Description

Pre-Paid Legal Services, Inc. (PPD) is a poster child for creative accounting. Share price plunged after the SEC questioned its method of accounting for commission advance receivables. The company has changed its accounting method, while appealing the SEC ruling. Even if it loses that fight, Pre-Paid remains a fast-growing, highly profitable, debt-free business that generates lots of cash. The stock is cheap, and, despite its troubles, insiders are buying.

Pre-Paid Legal Services, based in Tulsa, Okla., markets legal expense plans (Memberships), much like medical reimbursement plans. And, like HMOs and PPOs, members can choose from a network of providers or find their own lawyer, though since 1987, almost all memberships have been sold for the former. Basically, for an average $20 monthly fee, the company provides legal services to its members. Memberships averaged $246 a year; that compares to $237 in the same quarter last year. About 33 to 35 percent of the fee goes to provider law firms, 25 percent of the fee over the life of a membership is paid in commission and 10-12 percent pays overhead; pre-tax profit margins are about 30 percent.

The company recently had about 1.1 million members, compared to 890,264 at March 31, 2000, an increase of 25 percent. That’s good growth, but it is down from the fiscal year figure of 28.6 percent growth in 2000, 37.3 percent in 1999 and 41.8 percent in 1993. New membership sales increased 12 percent during the three months ended March 31, rising to 183,712 from 163,341 in the same quarter last year.

Its marketing method is multi-level, similar to Discovery Toys, Amway or Mary Kay Cosmetics. If a salesperson recruits another salesperson, the recruitor gets a piece, too. The company has programs in place to spur “associates” into signing up new members. (Associates to through a training program, then receive an advance commission. The more members they sign up, the more they are compensated. The company reports that associate services revenue increased 63 percent, from $6.2 million to $10.1 million, in the first quarter as compared to the same quarter last year. The associates pay a $184 training fee. In the quarter, 34,286 new associates were signed up, compared with 21,238 for the same period last year.

ACCOUNTING 101, ANYONE?
Pre-Paid has been recording its commission advances to salesmen as an asset on its balance sheet, and it totaled $156.2 million as of September 30. Pre-Paid acknowledges that adopting the SEC’s preferred method, which is to expense commission advances in the first year, its reported earnings for the past two years would be wiped out by half. The company estimates earnings would go from $.60 to $.27 per share for the first quarter of 2001, from $1.92 to 80 cents in fiscal 2000, and from $1.67 to 57 cents in fiscal 1999. Its accountant, which signed off on the past method, is Deloitte & Touche LLP. Obviously, this matter is a weight on the stock, but it is not news, and I believe the share price reflects the problem.

Meanwhile, three high-ranking insiders have been buying shares. Over the last six months, there have been 14 insider purchases, totaling 169,000 shares, 3.5 percent of insider holdings. Between March and April, President Wilburn Smith and Vice President Kathleen Pinson accumulated a combined
20,800 shares of the company, while Chairman Harlan Stonecifer added 10,000
and then another 2,000. In addition, the company also is repurchasing shares. As of April 26, PPD had reacquired 2.5 million shares; another 500,000 shares was recently authorized.

A potential negative: Short interest is high, 44.6 percent of float, as of May. The short ratio is 11.68. However, if the cloud over its accounting method blows away and the company continues to execute, there could be a huge short squeeze. Another negative: A plethora of shareholder lawsuits against both the company and its auditors.

RATIOS AND SUCH
As mentioned, the company has no debt. It’s gross margin for the latest year was 60.15, which compares favorably to its 5-year average of 55.63. Net margin was 19.01 percent, compared to its 5-year average of 16.74. Return on assets clocks in at 21.11, return on investment 26.65 and return on equity 35.27. Pre-Paid generates lots of cash. Cash flow from operations for the latest quarter was $10.8 million, compared with 5.2 million for the first quarter of 2000. Cash flow for fiscal year 2000 was $22 million, for 1999 $17.6 million, and for 1998 $10.9 million.


VALUATION
At its closing price of $20.76 per share on 6/25, Pre-Paid has a price/earnings ratio of 8.50. That’s down considerably from its 2000 high of 23.17 (and below its low P/E that year of 9.45). It is more than 50 percent down in share price from 2000, when it hit 48.75. Price/Book for its most recent quarter is 3.11; price/sales is 1.75. Price to free cash flow is 18.78.

If, as expected, PPD has to restate earnings to satisfy the SEC, the company
is not as cheap by P/E measure. Figuring 27 cents per share (per
company restatement) for the most recent quarter, 43 cents for December 2000
quarter (as restated), then halving estimates for the previous two quarters
totals $1.29 for the trailing twelve months. With PPD at $21.40 as of June
27, that's a P/E of 16.58. Not dirt-cheap but well-below the company's
growth rate. I don't believe any logical person would bet on PPD winning its
appeal of the SEC ruling, so I believe the news is priced into the stock.

Catalyst

A final SEC ruling on accounting should free the company to concentrate on
execution of its business plan. The ruling would remove any lingering
uncertainty about earnings that dragged down the share price. By the way, the stock has been on a tear recently, rising from $16.01 on June 1 to $22.60 on June 27. But with the stock
still near the low end of its 52-week range (10.0400 - 48.7500), there is room to
move higher. In addition, a share repurchase program is ongoing. And, maybe those insiders know something.