Pre-Paid Gets Clean Bill From Auditor

It still must resolve some internal control deficiencies, though.
By Melissa Davis ,

Pre-Paid Legal Services

(PPD)

has checked one major item off its lengthy to-do list.

The embattled legal services provider this week filed 2004 financial statements with a clean opinion from its auditor. Now, the company needs to resolve two "material weaknesses" that kept its auditor, Grant Thornton, from blessing its internal controls as well. It also faces new fraud trials in both April and May. And it continues to struggle with a growth rate that the company itself describes as "unacceptable."

The stock looks healthy, though. It jumped 1.9% to $35.44 on Friday and has rocketed more than 40% in a year.

Still, some believe the performance of the stock has very little to do with the performance of the company itself. Peter Cohan, a Massachusetts investment strategist with no position in the stock, views Pre-Paid as rather pricey on the basis of traditional measures. He notes that the company last year grew net income by a meager 2% and, even after borrowing money for massive stock buybacks, boosted earnings per share by only 9%. Nevertheless, he says, the stock is trading as if the company is growing annual earnings by 15% and carries with it an average risk profile.

That is not the case, he says, given the company's history of accounting problems and its pending litigation. But then again, he adds, Pre-Paid may never trade like a regular stock.

"Pre-Paid is a special company with all sorts of issues," Cohan says. "I think its valuation is a result of the war between short-sellers and company insiders."

More than half of Pre-Paid's shares have been sold short by bearish investors, who have been betting against the company for years. Nearly one-third reside in the hands of insiders and 5% owners of the stock. Founding CEO Harland Stonecipher, by himself, controls more than 7% of the shares.

Indeed, Stonecipher ranks among the greatest beneficiaries of Pre-Paid's rising stock price. Doug Minor, a Mississippi attorney who is battling the company and its founder in court, pegged Stonecipher's net worth at more than $40 million during the company's first trial last fall. He says that Stonecipher has seen his worth rise even as the company has seen its own value decline.

"Because of its aggressive stock buybacks and the other ways it spends its money, the company's net worth went down from about $40 million to about $25 million" between the second and third quarters of last year, Minor said. "Harland's went up. ... He's worth more than the company."

As a matter of policy, Pre-Paid refuses to comment for stories by

TheStreet.com

because it believes the coverage is negatively biased. According to Thomson/First Call, no analysts follow the stock.

New Math

To be fair, Pre-Paid's net worth did rise in the most recent quarter. It is listed at $31.4 million in the company's newly filed 10-K.

But the same filing causes some, like Cohan, to wonder about the reliability of Pre-Paid's numbers. In it, Grant Thornton warns that it can issue no opinion about the company's internal control over financial reporting because of two material weaknesses.

Granted, hundreds of small companies, faced with new requirements under the Sarbanes-Oxley Act, are reporting problems with their internal controls. But material weaknesses rank as the worst of the three most common issues being found. And material weaknesses -- which signal "more than a remote likelihood that a material misstatement ... will not be prevented or detected" -- can be especially worrisome at a company like Pre-Paid.

"Pre-Paid has a long history of disputes with the

Securities and Exchange Commission

on accounting," Cohan says. "Combine that with the auditor's finding of material weaknesses in the company's internal controls, and it doesn't give you a warm and fuzzy feeling about the reliability of their financials ... It definitely leaves open the question of how severe the material weaknesses are, whether they will require restatements and the extent of any restatements."

Investors must wait for those answers. In a February regulatory filing, Pre-Paid said the internal control problems could take several months to resolve.

Court Records

In the meantime, Pre-Paid is headed back to the courtroom.

The company is scheduled to begin its first trial in Alabama in April and its third trial in Mississippi in May. Last month, a Mississippi jury determined that both Pre-Paid and its CEO committed fraud when marketing the company's legal coverage. Pre-Paid policies offer limited coverage and require retainer fees for most common legal problems.

To be fair, Pre-Paid found itself ordered to pay only $45,000 to the plaintiffs -- and no punitive damages -- in a state known for its runaway jury awards. But the company had expected to win the trial outright.

After emerging from its first trial in Mississippi victorious last fall, the company assumed that a pattern had been established.

"We are very pleased with the jury's verdict and the impact this verdict may have on other pending litigation," Stonecipher said. "We hope this verdict, our first jury verdict in Mississippi, sets the tone for future legal developments in Mississippi."

The following month, Pre-Paid sounded even bolder. The company announced that two powerful groups -- the National Black Chamber of Commerce and the United States Chamber of Commerce -- had offered their support. All three would be fighting to recover the legal expenses Pre-Paid had incurred during the Mississippi trial. They deemed the lawsuit "frivolous" and hoped to teach the plaintiffs a lesson.

But they also had some undisclosed connections. Both the leader of the Black Chamber and his wife are Pre-Paid sales associates, according to the

New York Post

. And Stonecipher himself is a member of the board of directors of the U.S. Chamber of Commerce.

Stonecipher joined the U.S. Chamber board in 2003 as the representative of his company's home base in Oklahoma, according to the local

Journal Record

. He made the move as a board member of the State Chamber of Oklahoma, which had just honored him the previous year with its inaugural "Line in the Sand Award" for fighting off "frivolous" lawsuits.

In a 2002 press release, the State Chamber praised its own board member for "setting the precedent in this fight against meritless claims."

"Even if you've done nothing wrong, your business must play defense not only in a court of law but in the court of public opinion as well," State Chamber CEO Dick Rush said when unveiling the prize. "All in all, it is a very costly process that destroys many companies and reputations every year."

The chamber's first "Line in the Sand Award" appears to be its last. News of more recent winners could not be located by

TheStreet.com

.

Meanwhile, Pre-Paid continues to fight off negative publicity -- actually listed as a risk factor in its regulatory filings. And it faces more trials, with potentially larger damages, ahead.

"The more of these cases that come forward, the more juries will hear about the total lack of value in Pre-Paid's product," Minor said, adding that his plaintiffs will continue to fight for punitive damages "because we believe the conduct the jury found fraudulent is also conduct that should be punished."

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