Pre-Paid Legal Services

1. Pre-Paid Legal Services Presented by: Vincent, Yuting, Mary, Shaoying, and Feny

2. Agenda • Business Model • Strategy Analysis • Firm Analysis • Analyst Concern • Financial Statement Adjustment • Summary • Alternative • What Happened Next

3. Business Model • Provider of Legal Insurance Plans • Legal expense reimbursements • Will and testament preparation • Document review and letter writing • Employment-related trial defense • Traffic violation defense • Internal revenue service audits

4. Business Model • Revenue Generation • Sale of legal insurance memberships • 1998, premiums at $19.08 per month ($229 per year) • Premiums paid monthly • Member sales associate program and training • Legal Services • Open Panel: members use own attorney • Closed Panel: members use attorneys who are under contract with PPLS

5. Business Model • Member Sales Associate Program • Members became part of sales force • Commission based compensation • Pior to 1995, 70% of first year premium and 16% for subsequent year renewals • After 1995, flat 25% of annual premium, advanced 3 years commission on every new membership • If membership cancelled before advances recovered, PPLS deducts 50% of unearned advances from future commissions

6. Business Strategy Porter’s 5 Forces • Rivalry Among Existing Firms • Growing Insurance Industry • Expect significant increase in competition • Higher concentration of firms offering similar products and services • Customers can easily switch to other firms at low cost • Economies achieved through increasing number of participants in membership sales associate program (increasing number of new memberships) • Increasing demand for legal insurance met with increase capacity of sales force through membership associate program • Expect increase difficulty in maintaining growth as insurance industry begins to saturate

7. Business Strategy • Threat of New Entrants • Expected threat is medium, considering the need for significant capital resources required in case of premium payouts • Threat may be growing as more financial institutions are becoming more involved and interested in the insurance sector as an additional revenue source • PPLS enjoys first mover advantage, and hence better brand awareness to its potential customers • Due to the nature of legal services, new entrants requires access to legal experts which may not be readily available (meanwhile PPLS has access to highly rated legal firms in each of its 36 major markets)

8. Business Strategy • Threat of Substitute Products • Pricing and performance of products offered cannot be compared due to lack of information, but price competition is likely to increase as industry players increases • Based on current markets, customers’ willingness to switch to substitute insurance providers based on premium costs alone is high (no sense of customer loyalty in this industry)

9. Business Strategy • Bargaining Power of Buyers • Since cost of switching is low, bargaining power of buyers is relatively high • As the number of competing firms grows with the industry, more substitutes are available to customers • Quality of service is relatively important especially for those members who choose to use PPLS contracted attorneys • Volume of memberships purchased on an individual basis is expected to be low, therefore potential members would be more picky

10. Business Strategy • Bargaining Power of Suppliers • Main supplier of services would be PPLS contracted attorneys • Bargaining power is expected to be medium to high since attorneys are industry experts and highly rated • With growth of the industry, legal service providers have access to more firms to generate revenue • Highly rated legal firms are expected to be relatively less compared to common legal service providers • Quality and brand image is important to the legal service providers as it affects their own professional image when acting on behalf of the contracting firm

11. Business Strategy Porter’s Analysis Conclusions • Future growth potential in questionable considering the saturated market • Despite previous rapid growth, increasing competition will negatively affect potential future profitability since PPLS does not seem to have a competitive advantage • Continued profitability is largely dependent on PPLS’s ability to sustain membership renewals • Profitability outlook heavily relies on management estimates of membership growth and renewals

12. Business Strategy SWOT Analysis • Strengths • High capacity of sales force through its membership sales associate program • Access to highly rated legal firms for its markets • Weaknesses • Negative image portrayed by some analysts in regards to its accounting practices (commission advance) resulting in persistent short selling of the company’s stock • Resultant fluctuation of the company’s stock price • Profitability outlook relies heavily on management’s estimates of new memberships and membership renewals

13. Business Strategy • Opportunities • Growing insurance industry (but saturating) • Increasing popularity of legal service insurance • Potential partnerships and market access through mergers with larger market players and financial institutions Possibility for economies of scale and scope through employment of new technological tools (EDI, Internet payment, database and enterprise content management applications) • Threats • Increase competition from other market players as market saturates • Market for legal insurance may become unpopular and reduce demand for such products and services • SEC’s opposition to PPLS’s accounting method may further affect its stock performance and future profitability outlook

