Ac714- Pre Paid Legal Services 6y96d

Pre- Paid Legal Services, Inc

Tingting Pan Tianmiao Pang Leda Pires Songhua Qi

Agenda Business Description and services provided Financial Analysis Answers to questions 1- 5 Questions?

COMPANY’S MISSION

Pre- paid Legal plans are designed to help middle-income Americans have affordable access to quality legal assistance.

Business Description ● Founded in 1972 by Harland C. Stonecipher ● Sold legal expense insurance that provided for partial payment of legal fees in connection with the defense of certain criminal and civil actions. ● Went public in 1979 ● Grow rapidly throughout the 1980s ● Went to the New York Stock Exchange in 1999

Number of subscribers to legal service plans in the US from 1981 to 1997

What PPLS mainly offered?

Family plan

Multi-level program Multi-level program hip hip

Business Description Family plan -

Provided reimbursement for various legal expenses incurred by and their spouses (will and testament preparation, document review, letter writing, legal cost associated with employment-related trial defense, traffic violations, and Internal Revenue services audits.

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25% discount on attorneys rates for the purchase of extra legal services above the ones established on the contract.

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Specified number of attorney hours that a member was entitled to receive these services.

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94% of all hips in 1998

Business Description hip - In 1998 averaged $19.08 per month or $229 per year - Paid typically on monthly basis by automatic credit card charges or employee payroll deductions. - Guaranteed renewable and non-cancelable except for fraud, nonpayment of s or upon written request by a member.

Business Description Multi-level program - Encouraged buyers to become sales people. - Payment fee of $65 to become sales associate to cover training material, meetings and home office services. - Sales associates sold company’s services to their friends and family, and maybe created their own sales force. - Sales associates were compensated on a commission basis. - They changed their commission formula after 1995.

Summary: Commissions rates and timing of Payment for PPLS

Note: If hip lapsed before the advances had been recovered, PPLS deducted 50% of unearned services from future commissions to the sales associate.

Legal Services Provided Open hips

Closed hips

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Allowed to use their own attorney to provide legal services available under their policy.

- access legal services through a network of independent attorneys that were under contract with PPLS (selected my management).

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Member’s attorneys were reimbursed for their services using a payments schedule that reflected “usual, reasonable and customary fees” for a particular service and geographic area.

- Provided attorneys were paid a fixed monthly fee on a per capita basis to provide services to plan living within the state in which the attorney was licensed to practice.

Overall Financial View Strong financial performance and rapidly growth. Highly recommended among US equity analysts from 1997 to mid-1999. In 1999 its market capitalization reached $738 million, representing an increase of 101% over the previous year.

Fortune’s article ● States that company was using an inappropriate method of ing for sales commissions. ● Pre-paid spreads commissions to 3-year period make today’s earnings grown look stronger than it is. ● If cancellation policy increase, it can’t recover the commission it has already paid. ● Persistent short selling of the stocks. ● As a result of this uncertainty, stock price fluctuated from $40.50 to $13.50 through 1997 and mid-1999.

Financial Analysis On March 18, 1999, Pre-Paid filed its Form 10-K with the SEC for the year ended December 31, 1998. From a cash flow standpoint, the company just cannot handle the growth. PPLS’s ing for commissions is unrealistic and not in accordance with economic reality.

Financial Analysis Year 1996

Year 1997

Year 1998

Revenue

50,582

76,688

110,003

Net Income

10,263

17,523

30,210

(911)

14,472

9,895

Operating Cash Flows

• hip revenues increased by 52% in 1997 and 43% in 1998 • Net income increased by an average of 71% per year • Operating cash flows could not handle the growth

Financial Analysis --Sales generation

The major factors affecting the Company's profitability and cash flow are its hip Persistency Rate and Sales Compensation Program.

