-cost investment information may make it difficult for us to maintain or increase the prices we charge for our publications and services and

could lead to a lower demand for our products. A loss of a significant number of customers would adversely affect our financial results.

Certain products have historically made up a large percentage of our revenue base. Our business could suffer if sales of these products decline.

In 2005, Licensed Data, Morningstar Advisor Workstation, Principia, Morningstar.com, and Investment Consulting accounted for approximately 14.3%, 12.9%, 12.7%, 11.2%, and 9.6%, respectively, of our revenue. We believe that sales of these products will continue to have a material impact on our revenue for the foreseeable future. If we experience a significant decline in sales of any of these products for any reason, it would have a material adverse impact on our revenue and could harm our business. The independent equity research we’re providing to six investment banks under the terms of the Global Analyst Research Settlement accounted for a significant portion of our consolidated revenue in 2005. The period during which investment banks are required to provide independent equity research to their clients will expire in July 2009. We cannot guarantee that we will retain or replace this equity research revenue after that date. Because these contracts include both renewal and cancellation options and the firms named in the settlement are free to choose from a variety of research providers, we also cannot guarantee that we will retain this business for any period prior to July 2009.

Our reputation and business may be harmed by possible conflicts of interest.

We offer products and services to our institutional clients, which include banks, brokerage firms, insurance companies, mutual fund companies, media outlets, and retirement plan providers and sponsors. Our institutional business generated revenue, before intersegment eliminations, of $95.9 million, or 42.2% of our consolidated revenue in 2005 and $78.4 million, or 43.6% of our consolidated revenue, in 2004. We also provide ratings, analyst research, and investment recommendations on mutual funds and other investment products offered and securities issued by our institutional clients. The fact that our institutional clients pay us for certain products and services may create the perception that our ratings, research, and recommendations are not impartial. This perception may undermine the confidence of our customers and potential customers in our reputation as a provider of independent research. Any such loss of confidence or damage to our reputation could hurt our business.

Our failure to successfully integrate Ibbotson Associates and any other future acquisitions, investments, or joint ventures could strain our managerial, operational, and financial resources.

In March 2006, we completed our acquisition of Ibbotson Associates. This acquisition is substantially larger than any previous acquisition we have made and we cannot guarantee that we will successfully integrate Ibbotson’s employees, product lines, business systems, and operations. We expect to continue making acquisitions and establishing investments and joint ventures as part of our long-term business strategy. Acquisitions, investments, and joint ventures involve a number of risks, including the diversion of management’s attention from day-to-day operations. They could also result in dilution from equity securities issued, the incurrence of significant debt or other liabilities, or the loss of key employees. We may fail to successfully complete any acquisitions, investments, or joint ventures or fail to generate enough revenue from any acquired businesses, customer lists, products, services, or technologies to offset the associated costs.

We could face liability for the information we publish, including information based on data we obtain from other parties.

We may be subjected to claims for securities law violations, defamation (including libel and slander), negligence, or other claims relating to the information we publish. For example, investors may take legal action against us if they rely on published information that contains an error, or a company may claim that we have made a defamatory statement about it or its employees. We could also be subjected to claims based upon the content that is accessible from our Web site through links to other Web sites. We rely on a variety of outside parties as the original sources for information that is incorporated into our published data. These sources include securities exchanges, fund companies, and transfer agents. Accordingly, in addition to possible exposure for publishing incorrect information that results directly from our own errors, we could face

liability based on inaccurate data furnished to us by others. Defending claims based on the information we publish could be expensive and time-consuming and could adversely impact our business, operating results, and financial condition.

We could be subject to fines, penalties, or other sanctions as a result of investigations by the New York Attorney General’s Office, the SEC, and the Department of Labor related to the investment consulting services Morningstar Associates, LLC provides to retirement plan providers, including fund lineup recommendations for retirement plan sponsors.

On December 13, 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 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 request in the form of a subpoena to Morningstar Associates. The subpoena is virtually identical to the SEC’s February 2005 request. Although we believe the focus of these investigations is on Morningstar Associates, information and documents pertaining to Morningstar, Inc. and Morningstar Investment Services also have been requested. See Item 3—Legal Proceedings for additional information. 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. We have not established any reserves relating to these matters.

We could face liability as a result of a proceeding brought by Mr. Graham Rich, a former managing director, chief executive officer, and beneficial shareholder of Morningstar Research Pty Limited, and two companies controlled by Mr. Rich.

In 2001, Mr. Graham Rich, the then managing director and chief executive officer of Morningstar Research Pty Limited (Morningstar Australia), and 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. The claims seek various forms of relief, including monetary damages in the amount of Australian $25.0 million, the setting aside of transactions which resulted in Morningstar obtaining control of Morningstar Australia, and an order either setting aside Morningstar’s acquisition of 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 shareholders agreement of Morningstar Australia). The parties have discussed settling the claims but have been unable to reach an agreement. In the fourth quarter of 2003, we offered to settle all claims for Australian $1.3 million which then approximated U.S. $0.9 million, and, in accordance with SFAS No. 5, Accounting for Contingencies (SFAS No. 5), we recorded a reserve in this amount. In December 2005, we increased our offer to settle all claims to approximately Australian $2.5 million, which approximates U.S. $1.8 million, and, in accordance with SFAS No. 5, have a reserve recorded for this amount. While Morningstar is vigorously contesting the claims against it, we cannot predict the outcome of the proceeding. We cannot predict what impact, if any, this matter may have on our business, operating results, or financial condition.

