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National Research Corporation (NRCI) is involved in the development of healthcare metrics including consumer acceptance, brand awareness, etc., and has been in this business since 1981. The company is historically profitable, and is exhibiting good revenue growth. NRC is small, with 2012 revenues of just $86 Million. If recent trends continue, NRC is likely to have its first $100 Million revenue year in 2013. NRC occupies an interesting niche, as changes in health care delivery are occurring, and providers need to gauge how well changes are being accepted by their customers.

A recent recapitalization followed soon thereafter with the announcement of a public offering have combined to confuse the market regarding how to value this intriguing company. The premise of this article is that bad math by the market can provide investment opportunities. First we will review the recent timeline of events.

On May 7, after market close, NRC announced first quarter results through March 2013, with revenues at $24.9 Million, and net income of $4,470,000, or $0.64 per diluted share. There were 7,021,000 diluted shares outstanding. The next morning was the conference call. The Seeking Alpha transcript indicates there was some investor interest, as two analysts had questions for management. A read of the conference call indicates that management was bullish (though not very specific) on expecting continuing growth in revenues and profits. Shares (trading under the symbol NRCI) closed at a price of $60.96, indicating a market cap of $428.0 Million.

Recapitalization and Suspension of Cash Dividends

On May 9, the company announced that shareholders approved that day a recapitalization (first announced in March) effective when the market opens on May 22 (though the effective date was actually May 23). Under the recapitalization, the existing shares would be replaced by Class A and Class B shares. The shareholder owning 100 shares of NRCI at the close of business on May 20 would receive 300 new Class A shares (Symbol NRCIA) and 50 new Class B shares (symbol NRCIB). Said another way, shareholders would receive three Class A shares plus one-half Class B share for each old share of NRCI. The B shares were considered to be the surviving shares, though their number was half the old total shares outstanding. The press release also stated:

The Company's Board of Directors decided to suspend the payment of cash dividends 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 is established for each of the class A and class B common stock.

NRCI stock paid its last quarterly dividend at a rate of $0.31/ share on February 14, 2013.

The press release did not explain the differences between the A and B shares. The only place that a shareholder could learn of the differences on the Yahoo Finance page for NRCIB was in a press release dated March 25, 2013. (No SEC filings are available from the NRCIB Yahoo Finance page). This press release explained that the A shares would receive 1/100th of a vote per share and the right to receive 1/6th of the dividend, if any, paid on the Class B Common Stock. Class B shares would each receive 1 vote per share, and were promised to receive six times the dividends paid to the Class A shares.

If an investor wanted more detail, it was not available on Yahoo Finance's NRCIB page, but strangely could be found on the NRCIA page, under SEC filings. An 8K filed on May 23 (under the topic of "Material Modification to Rights of Security Holders") showed in detail how the earnings for the past quarter and past year would have been apportioned had the recapitalization been in effect as of the dates of those reports.

Total Earnings are to be Evenly Shared by A and B Shares, But Not Per Share

Interestingly, with the recapitalization, there are six times as many A shares as there are B shares, yet the B shares earn six times the dividends of the A shares. Therefore, the net income apportioned to the A shares is equal to the net income apportioned to the B shares, thanks to the symmetry of this structure. It should also not be forgotten that the B shares have 100 times the voting power of the A shares. Therefore, it would appear that the B shares should be valued at more than 6 times the value of the A shares. Clearly some premium over the 6 times multiple is in order for the 100 times greater voting power of the B shares.

How did the market react to the recapitalization? NRCI closed at $60.10 on May 22. The market cap based on 7,021,000 shares was $422 Million. The A and B shares started trading on May 23.The closing prices were $20.00 for the A shares and $22.75 for the B shares. There were 21,063,000 A shares and 3,511,000 B shares according to the May 23 8K. Therefore, the market cap of the A shares was $421 Million, while the B shares were valued at $80 Million. The total market cap had risen to $501 Million, but a controlling voting interest could theoretically be bought for a song. The A shares all combined possess just 210,630 votes, while the B shares have 3,511,000 votes, for a total of 3,721,630 votes.

A controlling interest could therefore be purchased for 1,860,816 B shares, which were valued on May 23 at $42.3 Million, which was 8% of the total market cap. This controlling interest would also receive 25% of the dividends produced by the company. Clearly, the B shares should be valued more than 6 times the price of the A shares, yet their prices were near parity. By June 5, the A shares had slipped to $12.46, while the B shares were $35.90. The multiple was now 2.9X, but still nowhere near 6.0X or 7.0X.

