(2) See Note 3 to Consolidated Financial Statements for information concerning the change in accounting principle in 2000.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - -------------------------------------------------------------------------------- RESULTS OF OPERATIONS - ---------------------
Change in Accounting Principle During 2000, the Company changed its methodology for evaluating the recoverability of its commission advance receivables from terminated or "D status" sales associates. See "Risk Factors" in this Item 7 below. "D status" associates are those that are no longer "active" because they fail to meet the Company's established vesting requirements by either selling at least three new Memberships per quarter or retaining a personal Membership. "D status" associates lose their right to any further commissions earned on Memberships previously sold at the time they are placed in "D status". As a result, the Company is entitled to retain all commission earnings that would otherwise be payable to these terminated associates to recover their unearned commission receivable balances.
Commission Advances Prior to January 1997 the Company advanced commissions at the time of sale of all new Memberships. In January 1997, the Company implemented a policy whereby the associate receives only earned commissions on the first three sales unless the associate has successfully completed the Fast Start training program that was implemented in 1997. For all sales beginning with the fourth Membership or all sales made by an associate successfully completing the Fast Start training program, the Company currently advances commissions at the time of sale of a new Membership. The amount of cash potentially advanced upon the sale of a new Membership, prior to the recoupment of any charge-backs (described below), represents an amount equal to up to three years commission earnings. Although the average number of marketing associates receiving an advance commission payment on a new Membership is 12, the overall initial advance may be paid to more than twenty five different individuals, each at a different level within the overall commission structure. This commission advance immediately increases an associate's obligation to the Company and represents a receivable from the associates.
Commissions are earned by and payable to the associate as Membership premiums are earned, usually on a monthly basis. The Company reduces Commission advance receivables or remits payment to an associate, as appropriate, when commissions are earned. Commission advance receivables on lapsed Memberships are recovered through commission earnings on an associate's remaining active Memberships or through a charge-back mechanism. Should a Membership lapse before the advances have been recovered for each commission level, the Company generates an immediate "charge-back" to the applicable sales associate to recapture up to 50% of any unearned advance. This charge-back is deducted from any future advances that would otherwise be payable to the associate for additional new Memberships. Any remaining commission advance receivable is recovered by withholding future residual earned commissions due an associate on active Memberships. Additionally, even though a commission advance may have been fully recovered on a particular Membership, no additional commission earnings from any Membership are paid to an associate until all previous advances on all Memberships, both active and lapsed, have been recovered.
The Company charges associates a fee on commission advance receivables relating to lapsed Memberships ("Membership lapse fee"). The fee is determined by applying the prime interest rate to the commission advance receivable balance pertaining to lapsed Memberships. The Company realizes and recognizes income only when the amount of the calculated fee is collected by withholding from cash commissions payments due the associate, because the Company's ability to recover fees in excess of current payments is primarily dependant on the associate selling new Memberships which qualify for commission advances.
The Company has the contractual right to require associates to repay commission advance receivables from sources other than earned commissions including cash (a) from all associates either (i) upon termination of the associate relationship or (ii) when it is ascertained that earned commissions are insufficient to repay the advance receivables and (b) upon demand, from agencies or associates who are parties to the associate agreements signed between October 1989 and July 1992 or July 1992 to August 1998, respectively. The sources, other than earned commissions, that may be available to recover associate commission advance receivables are potentially subject to limitation based on applicable state laws relating to creditors' rights generally. Historically, the Company has not demanded repayments of the receivables from associates, including terminated associates, because in the aggregate the Company's commission advance receivables have been substantially recovered from estimated future commission earnings, and collection efforts would likely increase costs and have the potential to disrupt the Company's relationships with its sales associates. However, the Company regularly reviews the commission advance receivable status of associates and will exercise its right to require associates to repay advances when management believes that such action is appropriate.
"D status" associates are those that are no longer "active" because they fail to meet the Company's established vesting requirements by selling at least three new Memberships per quarter or retaining a personal Membership. "D status" associates lose their right to any further commissions earned on Memberships previously sold at the time they are placed in "D status". As a result the Company has no continuing obligation to individually account to these associates as it does to active associates and is entitled to retain all commission earnings that would be otherwise payable to these terminated associates. The Company does continue to reduce the advance commission receivables for commissions earned on active Memberships previously sold by those associates. "D status" commission advance receivables were $20.5 million and $18.0 million at December 31, 2000 and 1999, respectively. Substantially all individual "D status" associate commission advance receivable balances were less than $1,000 and the average balance was $816 at December 31, 2000.