A prolonged outage of our database and network facilities could result in reduced revenue and the loss of customers.

The success of our business depends upon our ability to deliver time-sensitive, up-to-date data and information. We rely on our computer equipment, database storage facilities, and other office equipment, which are located primarily in our Chicago headquarters or elsewhere in the Chicago area. Our operations and those of our suppliers and customers are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks, wars, Internet failures, computer viruses, and other events beyond our control, including disasters affecting Chicago. Although we maintain off-site back-up facilities for our database and network equipment, these facilities may be subject to the same interruptions that may affect our headquarters. We do not currently have the capability to switch over all of our systems to a back-up facility immediately. In the event of a significant database or network facility outage, our business could experience some or complete disruption until we could fully implement our back-up systems. Any losses, service disruption, or damages incurred by us could have a material adverse effect on our business, operating results, or financial condition.

Our business relies heavily on electronic delivery systems and the Internet. Any failures or disruptions could result in reduced revenue and the loss of customers.

Many of our products and services depend heavily on our electronic delivery systems and the Internet. Our ability to deliver information using the Internet may be impaired because of infrastructure failures, service outages at third-party Internet providers, or increased government regulation. If disruptions, failures, or slowdowns of our electronic delivery systems or the Internet occur, our ability to distribute our products and services effectively and to serve our customers may be impaired.

We could face liability related to our storage of personal information about our users.

Customers routinely input personal investment and financial information, including portfolio holdings and credit card information, on our Web sites. We could be subject to liability if we were to inappropriately disclose any user’s personal information or if third parties were able to penetrate our network security or otherwise misappropriate any user’s name, address, portfolio holdings, or credit card information. Any such disclosure or breach could subject us to claims for unauthorized purchases with credit card information, impersonation, or other similar fraud claims, or claims for other misuses of personal information, such as unauthorized marketing or unauthorized access to personal portfolio information.

Our future success depends on our ability to recruit and retain qualified employees, including our executive officers.

Our success and future growth depend on our ability to recruit and retain qualified analysts, programmers, designers, product managers, sales staff, customer support representatives, and finance and accounting personnel. We experience competition for analysts and other qualified employees from financial institutions and financial services organizations. These organizations generally have greater resources than we do and therefore may be able to offer significantly more attractive compensation packages to potential employees. Competition for these employees is intense, and we may not be able to retain our existing employees or be able to recruit and retain other highly qualified personnel in the future.

Our future success also depends on the continued service of our executive officers, including Joe Mansueto, our chairman, chief executive officer, and controlling shareholder. The loss of one or more of our executive officers could hurt our business, operating results, or financial condition. We do not carry any life insurance on our executive officers. We do not have employment agreements or non-compete agreements in place with any of our executive officers. They may leave us and work for our competitors or start their own competing businesses.

Many of our business ventures are relatively new. Our new ventures (including any products yet to be launched) may not be successful.

A key aspect of our growth strategy is to expand our investment research capabilities and introduce new products and services. In 2005, 2004, and 2003 our development expense represented 8.7%, 9.0%, and 10.5%, respectively, of our revenue. We expect that development expense will continue to represent a meaningful percentage of our revenue in the future. A viable market for our new product offerings may not exist and may not develop, and our offerings may not be well received by potential customers. In addition, certain of our existing businesses, including our investment management operations, have limited operating histories and are not currently profitable. If these businesses do not develop, they could have an adverse impact on our business, operating results, or financial condition.

Changes in laws applicable to our investment advisory operations, compliance failures, or regulatory action could adversely affect our business.

Our investment advisory operations are relatively new and a growing part of our overall business. Our recent acquisition of Ibbotson Associates substantially increased our business in this area. The securities laws and other laws that govern our activities as a registered investment advisor are complex. The activities of our investment advisory operations are primarily subject to provisions of the Investment Advisers Act of 1940 (the Advisers Act) and the Employee Retirement and Investment Security Act of 1974 (ERISA). In addition, our investment management business is conducted through a broker-dealer registered under the Securities Exchange Act of 1934 (the Exchange Act) and is subject to the rules of the National Association of Securities Dealers, Inc. (NASD). It is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting our business. The laws, rules, and regulations applicable to our business may change in the future and we may not be able to comply with any such changes. If we fail to comply with any applicable law, rule, or regulation, we could be fined, sanctioned, or barred from providing investment advisory services in the future, which could materially adversely affect our business, operating results, or financial condition.

Our investment advisory operations may subject us to liability for any losses that result from a breach of our fiduciary duties.

Our investment advisory operations involve fiduciary obligations that require us to act in the best interests of our clients. We may face liabilities for actual or claimed breaches of our fiduciary duties. We may not be able to prevent clients from taking legal action against us for an actual or claimed breach of a fiduciary duty. Because we currently provide investment advisory services on substantial assets, we could face substantial liability to our clients if we breach our fiduciary duties. In addition, we may face other legal liabilities based on the quality and outcome of our investment advisory recommendations, even in the absence of an actual or claimed breach of fiduciary duty.

Our international operations are expanding and involve special challenges that we may not be able to meet.

