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MagicDiligence (< 20)

Magic Formula Stock Review: Pre-Paid Legal (PPD)

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April 30, 2010 – Comments (6) | RELATED TICKERS: PPD.DL , AVP

Pre-Paid Legal (PPD) offers what amounts to "legal insurance", where customers purchase a membership subscription and in return receive legal coverage for such incidents as traffic violations, trial defense, will preparation, identify theft, and so forth. Memberships are mainly sold to middle income individuals or families, and monthly fees range from about $15-25, with some products, such as the identity theft shield, extra. The company contracts with small legal firms around the U.S. and Canada, usually driving the bulk of business for these firms through customer referrals. This makes the relationships pretty solid, with most of the firms with PPD for over 8 years. Pre-Paid Legal pays these firms a monthly fixed fee that does not change based on the benefits realized by subscribers. This fact eliminates nearly all claims risk that most insurance companies face, making Pre-Paid less of an insurance provider and more of a referral company.

Let's address the positives first. Financially, Pre-Paid Legal's business model is an attractive one. Capital requirements are low for this kind of product, which allows the company to put up nice MFI return on capital (108%) and free cash flow (14% free cash margin) numbers. Management has been generous with this free cash flow, returning it to shareholders by aggressively repurchasing shares over the past 5 years. Shares outstanding have declined at a 6.7% per year clip in that period. Competitively, there are virtually no prepaid legal plan providers that target individual families. Nearly all competitors focus on larger employer groups, creating a nice niche for Pre-Paid to operate in. The company's marketing structure is very low cost and scales up and down naturally with the number of subscriptions sold.

Speaking of the marketing plan though, it's a multi-level marketing (MLM) strategy - also known as a "pyramid scheme". Pre-Paid recruits independent salespeople who sell the product and recruit associates to do the same, earning commissions on both their own and their associate's sales. If you've ever been roped into Amway or Avon (AVP), you know how this works... it usually doesn't! About 98% of its "associates" earn less than $250 per year selling product. As a result, Pre-Paid has to consistently renew its salesperson base, as generally over half of it turns over every year. While this leads to new one-time enrollment fee payments for new salespeople, it also leads to a lot of inexperienced and unqualified people hawking the product. This turns prospective customers off to the company and creates a bad reputation.

Scour Google and you will find no shortage of complaints against the company (here for starters). It's not just the obnoxious MLM marketing, either. At least Amway and Avon have respected products. Pre-Paid's legal coverages are fairly narrow. Hours covered in pre-trial expenses are anemic, usually less than 3 hours, with the rest fully payable by the member. Alcohol related vehicle incidents, a rather common occurrence, are not covered at all. IRS audit protection and will preparation coverage are both of little value; audit protection is usually provided by tax prep firms, and will creation can be easily done using computer software. I just don't see much value in these memberships. Few individuals or families will face a need for these protections in any given year.

Recently, the company has run into even more problems. The FTC and SEC are currently investigating the company. The FTC is concerned with the issues outlined above regarding the product and treatment of associates. The SEC is investigating the company's stock repurchase plan, which as mentioned above is very aggressive. One concern here is that Pre-Paid issues generous amounts of stock to management, who then sell it through the repurchase program at higher prices. Another concern is over the abrupt resignation of founder and long-time CEO Harland Stonecipher at the beginning of March. The timing is suspect, to say the least, as the government began to turn up the heat on what is clearly a questionable business strategy.

Add to these concerns the fact that operational metrics have been weak, and you have a MFI stock that is probably best avoided. Pre-Paid Legal has been seeing increasing weakness in their subscriber base numbers. New memberships have failed to cover the number of memberships cancelled, leading to slight declines in net subscribers. Legal services are increasingly becoming more available to individuals through online based providers. Revenue fell 1.3% in 2009, and sales growth will probably be right around 0% in 2010. MagicDiligence does not see any compelling growth or moat argument for this company.

Last but not least, Pre-Paid Legal is not particularly strong financially. Cash is about $36 million, debt about $42 million, with the debt-to-equity ratio high at 110% (I like to see 75% or lower). While it is far from the biggest concern, it is yet another strike against the stock.

All said, Pre-Paid Legal is just not an attractive investment from any angle, and the recent run-up in the share price doesn't help. Magic Formula investors should look elsewhere to invest.

Steve owns no position in any stocks discussed in this article.

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6 Comments – Post Your Own

#1) On April 30, 2010 at 11:05 AM, Textextextex (< 20) wrote:

Amway has ripped off millions of people for several decades, to the tune of 10s of billions of dollars.
Read about it on this website: http://thenetprofitgroup.yolasite.com and forward the information to everyone you know, so they don't get scammed.
Amway is a scam, and here's why: Amway pays out as little money as they can get away with, so they support the higher level IBOs ripping off their downline via the tool scam. 
As a result, about 99% of IBOs operate at a net loss, while the top 1% make several TIMES more from their Amway tool scam than from the Amway products. This was made illegal in the UK in 2008, but our FTC is unable to pull their heads out of their butts to stop it here. 

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#2) On April 30, 2010 at 12:42 PM, bw00lf (< 20) wrote:

Do you have any sales-person turnover statistics for Amway or Avon? I would be interested to see how these companies compare to PPD. I worked on a project recently and was quite surprised that sales people turnover at car deals was approximately 300% per year. I've seen your same concern regarding turnover in other places, but I'm not sure that it is that shocking when you compare PPD's turnover to other entry-level sales jobs in other industries. 

