PART I – Financial Information

ITEM 1. Financial Statements

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts and par value)

See accompanying notes to condensed consolidated financial statements

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except for per share amounts, unaudited)

See accompanying notes to condensed consolidated financial statements

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands, unaudited)

See accompanying notes to condensed consolidated financial statements.

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED Consolidated Statements of Shareholders’ Equity

(In thousands except share and per share amounts, unaudited)

See accompanying notes to condensed consolidated financial statements.

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED Consolidated Statements of Shareholders’ Equity

(In thousands except share and per share amounts, unaudited)

See accompanying notes to condensed consolidated financial statements.

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands, unaudited)

See accompanying notes to condensed consolidated financial statements.

NATIONAL RESEARCH CORPORATION AND SUBSIDIARY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Description of business and basis of presentation

National Research Corporation, doing business as NRC Health (“NRC Health,” the “Company,” “we,” “our,” “us” or similar terms), is a leading provider of analytics and insights that facilitate measurement and improvement of the patient and employee experience while also increasing patient engagement and customer loyalty for healthcare providers, payers and other healthcare organizations in the United States and Canada. Our portfolio of solutions represents a unique set of capabilities that individually and collectively provide value to our clients. The Company’s solutions enable its clients to understandare offered at an enterprise level through the voiceVoice of the customer with greater clarity, immediacyCustomer ("VoC") platform, The Governance Institute, and depth.legacy Experience solutions. 

The Company’s Our six operating segments 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 six operating segments are Experience, The Governance Institute, Market Insights, Transparency, NRC HealthNational Research Corporation Canada and Transitions, (formerly Connect), which offer a portfolio of solutions that address specific needs around market insight, experience, transparency and governance for healthcare providers, payers and other healthcare organizations.

TheOur condensed consolidated balance sheet of the Company at December 31, 2016, 2019 was derived from the Company’sour 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 considersthat we consider 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 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’sour Form 10-K10-K for the year ended December 31, 2016, 2019, filed with the Securities and Exchange Commission (the “SEC”) on March 3, 2017.6, 2020.

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 and itsour wholly-owned subsidiary, National Research Corporation Canada, doing business as NRC Health Canada. The condensed consolidated statement of income for the nine months ended September 30, 2016 also included Customer-Connect LLC.  Customer-Connect LLC became a wholly-owned subsidiary in March 2016 and was previously a variable interest entity for which NRC Health was deemed the primary beneficiary. On June 30, 2016, Customer-Connect LLC was dissolved. All significant intercompany transactions and balances have been eliminated.

TheOur Canadian subsidiary uses Canadian dollars as its functional currency of the Company’s foreign subsidiary, National Research Corporation Canada, doing business as NRC Health Canada, is the subsidiary’s local currency. The CompanyIt translates theits assets and liabilities of its foreign subsidiaryinto U.S. dollars at the period-endexchange rate of exchangein effect at the balance sheet date. It translates its revenue and its foreign subsidiary’s income statement balancesexpenses at the average exchange rate prevailing during the period. The Company records the resultingWe include translation adjustmentgains and losses in accumulated other comprehensive loss,income (loss), a component of shareholders’ equity. Since the undistributed earnings of the Company’s foreign subsidiary are considered to be indefinitely reinvested, no taxes were provided for on currency translation adjustments arising from converting the investment denominated in a foreign currency to U.S. dollars. Gains and losses related to transactions denominated in a currency other than the subsidiary’s localfunctional currency of the country in which we operate and short-term intercompany accounts are included in other income (expense) in the condensed consolidated statements of income.

Equity Investments

The Company acquires equity investments to promote business and strategic objectives. For investments that do not have a readily determinable fair value, the Company applies either cost or equity method of accounting depending on the nature of its investment and its ability to exercise significant influence. Investments are periodically analyzed to determine whether or not there are any indicators of impairment and written down to fair value if the investment has incurred an other than temporary impairment. During the three-month period ended September 30, 2017, the Company acquired a $1.3 million investment in convertible preferred stock of PracticingExcellence.com, Inc., a privately-held Delaware Corporation (“PX”), which is carried at cost and included in other non-current assets. The Company has a seat on PX's board of directors and the Company's investment, which is not considered to be in-substance common stock, represents approximately 15.7% of the issued and outstanding equity interests in PX at September 30, 2017.