Over the past three years, our international operations have generated an increasing amount of revenue, expanding from $20.1 million in 2003 to $25.4 million in 2004 to $29.4 million in 2005. There are certain risks inherent in doing business in some jurisdictions internationally, including difficulties in penetrating new markets due to established and entrenched competitors; difficulties in staffing, managing, and integrating foreign operations; differences in international laws and policies; exposure to varying legal standards, including intellectual property protection laws, in other jurisdictions; and foreign currency exchange rates and exchange controls. We do not currently hedge any of our international currency exposure, which may adversely impact our financial performance.

These risks could hamper our ability to expand successfully internationally, which may adversely affect our financial performance and ability to grow.

In addition, we now have approximately 130 programmers and data analysts working in our development center in China. Over the past several years, we have been moving a significant percentage of our data collection and development operations to this location. Because China has a restrictive government under centralized control, we cannot predict the level of political and regulatory risk that may impact our operations. Any difficulties that we face in successfully maintaining our development center in China may harm our business and have a negative impact on the products and services we provide.

Changes in market and economic conditions could lower demand for our products and services.

We provide our products and services to individual investors, financial advisors, and institutional clients. Conditions in the financial and securities markets may have an impact on our performance. For example, in the event that the U.S. or international financial markets suffers a downturn that results in a significant decline in investor activity, demand for our products and services may decline, and our revenue and profitability levels could be adversely affected. The financial markets and many businesses operating in the financial services industry are highly volatile and are affected by factors such as U.S. and foreign economic conditions and general trends in business and finance that are beyond our control.

Our results could suffer if the mutual fund industry experiences a downturn or a slowdown in growth.

A significant portion of our revenue is generated from products and services related to mutual funds. The mutual fund industry has experienced substantial growth over the past 20 years. Mutual fund assets may not continue to expand at the same rate in future years. Settlements and regulatory actions in the mutual fund industry following the market-timing scandal that emerged in 2003, downturns in the financial markets, or a relative increase in usage of other investment vehicles could cause a decline in investor interest in mutual funds. If the mutual fund industry experiences a downturn or a slower growth rate than in the past, it could negatively impact demand for our products.

Failure to protect our intellectual property rights could harm our brand-building efforts and ability to compete effectively.

The steps we have taken to protect our intellectual property may not be adequate to safeguard our proprietary information. Further, effective trademark, copyright, and trade secret protection may not be available in every country in which we offer our services. Our continued ability to market one or more of our products under their current names could be adversely affected in those jurisdictions where another person registers, or has a pre-existing registration on, one or more of them. Failure to adequately protect our intellectual property could harm our brand, devalue our proprietary content, and affect our ability to compete in the marketplace.

Control by a principal shareholder could adversely affect our other shareholders.

As of December 31, 2005, Joe Mansueto, our chairman and chief executive officer, owned approximately 75% of our outstanding common stock. As a result, he has the ability to control substantially all matters submitted to our shareholders for approval, including the election and removal of directors and any merger, consolidation, or sale of our assets. He also has the ability to control our management and affairs. This concentration of ownership may delay or prevent a change in control; impede a merger, consolidation, takeover, or other business combination involving us; discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of us; or result in actions that may be opposed by other shareholders.

Moreover, because of Joe Mansueto’s substantial ownership, we are a “controlled company” for purposes of the NASDAQ Marketplace Rules. This means that, if in the future we elect to be treated as a controlled company under the NASDAQ Marketplace Rules, we will not be required by NASDAQ to have a majority of independent directors or to maintain compensation and nominating and corporate governance committees composed entirely of independent directors to continue to list our shares on NASDAQ.

Fluctuations in our operating results may negatively impact our stock price.

We believe our business has relatively large fixed costs and low variable costs, which magnify the impact of revenue fluctuations on our operating results. As a result, a decline in our revenue may lead to a relatively larger impact on operating results. A substantial portion of our operating expense is related to personnel costs, marketing programs, and corporate overhead, none of which can be adjusted quickly. Our operating expense levels are based on our expectations for future revenue. If actual revenue is below management’s expectations, or if our expenses increase before revenues do, our operating results would be materially and adversely affected. In addition, we do not provide earnings guidance or hold one-on-one meetings with institutional investors and research analysts. Because of this policy and limited analyst coverage on our stock, our stock price may be volatile. If our operating results or other operating metrics fail to meet the expectations of outside research analysts and investors, the market price of our common stock may decline.

We have an accumulated deficit and have incurred net losses in the past. We may incur net losses in the future.

As of December 31, 2005, we had an accumulated deficit of $50.6 million. We incurred a net loss of $11.9 million in 2003, partly because of stock-based compensation expense of $29.0 million. We also incurred a net loss of $1.1 million in the fourth quarter of 2004, partly because of stock-based compensation expense of $8.0 million. We may incur net losses in the future.

The future sale of shares of our common stock may negatively impact our stock price.

If our shareholders sell substantial amounts of our common stock, the market price of our common stock could fall. A reduction in ownership by our controlling shareholder or any other large shareholders could cause the market price of our common stock to fall. In addition, the average daily trading volume in our stock is relatively low. The lack of trading activity in our stock may lead to greater fluctuations in our stock price. Low trading volume may also make it difficult for shareholders to make transactions in a timely fashion.

Our shareholders may experience dilution in their ownership positions.

