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Pre- Paid Legal Tingting Pan

Services, Inc Tianmiao Pang

Leda Pires

Songhua Qi
Agenda
Business Description and services provided

Financial Analysis

Answers to questions 1- 5

Questions?
COMPANYS 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


Premium Membership
Premium membership
Business Description
Family plan
- Provided reimbursement for various legal expenses incurred by
members 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.
- 25% discount on attorneys rates for the purchase of extra legal
services above the ones established on the contract.
- Specified number of attorney hours that a member was entitled to
receive these services.
- 94% of all memberships in 1998
Business Description
Membership premium
- 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 premiums 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 support services.
- Sales associates sold companys 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 membership lapsed before the advances had been recovered, PPLS
deducted 50% of unearned services from future commissions to the sales associate.
Legal Services Provided
Open panel memberships Closed panel memberships

- Allowed members to use - Members access legal services


their own attorney to provide through a network of independent
legal services available under attorneys that were under contract
their policy. with PPLS (selected my
management).
- Members attorneys were
reimbursed for their services - Provided attorneys were paid a
using a payments schedule fixed monthly fee on a per capita
that reflected usual, basis to provide services to plan
reasonable and customary members living within the state in
fees for a particular service which the attorney was licensed to
and geographic area. 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.
Fortunes article
States that company was using an inappropriate method
of accounting for sales commissions.
Pre-paid spreads commissions to 3-year period make
todays earnings grown look stronger than it is.
If cancellation policy increase, it cant 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.
PPLSs accounting for commissions is
unrealistic and not in accordance with
economic reality.
Financial Analysis
Year 1996 Year 1997 Year 1998
Membership
Premium 50,582 76,688 110,003
Revenue revenues
Net Income 10,263 17,523 30,210 increased by
Operating Cash (911) 14,472 9,895 52% in 1997 and
Flows 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 Membership
Persistency Rate and Sales Compensation Program.
Financial Analysis
1995 1996 1997 1998

Membership premium 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


Membership premium 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
Premium 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
PPLS stopped writing
cancels it before three
down the advances
years
The commission advances are essentially loans
A decreasing incentive for associates to sell new
memberships
Difficult for PPLS to recover commission advances
PPLS misrepresent its ability to collect charge-
backs
Overstate assets, net income, and stockholders
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 members through family plan or membership premiums.
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
premiums and cash outflows for commissions for years 1 to 3 that
would arise from the sign-up of 1,000 new members 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

Members 1000 75% renewal: 750 563

Inflows:premiums $229,000 $171,750 $128,927

Inflows: 0 (1000- (750-


Recovered 750)*229*0.25*0.5* 563)*229*0.25*0.5
commission 2*0.75= *0.75=
$10734.38 $4014.66

Outflows: 229,000*25%*3= 0 0
Post 1995 flat 25% $171,750
commission rate

Net Flows $57,250 $171,750 $128,812.5


How does PPLS account for transactions described above in question
2? Set up Commission Advance (gross), Commission Expense,
Allowance, and Cash T accounts, and trace the flows in and out of these
accounts 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 Fortunes criticism of PPLSs 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 Fortunes criticism:
1. PPLSs method spreads the commissions out over a three-year period
=>makes earnings growth look stronger
2. PPLSs method assumes that most of the new members will continue to
renew their contract (cancellation rate => not appropriate)
3. PPLS may not recover the commissions

1998 1997 1996 1998 1997 1996

Commissions Expenses 28,142 22,891 18,381 Commissions Expenses 24,261 16,717 11,476

Net Income 27,373 13,905 5,867 Net Income 30,210 17,523 10,263

Earnings Per Share $1.17 $0.60 $0.26 Earnings Per Share $1.29 $0.76 $0.46

Expensed all commissions immediately PPLSs method


What actions could PPLSs management take to reduce the
unease among key investors about the firms accounting policies
and its business model?

Question 5
1. Try to enhance the persistency rate of its
memberships and reduce the high cancellation rate.
(eg. carefully check the members profile before
signing contract).

2. Estimate cancellation rate and collection risks.

3. Disclosure the risk and rate of the situation in the


footnotes.
Questions?