The executive and administrative offices of the Company and its subsidiaries are located at 321 East Main Street, Ada, Oklahoma. These offices, containing approximately 40,000 square feet of office space, are owned by the Company. Additionally, during 1997, the Company completed construction of its material distribution center located approximately 5 miles from its administrative offices. This new structure contains approximately 8,600 square feet of inventory, package assembly and shipping space. While the Company currently fully utilizes these existing facilities, management believes that it will have no difficulty in securing additional facilities in close proximity to its office building if necessary for future expansion.
The following table sets forth selected historical financial and statistical data for the Company as of the dates and for the periods indicated. Certain reclassifications have been made to conform to current year presentation. This information is not necessarily indicative of the Company's future performance. The following information should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto included elsewhere herein.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ----------------------------------------------------------------------------- RESULTS OF OPERATIONS ---------------------
Contract benefit costs relating to open panel Contracts, which constituted approximately 9% of Contracts in force at December 31, 1997, are based on the usual, reasonable and customary fee for providing the required services. Such costs are generally paid on a current basis as most costs are certain in amount and require only limited investigation. The Company maintains a reserve for estimated incurred but not reported open panel Contract benefit costs as well as costs which are in the payment process. These reserves are reviewed annually by an independent actuary as necessary in conjunction with the preparation and filing of financial statements and other reports with various state insurance regulatory authorities. Underwriting risks associated with the open panel Contracts are managed primarily through contractual benefit limitations and, as a result, underwriting decisions are not necessarily based on individual Contract purchases.
Commissions Beginning with new membership Contracts written after March 1, 1995, the Company implemented a level commission schedule which results in the Company incurring commission expense related to the sale of its legal expense plans on a basis more consistent with the collection of the premiums generated by the sale of such Contracts. Prior to March 1, 1995, the Company had incurred much higher commissions (approximately 70%) during the first year of the membership with substantially lower commissions (approximately 16%) in all subsequent years. The level commission structure results in the Company incurring commissions at the rate of approximately 25% per year for all membership years.
Should a membership lapse before the advances have been recovered for each commission level, the Company immediately generates a "charge-back" to the applicable sales associate to recapture 50% of any unearned advance. This charge-back is immediately deducted from any future advances that would otherwise be payable to the associate for additional new memberships. The Company historically has been able to immediately recover the majority of such charge-backs. Any remaining unrecovered advance on a membership that has lapsed represents a receivable from the associate and is reflected as commission advances and is categorized as current or non-current based on the expected recovery period. Additionally, even though a commission advance may have been fully recovered on a particular membership, no additional commission earnings from any membership will be paid to an associate until all previous advances on all memberships, both active and lapsed, have been recovered. During 1997, 24% of all associates submitting new memberships accounted for 76% of all such new memberships produced thereby further enhancing the recovery of commissions advances.
The Company's commission advance policy exposes the Company to the risk of uncollectible commission advances particularly for associates who do not receive commissions on a large number of memberships or who experience below average Contract persistency. The Company closely monitors such commission advances to ensure maximum recoverability and maintains a recoverability reserve which at December 31, 1997 and 1996, was $3.7 million and $3.4 million, respectively.
Cash Flow Considerations Relating to Sales of Contracts The Company generally advances significant commissions at the time a Contract is sold. Since approximately 93% of Contract premiums are collected on a monthly basis, a significant cash flow deficit is created at the time a Contract is sold. This deficit is reduced as monthly premiums are remitted and no additional commissions are paid on the Contract until all previous commission advances have been fully recovered. Since the cash advanced at the time of sale of a new membership Contract will be recovered over a three year period, cash flow from operations may be adversely affected depending on the number of new membership Contracts written in relation to the existing active base of Contracts and the composition of new or existing sales associates producing such Contracts.