Morningstar has historically granted options to employees as a significant part of our overall compensation package. As of December 31, 2005, our employees and non-employee directors held options to acquire 11,134,807 shares of common stock, 8,295,917 of which were exercisable at a weighted average exercise price of $10.16 per share and 2,838,890 were not exercisable and had an average exercise price of $15.49 per share. We granted options to acquire 1,077,084 shares of common stock in 2005. To the extent that option holders exercise outstanding options to purchase common stock, there may be further dilution. Future grants of stock-based compensation to employees may also result in dilution. We may raise additional funds through future sales of our common stock. Any such financing may result in additional dilution to our shareholders.

We may not be able to raise additional funds to meet operating and cash needs that may arise.

As of December 31, 2005, we had cash and cash equivalents of $92.4 million, plus an additional $60.8 million of investments, consisting primarily of fixed-income securities. In February 2006, we used $22.4 million to pay annual bonuses to our employees. On March 1, 2006, we completed our acquisition of Ibbotson Associates for approximately $83 million of cash and investments, subject to adjustments for working capital and other items. We believe that our available cash balances and investments, along with cash generated from operations, will be sufficient to meet our operating and cash needs for the foreseeable future. However, we cannot guarantee that we will be able to raise additional funds to meet other operating and cash needs that may arise. We do not currently have any lines of credit in place that would enable us to quickly borrow funds. We cannot guarantee that we would be able to establish bank loans, lines of credit, or issue debt securities if we needed to access additional cash.

Item 2. Properties

Our headquarters are located in Chicago, Illinois, and consist of approximately 133,000 square feet of leased space. Our lease on this space expires in January 2009. We also lease approximately 68,000 square feet of office space in 12 countries around the world. We believe that our headquarters and other offices are adequate for our immediate needs and that additional or substitute space is available if needed to accommodate growth and expansion.

In December 2005, we signed a 15-year lease for approximately 210,000 square feet of office space in an office tower being constructed at 108 North State Street in Chicago, Illinois. The office tower is expected to be completed by late 2007, and we are scheduled to move into the new space on the lease commencement date, which is in March 2008.

Item 3. Legal Proceedings

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 also was 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 shareholders agreement of Morningstar Australia). 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 will be entitled to be paid costs 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 must 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 must also be paid to Morningstar.

In July 2005, Mr. Rich provided the indemnity and he and his companies paid Morningstar the costs in respect of the 2001 injunction proceedings in the amount of approximately Australian $116,000. Mr. Rich and his companies have satisfied the obligation to provide the court with security for Morningstar’s potential costs by arranging for two bank guarantees, one, as of July 12, 2005, in the amount of Australian $350,000, and a second, as of January 31, 2006, in the amount of Australian $300,000. Security for approximately Australian $275,000 is due to the court on June 30, 2006.

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 Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies (SFAS No. 5), Morningstar recorded a reserve in this amount. In December 2005, we increased our offer to settle all claims to approximately Australian $2,500,000 million, which approximates U.S. $1,800,000 million, and, in accordance with SFAS No. 5, have a reserve recorded for this amount. While Morningstar is vigorously contesting the claims against it, we cannot predict the outcome of the proceeding.

Securities and Exchange Commission “Wells Notice”

The staff of the Securities and Exchange Commission (SEC) conducted an investigation related to incorrect total return data that Morningstar published with respect to a single mutual fund, the Rock Canyon Top Flight Fund, that overstated the fund’s returns. In May 2004, Morningstar received a “Wells Notice” from the staff of the Division of Enforcement of the SEC indicating that it intended to recommend that the SEC take legal action against Morningstar alleging that it violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-5 promulgated thereunder. On February 7, 2006, the SEC’s Division of Enforcement informed Morningstar that it had decided not to proceed with an action against Morningstar.

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.

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

No matters were submitted to a vote of our security holders, through the solicitation of proxies or otherwise, during the quarter ended December 31, 2005.

Part II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

Our common stock is listed on the Nasdaq National Market under the symbol “MORN.”

The following table shows the high and low price per share of our common stock for the periods indicated, as reported on the Nasdaq National Market:

Year Ended December 31, 2005	High		Low

Second Quarter (our stock was first publicly traded on May 3, 2005)	$	29.59	$	18.51

Third Quarter	$	34.10	$	26.01

Fourth Quarter	$	37.43	$	24.83

As of March 2, 2006, the last reported price on the Nasdaq National Market for our common stock was $41.46 per share and there were approximately 70 shareholders of record of our common stock.

We do not currently pay cash dividends nor have we paid cash dividends during the period covered by the financial statements included in this Annual Report on Form 10-K. Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law, and other factors deemed relevant by the board of directors. Future indebtedness and loan facilities may also prohibit or restrict our ability to pay dividends and make distributions to our shareholders.

Our directors and executive officers may purchase or sell shares of our common stock from time to time. We encourage them to make these transactions through plans that comply with Exchange Act Rule 10b5-1(c). We intend to provide summary disclosure in our Form 10-Q and Form 10-K reports about plans adopted by our directors or executive officers that are then in effect.

Paul Sturm, who is a member of our board of directors but not employed by us, entered into a Rule 10b5-1 sales plan dated December 16, 2005 contemplating the sale of up to 120,000 shares during 2006 in monthly

increments of up to 10,000 shares. As of March 1, 2006, a total of 20,000 shares had been sold under this plan. As of March 1, 2006, none of our other directors or executive officers had Rule 10b5-1 plans in effect.

