National Research Corporation (NRC) Q2 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded, Wednesday, August 7, 2013. I would now like to turn the conference over to Michael Hays, Chief Executive Officer with National Research Corporation. Please go ahead, sir.

Thank you, Andre, and welcome everyone to National Research Corporation's 2013 second quarter conference call. My name is Mike Hays, the company's CEO, and joining me on the call today is Susan Henricks, President and Chief Operating Officer; as well as Kevin Karas, our Chief Financial Officer. Before we continue, I'd ask Kevin to review conditions related to any forward-looking statements that may be made as part of today's call. Kevin?

Thank you, Mike. This conference call includes forward-looking statements related to the company that involve risks and uncertainties that could cause actual results or outcomes to differ materially from those currently anticipated. These forward-looking statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. For further information about the facts that could affect the company's future results, please see the company's filings with the Securities and Exchange Commission. With that, I'll turn it back to you, Mike.

Thank you, Kevin, and again, welcome, everyone. As we kick off the call, let me first state the obvious, I'm clearly disappointed, as all shareholders should be, in our 8% top line growth rate this past quarter. Our post-acute care products, while up 5% from our first quarter, and clearly heading in the right direction, dampened what otherwise would have been a very strong quarter. Top line growth across our acute care product portfolio, which represents 78% of the company's total revenue, grew 20% this last quarter, continuing its similar growth over the past 4 quarters. In fact, over the past 12 months, top line growth has been 21% for this group, which is the top end of our growth expectations of 15% to 20%. Also of note, relative to our top line growth, is that our business development headcount is now 75, up from the mid-60s. Kevin will review in more detail the quarter's performance in just a moment, after which, I'll return and discuss the launch of Customer Connect, its strategic contribution to the company and its Phase 1 financial objectives. As well, Picker Institute will be introduced September 22, and during this call, I will provide you a preview as to its role as a signature offering of NRC. With that, Kevin, I will turn the call over to you.

Thank you, Mike. Net new sales of $4.5 million were added in the second quarter of 2013, which helped increase total contract value for the second quarter to $97.6 million. Subscription-based agreements now represent 83% of our total recurring contract value. I'm aware we have some new shareholders on the call today, and to clarify, total contract value represents the dollar amount of client contracts, which will be recognized as revenue over the next 12 months. As Mike reviewed, revenue for the second quarter was $22.4 million, an increase of 8% over the same quarter last year. Revenue growth for the quarter was comprised entirely from organic growth, which is driven by a combination of continued gains and market share and vertical growth from cross-selling and increasing contract value to existing clients. We continue, as Mike said, to realize the strongest revenue growth in our acute-care business with revenue in the second quarter increasing by 20% over the same quarter last year. Operating income for the second quarter of 2013 was $5.5 million or 25% of revenue compared $5.2 million, which was also at 25% of revenue for the same quarter last year. Total operating expenses for the second quarter increased by 9% from $15.4 million in 2012, to $16.8 million in 2013. Of that, direct expenses increased to $9.5 million for the second quarter, compared to $8.6 million for the same period in 2012. This is a result of increased variable costs related to revenue growth and higher survey volumes for subscription-based products. Direct expense as a percent of revenue was 42% for the second quarter and direct expense is expected to be at 41% of revenue for the full year of 2013. Our selling, general and administrative expenses increased to $6.4 million or 29% of revenue for the 3-month period ended June 30, 2013, compared to $5.6 million or 27% of revenue for the same period in 2012. Our SG&A expense for the second quarter of 2013 included $250,000 of expenses incurred for implementation of our recapitalization plan. For the full year of 2013, SG&A expense is expected to be 27% of revenue before Customer Connect expenses. The Incremental expenses that are projected to be incurred for Customer Connect resources are expected to increase the consolidated SG&A expense to 28% of revenue for the full year of 2013. I'd like to stop for a moment and touch on Customer Connect, which is a new growth platform rolled out June 1. We have this past quarter, and will be in future quarters, making investments in this initiative. These incremental expenses will be primarily seen in SG&A expense, which increased by $80,000 in the second quarter related to Customer Connect, reducing our operating income by that same amount. Every quarter, we'll be reporting financial results, both on a consolidated basis, with the results of the Customer Connect subsidiary, as well as reporting the impact of Customer Connect on the financial statement so you can monitor this investment, as well as incremental revenue contribution. Depreciation and amortization expense for the second quarter 2013 was $932,000 compared to $1.2 million in the second quarter of 2012, with the decrease being attributed to declining amortization-related intangible assets. Our depreciation and amortization expense was 4% of revenue for the second quarter and is expected to also be at 4% of revenue for the full year of 2013. The provision for income taxes totaled $2.0 million or $2 million for the 3-month period ended June 30, 2013, compared to $1.2 million for the same period last year. The effective tax rate for the second quarter of 2013 was 37.1% compared to 22.9% for the same period last year. This increase in the effective tax rate is primarily due to an adjustment to income tax expense of $575,000 for decreases in deferred state tax rates resulting from legislative changes which occurred in the second quarter of 2012. Our effective tax rate is expected to average 37.5% for the full year of 2013. Net income for the second quarter of 2013 decreased by 13% to $3.4 million, compared to $3.9 million in 2012. And then, for the second quarter of 2013, our diluted earnings per share for Class A common stock increased by 14% to $0.08 a share, compared $0.09 for the same period last year, and our diluted earnings per share for Class B common stock decreased by 14% to $0.49 a share, compared $0.57 for the same period last year. With that, I'll turn the call back to Mike.

