Pre-Paid Short Talks Back to the Bulls

Editor's Note: David Rocker is managing general partner of Rocker Partners, L.P., a New York hedge fund that he formed in 1985. (Rocker Partners owns 9.7% of TheStreet.com.)

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Last week, Gotham Partners published a 26-page report about Pre-Paid Legal Services (PPD - commentary - Cramer's Take), mostly debunking what it perceived as the bearish case on this company, which uses a network of sales personnel -- known as "associates" -- to market legal services to "members," customers who pay in advance. (An abbreviated version of the report ran on RealMoney.com.) One section was even titled, "How do the shorts sleep at night?" I don't need 26 pages to answer that question -- or to give you enough information to support a different conclusion.

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Opposing View: A Bull Defends Pre-Paid Legal

I am short Pre-Paid. (For full disclosure, I also own a 9.7% stake in TheStreet.com (TSCM - commentary - Cramer's Take), which publishes this Web site.) Simply, I believe Pre-Paid's structure has some of the features of a pyramid operation and that the company has been deceptive about the services it provides to its members and about the benefits of becoming an associate.

I don't believe its business model is sustainable, as recent membership trends already suggest. If you promise to sell a horse but deliver a mule, you can make a good one-time profit, but you won't stay in business for very long.

Pre-Paid likes to compare itself to an HMO for legal services (hence the term "members" for its customers), but it pays out only 34% of premium dollars it collects from members to compensate the actual providers of legal services, according to its latest 10-Q, while the average HMO pays out 80% of its premium revenue in payments to medical providers. Pre-Paid's biggest expense, according to its financial statements, is the commissions it ladles out to its high-pressure sales force.

In its report, Gotham Partners tried to paint Pre-Paid as a great future growth opportunity. But Pre-Paid already seems to be straining for growth. First, let's examine the membership numbers. In its most recent quarter, its active membership grew only 29,000 -- despite 197,000 new-member signups -- because 168,000 existing members had quit. Many of Pre-Paid's members are apparently unhappy with its legal service plans: Nearly 50% fail to renew after the first year.

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David Rocker is managing general partner of Rocker Partners, L.P., a New York hedge fund that he formed in 1985. (Rocker Partners owns 9.7% of TheStreet.com.) Prior to forming the partnership, he was a general partner in Century Capital Associates, a registered investment adviser, managing more than $600 million in assets. At the time of publication, he was short Pre-Paid Legal, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell, hold or short any security. Rocker earned his M.B.A. at Harvard Business School.