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Introduction:

This paper argues that the class B common stock of National Research Corporation (NRCIB) (the "company") is significantly undervalued following its recent share recapitalization. By tracing the economic incentives of the controlling shareholder and CEO as well as the stated acquisitive goals of the company, it is probable that NRCIB should trade more to reflect its superior economic claim on dividends and undistributed earnings versus the pro-rata treatment it would receive upon an acquisition. At prevailing prices, this implies that NRCIB has approximately 25% downside and could more than double under a realistic set of scenarios.

Herein, the author will give a very brief background on the company and the terms of its recent share recapitalization. Readers are encouraged to read relevant documents themselves which are all available on the SEC's website. (National Research Filings)

Business Background:

National Research Corporation was founded in 1981 by its current CEO, Michael Hays. "The company's portfolio of subscription-based solutions provide actionable information and analysis to healthcare organization and payers across a range of mission-critical, constituent-related elements, including patient experience and satisfaction, community population risks, workforce engagement, community perceptions, and physician engagement." (10-K Pg. 2) Over the past several years, the company has grown revenues in the mid-to-high teens and demonstrated substantial operating leverage and free cash flow conversion from its subscription model.

During fiscal 2012, NRCI generated earnings of $15.1 million and free cash flow of $16.8 million. The company has less than $1 million in net debt and a current market capitalization of ~$450 million. (10-K Pgs. 32-34).

Share class

Shares

Current Px

Mkt. Cap

NRCIB

3.52

$ 30.00

105.48

(NRCIA)

21.09

$ 16.50

347.90

Total

24.60

453.38

Recapitalization Summary:

On March 25th, 2013 the company announced a share recapitalization the highlights of which include: (S3/A Pgs. 17-21)

  1. For each share of NRCI owned, shareholders would receive a dividend of 3 shares of class A common stock ("NRCIA") and existing shares would be converted to .5 shares of NRCIB
  2. NRCIB shares would have 1 vote and NRCIA shares would have 1/100th of a vote
  3. Each share of NRCIA would be entitled to receive 1/6th of the dividend granted per share of NRCIB, if any. Undistributed earnings would also be allocated accordingly
  4. In the event of an extraordinary transaction (i.e., company is acquired) or distribution of property, shares of NRCIA and NRCIB would receive pro-rata distributions. Shares would also receive pro-rata treatment if the company were liquidated
  5. Neither share class could be converted into the other share class unless the Board of Directors deemed the dual-class status of the company violated the listing requirement of NASDAQ
  6. Finally, in co-ordination with the recapitalization, the company suspended its dividend.

Share class

Shares

Votes

Voting Int.

Dividend

Dividend Claim

Ext. Trans. Claim

Convertible

NRCIB

3.52

1

94.3%

1

50%

14.3%

No

NRCIA

21.09

1/100

5.7%

1/6

50%

85.7%

No

The recapitalization was consummated on May 22nd. While there are 6x the amount of NRCIA shares outstanding, NRCIB, as a share class, is entitled to 50% of any dividends and undistributed earnings of the company at the present level of shares outstanding. Moreover, NRCIB owners control over 94% of the voting power of the company given its preferential voting status. Unique to the company is the provision that if the company participates in an extraordinary transaction, most likely meaning that it is acquired, each share of NRCIA and NRCIB would receive the same consideration. This creates a binary option in the shares, where NRCIB should be valued at a significantly higher level than NRCIA if the company is an ongoing, dividend paying concern as opposed to if the company is acquired, which would mean that NRCIA and NRCIB should trade at parity. The valuation of this binary option is the most important consideration in determining the relative prices of NRCIB and NRCIA. The most important variable in determining that option price is the incentives of the Founder, CEO and Controlling Shareholder, Mr. Michael Hays.

