NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.       BASIS OF CONSOLIDATION AND PRESENTATION

The Company 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. NRC believes that access to and analysis of its extensive consumer-driven information will become even more valuable in the future as healthcare providers increasingly need to more deeply understand and engage patients and consumers in an effort towards effective population-based health management.

During the first quarter of 2013, the Company condensed its eight operating segments into two operating segments that are aggregated into one reporting segment because they have similar economic characteristics and meet the other aggregation criteria from the Financial Accounting Standards Board (“FASB”) guidance on segment disclosure.  The two operating segments, organized by geographic area, are National Research Corporation (United States) and National Research Corporation Canada, which each offer a portfolio of solutions to address specific market needs around growth, retention, engagement and thought leadership for healthcare organizations. 

The condensed consolidated balance sheet of the Company at December 31, 2012, was derived from the Company’s audited consolidated balance sheet as of that date. All other financial statements contained herein are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring adjustments) the Company considers necessary for a fair presentation of financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States.

Information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto that are included in the Company’s Form 10-K for the year ended December 31, 2012, filed with the Securities and Exchange Commission (the “SEC”) on March 1, 2013.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

The condensed consolidated financial statements include the accounts of the Company, its wholly-owned subsidiary, National Research Corporation Canada, and a variable interest entity, Customer-Connect LLC (“Customer-Connect”). NRC is deemed the primary beneficiary of the variable interest entity and has a 49% ownership interest in Customer-Connect. An entity is considered the primary beneficiary of a variable interest entity if it has both the power to direct the activities of the variable interest entity that most significantly impact the variable interest entity’s economic performance and an obligation to absorb losses or the right to receive benefits that could potentially be significant to the variable interest entity. Customer-Connect is thinly capitalized and relies on NRC advances and reimbursements to fund its operations. Together, NRC and NRC associates hold a majority of the voting rights on Customer-Connect board of directors and has the ability to direct the majority of Customer-Connect operations. All significant intercompany transactions and balances have been eliminated.

The functional currency of the Company’s foreign subsidiary, National Research Corporation Canada, is the subsidiary’s local currency. The Company translates the assets and liabilities of its foreign subsidiary at the period-end rate of exchange and its foreign subsidiary’s income statement balances at the average rate prevailing during the period. The Company records the resulting translation adjustment in accumulated other comprehensive income, a component of shareholders’ equity. Since the undistributed earnings of the Company’s foreign subsidiary are considered to be indefinitely reinvested, the components of other comprehensive income (loss) have not been tax effected. Gains and losses related to transactions denominated in a currency other than the subsidiary’s local currency and short-term intercompany accounts are included in other income (expense) in the condensed consolidated statements of income.

Recapitalization

In May 2013, the Company consummated a recapitalization (the “May 2013 Recapitalization”) pursuant to which the Company established two classes of common stock (class A common stock and class B common stock), issued a dividend of three shares of class A common stock for each share of the Company’s then existing common stock and reclassified each then existing share of common stock as one-half of one share of class B common stock. All previously reported share and per share amounts in the accompanying financial statements and related notes have been restated to reflect the May 2013 Recapitalization.

Fair Value Measurements

The Company’s valuation techniques are based on maximizing observable inputs and minimizing the use of unobservable inputs when measuring fair value. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The inputs are then classified into the following hierarchy: (1) Level 1 Inputs—quoted prices in active markets for identical assets and liabilities; (2) Level 2 Inputs—observable market-based inputs other than Level 1 inputs, such as quoted prices for similar assets or liabilities in active markets, quoted prices for similar or identical assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data; and (3) Level 3 Inputs—unobservable inputs.

The following details the Company’s financial assets and liabilities within the fair value hierarchy at June 30, 2013, and December 31, 2012:

The Company’s long-term debt is recorded at historical cost. The following are the carrying amounts and estimated fair values, based primarily on estimated current rates available for debt of the same remaining duration and adjusted for nonperformance and credit risk:

The Company estimated the fair value of its long-term, fixed-rate debt using a Level 2 discounted cash flow analysis based on current borrowing rates for debt with similar maturities .

The Company believes that the carrying amounts of trade accounts receivable, accounts payable and accrued expenses approximate their fair value due to the short maturity of those instruments. All non-financial assets that are not recognized or disclosed at fair value in the financial statements on a recurring basis, which includes goodwill and non-financial long-lived assets, are measured at fair value in certain circumstances (for example, when there is evidence of impairment). As of June 30, 2013, and
December 31, 2012, there was no indication of impairment related to the Company’s non-financial assets.

