National Research corporate does surveys for healthcare-related organizations. The operating business has grown around 14%/year over the last decade. Its CEO is obviously a Warren Buffett fan and (in my opinion) has higher integrity than Buffett.
Recently, National Research has performed a recapitalization that has created an A and B share structure. There is some uncertainty as to the relative economic interest between the two share classes. The B shares should be worth anywhere from 6X to 1X that of the A shares if voting rights and illiquidity are ignored. This is a huge range. Because of the uncertainty over the relative value of the two share classes, there are two different possible trades:
- Arbitrage. Go long the B shares and short the A shares. One could make the argument that the B shares have 6 times the economic interest of the A shares. On top of that, the B shares have higher voting power so they should trade at a slightly premium (though in practice it could trade at a discount due to illiquidity).
- Go long the B shares. National Research is a well-managed company run by a CEO with unusual integrity.
*Disclosure: Long NRCIB, no position in NRCIA.
What they do
I must admit that I don’t really understand their industry that well. They do surveys for healthcare providers and for governments. I presume that this is an open-ended problem with many opportunities to create value. Any idiot can administer a survey. But asking smart questions can make the survey more useful. From researching dialysis, it seems to me that there are many abusive practices going on in dialysis clinics. If I were in charge of a survey, I would ask patients relating to these practices. I’d ask patients if they know if their doctor owns their dialysis clinic, whether the lab techs repeat tests until better results are achieved, how they feel about self-cannulation, whether they know about in-home noctural dialysis, etc. etc. Asking smart questions could generate a lot of value. But I’m just making stuff up here. I really have no idea what National Research asks in its surveys.
I have no idea how they compare with their competitors. Presumably they are competitive since they are growing very quickly. Here are the company’s growth figures per share according to Gurufocus:
Revenue growth in last decade – 14.6%/yr
EBITDA growth in last decade – 14.2%/yr
Free cash flow growth in last decade – 14.1%/yr
(*If the company has bought back shares instead of issuing dividends, its per share figures would be higher.)
Take what I say with a grain of salt because I haven’t found a lot of information on this company and its industry.
The integrity of Michael Hays
Firstly, his compensation is extremely low. In 2012:
Michael Hays, CEO – $304,704
Kevin Karas, CFO – $538,335
Susan Henricks, COO – $936,415
The CEO paid himself less than his top lieutenants. He intentionally underpays himself, much like Warren Buffett. But he goes beyond what Buffett has done. Here is an excerpt from the 2007 annual report:
Share Repurchases—Our share repurchase program is limited to offsetting options granted which, if gone unchecked, would create dilution to current shareholders. We do not repurchase shares when we believe the Company is undervalued, or stop repurchasing if perception is one of overvalue. In fact, we don’t even waste our time asking the question. Consequently, no one should look at our share repurchasing as any signal to the market. After all, it is only shareholders via the market that have the right to deem what is an appropriate value.
Unlike Warren Buffett, he doesn’t trade against his own shareholders. While Buffett doesn’t like trading against his own shareholders, Buffett will still do it after giving shareholders a fair warning and explanation of Berkshire’s intrinsic value.
Michael Hays is getting old (he is currently 58). I don’t know if his age is a factor, but he has been slowly selling his stock. He has gotten close to the point where his ownership might drop below 50%. So, he wanted to create a dual class share structure with higher voting and lower voting shares. This would allow him to sell shares while maintaining control of the company. By maintaining control of his company, he can insulate it against the whims of Wall Street. I agree completely.
However, NASDAQ disagrees. I only learned this because of National Research, but apparently NASDAQ has rules against dual class share structures. Warren Buffett’s baby Berkshire shares would not be allowed today.
Baby Berkshire shares and Hays’ original plan
A long time ago, Berkshire Hathway’s share price had gotten so high that many retail investors couldn’t afford a Berkshire share. Arbitrageurs were thinking about buying Berkshire shares and selling fractional slices of Berkshire shares to retail investors. Buffett didn’t want the arbitrageurs to impose additional fees onto his investors. At the same time, he liked having a high share price because it discouraged frequent trading. So he didn’t want to simply split Berkshire shares.
What he did instead was to create two classes of Berkshire shares. Original Berkshire shares (the A shares) could be converted into 30 B shares. The B shares would have a lower share price and were within the price range of retail investors. It would probably also be more attractive to institutional investors due to the lower share price. However, the A shares would have more voting rights than 30 B shares. Breaking up the A shares would cause a loss in voting rights. This meant that Buffett would slowly get more and more voting control over Berkshire if he kept all of his A shares and some other people didn’t. He was hoping that the short-term oriented (institutional) shareholders would go for the B shares and essentially give away their voting power and leave the day-to-day management of Berkshire alone. You could argue that this is unfair to the shareholders who have given up their voting power.