In May 2005, we completed our initial public offering of 7,612,500 shares of our common stock. These shares commenced trading on May 3, 2005 on the Nasdaq National Market under the symbol “MORN.” All of these shares were sold by affiliates of SOFTBANK Finance Corporation, a wholly owned subsidiary of SOFTBANK Corp. We did not receive any proceeds from the sale of these shares. We granted the underwriters the option to purchase up to an additional 1,141,875 shares at the initial public offering price of $18.50 per share to cover over-allotments. In May 2005, the underwriters exercised their over-allotment option in full. Our net proceeds from the exercise of the underwriters’ over-allotment option were $18.1 million, after deducting underwriting discounts and commissions and approximately $2.6 million of offering expenses. On March 1, 2006, we completed our acquisition of Ibbotson Associates for $83 million in cash, subject to adjustments for working capital and other items. We funded a portion of the purchase price with our net proceeds from the exercise of the underwriters’ over-allotment option.

Item 6. Selected Financial Data

The selected historical financial data shown below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and related notes included elsewhere in this Annual Report on Form 10-K. We have derived our Consolidated Statements of Operations Data and Other Consolidated Financial Data for the years ended December 31, 2005, 2004, and 2003 and Consolidated Balance Sheet Data as of December 31, 2005 and 2004 from our audited Consolidated Financial Statements included in this Annual Report on Form 10-K. The Consolidated Statements of Operations Data and Other Consolidated Financial Data for the years ended December 31, 2002 and 2001 and Consolidated Balance Sheet Data as of December 31, 2003, 2002, and 2001 were derived from our audited Consolidated Financial Statements that are not included in this Annual Report on Form 10-K.

Consolidated Statements of Operations Data (in thousands except per share amounts)	2001			2002			2003			2004		2005
Revenue	$	91,230		$	109,619		$	139,496		$	179,658	$	227,114
Operating expense	107,621			117,959			150,250			161,923		180,634
Operating income (loss)	(16,391		)	(8,340		)	(10,754		)	17,735		46,480
Non-operating income, net	676			4,463			1,110			1,805		3,199
Income (loss) before income taxes, equity in net income of unconsolidated entities, minority interest in net loss of consolidated entities, and extraordinary gain	(15,715		)	(3,877		)	(9,644		)	19,540		49,679
Income tax expense (benefit)	(5,276		)	(311		)	2,950			11,574		20,224
Equity in net income of unconsolidated entities	359			750			697			843		1,662
Minority interest in net loss of consolidated entities	785			178			—			—		—
Income (loss) before extraordinary gain	(9,295		)	(2,638		)	(11,897		)	8,809		31,117
Extraordinary gain—acquisition	—			3,084			—			—		—
Net income (loss)	$	(9,295	)	$	446		$	(11,897	)	$	8,809	$	31,117
Basic income (loss) per share:
Income (loss) before extraordinary gain	$	(0.24	)	$	(0.07	)	$	(0.31	)	$	0.23	$	0.79
Extraordinary gain—acquisition	—			0.08			—			—		—
Basic income (loss) per share	$	(0.24	)	$	0.01		$	(0.31	)	$	0.23	$	0.79
Weighted average common shares outstanding—basic	38,298			38,345			38,382			38,418		39,392
Diluted income (loss) per share:
Income (loss) before extraordinary gain	$	(0.32	)	$	(0.17	)	$	(0.31	)	$	0.21	$	0.70
Extraordinary gain—acquisition	—			0.08			—			—		—
Diluted income (loss) per share	$	(0.32	)	$	(0.09	)	$	(0.31	)	$	0.21	$	0.70
Weighted average common shares outstanding—diluted	41,364			40,361			38,382			41,858		44,459

Other Consolidated Financial Data ($000)	2001			2002			2003			2004			2005
Stock-based compensation expense (income) under the liability method	$	(3,336	)	$	(3,283	)	$	17,796		$	8,963		$	2,810
Stock-based compensation expense under the equity method	9,003			10,575			11,233			7,760			8,085
Total stock-based compensation expense (1)	$	5,667		$	7,292		$	29,029		$	16,723		$	10,895
Operating income (loss) before stock-based compensation expense (2)	$	(10,724	)	$	(1,048	)	$	18,275		$	34,458		57,375
Sales tax expense (income) (3)		2,294			2,837			3,079			—			(300	)
Cash provided by (used for) investing activities		2,777			(6,068	)		(29,634	)		(22,750	)		(16,913	)
Cash provided by (used for) financing activities		(1,049	)		(1,952	)		(26	)		(6,367	)		25,256

Cash provided by (used for) operating activities	$	(5,183	)	$	16,542		$	29,705		$	32,862		$	48,445
Capital expenditures	(5,932		)	(5,989		)	(8,607		)	(7,730		)	(7,451		)
Free cash flow (4)	$	(11,115	)	$	10,553		$	21,098		$	25,132		$	40,994

Consolidated Balance Sheet Data As of December 31 ($000)	2001		2002		2003			2004		2005
Cash, cash equivalents, and investments	$	47,650	$	64,796	$	76,158		$	95,463	$	153,190
Working capital (deficit) (5)	1,165		10,005		(5,206		)	16,902		90,374
Total assets	128,735		152,781		180,265			213,361		296,311
Long-term liabilities (6)	26,315		21,243		25,486			30,128		6,756
Total shareholders’ equity (6) (7)	35,970		48,132		44,821			64,381		173,714

(1) We follow Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), in all periods presented. The total expense for stock-based compensation is distributed with other employee compensation costs in the appropriate expense categories of our Consolidated Statements of Operations. Prior to our initial public offering in May 2005, in accordance with SFAS No. 123, we used two accounting methods. For options granted under plans that may have required us to settle the options in cash, we used the liability method. Under this method we recorded a liability for a vested option equal to the difference between the option exercise price and the fair value of the shares of common stock underlying the option at the end of the reporting period. If this fair value increased over the reporting period, we recorded an expense and, if it decreased, we recorded income. For options granted under plans that did not require us to settle the options in cash, we used the equity method. Under this method we calculated the fair value of the option at the time of grant

using a Black-Scholes model and recorded expense over the vesting period. In each year, our aggregate stock-based compensation expense reflects the impact of options granted in prior years.

