Pre-Paid's Pickle Gets Juicier - TheStreet

The long slide continues at

Pre-Paid Legal Services

(PPD)

.

For a full year now, the embattled legal services company has failed to attract new customers and sales associates at the rapid clip of its glory days. During the third quarter, Pre-Paid added 15% fewer customers than it did a year ago. And it recruited less than half the number of sales associates -- who are crucial for future sales -- as it did in the same period last year.

Meanwhile, the company's overall customer base barely budged. Even after adding some 168,356 new customers, the company ended the quarter with only 15,000 more customers than it started with.

"The business is growing at a snail's pace at best," said one short-seller. "And the recruiting is just a joke."

Pre-Paid declines to comment for stories in

TheStreet.com

, saying it believes they are biased. Pre-Paid shares -- heavily shorted by hedge funds -- slipped a penny to $23.90 on Thursday.

Behind the Numbers

To be fair, the quarter wasn't a total disaster.

Although the company lost a huge number of customers -- equal to 11% of its total membership base -- it has lost more than that before. Until now, in fact, Pre-Paid had been shedding more than 160,000 customers quarterly for an entire year.

Still, critics have cast doubts on Pre-Paid's true customer retention rate. Pre-Paid associates themselves claim that the company continues to count customers as "active" long after they've canceled their policies. So short-sellers tend to view Pre-Paid's total customer count -- supposedly up 2.3% from a year ago -- with considerable skepticism.

"That's an area where we think the company is playing serious games," said one.

Pre-Paid has repeatedly pledged to improve the low customer retention rate that chips away at its customer base. (The company loses roughly half of all new members after just one year.) And reports from the field indicate that the company has taken some drastic steps to keep new members on the books. For example, one highly productive sales team reportedly saw their commission checks shrivel as punishment for the poor retention of customers they'd signed up over the Internet.

"The group's business was going gangbusters," said one sales associate. "But now, they're going to get into something else."

Two years ago, angry sales associates went so far as to file a class-action lawsuit that accused Pre-Paid of treating them unfairly. But the lawsuit, seeking more than $300 million in damages, recently failed to secure class-action status in an Oklahoma court. So the individual plaintiffs -- including some former Pre-Paid stars -- are simply seeking retribution for themselves.

Pre-Paid, which has reserved only $3 million for litigation despite a mountain of pending lawsuits, clearly needed the victory.

"Pre-Paid is pleased with this development in this case," the company said, "and will continue its vigorous defense against the plaintiffs' claims."

The company announced the Sept. 23 ruling along with its production numbers on Thursday. It did not, however, report a similar action -- allowing another associate lawsuit to move forward -- that went against it this summer. Nor did it provide any update on a series of customer lawsuits, seeking more than $800 million in damages, that are headed for trial in Mississippi.

There, Pre-Paid will face a former U.S. attorney -- representing dozens of unhappy customers -- who has accused the company and its local "provider" law firm of colluding to defraud the public.

The Real Deal

At least one insider, who recently left a provider law firm in another state, contends the company does in fact mislead innocent consumers.

"Litigation is expensive -- always and everywhere," the person said. "But the problem is that this fact is concealed from the consumers who, as with so many other aspects of the plan, are told that litigation is 'covered.'"

Pre-Paid charges roughly $25 a month for a policy that simply provides discounts -- instead of full coverage -- for such common legal problems as bankruptcy and divorce. Moreover, the company covers only a handful of the pretrial hours normally needed when customers are actually sued.

Ultimately, the former insider said, customers must cough up around $2,500 for a retainer to secure services they thought they had already paid for.

"And I assure you that most of the people who fall for this plan are low-income and cannot afford such retainers," the person said.

Recruiting Machine

In truth, Pre-Paid offers a legal policy that covers less -- but generally costs more -- than many plans in the industry. Moreover, the company has made few improvements to the plan despite the lift it might give customer retention. Instead, Pre-Paid relies heavily on its own sales force to buy and hold the policies and convince friends and family to do the same.

But Pre-Paid sales associates generally fail to profit from the difficult multilevel marketing business. So they tend to leave the company, canceling their own policies and taking their small base of customers with them.

As a result, Pre-Paid must constantly recruit new sales associates to replace the masses who depart or its customer base will shrivel. But the company, accused by critics of scamming both its sales associates and its regular customers, is weathering a sharp drop-off in recruiting as it heads toward a trial that could essentially decide whether it is an outright pyramid scheme.

Some Pre-Paid associates point to their own Web sites as evidence that the company is far more interested in recruiting people -- a hallmark of pyramid schemes -- than it is in selling a product. Until recently, visitors to the Web sites would find information about buying, as well as selling, Pre-Paid policies. But following a sudden update, the Web sites now promote only the Pre-Paid "opportunity" that invites people to sell Pre-Paid policies and recruit others to do so as well.

One successful associate, who shunned recruiting to focus on group sales, has grown suspicious of the company's true aim.

"I don't want to believe that the company doesn't want to make sales," he said. "But all they ever ask me is how my recruiting is going. And I just have to tell them, 'I'm not into that game.'"

The associate went on to say that Pre-Paid has actually bypassed opportunities to add thousands of customers who would simply use the service instead of selling it.

"Maybe they just don't want to present the plan to educated people who might stump them," he said. "Then, they wouldn't look so smart."

Short Tempers

At the moment, the same could be said for investors betting against Pre-Paid stock. The company's shares have held steady in the middle of their 52-week range in spite of a number of negative developments over the last year. This despite the fact that a huge number of shares have been borrowed by short-sellers hoping to make money by selling out as the stock falls.

In the past, the company has asked shareholders to prohibit brokers from lending out their stock to short-sellers. Meanwhile, the company has stepped into the market with large sums of money -- some of it borrowed -- to make stock repurchases that create what some say is the only real buying pressure on the shares.

Last month, the company announced that it would borrow $25 million -- on top of the $10 million it's already paid off -- to keep the buybacks going. By now, the buybacks have cost the company so much that shareholder equity, a measure of a company's net worth, has nearly vanished.

The company is also borrowing some $20 million to help fund construction of a new headquarters in its rural base of Ada, Okla. The company says it long ago outgrew its modest home on Main Street and desperately needs more space. But locals familiar with construction of the new building -- scheduled for completion this year -- say the elegant top floor is actually reserved for the CEO's living and entertainment quarters.

Fil Zucchi, a fund manager who writes for

Street Insight

, had wondered about the building's cost from the onset. Zucchi, who has a background in commercial real estate, determined that Pre-Paid was paying $160 per square foot (based on the $28.4 million price tag for the 177,500-square-foot building) in a town where new construction costs a fraction of that amount. To back up his claims, he pointed to the ADA Jobs Foundation Web site pegging industrial construction -- which can run about half the price of commercial building -- at $17 to $20 per square foot. Commercial lease space is an even cheaper $1.80 to $2 a foot.

"Inflation, I guess," said Zucchi, who is short Pre-Paid's stock.

Of course, other short-sellers have long accused Pre-Paid of recklessly blowing funds with little regard for shareholders.

"These guys are one jury decision away from being insolvent," another fund manager said. "And they won't be able to raise money or borrow money after that happens."