Operating Ratios Three principal operating measures monitored by the Company in addition to measures of Membership retention are the Membership benefit ratio, commission ratio and the general and administrative expense ratio. The Membership benefits ratio, the Commissions ratio and the general and administrative expense ratio represent those costs as a percentage of Membership fees. The Company strives to maintain these ratios as low as possible. These ratios do not measure total profitability because they do not take into account all revenues and expenses.
Income Tax Matters-Net Operating Losses The Company has NOLs in the amount of $2.8 million representing the remaining NOLs of TPN. The Company's wholly owned subsidiary UFL has an alternative minimum tax ("AMT") credit carryforward of $464,000 that does not expire. A valuation allowance has been established for these carryforwards as the Company does not believe it is more likely than not that the tax benefits of these carryforwards and credits will be realized prior to expiration due in part to utilization restrictions imposed by Section 382 as discussed below.
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"). One such limitation is contained in Section 382 of the Code which imposes an annual limitation on the amount of a corporation's taxable income that can be offset by those carryforwards in the event of a substantial change in ownership as defined in Section 382 ("Ownership Change"). In general, an Ownership Change occurs if during a specified three-year period there are capital stock transactions that result in an aggregate change of more than 50% in the beneficial ownership of the stock of the Company. However, the Company does not have control over all possible variables which can affect the Ownership Change calculation and, accordingly, it is possible that an Ownership Change could occur in the future. The effect of any such Ownership Change on the Company's financial condition or results of operations cannot be determined because it is dependent upon unknown future facts and circumstances at the time of any such change, including, among others, the amount of any Company's NOLs, the fair market value of the Company's stock and the Company's other tax attributes. The acquisition of TPN by the Company constituted an Ownership Change of TPN. As a result, the ability of the Company to utilize TPN's remaining $2.8 million in NOLs is limited to approximately $954,000 per year. Although the Company did not utilize any of the TPN NOL during 1998, it did fully utilize the available amount during 1999 and 2000. However, due to anticipated continuing growth and the expected availability of other tax benefits, the Company does not believe it is more likely than not that the tax benefits of the TPN NOL carryforward will be realized. The TPN NOL expires in years 2015 through 2018.
Associate Services The Company derives revenues from services provided to its marketing sales force from an enrollment fee of approximately $65 from each new sales associate for which the Company provides initial sales and marketing supplies and enrollment services to the associate. In January 1997, the Company implemented a training program ("Fast Start") that 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 fee of $184. The fee covers the additional training and materials used in the training program and are recognized in income upon completion of the training. The Company enrolled 97,617 new sales associates during 2000 compared to 92,644 during 1999 and 75,737 during 1998, resulting in significant increases in associate services revenues and costs. Associate services also includes revenue recognized on the sale of marketing supplies and promotional material to associates. The Company's 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 costs incurred in recruiting, training, monitoring and providing materials to sales associates and are not intended to generate profits from such activities.
Product marketing activities have declined significantly over the last several years and represents less than 1% of total revenues in 2000. The Company expects future product sales and costs will be immaterial.
The hypothetical changes in market interest rates reflect what could be deemed best and worst case scenarios. The fair values shown in the following table are based on contractual maturities. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and, therefore, actual results might differ from those reflected in the following table:
SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," ("SAB 101") was issued December 1999. This staff bulletin summarizes certain of the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 is effective no later than the fourth fiscal quarter of the fiscal years beginning after December 15, 1999. The Company implemented SAB 101 in the fourth quarter of 2000. Refer to Note 1 to the consolidated financial statements for a discussion of the effect on the consolidated financial statements.
One of the major factors affecting the Company's profitability and cash flow is the ability of the Company to retain a Membership, and therefore continue to receive fees, once it has been written. The Company monitors its overall Membership persistency rate, as well as the persistency rates with respect to Memberships sold by individual associates and agents and persistency rates with respect to Membership sales by year of issue, geographic region and payment method. The Company has historically disclosed its Membership persistency data as described below under "Membership Persistency". Certain other measures of Membership retention are described below together with an explanation of their potential use and limitations.