Thank you, Kevin. Let me jump right in to Customer Connect, which was launched June 1. Customer Connect is just not a product, rather a fully resourced business, complete with dedicated associates, development resources and clients, from which to build a very material revenue runway for NRC. As briefly previewed on our last call, Customer Connect provides healthcare organizations technology to engage patients through realtime identification and management of the individual's needs, preferences, risks and experiences within the care setting, during transitions between care settings and while at home. The Connect platform archives all knowledge gained from each of these discrete interactions with a patient and strings it together creating a longitudinal profile of the individual across the entire continuum of care. A nonclinical EMR, if you wish. As we strategized on the best way to build and bring Customer Connect to market, our due diligence was far and wide, including partnering, acquiring capabilities and/or building out one of our current products. At the end of the day, we became very comfortable with the Connect platform leveraging Illuminate, which as you know, is NRC's product that calls inpatients within 72 hours of their hospital discharge and identifies patient at risk for readmissions. Illuminate has been well-received by the market and is proven to be an efficient tool for transition management by screening millions of patients to identify ones at greatest risks. That's saving time, resources and even lives. Building out the Connect platform from the Illuminate foundation allows us to extend Illuminate's value to monitoring inpatients across the entire 30-day readmission penalty window, not just for the first hours of inpatient transition, which has been the case. Transitions, as we know, are the Achilles' heel of healthcare and are not limited to inpatient transitions, rather representing clear opportunity for enhanced effectiveness and efficiency in all care settings. Consequently, the Connect transition offering has addressable market including silo providers in every care setting, as well as those truly integrated provider organizations across the continuum. The Connect platform adds additional capabilities to Illuminate in that Connect is a multi-mobile outreach platform. Illuminate being limited to voice outreach only could never reach all at risk patients. Connect now enables a variety of outreach modalities, and as well, manages customer's communication modality preferences. In other words, reaching healthcare customers the right way, meaning their preferred way, will definitely increase engagement. Connect transitions also enable more intelligent outreach by understanding the patient over time. Answering the same questions multiple times, in fact, often every time, is a well-known healthcare problem. Connect's underlying asset is a longitudinal profile of each customer, which informs and empowers every interaction. In fact, with built-in predictive analytics, one could begin to imagine, for the first time, a healthcare provider organization known for its customer services. The Connect platform for transitions enables outreach, in summary, the right way at the right time with a robust longitudinal profile and is the first of 3 use cases being targeted. The other 2 use cases for the Connect platform deal with the effective and efficient service recovery and marketing communications. Customer Connect's go-to-market plan first will build on our 2.7 million in Illuminate client relationships, broadening the solution to an entire 30-day inpatient readmission problem, and thus increasing client spend. The second step in the go-to-market plan for Connect is to add new logos in both the inpatient care setting and across the entire continuum of care relative to transitions. The third leg of the plan is for Connect platform to monetize itself relative to service recovery and HCAHPS improvements through upselling Picker install base and for marketing communication use cases through an install base for Market Insight products. The go-to-market plan is very clear, as well are the economics. We have the right resources dedicated to Customer Connect housed in a totally separate business, highly focused with incentives very aligned. Not unlike if Customer Connect would have been stood up through acquisition. Phase 1 of the financial goal represents a modest penetration of the addressable market for transitions generating incremental recurring contract value of $10 million, with a minimum EBITDA contribution of $3.5 million. The results of which will be an increased NRC shareholder value in the range of 15%. Our goal is to compress the time needed to achieve this Phase 1 goal and move on the phases 2 and 3. In order to do that, in fact, we have highly incentivized the Customer Connect group through equity grants that will be monetized when NRC calls that equity on a triggering event of $10 million in incremental recurring contract value and the associated EBITDA contribution. So when you can monitor our progress, we'll provide visibility towards the $10 million goal in our quarterly reporting, as Kevin suggested, as well as our investment that we will be making in Customer Connect. I would now like to preview with you another new product, that being the Picker Institute, which will be NRC's signature patient experience offering. The Picker brand is very well-established and literally wrote the book on patient-centered care, and I'm pleased that its membership will now be an offering of NRC. From a financial perspective, the Picker Institute will mirror the Governance Institute's recurring revenue business model. To quickly highlight, the Governance Institute, for those that maybe less familiar, the Governance Institute now counts over 1,000 organization CEOs as its members, and given its membership model, margins are very attractive. As is its strategic contribution to NRC, which provides access to 20% of the nation's hospital boardrooms for all other product offerings, it is this unique access to the CEO suite that NRC will leverage in the rollout of the Picker Institute. The value proposition for the Picker Institute is all about improving the publicly reported patient experience ratings to which an estimated 85% of hospital CEOs have incentive dollars tied to. In addition, value-based purchasing and patient experience, as most of us realize, is a key metric. The world has shifted for measuring the patient experience and from publicly reporting the patient experience to the improvement of the most important aspects of the patient experience, and it is our goal to have the latter our sustainable point of differentiation in the marketplace. Operator, with that, I'd like to open the call to questions.

