Pre-Paid Short Talks Back to the Bulls

But even that doesn't tell the whole story. Pre-Paid aggressively recruited nearly 47,000 new sales associates in the third quarter, who themselves had to become members. This means that independent member signups totaled only 150,000. As a result, it appears that independent, nonsales-associate membership actually fell by 18,000 during the quarter.

Late last year, Pre-Paid cut its minimum associate fees from $249 to $149, and there have been additional promotions and reductions that bring it to a current level of $99. Pre-Paid seems to be cutting its start-up fees so that it can attract more sales associates, thereby maintaining the appearance of growth. The 47,000 new sales associates is more than double last year's recruitment number.

No Value Play

Gotham's valuation model also has flaws. The first part of Gotham's evaluation is based on recurring revenue from Pre-Paid's members. But even accepting flaws in the model, such as a 30% first-year lapse rate vs. the company's own published first-year lapse rate of 47% and a ridiculously low 10% discount rate, Gotham can only arrive at a value of $12 per share for its existing book of business.

The company's prepaid commission asset is valued at $5 per share by Gotham, but even this is questionable. Pre-Paid is unlikely to recover many commissions that Pre-Paid often pays in advance if frustrated sales associates quit. The company even acknowledges that two-thirds of its sales associates never sell a single membership.

These two items add up to only $17, well below Pre-Paid's current stock price.

The remaining value that Gotham places on this stock is from future membership sales -- a rather novel construct given Pre-Paid's obvious loss of sales momentum, which even Gotham highlights. This analysis reminds me of efforts to value Coke years ago, based on the premise that "if everyone in China just drank one Coke a week."

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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.