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NATIONAL RESEARCH CORPORATION

According to its SEC filings, ("National Research Corporation (NASDAQ:NRCIA)") "is a leading provider of analytics and insights that facilitate revenue growth, patient, employee and customer retention and patient engagement for healthcare providers, payers and other healthcare organizations. The Company's solutions support the improvement of business and clinical outcomes, while facilitating regulatory compliance and the shift to population-based health management for its clients. The Company's ability to systematically capture, analyze and deliver to its clients self-reported information from patients, families and consumers is critical in today's healthcare market."

Historical Financial Performance(#'s in millions except EPS)

YEAR20082009201020112012
REVENUE51.0157.6963.4075.7686.42
Op. Income11.9813.7013.8618.7422.72
Net Income7.458.498.5011.5615.07
EPS$1.11$1.28$1.29$1.73$2.22

As you can see, it has displayed impressive growth in EPS and operating income over the last 5 years.

Since its revenue is mainly based on annual subscriptions, it's safe to infer that it has been able to successfully retain and attract new customers.

It's also good to note that it has achieved all of this without increasing its financial leverage.

With the current uncertainty surrounding the healthcare system in the United States, we can be certain of one thing. Costs will rise. Companies are going to do all they can to minimize these future costs, and National Research Corporation is in a great spot to obtain significant amounts of new business by providing companies with the tools and information that they need to make cost-saving healthcare decisions today.

This isn't your typical hot stock idea that will be paraded across the headlines like GOOG, AMZN, or FB. If you are invested in companies like these and have been looking for other types of opportunities that aren't so correlated with the daily movements of the markets, these types of special situations (along with spin-offs & rights offerings) may be something to take a look at.

Recent Recapitalization & Huge Opportunity Created

Before The Recapitalization

As of two months ago, National Research Corporation had one class of common stock. Each share was entitled to 1 vote. There were 6,910,928 shares outstanding. Michael Hays, the CEO, beneficially owned 3,785,433 shares (54.4%).

On an annualized basis, the company would currently be paying out $8,568,000 in dividends according to their most recent normal quarterly dividend payment (page 7 indicates a quarterly dividend payment of 2.142 million).

The CEO would currently be receiving around $4.6 million dollars a year in dividend income based on the most recent dividend. This is important to remember for later reference.

I would also like to point out that the company decided to pay a special one-time 10 million dollar dividend before the end of 2012 to avoid the dividend tax increase. This CEO is no stranger to paying himself in the form of dividends.

Terms Of The Recapitalization

1. The dividend was suspended to insulate volume of the new shares until they form normalized trading patterns.

2. All outstanding shares were converted into 1/2 of a Class B share on the day of the recapitalization.

3. Also on the day of the recapitalization, every shareholder received 3 Class A shares in the form of a Dividend.

If this was all that had happened through this recapitalization then I wouldn't be writing this article. The reason that there is such an amazing arbitrage opportunity right now lies in the details of the differences in the rights of Class A and Class B shareholders that were created when the recapitalization took place.

Rights Of Each Share Class

Votes Per ShareRights To Future Dividends
Class A Shares1/100th of a vote1/6th of dividends paid to Class B
Class B Shares1 vote6 times the dividend paid to Class A

You would think that the market has factored this into its pricing of Class A and B shares.

Shouldn't class B shares be trading at a multiple of at least 6 times class A shares? My answer is to that question is absolutely.

You couldn't even convince me to buy class A shares if they were trading at 1/6th of the class B shares price. Class A shares should trade at less than 1/6th of Class B shares simply because you could effectively buy all of them and influence no voting power whatsoever.

After The Recapitalization

Michael Hays now owns 1,891,158 shares of Class B stock and 6,346,954 shares of Class A stock.

If the company paid out the same aggregate amount of annual dividends that it would have with respect to their most recent normal quarterly payment, then they would be paying out $8,568,000 as previously mentioned.

There are currently 20,732,784 shares of Class A stock outstanding and 3,455,463 shares of Class B stock outstanding.

Since there are 6 times as many Class A shares outstanding as there are Class B shares and the dividend rights are 1/6th of B's dividends going to A's shareholders, half of the 8.568 million would be paid to class A holders and half of the 8.568 million would be paid to class B shareholders. On a per share basis, this would amount to:

$0.2066 per class A share in dividends

&

$1.239 per class B share in dividends

Michael Hays would now be receiving $2,343,144 in dividend income from his class B shares and $1,311,280 in dividend income from his class A shares assuming he reinstates the dividend.