Reclassifications

Revenue Recognition

ReclassificationsWe derive a majority of our revenues from our annually renewable subscription-based service agreements with our clients, which include performance measurement and improvement services, healthcare analytics and governance education services. Such agreements are generally cancelable on short or no notice without penalty. See Note 2 for further information about our contracts with clients. We account for revenue using the following steps:

Our revenue arrangements with a client may include combinations of more than one service offering which may be executed at the same time, or within close proximity of one another. We combine contracts with the same client into a single contract for accounting purposes when the contract is entered into at or near the same time and the contracts are negotiated together, consideration in one contract depends on another contract, or services in one or more contracts are a single performance obligation. For contracts that contain more than one separately identifiable performance obligation, the total transaction price is allocated to the identified performance obligations based upon the relative stand-alone selling prices of the performance obligations. The stand-alone selling prices are based on an observable price for services sold to other comparable clients, when available, or an estimated selling price using a cost-plus margin or residual approach. We estimate the amount of total contract consideration we expect to receive for variable arrangements based on the most likely amount we expect to earn from the arrangement based on the expected quantities of services we expect to provide and the contractual pricing based on those quantities. We only include some or a portion of variable consideration in the transaction price when it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur. We consider the sensitivity of the estimate, our relationship and experience with the client and variable services being performed, the range of possible revenue amounts and the magnitude of the variable consideration to the overall arrangement. Our revenue arrangements do not contain any significant financing element due to the contract terms and the timing between when consideration is received and when the service is provided.

Our arrangements with clients consist principally of four different types of arrangements: 1) subscription-based service agreements; 2) one-time specified services performed at a single point in time; 3) fixed, non-subscription service agreements; and 4) unit-priced service agreements.

Subscription-based services – Services that are provided under subscription-based service agreements are usually for a twelve month period and represent a single promise to stand ready to provide reporting, tools and services throughout the subscription period as requested by the client. These agreements are renewable at the option of the client at the completion of the initial contract term for an agreed upon price increase each year. These agreements represent a series of distinct monthly services that are substantially the same, with the same pattern of transfer to the client as the client receives and consumes the benefits throughout the contract period. Accordingly, subscription services are recognized ratably over the subscription period. Subscription services are typically billed annually in advance but may also be billed on a quarterly and monthly basis.

One-time services – These agreements typically require us to perform a specific one-time service in a particular month. We are entitled to a fixed payment upon completion of the service. Under these arrangements, we recognize revenue at the point in time we complete the service and it is accepted by the client.

Fixed, non-subscription services – These arrangements typically require us to perform an unspecified amount of services for a fixed price during a fixed period of time. Revenues are recognized over time based upon the costs incurred to date in relation to the total estimated contract costs. In determining cost estimates, management uses historical and forecasted cost information which is based on estimated volumes, external and internal costs and other factors necessary in estimating the total costs over the term of the contract. Changes in estimates are accounted for using a cumulative catch up adjustment which could impact the amount and timing of revenue for any period.

Unit-price services – These arrangements typically require us to perform certain services on a periodic basis as requested by the client for a per-unit amount which is typically billed in the month following the performance of the service. Revenue under these arrangements is recognized over the time the services are performed at the per-unit amount.

Revenue is presented net of any sales tax charged to our clients that we are required to remit to taxing authorities. We recognize contract assets or unbilled receivables related to revenue recognized for services completed but not invoiced to the clients. Unbilled receivables are classified as receivables when we have an unconditional right to contract consideration. A contract liability is recognized as deferred revenue when we invoice clients in advance of performing the related services under the terms of a contract. Deferred revenue is recognized as revenue when we have satisfied the related performance obligation.  

Deferred Contract Costs

Deferred contract costs, net is stated at gross deferred costs less accumulated amortization. We defer commissions and incentives, including payroll taxes, if they are incremental and recoverable costs of obtaining a renewable client contract. Deferred contract costs are amortized over the estimated term of the contract, including renewals, which generally ranges from three to five years. The contract term was estimated by considering factors such as historical client attrition rates and product life. The amortization period is adjusted for significant changes in the estimated remaining term of a contract.  An impairment of deferred contract costs is recognized when the unamortized balance of deferred contract costs exceeds the remaining amount of consideration we expect to receive net of the expected future costs directly related to providing those services.  We have elected the practical expedient to expense contract costs when incurred for any nonrenewable contracts with a term of one year or less. We deferred incremental costs of obtaining a contract of $717,000 and $1.0 million in the three months ended September 30, 2020 and 2019, respectively. The company deferred incremental costs of obtaining a contract of $2.9 million and $1.8 million in the nine-month periods ended September 30, 2020 and 2019, respectively. Deferred contract costs, net of accumulated amortization was $4.5 million and $4.2 million at September 30, 2020 and December 31, 2019, respectively. Total amortization by expense classification for the three and nine-months ended September 30, 2020 and 2019 was as follows:

Additional expense included in selling, general and administrative expenses for impairment of costs capitalized due to lost clients was $20,000 and $1,000 for the three months ended September 30, 2020 and 2019, respectively and $25,000 and $22,000 in the nine months ended September 30, 2020 and 2019, respectively.

Trade Accounts Receivable

Trade accounts receivable are recorded at the invoiced amount. Effective January 1, 2020, we adopted Accounting Standards Update (“ASU”) 2016-13,Measurement of Credit Losses on Financial Instruments. This ASU requires the measurement of all expected credit losses for financial assets, including trade receivables, held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The adoption of this standard did not have an impact on our condensed consolidated financial statements. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable, determined based on our historical write-off experience, current economic conditions and reasonable and supportable forecasts about the future. We review the allowance for doubtful accounts monthly. Account balances are charged off against the allowance after all means of collection have been made from noncurrent deferred income taxesexhausted and the potential for recovery is considered remote. The COVID-19 pandemic has resulted in an increase in accounts receivables as some clients have delayed payments or are slower paying due to other noncurrent liabilitiessuch clients’ cash-flow issues.

The following table provides the activity in the 2016 condensedallowance for doubtful accounts for the nine months ended September 30, 2020 and 2019 (In thousands):

Leases

We determine whether a lease is included in an agreement at inception. Operating lease ROU assets are included in operating lease right-of-use assets in our consolidated balance sheetsheet. Finance lease assets are included in property and equipment. Operating and finance lease liabilities are included in other current liabilities and other long term liabilities. Certain lease arrangements may include options to extend or terminate the lease. We include these provisions in the ROU and lease liabilities only when it is reasonably certain that we will exercise that option. Lease expense for operating lease payments is recognized on a straight-line basis over the lease term and is included in direct expenses and selling, general and administrative expenses. Our lease agreements do not contain any residual value guarantees.

ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments during the lease term. ROU assets and lease liabilities are recorded at lease commencement based on the estimated present value of lease payments. Because the unrecognized tax benefits relatedrate of interest implicit in each lease is not readily determinable, we use our estimated incremental collateralized borrowing rate at lease commencement, to state taxes grosscalculate the present value of federal tax benefits, consistentlease payments. When determining the appropriate incremental borrowing rate, we consider our available credit facilities, recently issued debt and public interest rate information.

We elected the practical expedient to account for lease and non-lease components as a single lease component for all asset classifications. We have also made a policy election to not record short-term leases with a duration of 12 months or less on the balance sheet.

Implementation Costs of Hosting Arrangements

When a software license is included in a cloud computing arrangement and we have the legal right, ability and feasibility to download the software, it is accounted for as software, included in property and equipment, and amortized. If a software license is not included or we do not have the ability or feasibility to download software included in a cloud computing arrangement, it is accounted for as a service contract, which is expensed to direct expenses or selling, general and administrative expenses during the service period. Effective January 1, 2020, we prospectively adopted ASU 2018-15, Intangibles-Goodwill and Other-Internal Use Software (Subtopic 350-40). This ASU aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the 2017requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal use software license). The adoption did not significantly impact our results of operations and financial statement presentation. There was no impact on the previously reported net income and earnings per share.position.

Fair Value Measurements

The Company’sOur 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’sour market assumptions. The inputs are then classified into the following hierarchy: (1)(1) Level 1 Inputs—quoted prices in active markets for identical assets and liabilities; (2)(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)(3) Level 3 Inputs—unobservable inputs.

Commercial paper and Eurodollar deposits are included in cash equivalents and are valued at amortized cost, which approximates fair value due to their short-term nature. Eurodollar deposits are United States dollars deposited in a foreign bank branch of a United States bank and have daily liquidity. Both of these are included as a Level 2 measurement in the table below.

The following details the Company’sour financial assets and liabilities within the fair value hierarchy at September 30, 2017 2020 and December 31, 2016:2019:

There were no transfers between levels during the three-month period ended September 30, 2020.