[Operator Instructions] Our first question comes from the line of Ryan Daniels, William Blair. Ryan Daniels - William Blair & Company L.L.C., Research Division: Let me start with a few on Customer Connect, obviously, a big focus of the call. Mike, can you maybe start just talking about how big of a team you now have focused on that, and I guess, the derivative question, you mentioned sales force was up to the mid-70s level, was the bulk of the growth there dedicated to Customer Connect or some of that is split on the post-acute care business to drive stronger sales there?

Well, I'll be happy to, Ryan, thanks for the question. First of all, the simple answer on the headcount is that there are only currently 3 individuals in the Customer Connect team that are focused on business development, although we will be building that out. So the incremental increase in headcount relative to the 75 that we currently have today are exclusively incremental to the NRC side of the shop, which would be split across the acute and post-acute business. So all of that is post-acute and acute NRC revenue stream. In terms of the scope and scale of Customer Connect today, we moved I think it was 6 NRC associates over to Customer Connect. We also have a software development partner that has in the neighborhood of 6 to 8 development resources focused on the Customer Connect platform. We will probably grow that over time, somewhere in the neighborhood of doubling, maybe even tripling through the run towards a $10 million in recurring contract value. So it's a substantial group, 100% dedicated, 3% of which are focused on business development. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. And then, you mentioned on the press release, the $2.7 million already in CV for Customer Connect, is that primarily from the customers who are testing it or already using it or is that a number that's already been added since the official June 1 launch of Customer Connect?

I wish it would be an incremental since June 1, that would be a home run. But quite the opposite. The $2.7 million is Illuminate contract value that is represented of purchases by our customers of that particular platform and because Customer Connect is extending the Illuminate platform or essentially building off of its foundation, we moved the $2.7 million worth of contract value that NRC already had prior to June 1 to the Customer Connect team. Now it's important to note that the 2 point -- or excuse me, the $10 million worth of incremental contract value, which is the financial goal, is incremental to the $2.7 million. So perhaps another way to think about the financial goal for Customer Connect is that it really is $12.7 million, the originating $2.7 million from Illuminate and incremental $10 million on top of that. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. That's helpful. And then, you probably won't want to answer this but do you have an internal goal on the timeframe to get to that level?

Yes, we have an internal goal. You didn't ask me to divulge what that was though so. Ryan Daniels - William Blair & Company L.L.C., Research Division: I'll ask you now, can you divulge?

