Idea type:  GARP and/or share class arbitrage

Three years ago, I wrote about National Research Corporation, an obscure and illiquid company with a market cap of half a billion.  Since then, the company has continued to grow (around 11-14%/year) while the share price has stayed the same.  According to the 2015 10-K, EPS for class B shares was $2.52 so the GAAP P/E is around 14.  However, due to this company’s unusual structure, GAAP earnings overstate the true P/E.

The arbitrage trade might also be interesting since the spread between the B and A shares should be somewhere around 1:1 to 6:1 or higher (arguably close to 6:1), but is currently 2.16:1.

Here’s a recap of the capital structure:

1. If the company distributes ALL cash flows via dividends, then each B share will receive 6X the cash that each A share will.
2. If the company is immediately liquidated or sold, then each B share will receive 1X the cash that each A share will.
3. The B shares have more voting power.  So, the class B shareholders have a vested interest in ensuring that most of the company’s cash flows will be distributed via dividends.
4. The CEO may be an extremely ethical individual- his excellent shareholder letters talk about how he doesn’t want to rip off his shareholders via share repurchases.  He may not necessarily abuse his voting power to ensure that the B shares are worth closer to 6X rather than 1X.

So, the economic value of the B shares is somewhere between 1:1 to 6:1 that of the A shares.  In my opinion, it should be closer to 6:1 since the B shareholders will likely avoid a liquidation or sale of the company as mentioned earlier.  GAAP earnings are calculated with a 6:1 ratio, though you should ignore that.

The B shares arguably deserve a premium for the higher voting power.  However, in practice there are situations where super-voting shares trade occasionally at a discount (e.g. the Malone empire, Lennar, etc. etc.).

Lending your shares out

If you lend out your NRCIB shares, your broker may pay you several percent.  This situation is a little strange to me.  It seems like somebody thinks that the shares should trade closer to a 1:1 ratio… which strikes me as misguided.

In any case, if you are able to lend out your shares, then you would enjoy a tailwind on a long position in NRCIB shares.

Correction

In my original writeup, I said that an increase in the share prices of both classes would cause your arbitrage trade to lose money.  That is not necessarily true.  Suppose you go long $1M of NRCIB shares and short $1M of NRCIA shares.  If the share prices of both share classes double, then your profit and loss would be flat.

Instead of shorting 6 A shares for every B share long, you can short ~2.7 A shares for every B share long.

Please do your own homework

I don’t understand National Research’s industry… so I’m at a disadvantage.

*Disclosure:  Long NRCIB.  No short position in NRCIA.

Links

Original writeup on National Research

NRCIB: Closed my position for silly reasons