Fair Values Measured on a Recurring Basis

The Company’sOur long-term debt described in Note 4 is recorded at historical cost. The following arefair value of long-term debt is classified in Level 2 of the carrying amountsfair value hierarchy and was estimated fair values, using a Level 2 discounted cash flow analysis based primarily on estimated current rates available for debt of the same remaining duration and adjusted for nonperformance and credit risk:credit. The following are the carrying amount and estimated fair values of long-term debt:

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. Long-livedvalue. All non-financial assets that are not recognized or disclosed at fair value in the financial statements on a recurring basis, which includes ROU assets, property and equipment, goodwill, intangibles and cost method investments, are measured at fair value in certain circumstances (for example, when there is evidence of impairment). As of September 30, 2017, 2020, and December 31, 2016, 2019, there was no indication of impairment related to these assets.

Annually, we consider whether the recorded goodwill and indefinite lived intangibles have been impaired. However, goodwill and intangibles must be tested between annual tests if an event occurs or circumstances change to indicate that it is more likely than not that an impairment loss has been incurred (“triggering event”). We considered the current and expected future economic and market conditions, including the impact of the COVID-19 pandemic, on each of our reporting units. We also assessed our current market capitalization compared to book value, forecasts and margins in our last quantitative impairment testing. We concluded that a triggering event has not occurred which would require an interim impairment test to be performed as it is not more likely than not that an impairment loss has been incurred at September 30, 2020.

Our Canadian reporting unit generates service revenue from a relatively small number of clients with approximately 65.7% of its annual revenue concentrated in one client contract which currently expires in March 2021. While historically we have been successful in renewing or retaining contracts with our clients, should we be unable to or choose not to renew a significant contract, it would likely result in an impairment of goodwill at this reporting unit. The carrying amount of goodwill related to our Canadian reporting unit at September 30, 2020 was $2.3 million.

Commitments and Contingencies

From time to time, we are involved in certain claims and litigation arising in the normal course of business. Management assesses the probability of loss for such contingencies and recognizes a liability when a loss is probable and estimable. Legal fees, net of estimated insurance recoveries, are expensed as incurred. There were no outstanding claims at September 30, 2020.

A sales tax accrual of $775,000 was recorded in 2019 for sales taxes that should have been collected from clients in 2019 and certain previous years. We received a revenue ruling from the state of Washington noting that our services are not subject to retail sales tax, and therefore, reversed $268,000 of sales tax accrual for the state of Washington in the third quarter of 2020. At September 30, 2020, we have completed voluntary disclosure agreements with certain states, remitted past due sales tax, are remitting sales tax timely, are collecting sales tax from clients and no accrual for past due sales tax remains. State and local jurisdictions have differing rules and regulations governing sales, use, and other taxes and these rules and regulations can be complex and subject to varying interpretations that may change over time. As a result, we could face the possibility of tax assessment and audits, and our liability for these taxes and associated interest and penalties could exceed our original estimates.

We received $2.4 million in insurance recoveries in the nine-month period ended September 30, 2020, and $400,000 was paid directly to certain vendors from the insurer related to the February incident. These were recorded in selling general and administrative expenses. In the three-months ended September 30, 2020, we recorded an additional insurance recoverable of $913,000 from the February incident for the final insurance loss claim. Of this amount, we expect $866,000 to be reimbursed directly to us and the remainder to be paid to certain vendors. We recorded $533,000, representing reimbursement for lost revenues, as insurance recoveries, and the remainder as a reduction to operating expenses. We expect to receive the insurance proceeds in the three-month period ended December 31, 2020. Due to insurance recoveries, the February incident did not have a significant impact on our consolidated financial statements.

Recent Accounting Pronouncements Not Yet Adopted

In December 2019, the FASB issued ASU 2019-12, Simplifying the Accounting for Income Taxes (Topic 740). Among other clarifications and simplifications related to income tax accounting, this ASU simplifies the accounting for income taxes by eliminating certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, hybrid taxes and the recognition of deferred tax liabilities for outside basis differences.  The guidance is effective for fiscal years beginning after December 15, 2020 and interim periods within those fiscal years.  Early adoption is permitted in interim or annual periods with any adjustments reflected as of the beginning of the annual period that includes that interim period.  Additionally, entities that elect early adoption must adopt all the amendments in the same period.  Amendments are to be applied prospectively, except for certain amendments that are to be applied either retrospectively or with a modified retrospective approach through a cumulative effect adjustment recorded to retained earnings.  We believe the adoption will not significantly impact our results of operations and financial position.

