Pre-Paid Legal Services

Presented by:

Vincent, Yuting, Mary, Shaoying, and Feny

Agenda

Business Model Strategy Analysis Firm Analysis Analyst Concern Financial Statement Adjustment Summary Alternative What Happened Next

Business Model

Provider of Legal Insurance Plans Legal expense reimbursements Will and testament preparation Document review and letter writing Employment-related trial defense Traffic violation defense Internal revenue service audits

Business Model

Revenue Generation Sale of legal insurance memberships

1998, premiums at $19.08 per month ($229 per year)

Premiums paid monthly Member sales associate program and training Legal Services

Open Panel: members use own attorney Closed Panel: members use attorneys who are

under contract with PPLS

Business Model

Member Sales Associate Program Members became part of sales force Commission based compensation

Pior to 1995, 70% of first year premium and 16% for subsequent year renewals

After 1995, flat 25% of annual premium, advanced 3 years commission on every new membership

If membership cancelled before advances recovered, PPLS deducts 50% of unearned advances from future commissions

Business StrategyPorter’s 5 Forces

Rivalry Among Existing Firms Growing Insurance Industry

Expect significant increase in competition Higher concentration of firms offering similar products and

services Customers can easily switch to other firms at low cost Economies achieved through increasing number of

participants in membership sales associate program (increasing number of new memberships)

Increasing demand for legal insurance met with increase capacity of sales force through membership associate program

Expect increase difficulty in maintaining growth as insurance industry begins to saturate

Business Strategy

Threat of New Entrants Expected threat is medium, considering the need for

significant capital resources required in case of premium payouts

Threat may be growing as more financial institutions are becoming more involved and interested in the insurance sector as an additional revenue source

PPLS enjoys first mover advantage, and hence better brand awareness to its potential customers

Due to the nature of legal services, new entrants requires access to legal experts which may not be readily available (meanwhile PPLS has access to highly rated legal firms in each of its 36 major markets)

Business Strategy

Threat of Substitute Products Pricing and performance of products offered

cannot be compared due to lack of information, but price competition is likely to increase as industry players increases

Based on current markets, customers’ willingness to switch to substitute insurance providers based on premium costs alone is high (no sense of customer loyalty in this industry)

Business Strategy

Bargaining Power of Buyers Since cost of switching is low, bargaining power of

buyers is relatively high As the number of competing firms grows with the

industry, more substitutes are available to customers Quality of service is relatively important especially for

those members who choose to use PPLS contracted attorneys

Volume of memberships purchased on an individual basis is expected to be low, therefore potential members would be more picky

Business Strategy

Bargaining Power of Suppliers Main supplier of services would be PPLS contracted

attorneys Bargaining power is expected to be medium to high

since attorneys are industry experts and highly rated With growth of the industry, legal service providers

have access to more firms to generate revenue Highly rated legal firms are expected to be relatively

less compared to common legal service providers Quality and brand image is important to the legal

service providers as it affects their own professional image when acting on behalf of the contracting firm

Business Strategy

Porter’s Analysis Conclusions

Future growth potential in questionable considering the saturated market

Despite previous rapid growth, increasing competition will negatively affect potential future profitability since PPLS does not seem to have a competitive advantage

Continued profitability is largely dependent on PPLS’s ability to sustain membership renewals

Profitability outlook heavily relies on management estimates of membership growth and renewals

Business StrategySWOT Analysis

Strengths High capacity of sales force through its membership

sales associate program Access to highly rated legal firms for its markets

Weaknesses Negative image portrayed by some analysts in

regards to its accounting practices (commission advance) resulting in persistent short selling of the company’s stock

Resultant fluctuation of the company’s stock price Profitability outlook relies heavily on management’s

estimates of new memberships and membership renewals

Business Strategy Opportunities

Growing insurance industry (but saturating) Increasing popularity of legal service insurance Potential partnerships and market access through mergers with

larger market players and financial institutionsPossibility for economies of scale and scope through employment of

new technological tools (EDI, Internet payment, database and enterprise content management applications)

Threats Increase competition from other market players as market

saturates Market for legal insurance may become unpopular and reduce

demand for such products and services SEC’s opposition to PPLS’s accounting method may further

affect its stock performance and future profitability outlook

Business Strategy

SWOT Analysis Conclusions

Access to a large sales team and highly rated legal firms gives PPLS capacity for growth and sustaining memberships through quality service

Future outlook may be relies heavily on management estimates of memberships

Growing market is saturating, may reduce future growth potential

SEC opposition may force PPLS to change accounting methods, affecting its profitability outlook to the public and potential investors

