Melissa Davis

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Pre-Paid Struggling to Keep Customers

Melissa Davis

Pre-Paid Legal Services (PPD) broke its New Year's resolution.

The company's plans to improve customer retention have panned out about as well as a doomed fad diet. A year after promising better retention -- and sacrificing some growth in the process -- Pre-Paid is losing more customers than ever. For the second year in a row, the company has ended the fourth quarter with fewer customers than it started with.

Even after adding 153,501 customers, including a few thousand buyers of "identity theft shields," Pre-Paid finished the quarter nearly 2,000 customers short of where it started. A year ago, when its business started shrinking, Pre-Paid saw its stock slide 25% even as it rushed to reassure the market that the slowdown was temporary -- and even self-inflicted -- in nature.

"We continue to implement programs that we believe will improve future retention rates and took specific steps during the fourth quarter of 2002 to increase the focus of our sales force on membership retention," Pre-Paid CEO Harland Stonecipher announced last year. "These actions naturally reduced the number of new memberships written and new associates enrolled during the quarter but demonstrate our commitment to improve membership retention."

But good intentions hardly guarantee success, as many a resolution-breaker knows. Today, Pre-Paid is still struggling to keep old customers even it fights for the flood of replacement customers that it once took for granted. Five years ago, Pre-Paid was losing just over half as many customers as it was adding. But that cushion, which allowed the company's business to explode, has thinned to almost nothing in recent years. By 2003, the company was losing 95% as many customers as it was signing up. And the picture could get uglier.

Pre-Paid refuses to comment for stories by TheStreet.com because it believes the coverage is biased. But short-sellers were quick to declare the latest period a "disaster," particularly regarding customer attrition.

"Obviously, that number is now approaching 100%," said one hedge fund manager with a large short position in Pre-Paid's stock. "In a quarter or two, they could be losing more members than they are adding" on an annual basis.

While its customer base declined sequentially, Pre-Paid did manage to grow its business by 3% last year overall. But the same company indicated a year ago that its 2002 growth rate, at 11%, was already disappointing.

The company's recruiting, which is crucial to future growth, has also slowed down. Last year, Pre-Paid recruited 108,557 new associates -- customers who double as Pre-Paid sales agents -- or 30% fewer than it did a year earlier. Even fourth-quarter recruiting, which inched up 12% from last year's tough final period, struck short-sellers as "irrelevant."

Instead, they focused on the slump in "independent," nonassociate customers. After stripping away new sales associates -- and a few thousand identity theft protection customers -- Pre-Paid actually saw its independent customer base shrink by nearly 40,000 in the latest period, critics said.

One short-seller, pointing to Pre-Paid's growing reliance on sales associates for business, shook his head at that "record" number.

"Not only do these numbers show the obvious deterioration in their real business -- recurring membership sales -- but they highlight the pyramid nature of the company," he said. "This suggests the revenue mix is shifting from product sales to recruiting fees ... (and this) should concern both the (attorneys general) out there as well as the next associates recruited."

Instead, attorneys general -- particularly in Pre-Paid's home state of Oklahoma -- have lent support to the controversial company after pocketing generous campaign contributions from its employees and its sales force. But the company has attracted scrutiny closer to Wall Street. Both the Securities and Exchange Commission and the U.S. attorney's office in Manhattan are investigating Pre-Paid about questionable trading in the company's shares ahead of last year's devastating production report.

Pre-Paid also faces a class-action lawsuit that accuses the company of being an illegal pyramid scheme. In the meantime, short-sellers say the company continues to mislead its new recruits.

"Does anybody think for a second that these newly recruited, fee-paying associates are being told they are paying $100 to $149 for the opportunity to participate in a business whose product sales are down for the third consecutive quarter?" one asked. "I doubt that disclosure is part of the sales pitch."

Critics also question Pre-Paid's accountability to shareholders. They view the company's lavish new headquarters as a waste of shareholder money. But they are, if anything, more critical of the company's aggressive stock repurchases. In less than five years, Pre-Paid has spent $173 million -- some of it borrowed -- to reduce its share count by 30%. Critics challenge the soundness of that strategy.

"That's $10 of cash they've spent to improve the share price by a mere $4," one short-seller said. "So they've basically lost $6 a share for investors."

The company borrowed $14.2 million for fourth-quarter buybacks alone. It has $11 million left -- enough for around 425,000 shares -- on its treasury stock credit line.

In the meantime, critics continue to sell the stock short. At last official count, 8.2 million shares -- or 68% of the float -- were sold short. The stock drifted lower after Monday evening's update, slipping 42 cents to $25.03 in late-morning trading.