Pre-Paid Legal Services Inc. Case Analysis Alen Kokalovski & Tom Thipcharoen

Agenda Background Sales Compensation Programs Business Analysis Analyst’s Views Financial Analysis: Capitalization vs. Expensing Group Discussion Wrap-up

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

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

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%

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?

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

Business Analysis $1 Rev - $0.33 Cost - $0.25 Comm=$0.42 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

Operating Cash Flows

Capitalizing Advances

Expensing Advances

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

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)

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

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

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

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

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

Questions?

PPLS - Now

Assets

Income Statement