Associate Services The Company derives revenues from services provided to its marketing sales force, principally from a one-time enrollment fee of approximately $65 ($49 prior to February 1, 1996 and $55 prior to July 1996) from each new sales associate and the sale of marketing supplies and promotional materials to associates on an ongoing basis. Effective January 4, 1997, the Company implemented a training program which allows an associate who successfully completes the program to advance through the various commission levels at a faster rate. Associates participating in this program pay a one-time fee of $249 instead of the $65 fee. The increased fee covers the additional training and materials used in the training program. The Company enrolled 58,121 new sales associates during 1997 compared to 69,789 during 1996 and 50,464 during 1995, resulting in significant increases in associate services revenues and costs. The Company's direct costs of providing materials and services to associates are reflected as costs of associate services and direct marketing. Amounts collected from sales associates are intended primarily to offset the Company's direct and indirect costs incurred in recruiting, monitoring and providing materials to sales associates and are not intended to generate material profits from such activities.
Interest income for 1997 increased 26% to $1.6 million from $1.3 million for 1996. Interest income increased as a result of increases in the average investments outstanding. At December 31, 1997 the Company reported $29.5 million in cash and investments compared to $19.9 million at December 31, 1996.
Provision for income taxes increased significantly during 1997 to $10.1 million compared to $6.7 million for 1996, but remained at 35% of income before income taxes. The Company has established a valuation allowance for the portion of its deferred tax asset that the Company believes more likely than not will not be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize the benefits from its pre-1996 NOLs and certain other carryforwards before they expire, primarily as a result of future tax deductions attributable to expected levels of commissions to be paid on new Contract sales.
Comparison of 1996 to 1995 The Company reported net income applicable to common shares of $12.5 million, or $.56 per diluted common share, for 1996, up 74% from net income applicable to common shares of $7.2 million, or $.35 per diluted common share, for 1995. The increase in the net income applicable to common shares for 1996 is primarily the result of increases in every revenue category except for interest income for 1996 as compared to 1995.
Contract premiums totaled $50.6 million during 1996 compared to $31.3 million for 1995, an increase of 62%. The increase in Contract premiums was primarily the result of increased new Contract sales resulting in a higher number of active Contracts in force. New Contract sales during 1996 were 194,483 compared to 109,922 during 1995. At December 31, 1996, there were 294,151 active Contracts in force compared to 203,535 at December 31, 1995. Additionally, the average annual premium per Contract has increased from $200 for all Contracts in force at December 31, 1995 to $216 for all Contracts in force at December 31, 1996, a 8.0% increase, as a result of a higher portion of Contracts written during 1996 including the additional pre-trial hours benefit at an additional cost to the member.
Associate services revenue increased from $3.2 million for 1995 to $5.6 million during 1996 as a result of higher new associate enrollments and the increase in the fee paid for associate enrollment. New associates enrolled during 1996 were 69,789 compared to 50,464 for 1995, an increase of 38%. Associate services revenue also increased as a result of increases in sales of marketing materials used by the associates in sales presentations of the Company's Contracts. Associate services revenue for 1996 was comprised of $4.1 million in enrollment fees and $1.5 million in sales of marketing materials. Future revenues from associate services will depend primarily on the number of new associates enrolled, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of providing associate services.
General and administrative expenses during 1996 and 1995 were $6.2 million and $4.3 million, respectively, and represented 12% and 14% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $1.9 million during 1996, these expenses, as a percent of Contract premiums, decreased 2%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of Contract premiums should continue as a result of certain economies of scale pertaining to the Company's operating leverage.
Provision for income taxes increased significantly during 1996 to $6.7 million compared to $3.9 million for 1995, but remained at 35% of income before income taxes. The Company has established a valuation allowance for the portion of its deferred tax asset that the Company believes more likely than not will not be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize the benefits from its pre-1996 NOLs and certain other carryforwards before they expire, primarily as a result of tax deductions attributable to expected levels of commission to be paid on new Contract sales.