Financial Performance

After Changed the commission policy: Membership revenue average growth is 59% Net income growth is 71% Operating cash flow growth rate is 500%

Consistent earning growth in line with Wall Street estimation (projected 36%)

Strong buy recommendation on the stock (stock price target: from $26 to $34)

Ratio Analysis

1997 1998Profi tabi l i ty Rati os:Return on Assets: 0. 17 0. 18Return on Equi ty: 0. 25 0. 30Net I ncome Margi n: 0. 13 0. 19Asset Turnover: 1. 26 0. 96Li qui di ty Rati os:Current rati o: 2. 78 1. 68Worki ng Capi tal (000): $34, 783 $21, 180Stabi l i ty Rati os:Debt to Equi ty: 0. 52 0. 66Equi ty to Assets: 0. 66 0. 60

Key Success Factors

Membership benefit rate (33% current; 35% future)

Committed sales force (76% of 98’sales from 150,000 sale associates)

Arrangements with insurance and service companies (24% of 98’sales)

Accounting Issue

PPLS advance the sale associate 3 years of commission on every new membership

The advanced commission was capitalized and amortized into three years

Deferred expense recognition related to commission advances made its earning growth look stronger in the early years

Capitalization Method

Matching principle Conservative with stable Retention rate

Year Beginning

(1)

Sign up

(2)

Projected

(3)

Active

(4)

Retention

(4)/(3)

1996 203,535 194,483 398,018 294,151 0.74

1997 294,151 283,723 577,874 425,381 0.74

1998 425,381 391,827 817,208 603,017 0.74

Capitalization Method

Decrease in commission advance un-collectable rate

Year Allowance (1) (Million)

Commission Advance,

Current portion

(2) (Million)

Commission Advances, Net (3)

(Million)

Total (4)

(2)+(3)

(Million)

Un-collectable rate (1)/(4)

1997 $3.7 $15.705 $38.038 $53.743 6.89%

1998 $4.0 $21.224 $60.661 $81.885 4.88%

Analyst Concerns

Can PPLS estimate the performance in the future economic activity? Membership retention rate Advanced commission collectable rate

PPLS did not disclose enough information in the financial statement about how to measure and control the risks

Immediately expense may be the suitable accounting method to record the advanced commission

Expense Method

Higher risk in the future associated with significantly increase in new members

I ncrease rateYear Begi n Members I ncrease i n Year1996 203535

90616 47%1997 294151

131230 46%1998 425381

Based on Begi nni ng Members Onl y

Expense Method

Why PPLS changed the commission policy?

Is the previous cancellation rate too high?

Assume purpose: to retain the memberships

Expense Method

Big write-off possibility because of the significant increase in new contract sales

An upward trend of cancellation rate from SEC filings

Large portion of sales from sales associates (76%) Uncertain for the future revenue Increase the un-collectable risk

Expense Method

Commission as a large portion in the total asset

Year Commission Advance (1)

Total Asset (2) Portion of Asset

(1) / (2)

1997 $53,743 $105,716 51%

1998 $81,885 $167,903 49%

Cash Flows

Year 1 Year 2 Year 3 Total

Members 1,000 750

(1000* 0.75)

562.5

(750*0.75)

Premiums 228,000

(19*12*1000)

171,000

(19*12*750)

128,250

(19*12*562.5)

527,250

Commission paid

(171,000) (228,000*0.25*3)

(171,000)

Recovered Commission

10,000 4,000 14,000

Cash Flow 57,000 181,000 132,250 370,250

Immediate Expensing of Commission Advances

Year 1 Year 2 Year 3 Total

Revenues 228,000 171,000 128,250 527,250

Commission Expense

(171,000) 0 0 (171,000)

Expensed Commission Recovery

14,000

(10,000+4,000)

14,000

Operating Income

71,000 171,000 128,250 370,250

Straight-line Amortization of Commissions

Year 1 Year 2 Year 3 Total

Revenues 228,000 171,000 128,250 527,250

Commission Expense

(171,000/3)

(57,000) (57,000) (57,000) (171,000)

Expensed Commission

Recovery

(10,000+4,000)/3

4,666 4,667 4,667 14,000

Operating Income 175,666 118,667 75,917 370,250

Accounting Treatment of Commissions

Balance Sheet Income Statement

Cash+ Commission Advance +

Other Assets =

Liabilities +

R/E Revenue -

Expense =

NI

Immediate expensing of Commission

Year 1 -171,000 -171,000 +171,000 -171,000

Year 2 0 0 0 0

Year 3 0 0 0 0

Straight-Line Amortization of Commissions

Year 1 -171,000 171,000

-57,000

-57,000 57,000 -57,000

Year 2 -57,000 -57,000 57,000 -57,000

Year 3 -57,000 -57,000 57,000 -57,000

Accounting Adjustment to Financial Statements

Balance Sheet Income Statement

Cash+ Commission Advance +

Other Assets =

Liabilities +

R/E Revenue -

Expense = NI

1996 -18,381 -18,381 +18,381 -18,381

1997 -18,381(1996)