2.       VARIABLE INTEREST ENTITY

Customer-Connect was formed in June 2013 to develop and commercialize the customer connect programs. Customer connect programs provide healthcare organizations the technology to engage patients through real-time identification and management of individual patient needs, preferences, risks, and experiences.  The platform ensures that organizations have access to a longitudinal view of the patient to more effectively manage patient engagement across the continuum of care. NRC has a 49% ownership interest in Customer-Connect, and is deemed the primary beneficiary. NG Customer Connect, LLC holds 25% interest, and the remaining 26% is held by Illuminate Health, LLC. NRC has agreed to lease employees to Customer-Connect. In return for a fee, Customer-Connect will service the Company’s discharge call program clients. NRC will make an initial capital contribution of $100,000, and will make additional capital contributions of up to $2.5 million on an as-needed basis as determined by the Board of Directors of Customer-Connect. Profits and losses are allocated under the hypothetical liquidation at book value approach.

NRC has a future obligation to purchase the other equity units in Customer-Connect when certain targeted events have been achieved. If at any time there is at least $12.7 million of annual recurring contract value, including the NRC contracts being serviced, and the members have approved a financial statement showing a pro forma minimum 35% EBITDA margin for revenue on a going-forward basis, then within 90 days thereafter NRC is required to purchase from the other members, and the other members shall be required to sell to NRC, all of their equity units not owned by NRC. As of June 30, 2013, the price at which NG Customer Connect, LLC and Illuminate Health LLC had the obligation to sell their equity units to NRC was $0.

Included in the Company’s condensed consolidated financial statements for the quarter ended June 30, 2013 were Customer-Connect’s net property, plant and equipment of $28,000, accrued expenses of $36,000 and net operating loss of $80,000. The net operating loss attributable to NRC for the quarter ending June 30, 2013 was $80,000.

3.       INCOME TAXES

The Company’s effective tax rate increased to 37.1% for the three-month period ended June 30, 2013, compared to 22.9% for the same period in 2012. The effective tax rate for the six-month period ended June 30, 2013, increased to 37.2% compared to 29.5% for the same period in 2012. This increase was primarily due to an adjustment to income taxes of $575,000 for decreases in deferred state tax rates resulting from legislative changes in 2012, nondeductible fees associated with the May 2013 Recapitalization that were incurred during the six-month period ended June 30, 2013, and an increase in unrecognized tax benefits during the six-month period ended June 30, 2013, compared to a decrease in unrecognized tax benefits for the same period in 2012.

The unrecognized tax benefit as of June 30, 2013, was $265,000, excluding interest of $13,000 and no penalties. The full unrecognized tax benefits, if recognized, would favorably impact the effective income tax rate. The Company believes it is reasonably possible that the total amount of unrecognized tax benefits could decrease during the next 12 months due to the expiration of the U.S. federal statute of limitations associated with certain other tax positions. The Company accrues interest and penalties related to uncertain tax position in the statements of income as income tax expense.

4.     NOTES PAYABLE

The Company had two term notes, which were used to partially finance acquisitions in 2008 and 2010. Borrowings under the term notes bore interest at an annual rate of 3.79%.

On May 9, 2013, the Company refinanced the two existing term notes by combining them into one $11.8 million term note. The new term loan is payable in 60 monthly installments of $212,468. Borrowings under the new term note bear interest at an annual rate of 3.12%. The outstanding balance of the term loan at June 30, 2013 was $11.6 million.

The Company also has a revolving credit note that was renewed in May 2013 to extend the term to June 30, 2014. The maximum aggregate amount available under the revolving credit note is $6.5 million, subject to a borrowing base equal to 75% of the Company’s eligible accounts receivable. Borrowings under the revolving credit note bear interest at a variable annual rate, with three rate options at the discretion of management as follows: (1) 2.5% plus the daily reset one-month London Interbank Offered Rate (“LIBOR”) or (2) 2.2% plus the one-, two- or three- month LIBOR rate, or (3) the bank’s one-, two, three, six, or twelve month Money Market Loan Rate. As of June 30, 2013 the revolving credit note did not have a balance. According to the borrowing base requirements, the Company had the capacity to borrow $6.5 million as of June 30, 2013.

The term note and revolving credit note are secured by certain of the Company’s assets, including the Company’s land, building, trade accounts receivable and intangible assets. The term note and revolving credit note contain various restrictions and covenants applicable to the Company, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions on the ability of the Company to consolidate or merge, create liens, incur additional indebtedness or dispose of assets. As of June 30, 2013, the Company was in compliance with these restrictions and covenants.

5.     SHARE-BASED COMPENSATION

The Company measures and recognizes compensation expense for all share-based payments. The compensation expense is recognized based on the grant-date fair value of those awards. All of the Company’s existing stock option awards and non-vested stock awards have been determined to be equity-classified awards.