Dividends paid on outstanding preferred stock decreased to $15,000 for 1996 from $125,000 during 1995. This $110,000 decrease is attributable to the automatic conversion of preferred stock to common stock pursuant to its terms during February 1995.
General Consolidated net cash provided by operating activities was $7.7 million, $942,000 and $624,000 for 1997, 1996 and 1995, respectively. Cash provided by operating activities increased significantly during 1997 compared to 1996 and 1995 due to the $6.3 million increase in net income, an increase of $3.4 million in deferred income taxes and an increase of $1.2 million in accounts payable and accrued expenses, all of which more than offset the $4.5 million increase in commission advances.
During 1997, the Company had net cash provided by financing activities of $3.2 million as a result of the exercise proceeds of options to purchase common stock, an increase of $1.3 million from such proceeds in 1996. In 1995, the Company had net cash provided by financing activities of $6.5 million, after dividends of $125,000, as a result of the exercise proceeds of warrants to purchase common stock during May, 1995.
Consolidated Financial Statements - --------------------------------- Consolidated Balance Sheets - December 31, 1997 and 1996 Consolidated Statements of Income - For the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows - For the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Changes in Stockholders' Equity - For the years ended December 31, 1997, 1996 and 1995 Notes to Consolidated Financial Statements
To the Board of Directors and Stockholders of Pre-Paid Legal Services, Inc.
We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related statements of income, changes in stockholders' equity, and cash flows each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedule listed at Item 8 herein. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
Stockholders' equity: Preferred stock, $1 par value; authorized 400 shares; 5 issued and outstanding as follows: $3.00 Cumulative Convertible Preferred Stock, 3 and 5 shares authorized, issued and outstanding at December 31, 1997 and 1996, respectively; liquidation value of $55 and $84 at December 31, 1997 and 1996, respectively................................. 3 5 Special preferred stock, $1 par value; authorized 500 shares, issued and outstanding in one series designated as follows: $1.00 Non-Cumulative Special Preferred Stock, 23 and 32 shares authorized, issued and outstanding at December 31, 1997 and 1996, respectively; liquidation value of $304 and $430 at December 31,1997 and 1996, respectively.......................................... 23 32 Common stock, $.01 par value; 100,000 shares authorized; 23,151 and 22,459 issued at December 31, 1997 and 1996, respectively............................................ 232 225 Capital in excess of par value........................... 47,303 41,039 Retained earnings........................................ 25,127 6,350 Less: Treasury stock at cost; 747 shares................. (2,177) (2,177) ------- ------- Total stockholders' equity.............................. 70,511 45,474 ------- ------- Total liabilities and stockholders' equity............. $91,912 $57,532 ======= =======
Basic earnings per common share................ $ .85 $ .58 $ .38 ======= ======= ======= Diluted earnings per common share.............. $ .83 $ .56 $ .34 ======= ======= =======
Cash flows from financing activities: Proceeds from sale of common and preferred stock........................................ 3,230 1,964 6,670 Dividends paid on preferred stock............ (13) (15) (125) ------- ------ ------- Net cash provided by financing activities.. 3,217 1,949 6,545 ------- ------ -------
Net increase in cash and unpledged cash equivalents.................................. 6,972 342 4,977 Cash and cash equivalents at beginning of year. 14,831 14,489 9,512 ------- ------- ------- Cash and cash equivalents at end of year....... $21,803 $14,831 $14,489 ======= ======= =======
PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Amounts and shares in 000's, except dividend rates and par values)
Year Ended December 31, ----------------------- 1997 1996 1995 ------ ------ ------ Preferred Stock - $1 par value, 400 shares authorized; issued and outstanding in two series designated as follows: $2.40 Cumulative Convertible Preferred Stock, authorized 391 shares; shares issued and outstanding at beginning of year (299 in 1995)..... $ - $ - $ 299 Shares exchanged for Common Stock (299 in 1995)..... - - (299) ----- ----- ----- Shares issued and outstanding at end of year........ - - - ----- ----- -----