Subsequent to our initial public offering, we no longer settle stock options for cash. As a result, all of our options are currently accounted for under the equity method of SFAS No. 123. Refer to Note 12 of the Notes to our Consolidated Financial Statements for more information on our stock-based compensation.

SFAS No. 123 (Revised 2004), Share-Based Payment (SFAS No. 123 (R)), requires all public companies to measure compensation cost for all share-based payments (including employee stock options) at fair value. We adopted SFAS No. 123 (R) in January 2006, and will record a cumulative effect of accounting change, net of tax, of approximately $0.3 million in the first quarter of 2006.

(2) “Operating income (loss) before stock-based compensation expense” is defined as operating income (loss) before the effect of our stock-based compensation expense as described in note (1) above. We expect stock-based compensation expense to be a recurring cost. We have presented operating income (loss) before stock-based compensation expense solely as a supplemental disclosure to help investors better understand the performance of our business, to enhance comparison of our performance from period to period, and to allow better comparison of our performance with that of our competitors. We use operating income (loss) before stock-based compensation expense to evaluate the performance of our business. Operating income (loss) before stock-based compensation should not be considered an alternative to any measure of performance as promulgated under U.S. generally accepted accounting principles (U.S. GAAP) (such as operating income (loss)), nor should this data be considered an indicator of our overall financial performance or liquidity. Also, the calculation of operating income (loss) before stock-based compensation expense used by us may not be comparable to similarly titled measures reported by other companies. The table below reconciles operating income (loss) to operating income (loss) before stock-based compensation expense:

($000)	2001			2002			2003			2004		2005
Operating income (loss)	$	(16,391	)	$	(8,340	)	$	(10,754	)	$	17,735	$	46,480
Add back: Stock-based compensation expense	5,667			7,292			29,029			16,723		10,895
Operating income (loss) before stock-based compensation expense	$	(10,724	)	$	(1,048	)	$	18,275		$	34,458	$	57,375

(3) In 2003, we began participating in voluntary disclosure or similar programs related to state sales tax. Through these programs, we identified sales tax amounts due for prior years and negotiated or are in discussions with local tax authorities to settle these amounts. We recorded expense for these amounts in 2000, 2001, 2002, and 2003. During 2005, we decreased the liability related to these voluntary disclosure programs by $0.3 million due to changes in estimated liabilities.

(4) We define free cash flow as cash provided by (used for) operating activities less capital expenditures. We present free cash flow solely as supplemental disclosure to help investors better understand how much cash is available after we spend money to operate our business. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow should not be considered an alternative to any measure of performance as promulgated under U.S. GAAP (such as cash provided by (used for) operating, investing, and financing activities), nor should this data be considered an indicator of our overall financial performance or liquidity. Also, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

(5) We frequently invoice or collect cash in advance of providing services or fulfilling subscriptions for our customers. These amounts, which are recorded as deferred revenue on our Consolidated Balance Sheets, totaled $71.2 million as of December 31, 2005. As a result of recording deferred revenue, our working capital may at times be negative.

Item 7. 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 Annual Report on Form 10-K, contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 Item 1A — Risk Factors of this Annual Report on Form 10-K. 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 Annual Report on Form 10-K 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 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 to 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.

We manage Morningstar to maximize our long-term results, while staying focused on our mission of helping investors and adhering to our company values. We invest significantly in new product development and in enhancements to our current offerings. It typically takes many years to recoup these investments, but we believe they are critical to building long-term value for our shareholders.

We emphasize a decentralized approach to running our business to empower our managers and to create a culture of responsibility and accountability. Our decentralized business structure includes three global business segments: Individual, Advisor, and Institutional. Early in our history, our product lineup emphasized products for individual investors. As a result, the Individual segment contributed a majority of our revenue. In the early 1990s, our Advisor segment became a more important part of our business. More recently, we’ve begun serving more investors through our Institutional segment, which was the largest of our three segments in terms of revenue in 2005, 2004, and 2003. In all three of these segments, we believe our work helps individual investors make better investment decisions.

In March 2006, we acquired Ibbotson Associates, a privately held firm that specializes in asset allocation research and services, for approximately $83 million in cash, subject to adjustments for working capital and other items. This acquisition fits several of our growth strategies and broadens our reach in the areas of investment consulting, managed retirement accounts, and institutional and advisor software.

Key Business Characteristics

We believe our business has the following characteristics:

Recurring Revenue

We have historically generated recurring revenue because many of our products are sold through subscriptions or license agreements. These subscriptions and licenses generally come up for renewal after one- to three-year terms. Many of the license agreements in our Advisor and Institutional segments span multiple years. Because of this recurring revenue, we generally have subscriptions and license agreements in place for a meaningful percentage of our total annual revenue at the beginning of each year. We think of this as our “walk-in” revenue.