In March 2020, FASB issued ASU No.2020-04, "Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting", which provides optional expedients and exceptions for applying generally accepted accounting principles (GAAP) to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met. The amendments apply only to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued because of reference rate reform. The amendments are effective for all entities as of March 12, 2020 through December 31, 2022. We expect to apply the optional expedient for contract modification to account for the change in the reference rate on impacted credit facilities prospectively by adjusting the effective interest rate.

The following table disaggregates revenue for the three and nine-month periods ending September 30, 2020 and 2019 based on timing of revenue recognition (in thousands):

Our solutions within the digital VoC platform accounted for 74.0% and 63.8% of total revenue, in the three-month periods ending September 30, 2020 and 2019, respectively, and 72.0% and 61.3% of total revenue in the nine-month periods ending September 30, 2020 and 2019, respectively. The remaining revenue consists of legacy Experience and Governance Solutions.  

The following table provides information about receivables, contract assets, and contract liabilities from contracts with clients (In thousands):

Significant changes in contract assets and contract liabilities during the nine-months ended September 30, 2020 and 2019 are as follows (in thousands): 

We applied the practical expedient to not disclose the value of unsatisfied performance obligations for contracts with an original expected length of one year or less. Total remaining contract revenue for contracts with original duration of greater than one year expected to be recognized in the future related to performance obligations that are unsatisfied at September 30, 2020 approximated $124,000, of which $51,000 and $73,000 are expected to be recognized during 2020 and 2021, respectively.

The effective tax rate for the three-monththree-month period ended September 30, 2017 2020 increased to 42.1%17.9% compared to 35.3%17.2% for the same period in 2016 mainly2019 primarily due to $384,000 of additional tax expense from non-deductible proposed recapitalization expenses (see Note 9).higher state income taxes since we are filing in more states. The effective tax rate for the nine-monthnine-month period ended September 30, 2017 increased2020 decreased to 35.9%8.1% compared to 33.8%18.7% for the same period in 2016. The increase in2019 primarily from the effective tax rate for the nine-month period ended September 30, 2017 was primarily due to $384,000exercise and vesting of additional tax expense from non-deductible proposed recapitalization expenses, increases in the estimated state tax rates as well as a greater proportion of United States income subject to higher tax rates than Canadian income. The Company also had reduced tax expense in 2016 of $105,000 from United States federal tax examination adjustments, net of interest and penalties, and state tax return adjustments decreasing tax expense.  These areshared-based compensation awards partially offset by increasedhigher state income taxes.

In March 27, 2020, the U.S. federal government enacted the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The CARES Act is an emergency economic stimulus package in response to the coronavirus outbreak which, among other things, contains numerous income tax benefitsprovisions. As a result of $149,000 in 2017the CARES Act, we have deferred $800,000 of employer social security tax payments into future years. We have had no other impacts to our consolidated financial statements or related disclosures from the exercise of options and dividends paid to non-vested shareholders. CARES Act.

The Company’sOur long-term debt consists of the following:  

Our credit agreement (the “Credit Agreement”) with First National Bank of Omaha (“FNB”) was amended and restated on May 28, 2020 and includes (i) a $30,000,000 revolving credit facility (the “Line of Credit”), (ii) a $33,002,069 term note is payable in monthly installmentsloan (the “Term Loan”) and (iii) a $15,000,000 delayed draw-dawn term facility (the “Delayed Draw Term Loan” and, together with the Line of $212,468. Borrowings underCredit and the term note bear interest at an annual rate of 3.12%Term Loan, the “Credit Facilities”). The outstanding balanceDelayed Draw Term Loan may be used to fund any permitted future business acquisitions or repurchases of our Common Stock and the term note at September 30, 2017 was $1.7 million.Line of Credit can be used to fund ongoing working capital needs and for other general corporate purposes. The amendment increased the Line of Credit from $15,000,000 to $30,000,000.

The Company also has a revolving credit note which was amended and extended effective June 30, 2017 Term Loan revised the remaining payments for the existing balance outstanding of $33,002,069 to monthly installments of $462,988 through May 2025, with a balloon payment due at maturity datein May 2025. The Term Loan bears interest at a fixed rate per annum of June 30, 2018. The maximum aggregate amount available under the revolving credit note is $12.0 million. 5%.