I really don't know, Ryan. I was just kidding. We'll see what happens. I think the market test went very, very well. I think, in line if not a little ahead of our expectations. The most important component, I believe, relative to the timetable is the incentive structure that we have in place. Customer Connect is highly incentivized to compress to the absolute minimum, the amount of time it takes to get to $10 million incremental revenue. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. That's helpful. And then, the last one I'll ask on this and I'll hop back in the queue. As you think of this, you almost described it as a separate entity and I know you're going to give us kind of revenue CV and expenses related to it. Is it being run internally as kind of a separate silo right now. And then, as you branch into kind of the Phase 2 and Phase 3, it will get a little bit more integrated with the other business units and you'll try to do the upsell of Picker and Ticker and other aspects of that. Is that the way we should think about it?

I would think of it a little bit more discreet, even the math, it's a separate LLC, Customer Connect LLC, so it is legally a separate entity. There is equity held by National Research Corporation, as well as equity from an incentive standpoint cut across our development partners and other associates within the Customer Connect LLC. After Phase 1, the $10 million incremental revenue, we will see if it's working very, very well there. There's no reason to fix what is not broken, and perhaps that entity could remain a standalone entity reaching into and leveraging the client relationships that the other side of the house has. On the other hand, it might make perfect sense to integrate it in a more direct way. We have not premeditated the outcome of that, we're really focused just on Phase 1 at this Point. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. Maybe a quick one for Kevin, how will that be accounted for then if it's a separate LLC with some potential minority on this? Will you have the revenue recognition on a minority interest line?

Ryan, this is Kevin. It will be consolidated into our financial results. And when we file our 10-Q tomorrow, there's quite a bit of description around how it's setup and how the accounting will work. But essentially, it's a subsidiary and will be consolidated into our financial reporting. So that's how it will be set up.

[Operator Instructions] Our next question comes from the line of Frank Sparacino from First Analysis.

Maybe, Kevin, to start, I can't recall, did we get the same breakdown in Q1 in terms of the acute care revenue?

Yes, we quoted the growth rates for the different segments for acute care in Q1.

And I'm just trying to get a sense, Kevin, from a sequential basis, what type of improvement we saw?

The overall for the acute care segment, Frank, is relatively consistent with the Q1 growth. I believe it was 23% for Q1 for that group, and for Q2, it was at 20% year-over-year, quarter-over-quarter.

Okay. And then, just within that, I'm curious on, obviously, some of the segments are smaller and showing dramatic growth like Illuminate, but just trying to figure out sort of the relative momentum for something like CG-CAHPS?

It was pretty consistent with Q1 in the 30% range for both quarters, the mid to high-30s. So that stayed pretty consistent for CG-CAHPS. I think, each of the other elements as well, the Picker, the patient experience was high double-digits. Market Insights, as well as Canada, those were all in the teens, high-teens or low 20s, both quarters. So pretty consistent in terms of the growth rates from Q1 to Q2 within each of the elements.

Okay. Going back to Connect, obviously, the margin profile of that business is very strong and I'm just curious, relative to NRC today, what's driving that?

Well, I think the prospects for Connect relative to a margin are very attractive. It's a software as a service product, so it's a technology platform, and it has all the benefits that those types of business models bring to the party. Currently, NRC, being a subscription-based membership based product offering has very attractive EBITDA as well. I wouldn't be surprised when we achieve the $10 million mark that Connect is not slightly above the historical run rate on NRC's EBITDA simply because of the leverage you could get out of a SaaS product.

Yes, and my comment there, Mike, was more around -- right, at an early stage, typically, you don't see that type of margin, maybe at a more mature state, right, you would in a SaaS-type model, but at a $10 million run rate, I would expect you to be much lower than that, just given the investment?

Yes. We have targeted around $1 million worth of investment in the remainder of this calendar year, which will represent a 1% increase in SG&A, and we have targeted $1.5 million over and above the current of this year's $1 million. So $2.5 million total investment to get it to the $10 million run rate. But again, the business model and margins of the product are very, very attractive. So I think our goal is to be at 35% or above, even at that $10 million early mark.

Okay. And maybe lastly, Mike or Kevin, just curious, from a macro standpoint, obviously, you see a lot of different reports around hospitals in terms of negative volume trends and other sort of headwinds that they're facing and I'm just curious what you've seen and heard in discussions with hospital clients around their ability to spend?

Well, clearly, reimbursement is a problem. It always has been in healthcare. I don't know that, that will quite frankly ever change. It does put more onus on our sales group to focus on the value proposition and anytime you can get to saving dollars or reducing risk, you're taking cost out of the system. The value proposition, what we sell, clearly, is magnified in times when reimbursement is down. So you take -- the next value proposition is all about efficiency and being effective in targeting resources towards those who have the highest probability of readmission. You take all of the work we do in the patient experience world, it's all about maximizing value-based purchasing. So if you just walk down that line, we have to get crisper on our message relative to where we're saving or making dollars for the organization. So you're right, the backdrop is difficult, clients ask questions each and every day, and for those products that we have a great value proposition articulated, it doesn't seem to be any headwind.