Why Is This Bad Math Occurring?

The chart below shows some of the critical metrics for understanding the value of a stock, as supplied by three large investment firms plus three important financial information resources. It is to be expected that it takes a few days for these firms to get their data corrected when there is a stock split or recapitalization. As this article is being written, It has been over a month since the recapitalization was announced, and it is three weeks since the new shares began trading. It is disappointing that so much is still incorrect as of the close of the market on June 12. It appears likely that this misinformation is a significant contributing factor to the current overvaluation of NRCIA.

NRCIA
Date of Data/ ReportMarket Cap ($ Millions)Shares Outstanding (Millions)Trailing PEShare PriceDiv. Yield
Charles Schwab6/12/2013$0.0--$14.140%
Merrill Lynch6/12/2013$293.220.73-$14.140%
Scottrade6/12/2013$293.220.70-$14.140%
Standard & PoorsNo Report Available
Thomson ReutersNo Report Available
Yahoo Finance6/12/2012$97.06.896.3$14.14N/A
Valubyer6/12/2012$297.821.0637.9$14.140%
NRCIB
Date of Data/ ReportMarket Cap ($ Millions)Shares Outstanding (Millions)Trailing PEShare PriceDiv. Yield
Charles Schwab6/12/2013$144.13.4718.7$41.710%
Merrill Lynch6/12/2013$293.23.459.3$41.710%
Scottrade6/12/2013$144.13.5018.6$41.710%
Standard & Poors6/7/2013$147.03.46*9.4$42.445.8%
Thomson Reuters6/11/2013$147.03.59*9.4$40.980.9%
Yahoo Finance6/12/2012$287.06.8918.5$41.715.8%
Valubyer6/12/2012$146.43.5118.7$41.710%
*Shares outstanding were calculated by the author.

Note that not one of the six sources was correct for all five metrics for NRCIA. None had the correct PE ratio. Following the earnings allocation methodology shown in the May 23 8K report, the market cap of NRCIA is divided by 50% of trailing 12 months earnings of $15,689,000. (The other 50% of earnings are earnings to the B shares). Dividing $297.8 Million by $7.85 Million results in a lofty PE ratio of 37.9 for the A shares. It is also somewhat disturbing that three sources indicated current dividend yields for the B shares, while the dividend was suspended on May 9. Two sources had all five metrics substantially correct for the B shares. They were Charles Schwab and Scottrade.

As this article goes to press, there is further evidence of a lack of due diligence by those paid to have informed opinions. On June 13, TheStreet published a new report on NRCIB, and downgraded NRCIB from buy to hold. But the full report (dated June 12, and for which the author paid $10) states that the annual dividend is $2.48 and that the yield is 6.05%. Wrong. Both numbers are currently zero. The downgrade announcement goes on to state that EPS were $4.34 in 2012, and that the market expects $4.79/ share in 2013. Wrong. EPS based on the old shares were $15,068,000/ 7,000,000 = $2.15/ share, and if the allocation method used by management is used (as shown in their May 2013 8K), 2012 EPS applicable to NRCIB was $2.17/ share. The EPS for NRCIA was put at $0.36/ share. (Management actually publishes these numbers in this 8K). This downgrade report fails to mention either the new capital structure (with A and B shares) and also fails to mention the pending share offering (discussed below).

TheStreet covers itself with this caveat:

Editor's Note: TheStreet ratings do not represent the views of TheStreet's staff or its contributors. Ratings are established by computer based on metrics for performance...

The downgrade's author? The answer is vague:

Written by a member of TheStreet Ratings Staff.

A Comparison to Berkshire Hathaway, First by CEO Michael Hays

On the Investor Relations page of the NRC website there is a letter by founder and controlling shareholder Michael Hays that explains the recapitalization. This letter (still posted as of June 12) states:

Our plan is to first do no harm. Many public companies have liquidity problems and often resolve them by simply offering new shares to new shareholders. If we followed this path, current shareholders' ownership and voting power would be diluted and the Company would face an increased financial burden to maintain historical dividend payments across a larger number of shares without reducing cash resources to grow the business.