Financial Analysis 1995

1996

1997

1998

hip

31,290

50,582

76,688

110,003

Commission advances--current

3,923

9,108

15,705

21,224

Commission advances, net

8,548

21,744

38,038

60,661

Growth Rate

1996

1997

1998

hip

62%

52%

43%

Commission advances--current

132%

72%

35%

Commission advances, net

154%

75%

59%

PPLS' s commission advances were increasing faster than revenue.

Financial Analysis --Sales Commission Program Sales Compensation Program (effective in 1995)

Financial Analysis --Sales Compensation Program Revenue: $229 Advanced Commission:$172 (3 X 25% X $229) Wrote down 1/3 of the commission advances on its balance sheet each year that a policy was in force

Financial Analysis --Sales Compensation Program If the customer cancels it before three years

PPLS stopped writing down the advances

• The commission advances are essentially loans • A decreasing incentive for associates to sell new hips • Difficult for PPLS to recover commission advances • PPLS misrepresent its ability to collect “chargebacks” • Overstate assets, net income, and stockholder’s equity

Financial Analysis PPLS overstated its earnings through improper capitalization of current expenses and failure to write off uncollectible receivables

How does Pre-Paid Legal Services (PPLS) create value for its customers? What are the critical risks that it has to manage well?

Question 1

● Offering a wide range of legal expenses insurance incurred by through family plan or hip s. ● Multi-level program that encouraged buyers to become salespeople (commissions as incentives). Critical risks: ● Too much dependence on associates ● Management lags ● Brand maintenance ● Uncollectible risk

Based on the post-1995 commission formula and information in the case on pricing and commission rates, calculate the cash inflows for s and cash outflows for commissions for years 1 to 3 that would arise from the of 1,000 new at the beginning of year 1. Assume that: (a) actual member renewal rates are 75% for both years 2 and 3, and (b) 25% of recoverable commission advances in each of the years 2 and 3 are expected to prove uncollectible.

Question 2

Cash Flows

Year 1

Year 2

Year 3



1000

75% renewal: 750

563

Inflows:s

$229,000

$171,750

$128,927

Inflows: Recovered commission

0

(1000750)*229*0.25*0.5* 2*0.75= $10734.38

(750563)*229*0.25*0.5 *0.75= $4014.66

Outflows: Post 1995 flat 25% commission rate

229,000*25%*3= $171,750

0

0

Net Flows

$57,250

$171,750

$128,812.5

How does PPLS for transactions described above in question 2? Set up Commission Advance (gross), Commission Expense, Allowance, and Cash T s, and trace the flows in and out of these s for years 1 to 3. (use an appendix.) Compare the net income to the cash flows calculated in the question above and discuss the reason for differences and the potential issues that may arise.

Question 3

Do you agree with Fortune’s criticism of PPLS’s method for reporting commissions? Why or why not? Compute the net income and EPS effect if PPLS expensed all commissions immediately for 1996 thru 1998.

Question 4

We agree with Fortune’s criticism: 1. PPLS’s method spreads the commissions out over a three-year period =>makes earnings growth look stronger 2. PPLS’s method assumes that most of the new will continue to renew their contract (cancellation rate ↑ => not appropriate) 3. PPLS may not recover the commissions 1998

1997

1996

Commissions Expenses

28,142

22,891

18,381

Net Income

27,373

13,905

5,867

Net Income

$1.17

$0.60

$0.26

Earnings Per Share

Earnings Per Share

Expensed all commissions immediately

Commissions Expenses

1998

1997

1996

24,261

16,717

11,476

30,210

17,523

10,263

$1.29

$0.76

$0.46

PPLS’s method

What actions could PPLS’s management take to reduce the unease among key investors about the firm’s ing policies and its business model?

Question 5

1. Try to enhance the persistency rate of its hips and reduce the high cancellation rate. (eg. carefully check the member’s profile before g contract). 2. Estimate cancellation rate and collection risks. 3. Disclosure the risk and rate of the situation in the footnotes.

Questions?