Our next question is a follow-up question from the line of Ryan Daniels with William Blair. Ryan Daniels - William Blair & Company L.L.C., Research Division: Yes, Mike, I just want to talk about the revenue growth outlook. You indicated in the press release that given some of the new platform growth and momentum and I think the investment in the post-acute side, you could see this accelerate back to the mid to high-teens level. What's your expectation for that? Is that something that's reasonable to get to a mid-teens level by yearend, or is it kind of late in the year to assume that for that's more of a 2014 goal?

I would take it as a 2014 goal. It's a little hard for me gain visibility on how we can reverse or at least continue the turnaround in the post-acute business. And I guess, fortunately or unfortunately, in a subscription-based business, we can have robust sales, which post-acute is starting to have. But that trickles in on revenue recognition, of course, to that annualized contract. So the benefit of subscription is you got a lot of visibility, the negative on subscription takes a while for that to turn into recognized revenue. So I think the 15% to 20% mid-teens to high-teens growth rate aspirations and performance we've shown on the acute care side, assuming we can get the post-acute care up and Customer Connect starts adding to it, which I think, is probably the least of the problems, 2014 ought to be a 15% to 20% growth year. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. That's helpful color. And then, you mentioned the Picker Institute, I know you talked about that last call, it's got a great brand reputation. Are you getting early interest in that from customers yet regarding the membership or is that something you're really waiting to launch to start signing up customers?

Clearly, we're going to be ready to launch on the 22nd and we have not gone out in advance in any way, shape or form. So market acceptance is really untested in terms of actual people signing up. Ryan Daniels - William Blair & Company L.L.C., Research Division: Okay. And then, last one and I'll hop off. Just any update on the point of care mobile app, how that's rolled out thus far, and then I'm curious if that would eventually have the potential to morph into Customer Connect, given that it's kind of that realtime analytics while the patient is in the hospital and moving between units in a hospital, any thoughts on that?

Good question, don't know the answer to it. We focused Customer Connect on getting the Illuminate platform built out to have a lot of the added feature functionality and we have not addressed if, when or ever a rounding app would be part or parcel of that. So I don't know really how to answer that part. In terms of rounding application, it's early in the game. We're getting people to use it. The real question is going to be the stickiness. We're focused on one side of the puzzle relative to rounding and that's all about service recovery and increasing patient experience, there's a lot of other components to rounding that this particular application does not cover. So it's a little wonderment in my mind whether we're going to have a conflict on just too many things hanging around the nurse's neck but we'll find out on a go-forward basis whether or not that works or does not work. Ryan Daniels - William Blair & Company L.L.C., Research Division: Right. I guess, part of the reason I ask, you mentioned the service line recoveries or effective service recoveries is in stage 2 for the Customer Connect and it seems like the mobile rounding app is exactly what that addresses. So it seems to be a natural part of the Customer Connect evolution. But is there another way you could do it with Customer Connect without tying it into the rounding application?

Well, we see -- good question, and I see where you're headed. So the Customer Connect service recovery module, as we've currently defined it, is more about after the person leaves the organization and to follow-up and try to understand whether any service infractions occurred, and if so, triage them in the service recovery way to satisfy that. So currently, as an example, within the Illuminate calls, 8% of the calls result in identifying the service infraction. We know that if we can have somebody at the hospital reach out and satisfy that customer relative to that service infraction, that 90% of those people will give a positive rating on their HCAHPS scores, which is of course far higher than they would have had that service infraction not been satisfied. So our ROI has been focused within Customer Connect. Our ROI has been focused on finding those 8% in efficient and effective way and assuming that the organization using our tools will satisfy that or reverse that problem and increase HCAHPS scores after the fact. It very well could back up into the organization because the best time to solve the problem is before the person ever walks out the door. So if we can figure out a way for that to happen, that will even create more seamlessness.

We presently have no further questions at this time.

Thank you. I appreciate everybody's time today and welcome to the new shareholders that joined the call. As always, Kevin, Susan and I look forward to communicating our progress next quarter. Thank you again for your time.

Ladies and gentlemen, this does conclude the conference for today. We thank you for your participation, and ask that you please disconnect your lines.