At Pre-Paid, Clinging to Customers

Pressured by strict terms from its lenders, Pre-Paid Legal Services ( PPD) is taking dramatic steps to hold onto its customers.

The Oklahoma-based company, which employs the sales and recruiting strategy made famous by Amway, this month severed ties with two of its most productive sales associates because their customers were departing at a rapid rate. The legal services provider is also waiting longer to formally cancel policies that customers no longer want.

Short-sellers, who have challenged everything from the company's accounting to the legitimacy of its business, say the moves show the Pre-Paid growth story is running out of steam. The company's strong membership and revenue growth have kept its stock rising, but the shorts -- and there are many investors betting against Pre-Paid -- say those numbers obscure fundamental flaws that will eventually punish shareholders.

As a matter of policy, Pre-Paid does not comment for stories published by TheStreet.com because it believes the coverage is unfairly negative.

Pressure Cooker

Pre-Paid has long suffered from a dismal customer retention rate, losing nearly half of all new policyholders within a year of when they sign up for the $26-a-month service. But the company is now under pressure to retain more customers.

This year, Pre-Paid sacrificed its debt-free status by taking out a bank loan to help fund an aggressive stock repurchase program and the construction of a new corporate headquarters. The $30 million credit line, extended by Bank of Oklahoma ( BOKF), includes covenants that specifically address customer retention. To avoid default, Pre-Paid must post a customer retention rate of at least 50% on policies that have been in force for less than 12 months. In 2003, that rate will climb to 55%.

Alan Weber, a New York analyst and Pre-Paid sales associate, expressed little concern about a potential default.

"Pre-Paid could pay the loan off in three to six months," said Weber, whose firm owns 1% of Pre-Paid's stock. "All it would mean is that the company would be buying back less of its own stock."

Ultimately, Weber believes Pre-Paid can remain in compliance with its bank covenants. But some critics note that Pre-Paid's first-year retention rate was a meager 52.7% last year, and point to at least two recent developments as fresh evidence of retention problems.

Tennis Elbow?

For starters, Pre-Paid is now allowing customers an extra 15 days to reconsider dropping their coverage before the company formally cancels the policies. With this extension, company letters show, some memberships are remaining in force nearly two months after they've been canceled -- at least postponing the hit to retention.

Perhaps more dramatically, Pre-Paid has also stopped accepting new business from two leading sales associates -- Sheri Sharman and Buck Reed -- who were previously celebrated for their record-breaking performance. In a Dec. 4 letter to his sales force, Pre-Paid CEO Harland Stonecipher described the pair's customer retention as "very poor" and warned against using sales and recruiting techniques that lack corporate approval.

"If you have attended their trainings or adopted the training methods utilized by Sheri Sharman and Buck Reed, please consider the effect it will have on your business," Stonecipher wrote. "You cannot build a successful Pre-Paid business on that level of persistency."

Sharman and Reed both made their names as superstars at Equinox, an alleged illegal pyramid scheme shut down by federal regulators in 2000 after the pair departed. The Las Vegas-based corporation ran afoul of pyramid laws by charging participants thousands of dollars to sell water filters and -- more importantly -- recruit others to do the same.

Equinox "survivors" have described Sharman as the former sidekick for Equinox founder Bill Gouldd, who added the extra "d" to his last name to represent the word "dollars." (Gouldd boasted a net worth of more than $300 million before the pyramid collapsed and he was banned from the network marketing industry forever.) Reed also earned high praise from Gouldd.

"I'll tell you one person who's doing this thing right: Buck Reed," Gouldd is quoted as saying to Robert Styler, a top Equinox distributor who later exposed the company in a book called Spellbound. "I only need to tell the man something once, and he does it. No questions asked."

In recent years, Sharman and Reed have revamped their lucrative training seminars to motivate peddlers of legal plans instead of expensive water filters. A former Amway star who attended a Pre-Paid training seminar led by the pair marveled at the spectacle.

"Curiously, people were 'camped out' in the hallway in front of the doors to the meeting room at 4:30 a.m.," he wrote. "I still haven't figured out why ... since the room was never filled to capacity, and there were empty seats at every session."

Wealth and Democracy

Both Sharman and Reed ranked high in the elite category of Pre-Paid associates who collect six-figure incomes. Sharman was in fact named No. 1 Rookie of the Year shortly after joining Pre-Paid. And Reed shattered the company's longstanding production records in a matter of months.

"I have never heard of a company that has people making what people can make in Pre-Paid Legal in such a short time," Reed states in a Web site testimonial. "My best friends are now making six-figure incomes this year."

But typical Pre-Paid associates earn far less, if they earn anything at all. Robert FitzPatrick, president of Pyramid Scheme Alert, calculates the average take-home pay for Pre-Paid associates at less than $3 a week. And many Pre-Paid associates -- who number more than 280,000 -- never even recoup the $249 they pay to access the Pre-Paid "opportunity."

"Pre-Paid Legal has no sustainable customer base or sales organization," FitzPatrick told the consumer watchdog site Citizens for Justice. "It is strictly a recruitment scheme. The majority of the sales reps never earn a penny of true profit."

Pre-Paid currently faces a slew of lawsuits from disgruntled associates and customers who feel they've been misled. Those cases -- seeking more than $1 billion in damages -- will begin to go to trial in February.

The company has set aside $3.3 million for potential courtroom losses. But any loss exceeding $500,000 would trigger a separate bank default, according to the covenants laid out in Pre-Paid's regulatory filings.

Bank of Oklahoma Vice Chairman Burns Hargis said the bank does not comment on contracts with its clients.

Pre-Paid's stock climbed 30 cents to $27.10 in Monday's session. The stock has fallen from a recent high of $30, set after the Gotham Partners hedge fund issued a favorable report on the company in late November. The New York Times reported Sunday that Gotham Partners actually sold one-quarter of its stake in Pre-Paid at the same time it was recommending the stock.

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