Could I Be Missing Something?

1. The market could be pricing in the risk that the company will potentially not reinstate its' dividend. It stated that it may not reinstate it but I think that is just legal jargon. In my opinion the CEO's interests are too in favor of reinstating the dividend for this not to happen.

Michael Hays has only had a base salary of $127,400 for the past 3 years and his total annual compensation has never been more than $305,000 for the past 3 years (scroll down to page 18).

He isn't just going to be satisfied with $305,000 when he has been used to getting 4 million dollars in dividend income every year.

2. There are two types of discounts that should be considered when valuing NRCIB's shares.

One is a discount for a lack of control. However, this discount should have already been incorporated into their valuation before this recapitalization. Since voting rights can act as a proxy for control, you can assume that there was no real change in minority investors' ability to have control over the company. Hence, there should be no discount for a lack of control since that discount was already reflected in the share price.

The second type of potential discount is a discount for a lack of marketability (or liquidity). The total number of class B shares outstanding was cut in half through this recapitalization, and since Michael Hays owns 54% of these shares, there is only a float of about 1.575 million shares.

The company even states that "the Company is more likely to issue additional Class A Common Stock than Class B Common Stock in the future to finance acquisitions of fund associate stock incentive programs. Furthermore, significant shareholders may be more likely to dispose of Class A Common Stock over time than Class B Common Stock. Any such issuance of additional Class A common Stock by the Company of dispositions of Class A Common Stock by significant of other shareholders may serve to further increase market activity in Class A Common Stock relative to the Class B Common Stock." (from their most recent Proxy)

Currently

Class A shares (NRCIA) trade at $16.80

Class B shares (NASDAQ:NRCIB) trade at $34.23

Valuation

If shares trade as they were valued in the recap, Class A shares would be worth around $10 and Class B shares would be worth around $60.

I personally believe that interest in Class A shares will die and they will be only valued from their potential claims to dividends.

NRCIB should be trade at a price at least 6 times greater than NRCIA. If markets are currently pricing NRCIA shares correctly (which I do not believe they are) then NRCIB is worth $103.92.

I believe that an earnings multiple valuation more in-line with their historical P/E range of 17-27 is appropriate. This would value NRCIB around $49 assuming earnings are paid proportionately between class A and B shares as dividends.

From a Free Cash Flow multiple perspective, if you assumed the same distribution of FCF between each class of shares proportionately and applied historical multiples then NRCIB shares would be worth around $77.

In all different valuation models I have experimented with, it appears as though NRCIA shares are grossly overvalued and NRCIB shares are grossly undervalued.

Evidence NRCIB Shares Will Be Used To Enrich The CEO

As mentioned above, Class A shares have 1/6th of the dividend rights that Class B shares have. This was the result of adjusting a previous proposal made by the CEO to have multiple share classes.

He made a proposal to the board in January of this year. In this proposal, he suggested that Class A shares be entitled 1/100th of a vote (like they currently are), and also 1/100th of the dividend paid to Class B shares.

The motivation behind this ridiculous proposal could have only been that Mr. Hays wanted more money for himself and that he didn't want to have to pay minority shareholders dividends (middle of page 27).

Thank goodness the board threw that idea out.

It's clear that National Research Corporation Class B shares will be used as a method to pay dividends in the future.

Conclusion

If Class B shares are currently trading at a discount for reasons of low liquidity, this will not last. If the company reinstates its dividend, which is in the CEO's best interest, these shares will immediately trade at a more appropriate valuation.

Even if the dividend isn't immediately reinstated, there is a serious disconnect between price and value in Class B shares because of their claims to potential dividends and their almost sole voting power. The discrepancy between price and value in NRCIB shares will disappear sooner rather than later upon investors reading the about the details of this recent recapitalization.

Class B shares are undervalued and Class A shares are overvalued. The CEO's enormous amounts of annual dividend income in the past (including the 10 million dollar special dividend a few months ago) aligns his interests with the interests of the Class B shareholders.

All of the share class arbitrage stuff aside, this company has showed serious consistency in its EPS growth and it has consistently continued to enhance shareholder value over the past 10 years. Owning shares may not be such a bad idea anyways.

Source: Huge Share Class Arbitrage Opportunity In National Research Corporation Class B Shares

Additional disclosure: I may initiate a short position in NRCIA shares over the next 72 hours