The following table sets forth selected historical financial and statistical data for the Company as of the dates and for the periods indicated. 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 Premiums and Contract Benefit Costs The Company's principal revenues are derived from Contract premiums, most of which are collected on a monthly basis. Contracts are generally guaranteed renewable and non-cancelable except for fraud, non-payment of Contract premiums or upon written request by the member.
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. Historically, 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.
Associates also receive compensation when associates sponsored by them or other associates that they have sponsored in their organization successfully complete the new training program implemented by the Company January 4, 1997.
Contract Persistency One of the major factors affecting the Company's profitability and cash flow is Contract persistency, which represents the ability of the Company to retain a Contract, and therefore receive premiums, once it has been written. The Company periodically monitors its overall Contract persistency rate, as well as the persistency rates with respect to Contracts sold by individual associates and agents and persistency rates with respect to Contract sales by geographic region and payment method. The Company's Contract persistency rate measures the number of Contracts in force at the end of a year as a percentage of the total of (i) Contracts in force at the beginning of such year, plus (ii) new Contracts sold during such year. From 1981 through the year ended December 31, 1996, the Company's annual Contract persistency rates, using the foregoing method, have averaged approximately 76%. The annual Contract persistency rates were 74.0%, 80.0% and 80.7% for 1996, 1995 and 1994, respectively. The Company's overall Contract persistency rate varies based on, among other factors, the relative age of total Contracts in force. The Company's overall Contract persistency rate could be lower when the Contracts in force include a higher proportion of newer Contracts. The Company has recently experienced significant increases in new Contract sales and, as a result, the percentage of newer Contracts in its total Contracts in force has increased. Unless offset by other factors, this increase could result in a decline in the Company's overall Contract persistency rate as it did during 1996. The Company's financial condition and results of operations may be materially adversely affected if the persistency rates of existing and new Contracts are materially lower than the Company's historical experience.
Cash Flow Considerations Relating to Sales of Contracts The Company advances significant commissions at the time a Contract is sold. Since approximately 92% 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 and the composition of new or existing sales associates producing such Contracts.
Investment Policy The Company's investment policy is to some degree controlled by certain insurance regulations, which, coupled with management's own investment philosophy, results in a conservative investment portfolio that is not risk oriented. The Company's investments consist principally of short term instruments issued by the United States Treasury, insured bank certificates of deposit, high grade government bonds and similar investments. The Company is required to pledge investments to various state insurance departments as a condition to obtaining authority to do business in certain states.
Forward Looking Statements All statements in this report concerning the Company other than purely historical information, including, but not limited to, statements relating to the Company's future plans and objectives, expected operating results and assumptions relating to future performance constitute "Forward-Looking Statements" within the meaning of Section 21E of the Securities Exchange Act of 1934 and are based on the Company's historical operating trends and financial condition as of December 31, 1996 and other information currently available to management The Company cautions that the Forward- Looking Statements are subject to all the risks and uncertainties incident to its business, including but not limited to risks relating to the marketing of its Contracts, Contract persistency, regulation and competition risks and the risk relating to the continued active participation of its principal executive officer, Harland C. Stonecipher. Moreover, the Company may make acquisitions or dispositions of assets or businesses, enter into new marketing arrangements or enter into financing transactions. None of these can be predicted with certainty and, accordingly, are not taken into consideration in any of the Forward-Looking Statements made herein. For all of the foregoing reasons, actual results may vary materially from the Forward-Looking Statements.
Comparison of 1996 to 1995 The Company reported net income applicable to common shares of $12.5 million, or $.56 per common share, for 1996, up 74% from net income applicable to common shares of $7.2 million, or $.35 per 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.
Interest income for 1996 equaled interest income for 1995 of $1.3 million. Included in 1995 interest income was $187,000 for prior years interest pertaining to outstanding notes receivable. Such amounts were previously not considered recoverable but were subsequently collected. Interest income would have otherwise increased as a result of increases in the average investments outstanding and higher interest rates on investments. At December 31, 1996 the Company reported $19.9 million in cash and investments compared to $18.3 million at December 31, 1995.