14. Business Strategy SWOT Analysis Conclusions • Access to a large sales team and highly rated legal firms gives PPLS capacity for growth and sustaining memberships through quality service • Future outlook may be relies heavily on management estimates of memberships • Growing market is saturating, may reduce future growth potential • SEC opposition may force PPLS to change accounting methods, affecting its profitability outlook to the public and potential investors

15. Financial Performance • After Changed the commission policy: • Membership revenue average growth is 59% • Net income growth is 71% • Operating cash flow growth rate is 500% • Consistent earning growth in line with Wall Street estimation (projected 36%) • Strong buy recommendation on the stock (stock price target: from $26 to $34)

16. Ratio Analysis

17. Key Success Factors • Membership benefit rate (33% current; 35% future) • Committed sales force (76% of 98’sales from 150,000 sale associates) • Arrangements with insurance and service companies (24% of 98’sales)

18. Accounting Issue • PPLS advance the sale associate 3 years of commission on every new membership • The advanced commission was capitalized and amortized into three years • Deferred expense recognition related to commission advances made its earning growth look stronger in the early years

19. Capitalization Method • Matching principle • Conservative with stable Retention rate

20. Capitalization Method • Decrease in commission advance un-collectable rate

21. Analyst Concerns • Can PPLS estimate the performance in the future economic activity? • Membership retention rate • Advanced commission collectable rate • PPLS did not disclose enough information in the financial statement about how to measure and control the risks • Immediately expense may be the suitable accounting method to record the advanced commission

22. Expense Method • Higher risk in the future associated with significantly increase in new members

23. Expense Method • Why PPLS changed the commission policy? • Is the previous cancellation rate too high? • Assume purpose: to retain the memberships

24. Expense Method • Big write-off possibility because of the significant increase in new contract sales • An upward trend of cancellation rate from SEC filings • Large portion of sales from sales associates (76%) • Uncertain for the future revenue • Increase the un-collectable risk

25. Expense Method • Commission as a large portion in the total asset

26. Cash Flows

27. Immediate Expensing of Commission Advances

28. Straight-line Amortization of Commissions

29. Accounting Treatment of Commissions

30. Accounting Adjustment to Financial Statements

31. Impact to the Net Income

32. Financial Information Summary

33. Financial Performance Comparison

34. Class Discussion Based on what we have reviewed: • Consider which method is more effective? • What are the risks need for consideration? • Should PPLS consider to restructure their business model?

35. Summary

36. Method to Consider Capitalized method when: • Support large loss reserves for insurance companies • Management able to predict future correctly • On track with matching and conservative • Accountant choice • Consideration: • When management can estimate revenue using the renewal (based on commission)

37. Method to Consider Expensing method when: • Contingencies of future revenue • Capture business reality in an unbiased manner • Stock performance stability • Financial analyst choice • Consideration: • When management unable to predict future revenue

38. Alternative & Consideration • Restructure their business model • Change their commission policy • Buying back the stocks • Privatize the company • High cash flow • Lender

39. What Happened Next? • Year End 2000 • By year end, PPLS changed to a more conservative method for estimating unrecoverable commissions for terminated sales associates • Reduced beginning retained earnings by $4.1 Million and 2000 earnings by $3.1 Million • Early 2001 • PPLS was sued by shareholders for misleading accounting for commission advances • SEC investigates PPLS’s accounting practices, and advises PPLS that their accounting practice is not consistent with GAAP • PPLS repurchases 2 Million shares and announces further repurchase of 0.5 Million shares • PPLS appeals and SEC announces that PPLS must restate its prior years financials to expense commission outlays

40. What Happened Next? • Mid 2001 • Reaffirmation by SEC resulted in additional suits against PPLS’s management for causing PPLS to violate GAAP • Deloitte & Touche resign from audit and indicated that they disagree with SEC ruling to expense commissions as paid • PPLS hires Grant Thorton as the new auditors in replacement of Deloitte & Touche

41. Question?