Pre-Paid Legal Services Inc. Case Analysis

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Pre-Paid Legal Services Inc.Case Analysis

• Alen Kokalovski Tom Thipcharoen

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Agenda

• Background
• Sales Compensation Programs
• Business Analysis
• Analysts Views
• Financial Analysis Capitalization vs. Expensing
• Group Discussion
• Wrap-up

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Pre-Paid Legal Background

• Founded in 1972 by Harland Stonecipher
• Company went public in 1979 and grew rapidly as
  many began to subscribe to legal service
  insurance
• In 1999 it began trading on the NYSE and had a
  market Cap of 740 million
• Between 97 and 98, revenue grew by 59, net
  income by 71
• At 1999, PPLS had 648K active members that was
  growing at 40 per year

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Family Plan

• Accounted for 94 of all memberships
• Legal services covered include wills, defense of
  traffic violations, IRS audits employer
  disputes
• Excluded services domestic matters, bankruptcy,
  deliberate criminal acts, business matters,
  alcohol or drug related matters
• Open vs. closed panel memberships
• Premiums 229 per year or 19 per month

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Sales Generation

• 24 sales generated through insurance and service
  companies
• 76 sales generated through existing members who
  become sales associates and are able to earn
  commissions
• Membership persistency was approx. 75

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Compensation Program

• Prior to 1995 sales associates earned 70
  commission of the 1st year and 16 commission for
  subsequent renewals
• After 1995 sales associates earned 25
  commission for the first and subsequent renewals,
  they were advanced commissions for 3 years worth
  of premiums.
• Why did PPLS change commissions policy?

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Mixed Analyst Opinions

• Some Analyst gave strong buy recommendations due
  to consistent earnings growth, ability to
  generate positive cash flows and expectation of
  an alliance with a major insurance company
• Others recommended short selling due to
  inappropriate methods of accounting for
  commissions
• As a result of uncertainty, stock price
  fluctuated from 14 to 41 from 97 to 99

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Business Analysis

• 1 Rev - 0.33 Cost - 0.25 Comm0.42 Profit
• No substitutes other than pay-per-use
• Abundant amount of law firms to choose from
• No brand distinction no threat of backward
  integration
• Sales channels are key to the success of the
  business

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Operating Cash Flows
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Capitalizing Advances
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Expensing Advances
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Group Discussion

• Break up into 2 groups
• Discuss pros and cons to capitalizing vs.
  expensing of commissions

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Arguments For Capitalizing Commissions

• Companies subscription base is their key asset
• Primary activity of company is to manage this
  asset base
• Company can reasonably estimate renewal and
  cancellations
• Better looking numbers on the book (Net Income
  Assets)

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Arguments For Expensing Commissions

• At best, commission advances is an intangible
  asset - dependent on renewal rates, therefore it
  is not guaranteed.
• Concern over whether managers can accurately
  estimate renewals/cancellations
• Defer other expenses tax provision, profit
  sharing

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Effects of Expensing Commissions

• Accounting Adjustments
• Year Balance Sheet Income Statement
• Assets liabilities RE Expenses Net Income
• 1996 -18381 -18381 18381 -18381
• 1997 -22891 -22891 22891 -22891
• 1998 -28142 -28142 28142 -28142

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Effects of Expensing Commissions

• Balance Sheet Effects
• Commission advances on balance sheet represent
  approx.. 50 of the total assets in 1997 and 1998
  
• Income Statement Effects
• Year 1998 1997 1996
• NI with no adjustment 30186 17523 10263
• adjustments (page 4-56) -28142 -22891
  -18381
• NI with adjustments 2058 -5381 -8133

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Red Flags

• of new memberships to total memberships is
  growing lead to lower persistency rate (10-K)
• No disclosure of how commission advances are
  amortized
• No disclosure of how allowance for uncollectible
  advances is calculated
• The allowance for estimated uncollectible
  premiums decreased from 97 to 98

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What Happened?

• In 2000, PPLS changed to more conservative method
  of recognizing commissions
• SEC ruled that estimation was too difficult and
  needed to expensed instead
• Shareholders sued for misleading accounting for
  commission advances
• In 2001, SEC investigation concluded that the
  accounting not consistent with GAAP
• In Aug 2001, Auditors resigned indicating that
  they disagree with SEC ruling

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Questions?
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PPLS - Now
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Assets
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Income Statement