The Company’s 2001 Equity Incentive Plan provides for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 1,800,000 class A and 300,000 class B shares of the Company’s common stock. Stock options granted may be either nonqualified or incentive stock options. Stock options vest over one to five years following the date of grant and option terms are generally five to ten years following the date of grant.

The Company’s 2004 Non-Employee Director Stock Plan (the “2004 Director Plan”) is a nonqualified plan that provides for the granting of options with respect to 1,650,000 class A and 275,000 class B shares of the Company’s common stock. The 2004 Director Plan provides for grants of nonqualified stock options to each director of the Company who is not employed by the Company. On the date of each annual meeting of shareholders of the Company, options to purchase 36,000 class A shares and 6,000 class B shares of the Company’s common stock are granted to directors that are re-elected or retained as a director at such meeting. Stock options vest one year following the date of grant and option terms are generally ten years following the date of grant, or three years in the case of termination of the outside director’s service.

The Company’s 2006 Equity Incentive Plan provides for the granting of stock options, stock appreciation rights, restricted stock, performance shares and other share-based awards and benefits up to an aggregate of 1,800,000 class A and 300,000 class B shares of the Company’s common stock. Stock options granted may be either incentive stock options or nonqualified stock options. Vesting terms vary with each grant and option terms are generally five to ten years following the date of grant.

The Company granted options to purchase 232,344 shares of the Company’s class A common stock and 38,718 shares of the class B common stock during the six-month period ended June 30, 2013. The Company granted options to purchase 238,890 class A and 39,815 class B shares of common stock during the six-month period ended June 30, 2012. Options to purchase shares of common stock were granted with exercise prices equal to the fair value of the common stock on the date of grant. The fair value of stock options granted was estimated using a Black-Scholes valuation model with the following assumptions:

The risk-free interest rate assumptions were based on the U.S. Treasury yield curve in effect at the time of the grant. The expected volatility was based on historical monthly price changes of the Company’s stock based on the expected life of the options at the date of grant. The expected life of options is the average number of years the Company estimates that options will be outstanding. The Company considers groups of associates that have similar historical exercise behavior separately for valuation purposes.

The following table summarizes stock option activity under the Company’s 2001 and 2006 Equity Incentive Plans and the 2004 Director Plan for the six months ended June 30, 2013:

The following table summarizes information regarding non-vested stock granted to associates under the 2006 Equity Incentive Plan for the six months ended June 30, 2013:

As of June 30, 2013, the total unrecognized compensation cost related to non-vested stock awards was approximately $410,000 and is expected to be recognized over a weighted average period of 3.01 years.

Intangible assets consisted of the following:

8.      EARNINGS PER SHARE

Net income per share of class A common stock and class B common stock is computed using the two-class method. Basic net income per share is computed by allocating undistributed earnings to common shares and using the weighted-average number of common shares outstanding during the period.

Diluted net income per share is computed using the weighted-average number of common shares and, if dilutive, the potential common shares outstanding during the period. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options and vesting of restricted stock. The dilutive effect of outstanding stock options is reflected in diluted earnings per share by application of the treasury stock method.

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 (1/6 th ) 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.

The Company excluded 172,212 and 230,703 shares of class A common stock options and 12,106 and 38,451 shares of class B common stock options for the three-month periods ended June 30, 2013 and 2012, respectively, from the diluted net income per share computation because the exercise or grant price exceeded the fair market value of the common stock on such date. The Company excluded 127,581 and 283,155 shares of class A common stock options and 12,920 and 47,193 of the class B common stock options for the six-month periods ended June 30, 2013 and 2012, respectively from the diluted net income per share computation because the exercise or grant price exceeded the fair market value of the common stock on such date. No restricted stock awards were excluded from the calculation during the three-month periods or six-month periods ended June 30, 2013 and 2012.

9.     RELATED PARTY TRANSACTIONS     

A board member of the Company serves as an officer of Ameritas Life Insurance Corp. (“Ameritas”). In connection with the Company’s regular assessment of its insurance-based associate benefits, which is conducted by an independent insurance broker, and the costs associated therewith, in 2007, the Company began purchasing dental insurance for certain of its associates from Ameritas and in 2009, the Company also began purchasing vision insurance for certain of its associates from Ameritas. The total value of these purchases was $52,000 and $51,000 for the three-month periods ended June 30, 2013 and 2012, respectively, and $108,000 and $99,000 for the six-month periods ended June 30, 2013 and 2012, respectively.

Michael Hays, our Chief Executive Officer, is a director and owner of 14% of the equity interests of Nebraska Global Investment Company LLC. The Company purchased certain technology consulting and software development services from Nebraska Global Investment Company LLC. There were no purchases for the three-month periods ended June 30, 2013, and the total value was $57,000 for the six-month periods ended June 30, 2013. No purchases were made during the same period in 2012.