Special Preferred Stock - $1 par value, 500 shares authorized; series of fixed annual dividends $1, non-cumulative, convertible, shares issued and outstanding at beginning of year (32 in 1997, 45 in 1996, and 60 in 1995)............................... 32 45 60 Shares exchanged for Common Stock (9 in 1997, 13 in 1996, and 15 in 1995)............................... (9) (13) (15) ----- ----- ----- Shares issued and outstanding at end of year (23 in 1997, 32 in 1996, and 45 in 1995), liquidation value of $304 at December 31, 1997.................. 23 32 45 ----- ----- -----
Year Ended December 31, ------------------------- 1997 1996 1995 ------ ------ ------ Retained Earnings (Deficit) Balance at beginning of year...................... $ 6,350 $(6,105) $(13,292) Net Income........................................ 18,790 12,470 7,312 Cash dividends.................................... (13) (15) (125) ------- ------- ------- Balance at end of year............................ 25,127 6,350 (6,105) ------- ------- ------- Treasury stock Balance at beginning and end of year (747 shares). (2,177) (2,177) (2,177) ------- ------- -------
Commissions Effective March 1, 1995, the Company implemented a level commission schedule of approximately 25% of annual premium revenue for all membership years. This commission schedule results in the Company incurring commission expense related to the sale of its legal expense plans on a basis consistent with the collection of the premiums generated by the sale of such Contracts. The Company currently advances the equivalent of three years of commissions on new Contract sales. Effective January 4, 1997, the Company implemented a new policy whereby associates receive only earned commissions on the first three memberships submitted unless the associate successfully completes a training program which includes an intensive one-day training seminar, produces three memberships and recruits one associate within 15 business days from their training date. Prior to March 1, 1995, first year commissions payable on the sale of a Contract, and earned in the first Contract year, were approximately 70% of annual Contract premiums while renewal commissions (payable as earned after the first Contract year) were approximately 16% of annual premiums.
Investment Securities The Company accounts for its investments in debt and equity securities in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115"). Investments classified as trading are accounted for at fair value, available for sale investments are accounted for at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of stockholders' equity, and held to maturity investments are accounted for at amortized cost.
Commission Advances Commission advances represent the unearned portion of commissions advanced to Associates on sales of memberships. Commissions are earned as premiums are collected, usually on a monthly basis. The Company reduces Commission advances as premiums are paid and commissions earned. Unearned commission advances on lapsed memberships are recovered through collection of premiums on an associate's active memberships. At December 31, 1997, the Company maintains an allowance of $3.7 million to provide for estimated uncollectible balances. Effective November 1, 1993, the Company imposed a charge of 1.5% per month on unearned commission advances made between November 1, 1993 and March 1, 1995. Effective March 1, 1995, and in conjunction with other commission structure changes, the Company reduced the charge from 1.5% to .17% per month for commission advances made after such date. Effective January 4, 1997, the Company implemented a change to the method used in calculating the charge on unearned commission advances to only calculate a charge against unearned commission advances on memberships which canceled subsequent to the advance being made. The charge was also changed to equal the prime rate.
Long-Lived Assets The Company records impairment losses on long-lived assets used in operations when events or changes in circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets.
Stock-Based Compensation Compensation expense is recorded with respect to stock option grants and restricted stock awards to employees using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). This method calculates compensation expense on the measurement date as the excess of the current market price of the underlying Company stock over the amount the employee is required to pay for the shares, if any. The expense is recognized over the vesting period of the grant or award. The Company has elected not to adopt the fair value method of accounting for stock-based compensation which is encouraged, but not required, by Statement of Financial Accounting Standards No 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). The Company has adopted the disclosure requirements of SFAS 123 in preparing its financial statement disclosures.