Incentives of the CEO:

As noted, Mr. Hays founded the company in 1981 when he was in his mid-20s. By any objective measure, Mr. Hays has done a fantastic job of continually growing the business and creating shareholder value. Moreover, Mr. Hays deserves much credit for paying himself a significantly below-market salary while opting to receive the lion's share of his compensation in the form of dividends on his stock holdings. In short, he has been an exceptional steward of shareholder capital.

Given that Mr. Hays has been running the company for the vast majority of his adult life, it may be reasonable to assume that his shareholdings in National Research represent the preponderance of his wealth. Prior to the recapitalization, Mr. Hays owned approximately 54%, a holding of significant value. Given that Mr. Hays is now 58 years old, it would make sense for him to consider ways to:

  1. Liquidate a portion of his wealth held in that asset
  2. Liquidate that portion at the highest possible price
  3. Keep control of the company he founded

In the author's opinion, the share recapitalization accomplished all of these objectives for the CEO. First, post-recap, there are now 3.5x as many shares outstanding as there were prior to the recap. Hence, Mr. Hays can liquidate his shares in the open market with a smaller impact on the trading price of the shares.

As previously mentioned, the company cancelled its dividend post the recapitalization "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." (S3/A Pg. 17) It is unclear to the author how not paying a dividend from a cash generative company helps minimize volatility. However, it is clear that if the company were trying to increase the value of NRCIA, canceling the dividend would make sense as investors would put greater emphasis on NRCIA's liquidation/extraordinary transaction valuation relative to its dividend paying potential. Coincidentally, this would allow Mr. Hays to liquidate some portion of his NRCIA at a price higher than what he might receive if investors were focused solely on the long-run dividend paying potential of NRCIA.

To this end, Mr. Hays gifted 5 million shares of NRCIA to the Michael and Karen Hays Grandchildren's Trust on June 4th at a price of $14.15. (June 4 Form 4) Mr. Hays also sold 13,153 shares of NRCIA in the open market on June 28th at a price of $18. (June 28 Form 4) Mr. Hays has not liquidated any shares of NRCIB even though the shares have traded above $43 and at ratios above 3x the value of NRCIA. Hence, Mr. Hays has revealed his preference for maintaining his position in NRCIB even as it traded at significantly above current prices and his preference for divesting NRCIA even as it traded significantly below the current trading price. It is therefore logical to ask, if Mr. Hays considered the liquidation value/extraordinary transaction value as the primary determinant of value, why would he hold an asset (NRCIB) that would depreciate massively and sell an asset (NRCIA) that would appreciate massively upon a sale of the company? Perhaps this is because Mr. Hays has no intention of selling the company.

Finally, the share recapitalization is elegantly constructed to allow Mr. Hays to maintain control of the company while monetizing a substantial portion of his holdings. At present, Mr. Hay's holdings of 1.8685 million NRCIB gives him 50.14% of the company's votes - assuming full dilution. Therefore, he could liquidate his remaining 6.21 million shares of NRCIA and still exercise full control over the company. Again, this begs the question, if Mr. Hays had any intention of selling the company, why would he hold onto what would then be overvalued stock when voting control would be rendered worthless upon a sale? (S3/A pgs. 10-12)

Share class

Hays Ownership

% of class

Vote %

NRCIB

1.87

53.14%

50.14%

NRCIA

6.21

29.46%

1.67%

Total

8.08

51.80%

Finally, it is the author's hope to demonstrate that given Mr. Hays' current overweight position in NRCIB relative to NRCIA, the economics of selling the company would be of minimal benefit to him and in certain circumstances could result in him actually losing money - even if the company is acquired at a premium. For instance, the current market capitalization of the company is approximately $450 million. If an acquirer made a cash tender offer at a 20% premium this would equate to roughly $545. In this case, Mr. Hays would lose approximately $15 million on his position in NRCIB and make approximately $35 million in his share position in NRCIA. Hence, on his current shareholdings valued at approximately $159 million, Mr. Hays gain would "only" be $20 million, or 12.7%, whereas shareholders who own NRCIA and NRCIB at a 6:1 ratio would receive the full 20% premium.