Michael Hays, CEO (From the first page of NRC's Investor Relations webpage)

This pledge to not dilute was broken on June 6 (see below). Mr. Hays then compares NRC's recapitalization into two classes of stocks as being similar to the strategy of another Nebraska headquartered business that you may be familiar with: Berkshire Hathaway. A few years ago, Warren Buffett and his shareholders decided to rename their old shares as A shares and they created a new B share. The B shares are entitled to 1/1500th of a vote and are entitled to 1/1500th of the dividends paid to the owners of A shares. As this article is being written, the A shares were priced at $169,195.00, with the B at $112.95. The ratio is very close to exactly 1/1500th in spite of the fact that Berkshire Hathaway does not pay dividends. The B shares are actually overpriced by $0.15 or one tenth of 1%. The ratio is kept very close to exactly correct because Berkshire Hathaway is heavily traded and has a market cap of around $280 Billion.

Valuing NRCIA and NRCIB

What would the right prices be for NRCIA and NRCIB? Let us start with the premise that the market cap on May 22 was correct at $422 Million. That market cap indicates a PE ratio of 27 times trailing 12 months earnings, and is 23.6X compared to March 31, 2013 earnings on an annualized basis. These PE ratios are not low, but NRC is showing good revenue and earnings growth, making these PE ratios acceptable.

If we forget for just a moment that the B shares have much greater voting power, the market cap for the A shares should have been $211 Million, with the B shares also at $211 Million. Divide $211 Million by 21.063 Million A shares and by 3.511 Million B shares, and the prices compute to $10.02 for an A share and $60.10 for a B share. Amazingly, the ratio is 6 to 1 before considering the voting power of the B shares. At a 10% premium, the B shares would be worth $66/ share, while the A would be worth $9 each, which is a ratio of 7.3X.

Offering Announced June 6

On D-Day, the company announced on SEC Form S-3/A that the company would issue 6,000,000 A shares and 1,000,000 B shares. They also announced that Mr. Hays and other major holders were selling 13,800,000 A shares and 2,300,000 B shares. While shareholders hate to see dilutive stock offerings, at least they kept the ratio at the same 6 to 1 ratio. As offerings go, this one is quite seriously dilutive, as the count of outstanding shares was being increased by 28.5% for both the A and B shares. As this article is being written, it is not known what the offering prices will be.

Conclusions

It is simply illogical (but true) that the market cap of 100% of the A shares is $298 Million as of June 12, while the market cap of the B shares totals $146 Million. The A shares on a combined basis have less than 6% of the voting power and 50% of the dividends, while the B shares have 94% of the voting power and also have 50% of the dividends. The low EPS of the A shares and the six times higher EPS of the B shares is clearly shown by management in their May 23 8K. With there being 6 times as many A shares as B shares, the stock price ratio must be at least 1 to 6 if not 1 to 7 or higher. The $14.14 A share price implies a value of at least $85 for the B shares, while the $41.71 B share price implies a value for the A shares of $6.95 at most. (The author does not suggest that the B shares are worth $85, but presents this corollary as evidence that the A shares are overvalued).

NRCIA and NRCIB are both thinly traded. This is clearly part of the reason that the market has not done a good job in valuing the new A and B shares. With a June 12 share price of $41.71 for the B shares, the direction the B shares will move is difficult to estimate. If the B shares are worth $66 before the offering, taking say 25% off the B share value (for dilution) would result in a price of $49.50. But if the market takes the dilution haircut off the current price, The B shares could revisit a price near $30. It could be a volatile time for the B shares as there are factors that should push the B shares up (namely the need for the 6 to 1 or better price ratio) while the dilution will push the B shares down. The author had been long on the B shares until seeing the offering announcement, and the author does not have a position in the B shares at the time of this article.

The A shares, priced at $14.14 on June 12, are not difficult to analyze. Their value should probably be no more than $9 on a pre-offering basis, and after the market is flooded with both new and used A shares, their price appears likely to fall to $6.75 or lower. The ratio between the A shares and B shares should never be less than 1 to 6, and this investor sees the ratio as approximating 1 to 7.3X. The author is short the A shares. NRC appears to be in a desirable market niche, and long run, the company should do well, but bad math by Mr. Market creates a compelling short opportunity.

Disclosure: I am short NRCIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: The Market Gets An 'F' In Math In The Valuation Of National Research Corp.