We separate our annual revenue into three categories, defined as follows:

• New revenue. We define new revenue as revenue from selling additional products to current customers or from selling to new customers;

• Renewal revenue. We define renewal revenue as revenue from renewals of subscriptions or licenses; and

• “Walk-in” revenue. We define “walk-in” revenue as revenue we expect to recognize during the year from subscriptions and license agreements in place as of January 1 of each year adjusted for cancellations, currency translations, and other routine adjustments during the year. For example, as of January 1, 2005, we had agreements in place that were expected to generate $124.9 million of revenue in 2005. During 2005, cancellations and other routine adjustments subsequently reduced this revenue by approximately 2%. As we progress through the calendar year, we expect that walk-in revenue will represent a smaller part of each quarter’s revenue as subscriptions and license agreements in place at the beginning of the year expire or come up for renewal; similarly, we expect that revenue from new contracts and renewals will represent a greater share of each sequential quarter’s revenue.

In addition to looking at the mix of walk-in, renewal, and new revenue for each period, we calculate a retention rate to evaluate how successful we’ve been in maintaining existing business for products and services that have renewable revenue. We use two different methods for calculating retention. For subscription-based products (including our print newsletters, Morningstar.com Premium Membership service, and Principia), we track the number of subscriptions retained during the year. For products sold through contracts and licenses, we use the contract value method, which is based on tracking the dollar value of renewals compared with the total dollar value of contracts up for renewal during the period. We include changes in the contract value in the renewal amount, unless the change specifically results from adding a new product that we can identify. The retention rate excludes setup and customization fees, migrations to other Morningstar products, and contract renewals that were still pending as of January 31, 2006.

Significant Operating Leverage

Our business requires significant investments to create and maintain proprietary databases and content. We strive to leverage these costs by selling a wide variety of products and services to multiple investor segments, through multiple media, and in many geographic markets. 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. Historically, we have made investments in building our databases and content that have adversely affected our short-term operating results for certain periods. In the past several years, our profitability has improved because we’ve been able to increase revenue without increasing our cost base at the same rate. We look for this operating leverage to be evident in our operations over the long term.

Deferred Revenue

We frequently collect cash in advance of providing services or fulfilling subscriptions for our customers. As a result, we can use some of this cash to fund our operations and invest in new product development. Although we may need to issue refunds for the unused portion of the subscription if a customer cancels, we generally have used cash collected in advance of providing services or fulfilling subscriptions to fund many of our other activities. The deferred revenue shown on our balance sheet totaled $71.2 million and $63.4 million as of December 31, 2005 and 2004, respectively.

How We Evaluate Our Business

When our analysts evaluate a stock, they focus on assessing the company’s estimated intrinsic value—the value of the company’s future cash flows, discounted to their worth in today’s dollars. Our approach to evaluating our own business works the same way. Our goal is to increase the intrinsic value of our business over time, which we believe is the best way to create value for our shareholders.

We do not make public financial forecasts for our business because they are, by their nature, subjective and could have an effect on our company’s stock price. We want to avoid creating any incentive within our company to alter behavior to “make the numbers.”

We provide three specific measures that can help investors generate their own assessment of how our intrinsic value has changed over time:

• Revenue;

• Operating income (loss); and

• Free cash flow.

We define free cash flow as cash provided by operating activities less capital expenditures. We present free cash flow solely as supplemental disclosure to help investors better understand how much cash is available after we spend money to operate our business. Our management team uses free cash flow to evaluate the performance of our business. Free cash flow should not be considered an alternative to any measure of performance as promulgated under U.S. generally accepted accounting principles (U.S. GAAP) (such as cash provided by (used for) operating, investing, and financing activities), nor should this data be considered an indicator of our overall financial performance or liquidity. Also, the free cash flow definition we use may not be comparable to similarly titled measures reported by other companies.

How Our Business Works

Revenue

We earn revenue by selling a variety of investment-related products and services. Many of our offerings, such as our newsletters, Principia software, and Premium service on Morningstar.com, are sold via subscriptions. These subscriptions are mainly offered for a one-year term, although we also offer terms over other periods ranging from one month to three years. We also sell advertising on our Web sites in the United States and internationally. Several of our other products are sold through license agreements, including Morningstar Advisor Workstation, Morningstar Equity Research, Morningstar Direct, Morningstar Retirement Manager, and Licensed Data. Our license agreements typically range from one to three years. For some of our other institutional services, mainly Investment Consulting, our fees are generally based on the scope of work and the level of service we provide. Finally, we collect fees relating to Morningstar Managed Portfolios, managed retirement account services, and Investment Consulting that are calculated as a percentage of total assets under management.

Operating Expense

We classify our expenses into separate categories for cost of goods sold, development, sales and marketing, general and administrative, and depreciation and amortization, as described below. We include stock-based compensation expense, as appropriate, in each of these categories.

• Cost of goods sold. This category includes the compensation expense for employees who produce the products we deliver to our customers. For example, this category covers the cost of production teams and analysts who write investment research reports. Cost of goods sold also includes other expenses such as postage, printing, and CD-ROM replication, as well as shareholder servicing fees for Morningstar Managed Portfolios.