Primarily as a result of the increase in Contract premiums, total revenues increased to $59.9 million for 1996 from $37.1 million during 1995, an increase of 61%.
Contract benefits totaled $17.6 million for 1996 compared to $10.6 million for 1995, an increase of 66%. However, the loss ratio for the 1996 period of 35% was approximately the same as the 34% for the comparable period of 1995 and should remain near 35% as the portion of active Contracts which provide for a capitated benefit continues to increase.
Contract premiums totaled $31.3 million during 1995 compared to $22.9 million for 1994, an increase of 37%. 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 1995 were 109,922 compared to 45,893 during 1994. At December 31, 1995, there were 203,535 active Contracts in force compared to 144,438 at December 31, 1994. Additionally, the average annual premium per Contract has increased from $229 for those Contracts written in 1994 to $239 for Contracts written during 1995, a 4.0% increase, as a result of a higher portion of Contracts written during 1995 including the additional pre-trial hours benefit at an additional cost to the member.
Commission expense was $7.7 million for 1995 compared to $6.8 million for 1994, and represented 24% and 30% of Contract premiums for 1995 and 1994, respectively. Commission expense, as a percentage of Contract premiums, declined as a result of changes in the commission structure for Contracts sold after March 1, 1995.
Direct marketing costs increased to $2.6 million for 1995 from $1.5 million for 1994 but were fairly consistent as a percent of Contract premiums and include those costs other than commissions, which are directly associated with new Contract sales.
The Company's expense ratio decreased from 56% for 1994 to 45% for 1995. These factors resulted in a combined loss and expense ratio of 79% and 91% for 1995 and 1994, respectively.
The Company has an unsecured revolving credit agreement with Bank One, Texas under which the Company may borrow up to $5 million, as determined by the borrowing base defined by the agreement, through July, 1997. The borrowing base is determined by a formula based on 80% of the net cash flow from certain of the Company's Contracts that have been in existence for 18 months or more. At December 31, 1996, the borrowing base was approximately $5 million. Under the agreement, the interest rate, at the option of the Company is at the bank's base lending rate or an adjusted London interbank rate and is determined at the time of borrowing. Interest is to be paid monthly and any outstanding principal, unless converted to an 18 month term loan upon the occurrence of certain events, comes due in its entirety on July 1, 1997. The agreement contains restrictions which, among other things, require maintenance of certain financial ratios, restrict encumbrance of assets and creation of indebtedness, and limit the payment of dividends. To date, the Company has not borrowed under the bank credit agreement. The Company expects to renew or replace the credit agreement at its expiration in July 1997.
The Company believes that it has significant ability to finance expected future growth in Contract sales based on its existing amount of cash and cash equivalents and investments at December 31, 1996 ($17.1 million) and the unused revolving credit agreement availability of $5 million.
Public unit offering During the second quarter of 1994 the Company completed the sale of 346,500 units consisting of a total of 346,500 shares of $2.40 Cumulative Convertible Preferred Stock and 2,425,500 common stock purchase warrants in a public offering. Each unit, sold at a price of $24.00 per unit, consisted of one share of preferred stock and seven warrants. Each share of preferred stock had a cumulative dividend of $2.40 per year, a liquidation preference of $24.00 per share and was convertible at any time at the option of the holder into 14 shares of common stock. Each share of preferred stock was also automatically convertible into common stock if the closing price of the preferred stock exceeded $33.60 for ten consecutive trading days. The closing price of preferred stock exceeded such price level for the 10 consecutive trading days ending February 24, 1995, and, as a result, the then outstanding 277,700 shares of preferred stock were converted into common stock. The remaining shares of preferred stock had been previously voluntarily converted. The automatic conversion of the preferred stock together with earlier voluntary conversions resulted in savings of $831,600 per year in dividends.
LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Contract benefits...................................... $ 1,862 $ 1,547 Accounts payable and accrued expenses.................. 912 646 Contingency reserves on trust preparation services..... - 130 ------ ------ Total current liabilities......................... 2,774 2,323 Deferred income taxes.................................... 9,284 3,566 ------ ------ Total liabilities.................................... 12,058 5,889 ====== ======
PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF INCOME (Amounts in 000's, except per share amounts)
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 (45 in 1996, 60 in 1995, and 62 in 1994)............................... 45 60 62 Shares exchanged for Common Stock (13 in 1996, 15 in 1995, and 2 in 1994)................................ (13) (15) (2) ------ ------ ------ Shares issued and outstanding at end of year (32 in 1996, 45 in 1995, and 60 in 1994), liquidation value of $430 at December 31, 1996.................. 32 45 60 ------ ------ ------
PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (continued) (Amounts and shares in 000's, except dividend rates and par values)
Year Ended December 31, ----------------------------- 1996 1995 1994 --------- -------- -------- Retained Earnings (Deficit) - --------------------------- Balance at beginning of year...................... $(6,105) $(13,292) $(16,542) Net Income........................................ 12,470 7,312 3,715 Cash dividends.................................... (15) (125) (465) ------- -------- -------- Balance at end of year............................ 6,350 (6,105) (13,292) ------- -------- --------
Treasury stock - -------------- Balance at beginning and end of year (747 shares). (2,177) (2,177) (2,177) ------- ------- -------
The accompanying notes are an integral part of these financial statements.
Nature of Operations Pre-Paid Legal Services, Inc. (the "Company") underwrites and markets legal service plans (referred to as "Contracts") which provide for or reimburse a portion of legal fees incurred by members in connection with specified matters. Contracts are guaranteed renewable, are principally collected on a monthly basis and are marketed primarily in 24 states by an independent sales force referred to as "Associates".
Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, as well as those of PPL Agency, Inc. (See Note 7 for additional information regarding PPL Agency, Inc.) The primary subsidiaries of the Company include Pre-Paid Legal Casualty, Inc. (PPLCI) and Pre-Paid Legal Services, Inc. of Florida (PPLSIF). All significant intercompany accounts and transactions have been eliminated.
Revenue Recognition Contract premiums are recognized in income when due in accordance with Contract terms which generally require the holder of the Contract to remit premiums on a monthly basis. Contracts are canceled for nonpayment of premium after ninety days. Premiums due but not collected at the end of an accounting period are recorded as accrued Contract income; a provision for uncollectible premiums, if any, is recorded currently. Sales of marketing kits to Associates are recognized as revenue when cash is received.
Long-Lived Assets The Company records impairment losses on long-lived assets used in operations when events and 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. Long-lived assets that are held for disposal are valued at the lower of the carrying amount or fair value less cost to sell, except for assets that constitute a discontinued operation. Assets of discontinued operations are valued at estimated net realizable value.
Accounting Standards to be Adopted In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128 establishes standards for computing and presenting earnings per share ("EPS"), and is effective for financial statements issued for periods ending after December 15, 1997, including interim periods. This Statement simplifies the standards for computing earnings per share previously found in APB Opinion No. 15, Earnings per Share, and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures. Management has not yet evaluated the effect of this pronouncement on the Company's consolidated financial statements.
December 31, 1995 ------------------------------------- Amortized Gross Unrealized Fair Cost Gains Losses Value --------- ------- ------- -------
Property and equipment is comprised of the following: December 31, Estimated ---------------- Useful Life 1996 1995 ----------- ------- ------ Equipment, furniture and fixtures...3-10 years $5,283 $4,338 Computer software................... 5 years 2,087 1,822 Building and improvements...........20 years 1,653 1,621 Automotive.......................... 3 years 213 163 Land................................ 110 110 ------ ------ 9,346 8,054 Accumulated depreciation............ (6,391) (5,852) ------ ------ Property and equipment, net......... $2,955 $2,202 ====== ======
Year Ended December 31, -------------------------- 1996 1995 1994 ------- ------- -------- Current............................. $ - $ - $ 43 Deferred............................ 6,715 3,932 (362) ------ ------ ------ Total provision (benefit) for income taxes....................... $6,715 $3,932 $ (319) ====== ====== ======
December 31, ---------------- 1996 1995 ------- ------- Deferred tax liabilities: Commissions advanced........................ $10,772 $4,408 Depreciation................................ 175 179 ------- ------- Total deferred tax liabilities........... 10,947 4,587 ------- ------- Deferred tax assets: Litigation accruals......................... - 135 Contract benefit reserve.................... 139 226 Receivables allowance....................... 201 201 Net operating loss carryforward............. 4,198 3,188 Capital loss carryforward................... 654 653 General Business Credit carryforward........ 325 325 AMT Credit carryforward.................... 366 366 ------- ------- Total deferred tax assets................. 5,883 5,094 Valuation allowance for deferred tax assets. (4,220) (4,073) ------- ------- Total net deferred tax assets............. 1,663 1,021 ------- ------- Net deferred liability...................... $(9,284) $(3,566) ======= =======
On February 27, 1995, all of the Company's remaining outstanding $2.40 Cumulative Convertible Preferred Stock automatically converted into common stock pursuant to its terms. Approximately 3.9 million shares of common stock were issued as a result of this conversion.