Takeout Scenario

Current Market Cap

453.38

Premium

20.00%

Takeout Value

544.059

Diluted Shares

24.60

Per Share Consideration

$22.12

Hays' Ownership

8.08

Hays' Takeout Value

178.69

Value of Existing Holdings

NRCIB

1.87

$ 30.00

56.06

NRCIA

6.21

$ 16.50

102.49

Total

8.08

158.54

Premium received by Hays on 20% Takeout

12.71%

If Mr. Hays continues to sell or divest his position in NRCIA, his willingness to sell the company would be further diminished. For instance, if Mr. Hays sold his remaining NRCIA, a potential acquirer would need to offer a 63% premium to the current market capitalization just to make Mr. Hays economically indifferent between selling the company or continuing to hold his shares - assuming NRCIB trades continues to trade at $30. From a valuation perspective, this equates to 49x 2012 net income.

To summarize, the recapitalization has opened up a new and liquid market for Mr. Hays to diversify some of his substantial holdings in the company. Mr. Hays has promptly sold and gifted shares of NRCIA at prices substantially below what their value would be if the company was going to be acquired. Simultaneously, Mr. Hays has maintained the entirety of his holdings in NRCIB at prices substantially above what they would be worth if the company were to be acquired. Finally, Mr. Hays has structured his holdings such that it has become progressively more difficult for an acquirer to offer sufficient premium to induce him to sell the company.

Incentives of the company:

The author strongly contends that the company intends to use NRCIA as an acquisition currency and wants that currency to have the highest valuation possible, such that future acquisitions will be more accretive. The company has been transparent in this regard. From their Proxy "The company intends to use class A common stock if it decides to raise equity capital in the future and because class B common stock is paid a higher dividend, the dividend dilution to the existing minority shareholders on future equity raises is not as large." (Proxy/A Pg. 33) More recently, the company notified investors that "Management and the Board of Directors have identified a number of organic and inorganic investment opportunities, which could materially increase the growth trajectory of the company" (Press Release 8/19/2013)

This gets us back to the company suspending its dividend policy in co-ordination with the recapitalization. To reiterate, the company stated its logic in suspending the dividend was "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." Subsequent to this, the company stated in their most recent press release that Board of Directors has elected not to pay a dividend until 2015 "in order to maximize available cash" in reference to the "organic and inorganic investment opportunities" being considered. (Press Release 8/19/2013)

However, a closer examination of the company's own filings points to a potential inconsistency in these statements. During the summer of 2012, the company "began to consider a potential recapitalization" and had asked their legal counsel, Foley & Lardner, to inquire with NASDAQ as to whether said recapitalization would comply with the Exchange's Voting Rights Rule. Furthermore, the Board discussed recapitalization proposals at a scheduled meeting on July 10, 2012 and formed a Special Committee to investigate the recapitalization on October 25, 2012. (Proxy/A pgs. 25-29) Thus, if the Board knew that it was likely to approve a dual-class listing during the summer of 2012 and the reason for that listing was partially to "enhance the ability of the company to raise capital," why did it then declare a special dividend of $1.50 per NRCI share on November 6, 2012, equating to 61% of the 2012's free cash flow, only to suspend dividend payments 4 months later and then cite the need for preserving cash? (Press Release 11/6/2012)

Therefore, the author suggests that suspending the dividend has less to do with insulating "volume and trading" of the respective share classes and more to do with having investors solely focus on the liquidation/extraordinary transaction value of NRCIA rather than the long-run dividend paying and earnings potential of the security. In turn, this has likely inflated the value of the company's preferred acquisition currency such that they are able to make future acquisitions with a lower cost of capital. It also probably does not hurt that it elevates the value of the share class that the CEO has been liquidating. Additionally, Mr. Hays' share of the special dividend was approximately $5.6 million, or slightly less than he would have received if the company maintained its previous dividend policy between the announcement of the suspension and reinstatement in 2015.