Amortized Cost Fair Value --------- ---------- One year or less............... $2,850 $2,853 Two years through five years... 650 650 ------ ------ Total.......................... $3,500 $3,503 ====== ======
The Company's investment securities are included in the accompanying consolidated balance sheets at December 31, 1997 and 1996 as follows.
December 31, Estimated ---------------- Useful Life 1997 1996 ------------ ------ ------
Deferred tax liabilities and assets at December 31, 1997 and 1996 are comprised of the following:
Deferred tax assets: Expenses not yet deducted for tax purposes........ 445 340 Depreciation ..................................... 14 - Net operating loss carryforward................... 5,099 4,198 Capital loss carryforward ........................ - 654 General Business Credit carryforward.............. 325 325 AMT Credit carryforward .......................... 366 366 ------- ------ Total deferred tax assets ........................ 6,249 5,883 Valuation allowance for deferred tax assets....... (3,936) (4,220) ------- ------ Total net deferred tax assets..................... 2,313 1,663 ------- ------ Net deferred liability ........................... $(16,471) $(9,284) ======== =======
The Company generated tax losses of $2.6 million and $2.8 million for the years ended December 31, 1997 and 1996, respectively. The Company believes it will realize the approximate $1.9 million future tax benefits from these tax losses and has appropriately not provided a valuation allowance against this amount.
The exercise of stock options which have been granted under the Company's various stock option plans give rise to compensation which is includable in the taxable income of the option grantee and deductible by the Company for federal and state income tax purposes. Such compensation results from increases in the fair market value of the Company's common stock subsequent to the date of grant of the applicable exercised stock options, and in accordance with Accounting Principles Board Opinion No. 25, such compensation is not recognized as an expense for financial accounting purposes and the related tax benefits, including the $1.9 million of future tax benefits of net operating loss carryforwards, are recorded in capital in excess of par value.
The ability of the Company to utilize NOLs and tax credit carryforwards to reduce future Federal income taxes of the Company is subject to various limitations under the Internal Revenue Code of 1986, as amended (the "Code"). The utilization of such carryforwards may be further limited upon the occurrence of certain capital stock transactions, including the issuance or exercise of rights to acquire stock, the purchase or sale of stock by 5% stockholders, as defined in Temporary Treasury Regulations, and the offering of stock by the Company during any three-year period resulting in an aggregate change of more than 50% ("Ownership Change") in the beneficial ownership of the Company. In the event of an Ownership Change, Section 382 of the Code imposes an annual limitation on the amount of a corporation's taxable income that can be offset by those carryforwards.
Each share of the Special Preferred Stock is entitled to a non-cumulative annual dividend of $1.00 per share, is convertible into 3.5 shares of Common Stock and is redeemable at the option of the Company at $13.34 per share, plus all accumulated and unpaid dividends. The Special Preferred Stock had a liquidation value of $304,000 at December 31, 1997. During 1997, 1996 and 1995, Special Preferred Stock consisting of 9,767, 12,812 and 14,841 shares, respectively, were converted into 130,970 shares of Common Stock.
The Company's ability to pay dividends is dependent in part on its ability to derive dividends from its subsidiaries. The payment of dividends by PPLCI is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits. At December 31, 1997, PPLCI did not have funds available for payment of dividends without the approval of the Oklahoma Insurance Commissioner.
At December 31, 1997, the Company had outstanding options to purchase a total of 560,100 shares of the Company's Common Stock at an average price of $15.89 per share expiring at various periods through July, 2003.
Aggregate rental expense under all operating leases was $17,000, $27,000 and $28,000 in 1997, 1996 and 1995, respectively. There are no significant operating lease commitments in effect at December 31, 1997.