Did you by chance actually speak to someone who has the service? It looks like you read several blogs to see complaints, but I'm wondering if you only focused on the loud minority of former customers. It has been a while since I've looked, but average customer retention is somewhere between 3.5 - 7.0 years. If the service is really that bad and has little value, can you explain why people stick around for so long? 

You also mentioned the CEO's abrupt departure. He is 70 years old and retired from the CEO role. He is still the chairman of the board. What you failed to mention is anything about the Company's largest shareholder, Thomas Smith. Within a day or two of Stonecipher saying that he is stepping down as CEO (but still keeping the Chairman role), Smith said that he was stepping down as a Director and that he would possibly start selling off his position--he is 80+ years old. In these two cases, I'm not sure that you can clearly point to them and say, "there is a problem." I think I remember Christopher Browne (Tweedy Browne) writing that management purchases can be a very good indicator of management's view of the company, but sales are more of a challenge to determine. Unless you have spoken to the individual selling the shares, you have no idea why the person is selling. Do they want to build a new mansion? Are they going through a divorce? Do they want to diversify? I don't think that you can put equal weight on management stock dispositions and management stock purchases. 

Lastly, you mentioned that PPD is not very strong financially. You may want to go back and re-evaluate this point. In your second paragraph above, you mention that management has been very aggressive in repurchasing stock. They use all excess cash to buy back stock and therefore have high debt to equity ratio. When making capital allocation decisions, management has determined that at the current stock price, shareholders get a better return buy repurchasing stock than to retire the debt early. Last year PPD generated in excess of $60 million in cash flows. The debt could have been repaid if that was the best use of capital.

 To Textextextex: First, I am not a MLM sales person. I know that I don't have skill-set or personality to do well. I would be one of those people who quit within the first year. However, people need to start thinking about being a MLM sales person consistently with buying a franchise. If you bought a Subway franchise and for some reason were not a very good operator, would you say that Subway is a rip-off?

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#3) On April 30, 2010 at 12:46 PM, SUPERMANSTOCKS (55.80) wrote:

PPD SELL SELL SELL!!! GET RID OF THAT JUNK!

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#4) On April 30, 2010 at 1:49 PM, MagicDiligence (< 20) wrote:

I would be speculating as to the customer retention point, but it seems to me like PPD's service is somewhat like insurance.  It's worthless until you need it.  The problem is, when people do need it, they are finding out that coverages are pretty poor.

The issue is not so much with Stonecipher stepping down as it is with the investigations.  He stepped down after they started.  As founder and long-time CEO, it appropriately brings to question why he picked now to step down?  Why wouldn't he want to see them through and defend what is essentially his company, then retire?

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#5) On May 01, 2010 at 3:19 PM, truthonmlm (< 20) wrote:

If I was Stonecipher, I would have retired early on.  He's an old guy with a lot of money.  He's created somewhat of a legacy and there's not much reason to work - except for his passion in the work that he's done.  Like you said, it is an insurance service.  Most people don't use it, but when they do need it, they will.  There's nothing wrong with insurance if a person wants it and buys into the whole idea of it...and there's nothing wrong being a middleman.  That's the nature of alot of businesses.  Most manufacturing companies don't sell directly to consumers.

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#6) On May 27, 2010 at 4:17 AM, 748392 (< 20) wrote:

Not sure who this Steve guy is, but he's someone that doesn't have his facts straight, that's for sure.  His figures are completely wrong.  Consumers have a choice between the most expensive legal family plan which is only $26 and includes 24/7 access to an attorney in case of emergency. The pre-trial time is 13.5 hrs not 2.5 hrs.  If they want a cheaper plan than $26, there is obviously less coverage.  Free wills online are unlikely to hold up in court as they recommend in the fine print that you have them reviewed by an attorney.  Different states have different rulings about them and it was just in the news that they had been rejected as valid.  It's costs about $300-$500 to sit down with an attorney outside of PPL.  Hmmm.  $26 or $500??  Hello??  No brainer.  I am a happy customer and at one time had 3 different attorneys working on 3 different questions for me.  There's no way I could afford something like that without PPL's help.  Because of PPL writing a letter and making a phone call, B of A refunded me $400 B of A told me I'd never get back!  Verizon Wireless tried overcharging me but because of PPL, Verizon knocked $141 off my bill.  PPL has $56 million in cash and liquid assets sitting in the bank, not $36 million as this guy incorrectly stated.  Better to trust Forbes Magazine, who has thousands of dollars for R&D, who has ranked PPL in the top 200 Best Small businesses in the U.S. for 8 out of the last 11 years, including last November, USA Today who recommends PPD as a great stock for your retirement portfolio, Money Magazine who ranked PPL stock(PPD) as 1 of the top 50 stocks of the decade, and of those 50 stocks, PPL ranked #1 for the last 2 years in a row for ROI!  The founder abruptly resigned because his only child, her husband and his little grandaughter were killed in a plane crash and he wants to help other grieving families who have lost their children!  The writer of this article should be ashamed of himself, can't get his facts straight, and obviously has an ax to grind!

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