Pre-Paid's Cash Picture Clouds Over - TheStreet

Pre-Paid's Cash Picture Clouds Over

The legal services company says cash flow is slowing to a trickle.
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Pre-Paid Legal Services

(PPD)

isn't the cash cow it once was.

Hurt by slowing business, the Oklahoma-based legal services provider milked only $11.3 million worth of cash flow -- down 27% from a year ago -- out of the latest quarter. The company, which generally touts cash flow as a key measure of its health, posted a 46% jump in cash flow just one quarter earlier.

Earnings rose 17% from a year ago to 54 cents a share, but other key metrics showed clear signs of deterioration. Third-quarter net income slipped $600,000 from second-quarter levels, and earnings per share fell sequentially for the first time in more than a year. Revenue fell for the first time in recent memory.

"The company is now actively shrinking," said one hedge fund manager with a large short position in the stock. "Total sales have gone down for the first time since 1996."

The stock, largely held by devout Pre-Paid fans, actually climbed 1.5% to $25.95 on Tuesday.

Fast Start Indeed

Despite a 4% increase in membership fees, Pre-Paid saw third-quarter revenue fall slightly -- dipping to $90 million -- because of a sharp decline in fees from its crumbling base of sales associates. The company, which has historically downplayed contributions from its sales associates, finally highlighted the impact in its latest quarterly report.

"Associate services revenue decreased 36% to $6 million for the third quarter of 2003 from $9.4 million during the same period of 2002 primarily as a result of less new associates enrolled during the third quarter of 2003 of 22,987 compared to 46,653 enrolled during the comparable period of 2002," the filing states. "Additionally, as a result of fewer associates subscribing to the company's Web-related services, revenue attributable to such subscriptions declined by approximately $1.3 million during the 2003 period compared to the comparable period of 2002."

The importance of associate revenue, clearly apparent in the latest results, only fuels arguments by Pre-Paid critics who have long described the company as an illegal pyramid scheme that makes bucketloads of money on the backs of its own sales force. One hedge fund manager, who's been tracking the company for years, claims that associates alone -- footing the bill for a so-called "Fast Start" training program -- have kept the company operating in positive territory for years.

"Until they implemented Fast Start," the fund manager said, "this company did not turn cash-flow positive."

Pre-Paid's own sales associates have, in fact, filed a class-action lawsuit that accuses the company of being an outright pyramid scheme. Despite Pre-Paid's attempts to have the case dismissed, it has instead moved into the discovery stage and is now proceeding toward trial.

All told, the company faces more than 40 lawsuits even after settling five multiple-party complaints for a modest sum of $27,000 in recent months. And the litigation is starting to take a real toll on the company's bottom line. In presenting its latest results, Pre-Paid specifically pointed to legal costs as a big reason for the 16% surge in third-quarter general and administrative expenses. It predicted that litigation costs would continue to weigh on results through 2003, after which time the cases are actually scheduled for the particularly expensive trial stage.

"They say they don't worry about legal expenses," one short-seller said. "But that's already starting to be a factor -- even before the suits start going to trial."

Mounting Expenses

Pre-Paid faces multiple lawsuits -- seeking $90 million apiece -- in one state alone. But the company has barely reserved for these cases, setting aside just $3.3 million total, even though it's headed for trial in a state perhaps best known for its runaway jury awards.

The trials, set to begin four months from now in Mississippi, will come at a time when the company is already facing mounting expenses that are unrelated to litigation. By then, Pre-Paid will be forking over big monthly payments to lenders who are financing the company's new $30 million headquarters and aggressive stock repurchases.

In recent years, Pre-Paid has been spending every excess dollar -- and then some -- to buy back its own shares. Since April 1999, the company has paid nearly $160 million to reduce its share count by nearly one-third. And it recently arranged its second credit line, totaling $25 million, to fund stock repurchases going forward.

Meanwhile, insiders themselves have poured far less money into the company's stock. They have, in fact, been trimming their stake in the company. Director Peter Grunebaum, a regular seller of the company's shares, collected about $85,000 from stock sales earlier this year. And fellow director Martin Belsky, who doubles as dean of the Tulsa law school, has since cashed out $40,000 in options transactions.

Meanwhile, more than a full year has passed since the last insider actually threw money at the stock. In August 2002, Thomas W. Smith -- a big Pre-Paid shareholder who owns 18% of the company -- made a token purchase of 3,400 shares. Smith, who easily ranks as Pre-Paid's largest holder with more than 3.16 million shares, made an even tinier purchase of 700 shares five months earlier.

But after that, corporate executives went on to trim their own holdings. As 2002 drew to a close, CEO Harland Stonecipher sold 4,200 shares -- or 100 more than Smith purchased all year -- in a private transaction. CFO Randy Harp, who cashed in $1.6 million worth of stock to pay off an insider loan, raised more eyebrows shortly afterward. Harp's transaction, executed as the stock rocketed on a bullish report by Gotham Partners, came just ahead of news about a dismal fourth-quarter performance. Both Pre-Paid and Gotham Partners, a defunct hedge fund which began selling Pre-Paid's stock after issuing its report, have since come under scrutiny by federal authorities.

In its latest quarterly report, Pre-Paid acknowledged that it "has and will continue to respond to ... requests" from both the

Securities and Exchange Commission

and the U.S. attorney in the Southern District of New York.

Oversold Levels?

Pre-Paid also faces a series of lawsuits -- and at least one state investigation -- for allegedly overselling its product. The company, which provides limited legal coverage for around $25 a month, has been accused of promising full legal coverage and then delivering very little service at all. Brad Pigott, a former U.S. attorney, is representing hundreds of disgruntled Pre-Paid customers in the plaintiff-friendly state of Mississippi. Mississippi Attorney General Mike Moore is also probing the company. Indeed, the company revealed Tuesday that Moore has now intervened on behalf of Mississippi plaintiffs three separate times -- most recently in August -- although it heard nothing more from the prosecutor in September.

Until now, at least, Pre-Paid has largely managed to skirt the regulatory fire that's burned others in the so-called multilevel marketing industry. Just last week, for example,

MemberWorks

(MBRS)

took a huge hit on news that Florida authorities were investigating the company for some of the same deceptive practices -- particularly aggressive customer billing -- that have been attributed to Pre-Paid. MemberWorks, a company that's also heavily owned by Pre-Paid's largest shareholder, has previously settled complaints with attorneys general in at least three other states. But the new civil case in Florida, seeking up to $15,000 per transgression, could prove especially expensive.

"Based upon the investigation, an estimated 50% of all sales are reported as 'unauthorized' by consumers," the Florida attorney general announced last week. "These citizens were unknowingly victimized and deserve to be reimbursed."