Incentives of the Non-Controlling Shareholders:

It is worthwhile to consider how the incentives of existing shareholders change if the company is to effectuate an acquisition using NRCIA. The author contends that every share of NRCIA that the company issues in an acquisition lessens the likelihood of being acquired. For instance, say you owned 100 shares of NRCI pre-recap, post-recap you would own 300 shares of NRCIA and 50 shares of NRCIB. In this case you would also be indifferent to the company's dividend policy, as your 50 shares of NRCIB would receive the same amount of dividends as your 300 shares of NRCIA. As a corollary, you would be indifferent (outside of the premium to the aggregate value of your shareholdings) as to whether the company sold itself.

Pre-recap NRCI

100

Post-recap

Shares owned

Hypothetical Dividend

Dividend Earnings

NRCIB

50

$ 6.00

300

NRCIA

300

$ 1.00

300

However, this indifference changes the minute the company issues shares of NRCIA to effectuate an acquisition. First, the earnings power of an acquisition disproportionately benefits the existing holders who own NRCIA and NRCIB in a 6:1 ratio, opposed to new shareholders who own solely NRCIA. For instance, say the company was generating $20 million in net income and acquired an additional $10 million of net income by issuing 12.1 million shares of NRCIA at a cost of $16.50 (~$200 million acquisition). Pro-forma for the acquisition, existing and new shareholders would receive 78% and 22% of the $30 million of net income, respectively. However, if the company was to be acquired, existing shareholder would receive only 67% of the total consideration while new shareholders would be granted 33%. Therefore, it can be surmised that the issuance of shares of NRCIA has a de-facto anti-takeover effect. It should be noted that new shareholders would have little recourse to in regards to effectuating a sale of National Research given the limited voting rights of NRCIA. Therefore, the issuance of NRCIA to make acquisitions is analogous to Mr. Hays selling NRCIA in that it makes the existing shareholders less likely to support an acquisition and more interested in receiving dividends vis-à-vis holdings in NRCIB.

Pre-Acquisition NRCI

Net Income ($ Million)

20

Shares Outstanding

Claim on Earnings

Share class Income

Liquidation/Extraordinary Transaction Claim

NRCIB

3.52

50%

10

14.3%

NRCIA

21.09

50%

10

85.7%

Total

24.60

100%

20

100.0%

Pro-Forma NRCI

Net Income ($ Million)

30

Existing Shareholders

Shares Outstanding

Claim on Earnings

Share class Income

Liquidation/Extraordinary Transaction Claim

NRCIB

3.52

38.8%

11.65

9.6%

NRCIA

21.09

38.8%

11.65

57.4%

Subtotal

24.60

77.7%

23.31

67.0%

New NRCIA Holders

12.12

22.3%

6.70

33.0%

Total

36.72

100.0%

30.01

100.0%

Summary:

At this point, it has been established the that CEO and Controlling Shareholder has little incentive to sell the company, the company has an incentive to issue shares of NRCIA to fund acquisitions, and once those share are issued, non-Controlling Shareholders become proportionally overweight NRCIB and are less likely to support the sale of the company.

The Valuation of NRCIB:

Downside:

As an owner of NRCIB, the obvious downside condition is if the company decides to sell itself at a small takeover premium. However, the authors feels that this is very unlikely given the recent statement that, "The company believes that the Existing Stock currently trades at a discount to its peers." (Proxy/A pg. 37) Hence, a significant takeout premium would likely be needed to induce the company to sell itself, especially as the Controlling Shareholder would not receive the full premium given the composition of his holdings. To be conservative, the author will use the example of the 20% takeout premium to frame the downside case.

