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Valuation IssuesPre-Paid now trades at about 9.5 times projected after-tax free cash flow of more than $50 million this year and 7.9 times 2003 cash flow before the impact of additional share repurchases. The company has used and will likely continue to use all of its free cash flow to repurchase and retire shares. At the current share price, the company can buy back nearly 11% of its outstanding shares each year. Our financial model conservatively values the business in three parts:
The existing base of 1.39 million current members, which, based on 26 years of retention statistics, has an after-tax present value of $230 million, or $12.11 per share;
the off balance sheet pre-paid commission asset of $209 million, which, based on historical retention data, has an after-tax present value of $94.6 million, or $4.98 per share; and
the potential to add new members in the future, which, based on conservative sales projections ranging from a 2% annual reduction to 8% annual growth, generates a value between $294 million and $948 million, or a range of $15 to $50 a share. In other words, the existing membership base plus the existing pre-paid commission asset are together worth about $17 a share -- even if Pre-Paid never sells another membership. At today's price of $25 per share, an investor is paying only about $8 per share for $15 to $50 per share of value from future sales.
The Shorts' StoryShort-sellers have made a series of arguments for why the company will fail. I've summarized -- and responded to -- five of them here: Shorts argue that Pre-Paid used to overstate its earnings by capitalizing commission advances and then amortizing them over the average life of a customer. Putting aside the fact that inflating the share price while aggressively buying back shares makes no sense, I don't believe there was an overstatement. Regardless of the company's accounting treatment of commission advances, its cash flow, our key determinant of value, has consistently grown and been fully and clearly disclosed. The GAAP treatment of commission advances never affected the economic substance of the business. Today, Pre-Paid expenses its commission advances immediately and, as a result, has an enormous off-balance-sheet asset. Critics say Pre-Paid's growth is slowing, members are leaving, and the business is about to implode. In making this argument, shorts are ignoring the enormous value in the existing membership base and in the pre-paid commission asset. Although its growth rate has slowed, the membership base has continued to expand. New membership sales have averaged 180,000 per quarter for several years and show no sign of a material decline. About 71% of new members cancel before their third anniversary, but members who stay for three years have an annual retention rate of more than 80%. Therefore, the core membership gets more valuable each year.
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In this writing, David P. Berkowitz represents his firm, New York-based Gotham Partners. This report is not intended as investment advice or as a solicitation of any kind. It is based on Gotham's analysis of Pre-Paid's SEC filings as well as other public documents and is also informed by their knowledge of, experience in and opinions about Pre-Paid's business and other relevant businesses. At time of publication, Gotham Partners and related entities hold more than 1 million shares of Pre-Paid Legal Services, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. A more complete version of this report can be found at www.gothampartners.com.
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