Hays’ original plan was a little different. Shares of NRCI would be replaced by low voting and high voting shares. Each shareholder would have the same voting and economic interest in the company. However, Hays would be able to sell the lower voting shares and still maintain control of his company (by hanging onto his higher voting shares). I guess NASDAQ didn’t like this as the plan helps to keep management entrenched.
Personally I am a fan of quality CEOs being entrenched. I want the Michael Hays, Warren Buffetts, and John Malones of the world to have control over their companies. (Though perhaps Malone is tolerated only because he is so talented.) Assholes who abuse control like Frank Stronach are the exception, not the rule.
The recap plan that actually went through
So the two important changes to the plan are as follows:
- The B shares are entitled to 6 times the dividends of the A shares. If all earnings and assets of the company were distributed this way, the B shares would have 6 times the economic interest of the A shares.
- In other scenarios such as a takeover or liquidation, the A and the B shares have the same economic interest.
So basically… the B shares should be worth somewhere between 6:1 and 1:1. And it all depends on how earnings and assets of the company are distributed to shareholders. In practice, the B shareholders have voting control of the company. The B shareholders will likely collude so that the board of directors is friendly towards the B shares. Because Hays will likely always have >50% voting power, he will basically determine the board of directors and how the company is run. This should mean that virtually all earnings will ultimately be distributed as dividends, supporting a 6:1 ratio. There may be freaky events that can cause a 1:1 distribution to take place (e.g. bankruptcy, regulators can request that the share structure be collapsed at 1:1, with approval of the board), so I’m not sure I’d assume that the economic interest will get all the way up to 6:1. The current ratio is around 1.75:1. This suggests a gross mispricing.
There are two other factors that affect the relative pricing of the A and B shares. The first is voting power. Shares with higher voting power often but not always trade at a premium to lower voting shares. (e.g. Lennar is one of the exceptions.) The second factor is liquidity. The shares that trade more frequently and have lower spreads often trade at a premium to illiquid shares. This is the commonly accepted explanation for why lower voting shares sometimes trade at a premium to higher voting shares. In practice, the discounts/premiums rarely exceed 20%. So the discrepancy in National Research’s A and B shares should be attributed to confusion over the economic interest.
Why are people confused?
Immediately before the recap, the company suspended its dividends. This might lead investors to think that the company will only distribute very little of its cash flow through dividends (and one day be taken over or liquidated???). So, one might be confused into thinking that the ratio should be close to 1:1 if the company isn’t going to pay much dividends.
If you read the 2013 proxy statement / 2012 AR (PDF), the fairness opinion suggested that the economic interest between the shares should be 1:1 according to the diagram on page 33. (Personally I feel that fairness opinions are a massive waste of money because the opinion is always favorable to whatever management wants to do. But the I don’t see any fairness in having to waste shareholder money.)
If you read the latest 10-Q, page 14/15 explains why a 6:1 ratio is used in computing EPS:
The liquidation rights and the rights upon the consummation of an extraordinary transaction are the same for the holders of class A common stock and class B common stock. Other than share distributions and liquidation rights, the amount of any dividend or other distribution payable on each share of class A common stock will be equal to one-sixth (1/6th) of the amount of any such dividend or other distribution payable on each share of class B common stock. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the class A and class B common stock as if the earnings for the year had been distributed.
There is some confusion in the company’s own filings to begin with. In the end (and this might be decades from now), the company will likely distribute out its earnings as dividends. The B shareholders aren’t going to screw themselves over. They will try to get their 6:1. And because they exercise control over the company, they will get their way.
*Technically, if Hays owns more A shares than B shares while having more than 50% of the vote, he would have an incentive to screw the B shareholders over. But he has been selling his A shares so this won’t matter.
To see what some Wall Streeters think, go over to the VIC writeup for NRCIB. Many of the people on VIC are institutional portfolio managers. Some of them argue for a 1:1 ratio.
Why I dislike the arbitrage trade
This is a management-driven business with excellent management. In the long run, this stock will probably go up a lot. If both classes of shares double, the arbitrage trade could get really ugly. The arbitrage spread will double against you and you’ve just lost a lot of money.
In general, I dislike arbitrage trades because the risk/reward is often poor given the amount of margin the trade sucks up.
Why I am long the B shares
As I said earlier, this is a management-driven business with excellent management. I’m hoping that its performance will continue onto the future. The valuation is ok as the P/E is around 12.9 (assume 6:1 distribution of earnings, TTM income of $15.8M, and a market cap of $101.89M). On top of that, there is potential upside from the B shares trading at a 6:1 ratio with the A shares.
The company actually understates its earnings a little as it amortizes intangibles related to acquisitions.
I apologize if this writeup isn’t that in-depth as I haven’t looked into this company that deeply.