National Research Corporation (NRC) was founded in 1981 and has been public since 1997 with headquarters in Lincoln, Nebraska. NRC develops tools that enable healthcare organizations (primarily hospitals) to obtain performance measurement information necessary to comply with industry and regulatory standards and to improve their business practices so that they can maximize resident/patient attraction, experience, retention, and the organization’s profitability. Significant portion of their business is subscriptions based.

Company generated $86mn in revenues in 2012 with gross margins of 59% and EBIT margins of 26%.  To put things into perspective, company generated $44mn of revenues in 2006 with gross margins of 56% and EBIT margins of 23%.  Company generates ~$20MM in operating cash, has minimal capex needs, resulting in ROIC of over 20%.  Company has consistently paid out a dividend since 2005 and in 2012, company paid out regular dividends of $7mn + $10mn special dividend distribution. 

As of May 22nd, the company had 7mn shares outstanding with a price of $60, resulting in a marked cap of ~$420mn.  CEO, Michael Hays, owned 54% of the company.  On May 23rd, the company went through a recap program (announced in March by company and approved by Board in beginning of May) which resulted in the creation of two new share classes, A & B.  Existing shareholders would receive 3 A shares and 1/2 B shares.  Most importantly, shareholders of A&B classes have the same right and rank equally except for rights to votes and dividends:

-          A shareholders are entitled to 1/100^th of a vote per share and 1/6^th of any dividends distributed

-          B shareholders are entitled to 1 vote per share and 6x of any dividends distributed

Dividends were also suspended in “order to try to insulate the volume and trading price of the Class A Common Stock and the Class B Common Stock from significant fluctuations resulting from the Recapitalization until a sufficient and independent trading market was established for each of the Class A Common Stock and the Class B Common Stock” (per company filings).

As a result of the recap program, 21mn of A shares and 3.5mn of B shares were created.  Using the pre-recap market cap of $420mn as the basis, the market cap for NRCI-A and NRCI-B should be $210mn each post-recap.  Applying these market caps and taking the new share count for each share class, A shares should be trading at $10 (210/21) and B shares should be trading at $60 (210/3.5).  A shares are currently trading at $18 per share and B shares are trading at $40 per share.  Clearly, there is a mispricing between the current market price of A & B shares and where they should be actually trading based on the recap.  Given the difference in share count between A and B shares, the stock price ratio should be 1 to 6.  B shares should actually trade at a premium to 6:1 given the voting rights it controls.   Part of the mispricing occurs because shares are fairly illiquid.  Average trading volume for A shares is ~15k per day while for B shares it is ~9k per day.

An important part of this analysis is to understand the reasoning of the recap as well as CEO incentives as he controls 54% of the company.  Per the company’s filings, rationale for recap is to “improve liquidity and expand institutional ownership base, maintain voting continuity while increasing shareholder flexibility, minimize voting and dividend dilution to existing holders on future equity issuance.”  While at face value this might look like a legitimate reason, the whole purpose of the recap is to provide a liquidity vehicle for the CEO while maintaining control of the company. If we do the math, any existing shareholders before the recap would have the following breakdown from their A/B share distributions:

-          A’s would control 85.7% of the sharecount while Bs would have 14.3%

-          A would have 6% of the voting while Bs would have 94% of the voting

-          Dividends would be split 50/50 between A & B (6x B vs. A on a per share basis)

Hence, after the recap, existing shareholders could sell all of their A shares, liquidating 85.7% of their holdings, but would retain 94% of their voting control and still retaining 50% of their dividend distributions.  Looking at the filings, the CEO has transferred large blocks of A shares to personal trusts set up for his family.  To the extent the CEO or trust sells all of their shares, the CEO would still maintain at least 50% of the company (this is how they arrived at the initial 1:6 ratio share count and 1:100).  The 50% ownership is a minimum threshold the CEO needs to maintain in order to have "unilateral ability to elect all of the directors and to determine the outcome of most matters submitted for a vote."  

 

Another key to this investment thesis is the reinstatement of dividend distributions as B shares would receive 6x the amount of dividends on a per share basis relative to A shares.  Looking again at the alignment of interest between the CEO and minority shareholders, I believe the CEO will reinstate dividends.  On a previous proposal submitted which was voted down by the board, the CEO had initially asked for the board to approve a recap program where A shares would receive 1/100^th in voting rights AND dividends.  Clearly, the only reason for this proposal would be to benefit distributions to B shareholders.  Furthermore, looking at the compensation of Hays, his base salary in 2012 was $127,400 with total compensation of $304,704 (includes options, incentive plan comp, and other).  The bulk of his comp came from dividend distributions. Again, taking $7.1mn in regular dividends distributed in 2012, and CEO having 54% ownership results in over $3.8mn of comp coming from regular dividend distributions.  Thus the bulk of his income comes from dividends and not his base + stock comp.  I highly doubt any CEO would be content going from receiving between $1.5-3.8mn as part of his annual comp (dividends allocated to CEO between 2006-2012) to $0.