The Company has a stock option plan ("Plan") under which the Board of Directors ("Board") or its Stock Option Committee ("Committee") may grant options to purchase shares of the Company's common stock. The Plan permits the granting of options to directors, officers and employees of the Company to purchase the Company's common stock at not less than the fair value at the time the options are granted. The Plan provides for option grants to acquire up to 1,000,000 shares and permits the granting of incentive stock options as defined under Section 422 of the Internal Revenue Code at an exercise price for each option equal to the market price of the Company's common stock on the date of the grant and a maximum term of 10 years. Options not qualifying as incentive stock options under the Plan will have a maximum term of 15 years. Vesting of options granted under the Plan is determined by the Board or Committee. No options may be granted under the Plan after December 12, 2005.
A summary of the status of the Company's Plan as of December 31, 1997, 1996 and 1995 and changes during the years ending on those dates is presented below:
In addition to those options issued pursuant to the Plan and those options issued to marketing associates in the two preceding tables, the Company has other options outstanding. A summary of the status of such options as of December 31, 1997, 1996 and 1995 and changes during the years ending on those dates is presented below:
The following table summarizes information about stock options other than those included in the Plan or issued to marketing associates outstanding at December 31, 1997:
Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS 123") establishes a fair value method and disclosure standards for stock-based employee compensation arrangements, such as stock purchase plans and stock options. It also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees, requiring that such transactions be accounted for based on fair value. As allowed by SFAS 123, the Company will continue to follow the provisions of Accounting Principles Board Opinion No. 25 and related interpretations for its employee compensation arrangements, and disclose the pro forma effects of applying SFAS 123. Had compensation cost for the Company's employee related stock option plans been determined based on the fair value at the grant dates for awards under the Plan consistent with the method of SFAS 123, the Company's net income and earnings per share for 1997 and 1996 would have been reduced to the pro forma amounts indicated below:
Diluted earnings per common share: As reported.................. $ .83 $ .56 Pro forma.................... $ .78 $ .55
In accordance with SFAS 123, the Company recorded compensation expense related to the issuance of stock options to marketing associates of $100,000, $318,000 and $76,000 during 1997, 1996 and 1995, respectively. The weighted average fair value of options granted that met the minimum exercise criteria during 1997 was $1.07 per share. The fair value of each stock option grant to marketing associates was measured on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions used: no dividend yield; risk-free interest rate of 5.00%; expected life of 1 year; and expected volatility of 30%.
Diluted earnings per common share are computed by dividing net income applicable to common stockholders by the weighted average number of shares of common stock and common stock equivalents outstanding during the year. The $3.00 Cumulative Convertible Preferred stock is not included in the weighted average number of common shares outstanding since such shares are considered antidilutive and therefore ignored in the computation of diluted earnings per share. Special Preferred Stock is considered to be a dilutive common stock equivalent and the number of shares issuable on conversion of the Special Preferred Stock is added to the weighted average number of common shares. The weighted average number of common shares is also increased by the number of shares issuable on the exercise of warrants and options less the number of common shares assumed to have been purchased with the proceeds from the exercise of the options and warrants pursuant to the treasury stock method; those purchases are assumed to have been made at the average price of the common stock during the respective period. Additionally, the $2.40 Cumulative Convertible Preferred Stock, which was actually converted during 1995, is assumed to have been converted at the beginning of 1995 and the respective dividends are included in determining net income applicable to common stockholders.
Year Ended December 31, ------------------------- 1997 1996 1995 ------ ------ -------
Earnings: - --------- Net income applicable to common stockholders......... $18,777 $12,455 $7,187 Add: Dividends on assumed conversion of preferred stock.............................................. - - 110 ------- ------- ------ Income available to common stockholders and assumed conversions........................................ $18,777 $12,455 $7,297 ======= ======= ======
Following is a summary of the unaudited interim results of operations for the years ended December 31, 1997 and 1996.
---- First quarter.... $12,354 $3,954 $2,566 $.12 $.12 Second quarter... 14,796 4,862 3,156 .15 .14 Third quarter.... 15,760 5,006 3,251 .15 .15 Fourth quarter... 17,036 5,363 3,482 .16 .16