Takeout Scenario

Current Market Cap

453.4

Premium

20.00%

Takeout Value

544.1

Diluted Shares

24.60

Takeout Consideration

$22.12

NRCIB Px

$30.00

Loss per Share

$ 7.88

% of Capital

-26%

Break-even Scenario:

This is a somewhat more difficult exercise as it relies on subjective future estimates. For instance, the author assumes that National Research will generate approximately $18 million in net income in 2013, implying that the stock is trading at 25x current estimates. By 2015, the author estimates that National Research will generate approximately $24 million in net income. If the company continued to trade at 25x earnings and was take out a 20% premium to that valuation, the owner of NRCIB would essentially breakeven at the current cost basis of $30.

Break-Even Scenario

Est. 2015 Net Income ($ Millions)

24

Earning Multiple

25

Equity Value

600

Takeout Premium

20%

Takeout Equity Value

720

Diluted Shares

24.60

Takeout Consideration

$29.27

NRCIB Px

$30.00

Loss per Share

$ 0.73

% of Capital

-2.44%

Upside Scenario 1:

In this scenario, the author again assumes that National Research generates $24 million in net income in 2015 - the year in which the Board of Directors has stated they will re-initiate a dividend. Coincident with the dividend reinstatement, the author assumes that investors apply the aggregate multiple of 25x currently being applied to the company in regards to NRCIB's then-current economic claim on earnings. This translates to a return of 184% on the current share price of $30.

Upside 1

Est. 2015 Net Income ($ Millions)

24

NRCIB Economic Claim on Earnings

50%

NRCIB Share class Earnings ($ Millions)

12

Multiple

25

Value

300

NRCIB Shares

3.52

Implied NRCIB Px

$85.32

NRCIB Px

$30.00

Gain per Share

$55.32

% of Capital

######

Upside Scenario 2:

In this scenario, the author again assumes that National Research generates $24 million in net income in 2015, but also acquires $10 million in net income through the issuance of 12.1 million shares of NRCIA. This has the effect of reducing the economic claim on earnings of NRCIB from 50% to 38.8%, which is more than offset by the accretive nature the acquisition. The earnings multiple is the same as in the previous example. This translates to a return of 213% on the current share price.

Upside 2

Est. 2015 Net Income ($ Millions)

24

Acquired Earnings ($ Millions)

10

Total Earnings

34

NRCIB Economic Claim on Earnings

38.8%

NRCIB Share class Earnings ($ Millions)

13.21

Multiple

25

Value

330.22

NRCIB Shares

3.52

Implied NRCIB Px

$93.92

NRCIB Px

$30.00

Gain per Share

$63.92

% of Capital

######

Expected Value Calculation:

Here the author assigns an equal probability to each of the aforementioned scenarios to determine the expected return on capital deployed. Again, the author feels, on aggregate, that this calculation is somewhat conservative given that it is felt that the probability of the company selling itself at a small acquisition premium to current levels is negligible. It should be emphasized that these calculations are inherently incorrect given the level of assumptions and are used solely to give a sense of risk/reward rather than quantify a specific projection.

Expected Value Calculation

Probability

Px

Weighted Px

Downside

25%

$ 22.12

$ 5.53

Break-even

25%

$ 29.27

$ 7.32

Upside 1

25%

$ 85.32

$ 21.33

Upside 2

25%

$ 93.92

$ 23.48

Expected Value

$ 57.66

NRCIB Px

$ 30.00

Gain per Share

$ 27.66

% of Capital

92.19%

Concluding Thoughts:

In conclusion, the author feels that the recently completed share recapitalization of National Research benefits both the controlling shareholder and non-controlling shareholders by granting company an acquisition currency and Mr. Hays means to monetize his significant holdings. Mr. Hays has built tremendous value during the tenure as the company and deserves the good-faith of investors to allow him to deploy more capital in the form of NRCIA stock. Moreover, one cannot begrudge the desire to take some money off the table, especially as he has paid himself significantly less than executives at comparable companies.

However, this does not mean that it isn't important to consider what the incentives are of the company and its controlling shareholder and to align one's shareholdings with those interests. If the author has correctly analyzed these incentives, it would appear NRCIB is a significantly undervalued security.

Source: National Research Corporation: Follow The Incentives