Each share of $3.00 Cumulative Convertible Preferred Stock is entitled to receive cumulative cash dividends at the annual rate of $3 per share, payable quarterly, is convertible into 2.5 shares of Common Stock and is redeemable at the option of the Company at $25 per share. The $3.00 Cumulative Convertible Preferred Stock had a liquidation value of $84,000 at December 31, 1996.
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 $430,000 at December 31, 1996. During 1996, 1995 and 1994, Special Preferred Stock consisting of approximately 13,000, 15,000 and 2,000 shares, respectively, were converted into 105,000 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, 1996, PPLCI did not have funds available for payment of dividends without the approval of the Oklahoma Insurance Commissioner. The Company's ability to pay dividends is also restricted under a line of credit agreement which precludes payments of dividends on Common Stock as long as any amounts are outstanding pursuant to such credit agreement. To date, the Company has not borrowed under the bank credit agreement.
At December 31, 1996, the Company had outstanding warrants and options to purchase a total of approximately 988,000 shares of the Company's Common Stock at an average price of $6.47 per share expiring at various periods through December, 2005.
Aggregate rental expense under all operating leases was $27,000, $28,000 and $42,000 in 1996, 1995 and 1994, respectively. There are no significant operating lease commitments in effect at December 31, 1996.
The Company is a named defendant in certain lawsuits arising in the ordinary course of the Company's business. While the outcome of these lawsuits cannot be predicted with certainty, the Company does not expect these matters to have a material adverse effect on the Company's financial condition, liquidity or results of operations.
The Company, effective July 3, 1995 and pursuant to a registration statement on Form S-3, initiated a stock option plan for its marketing associates whereby the associates could earn stock options based upon their production and recruiting efforts. These options were issued to qualifying associates at each month end from July, 1995 through March 31, 1996 based on that month's production and recruiting results. The exercise price is equal to the closing stock price on the last trading day of each respective month. Additional grants pursuant to the plan ceased March 31, 1996. Activity related to this plan was as follows during 1996 and 1995:
1996 1995 ------------------ ---------------- Weighted Weighted Average Average Exercise Exercise Shares Price Shares Price -------- -------- -------- --------- Outstanding at beginning of year.................... 298,225 $ 8.02 - $ - Granted....................... 177,133 12.50 299,785 8.02 Exercised..................... (70,516) 8.95 (1,560) 7.03 Terminated.................... (54,750) 8.63 - - ------- ------ ------- ------ Outstanding at end of year... 350,092 $10.00 298,225 $ 8.02 ======= ====== ======= ====== Options exercisable at year end................... 350,092 $10.00 298,225 $ 8.02 ======= ====== ======= ======
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 1996 and 1995 would have been reduced to the pro forma amounts indicated below: 1996 1995 ------- ------- Net income applicable to common shares: As reported............................. $12,455 $ 7,187 Pro forma............................... $12,227 $ 6,428
Earnings per common and common equivalent share: As reported............................. $ .56 $ .35 Pro forma............................... $ .55 $ .31
The estimated fair value of options granted to employees was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used: no dividend yield; risk-free interest rate of 6.00%; expected life of 5 years; and expected volatility ranging from 53.74% to 63.75%.
Following is a summary of the unaudited interim results of operations for the year ended December 31, 1996 and 1995.