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

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

3. 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

4. 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

5. 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%

6. 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?

7. 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

8. 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

9. Operating Cash Flows

10. Capitalizing Advances

11. Expensing Advances

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

13. 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)

14. 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

15. Effects of Expensing Commissions
Accounting Adjustments:
Year Balance Sheet Income Statement
Assets =liabilities + RE Expenses Net Income

16. 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
NI with no adjustment $ $ $10263
adjustments (page 4-56) -$ $ $18381
NI with adjustments $ $ $8133

17. 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

18. 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

19. Questions?

20. PPLS - Now

21. Assets

22. Income Statement