-22,891

-18,381

-22,841

+22,881 -22,891

1998 -18,381(1996)

-22,891(1997)

-28,142(1998)

-18,381

-22,891

-28,142

+28,142 -28,142

Impact to the Net Income

($000) Dec 31,1998 Dec 31,1997 Dec 31,1996

Revenues 160,453 133,404 85,634

Costs & Expense 119,121 103,500 69.514

Income before tax 41,332 29,904 16,120

Provision for income taxes

11,122 12,381 5,857

Net Income 30,210 17,523 10,263

Less: Dividend on PS 10 13 15

Net Income applicable to common Stockholders

30,200 17,510 10,248

Adjusted (28,142) (22,891) (18,381)

Adjusted NI 2,068 (5,381) (8,133)

Financial Information Summary

Year ended December 31

Capitalization Expense

(in $000) 1998 1997 1998 1997 1996

Membership revenues 110,003 76,688 110,003 76,688 50,582

Expenses 119,121 103,500 147,263 126,391 87,895

Net income 30,210 17523 2,068 (5,368) (8133)

Cash from operations 9,895 14,472 9,895 14,472 (911)

Total assets 167,903 105,716 98,489 64,444

Book value of equity 101,304 69,470 31,890 28,198

Current Assets 52,261 54,320 24,119 31,429

Financial Performance Comparison

Growth Rati os: 1997 Adj usted 1998 Adj ustedProfi tabi l i ty Rati os:Return on Assets: 0. 17 -0. 08 0. 18 0. 02Return on Equi ty: 0. 25 -0. 19 0. 30 0. 06Net I ncome Margi n: 0. 13 -0. 04 0. 19 0. 01Asset Turnover: 1. 26 2. 07 0. 96 1. 63Li qui di ty Rati os:Current rati o: 2. 78 1. 61 1. 68 0. 78Worki ng Capi tal (000): $34, 783 $11, 892 $21, 180 -$6, 962Stabi l i ty Rati os:Debt to Equi ty: 0. 52 1. 29 0. 66 2. 09Equi ty to Assets: 0. 66 0. 44 0. 60 0. 32

Class Discussion

Based on what we have reviewed: Consider which method is more effective? What are the risks need for consideration? Should PPLS consider to restructure their

business model?

Summary

Capitalized Method Expensing Method

Capitalize the commission advance and amortize it into three year”

All commission are expensed when paid. No asset “membership commission advances” exists on balance sheet

Based on matching and conservative principle (amortization)

May face a big write off if management’ estimate false

No write off

Current operating income higher than subsequent years

Current operating income is lowest than subsequent years

Operating profit over 3 years has no impact

Operating profit over 3 years has no impact

Method to Consider

Capitalized method when: Support large loss reserves for insurance

companies Management able to predict future correctly On track with matching and conservative Accountant choice

Consideration: When management can estimate revenue using

the renewal (based on commission)

Method to Consider

Expensing method when: Contingencies of future revenue Capture business reality in an unbiased

manner Stock performance stability Financial analyst choice

Consideration: When management unable to predict future

revenue

Alternative & Consideration

Restructure their business model Change their commission policy Buying back the stocks Privatize the company

High cash flow Lender

What Happened Next?

Year End 2000 By year end, PPLS changed to a more conservative method for

estimating unrecoverable commissions for terminated sales associates

Reduced beginning retained earnings by $4.1 Million and 2000 earnings by $3.1 Million

Early 2001 PPLS was sued by shareholders for misleading accounting for

commission advances SEC investigates PPLS’s accounting practices, and advises

PPLS that their accounting practice is not consistent with GAAP PPLS repurchases 2 Million shares and announces further

repurchase of 0.5 Million shares PPLS appeals and SEC announces that PPLS must restate its

prior years financials to expense commission outlays

What Happened Next?

Mid 2001 Reaffirmation by SEC resulted in additional

suits against PPLS’s management for causing PPLS to violate GAAP

Deloitte & Touche resign from audit and indicated that they disagree with SEC ruling to expense commissions as paid

PPLS hires Grant Thorton as the new auditors in replacement of Deloitte & Touche

Question?