• Development. This category mainly includes compensation expense for programmers, designers, and other employees who develop new products and make enhancements to existing products. In some cases, we capitalize the compensation costs associated with certain development projects. This reduces the expense that we would otherwise report in this category. We amortize these capitalized costs over the estimated economic life of the software, which is generally three years.

• Sales and marketing. This category includes compensation expense for our sales teams, product managers, and other marketing professionals. We also include the cost of advertising, direct mail campaigns, and other marketing programs to promote our products.

• General and administrative. This category consists mainly of compensation expense for each segment’s management team, as well as human resources, finance, and support employees for each segment. The category also includes compensation expense for senior management and corporate expenses, including corporate systems, accounting, legal, and facilities expense.

• Depreciation and amortization. Our capital expenditures consist mainly of computers, leasehold improvements, and capitalized product development costs related to certain software development projects. We recognize depreciation and amortization costs for these items over their estimated useful lives, generally ranging from three to seven years. We also include amortization related to intangible assets in this category.

International Operations

We consolidate the results of our majority-owned international operations. We account for our 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 fell behind the double-digit gains shown in 2003 and 2004, but stocks continued to generate positive returns in 2005. Morningstar’s U.S. Market Index, a broad equity market benchmark, posted total returns of 6.5% for the year. With the investment climate generally favorable and all domestic equity-fund categories posting positive total returns for the year, mutual funds based in the United States enjoyed positive cash flows for the year, although cash flows into equity and hybrid funds were lower than in 2004. Net cash flows into taxable bond, municipal bond, and money market funds all increased over 2004 levels. Although the number of mutual funds declined slightly during 2005, total fund assets increased by about 9.4% to $8.9 trillion as of year-end. The Investment Company Institute estimates that approximately 53.7 million households in the United States, or 47.5% of all households, own mutual funds, which is down slightly from the peak level in 2001. We believe that continued asset growth and widespread usage of mutual funds is significant because a large portion of Morningstar’s business has historically focused on this area. We estimate that information and analysis related to mutual funds account for approximately two thirds of our total revenue, although this amount has been declining as we expand into equity research and other areas.

We continued to see debate about pricing models for securities research during 2005, which we think is significant because it has long-term implications for all independent equity research providers. During 2005, Fidelity announced a pilot program to unbundle its research and trade execution costs with Lehman Brothers and will pay for them separately going forward. Fidelity also announced an agreement with Deutsche Bank Securities to pay separately for its proprietary research instead of including it in trading costs. This follows a similar move by MFS Investment Management, which discontinued its use of soft dollar research payments in 2004. During 2005, the SEC issued more specific guidance on soft dollar research payments. We believe these developments will help enhance pricing transparency for mutual fund shareholders and others, as well as encouraging debate about the value of independent research.

We continued to see strong interest in alternative asset classes during 2005. Hedge funds, in particular, continued to enjoy strong growth. Based on the latest Hedge Fund Manager/Advent survey of hedge fund administrators, total hedge fund assets worldwide increased to $2.2 trillion as of November 2005, a 49% increase from $1.5 trillion in November 2004. Single-managed hedge funds now claim $1.4 trillion in total assets, while assets in hedge funds of funds total about $700 billion. The number of hedge funds and funds of funds continued to balloon, with more than 15,000 funds in existence as of November 2005, compared with about 12,000 as of November 2004. We continue to invest in developing our hedge fund database and plan to continue expanding our efforts in this area to meet investors’ need for information on this asset class.

Asset growth in separately managed accounts was also relatively strong in 2005. Based on data from the Money Management Institute, assets in separate accounts increased by about 21% to reach $646 billion as of September 30, 2005. The average account balance and number of separate accounts have also continued to expand. Until now, however, separate account performance and operations information has largely only been available from advisors or investment consultants. To help enhance investor understanding of separately managed accounts, we recently partnered with Barron’s to create a new Separate Accounts Quarterly Review. The new section, which will appear in Barron’s print and online editions on a regular basis, will include articles about the separate account industry accompanied by a series of data tables. We are providing several statistics such as total returns, fee information, and Morningstar Ratings for our entire database, which includes approximately 5,000 separate account strategies (including retail and institutional accounts) from about 1,000 money managers.

Assets in exchange-traded funds increased 30.8% to reach about $296 million as of December 2005, compared with $226 million as of December 2004, based on data from the Investment Company Institute. Exchange-traded funds continued to gain share from mutual funds in some specialized areas of the market thanks to their lower annual costs, particularly in passive investing strategies. To meet greater investor demand for information on exchange-traded funds, we have increased our analyst coverage in this area and recently introduced the Morningstar ETFs 100, an annual softcover reference guide. In March 2006, we introduced a new rating system for exchange-traded funds.

Individual Investor Market

With market conditions generally positive, the environment for advertising sales has been relatively healthy. A recent report from Credit Suisse First Boston increased previous estimates for online advertising in the fourth quarter of 2005, as well as projected spending for 2006. Based on a survey of online advertisers, the report forecasts total spending on online advertising to reach $16.6 billion in 2006, compared with a previous estimate of $14.9 billion, reflecting a shift from traditional print, radio, and television placements to online. Because of favorable conditions for Internet advertising, we plan to increase our prices for online advertising in 2006.

Based on research from Nielsen NetRatings, Yahoo! Finance maintained a dominant share of total page views and user visits compared with other retail investment Web sites in 2005. Page views to Morningstar.com remained lower than those of supersites