Average Member Life A third measure of persistency, commonly used by actuaries for comparing the longevity of renewable membership services, such as subscriptions, life insurance services, etc. is the Average Member Life. It is based on a model that assumes that a fixed number of new members have been historically enrolled in each previous year, so that the distribution of actual lifetimes of the members in force mirrors the membership retention rates described above.
Expected Lifetime Value Years Paid X Average Average Year Members Members ---- ------- ------- 1 76.69 76.69 2 45.17 90.34 3 32.82 98.45 4 26.13 104.52 5 21.83 109.13 6 18.72 112.29 7 16.37 114.56 8 14.55 116.36 9 13.09 117.81 10 11.90 119.00 11 10.90 119.90 12 10.06 120.72 13 9.35 121.55 14 8.72 122.01 15 8.12 121.80 16 7.54 120.56 17 7.00 119.00 18 6.54 117.72 19 6.18 117.33 20 5.89 117.70 Totals ------------- --------- 357.52 A 2,257.42 B ----------------------- Expected Membership lifetime value (B / A) 6.31 years of revenue -----------------------
Using this data, if a fixed number of members had been enrolled in each of the past twenty years, the current Average Member Life of active members would be 6.3 years. Note that this is a model distribution for comparison purposes only. Since Membership enrollment rates have grown significantly over the years, the Company's actual Membership population is weighted more heavily by recent new enrollments, hence the average age of the current Membership population will be lower than this number. It should be noted that the Average Member Life may be useful for comparison for the Company's member longevity versus other services, since it is not affected by historical new enrollment rates or rates of growth, which may vary between services being compared. It is not directly useful for nor is it used by the Company in any way to assess risks and required reserves for uncollectible commission advance receivables, or any other financial factor.
Comparison of 2000 to 1999 The Company reported net income applicable to common shares of $43.6 million, or $1.92 per diluted common share, for 2000 after a current year after-tax charge of $4.1 million relating to the cumulative effect on prior years of changing the accounting for Membership commission advance receivables as discussed in Note 3 to the Consolidated Financial Statements. The net income per diluted share was up 12% from net income applicable to common shares of $38.9 million, or $1.67 per diluted common share, for 1999. The increase in the net income applicable to common shares for 2000 is primarily the result of increases in Membership fees for 2000 as compared to 1999.
Membership fees totaled $210.4 million during 2000 compared to $157.2 million for 1999, an increase of 34%. Membership fees and their impact on total revenues in any period are determined directly by the number of active Memberships in force during any such period. The active Memberships in force are determined by both the number of new Memberships sold in any period together with the renewal rate of existing Memberships. New Membership sales increased 28% during 2000 to 670,118 from 525,352 during 1999. At December 31, 2000, there were 1,064,805 active Memberships in force compared to 827,979 at December 31, 1999, an increase of 29%. Additionally, the average annual fee per Membership has increased from $238 for all Memberships in force at December 31, 1999 to $244 for all Memberships in force at December 31, 2000, a 3% increase, as a result of a higher portion of active Memberships containing the additional pre-trial hours benefit at an additional cost to the member together with increased sales of the Business Owners' Legal Solutions plan.
Associate services revenue increased 33% from $22.8 million for 1999 to $30.4 million during 2000 as a result of more new associates recruited and as a result of Fast Start which resulted in the Company receiving training fees of approximately $16.8 million during 2000 compared to $12.6 million during 1999. The field training program, titled Fast Start to Success ("Fast Start") is aimed at increasing the level of new Membership sales per associate. Fast Start requires a training fee of $184 per new associate and upon successful completion of the program provides for the payment of certain training bonuses. In order to be deemed successful for Fast Start purposes, the new associate must write three new Memberships and recruit three new sales associates or personally sell five Memberships within 60 days of becoming an associate. The $16.8 million and $12.6 million for 2000 and 1999, respectively, in training fees was comprised of $184 from each of approximately 91,432 new sales associates who elected to participate in Fast Start in 2000 compared to 68,535 that paid the $184 during 1999. New associates electing to participate in Fast Start increased to 94% of new associates during 2000 from 74% for 1999. Total new associates enrolled during 2000 were 97,617 compared to 92,644 for 1999, an increase of 5%. While the number of new associates increased during 2000, the number of new Memberships sold, at least partially as a result of the Fast Start program, increased even more significantly. Future revenues from associate services will depend primarily on the number of new associates enrolled and the number who choose to participate in the Company's training program, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of training (including training bonuses paid), providing associate services and other direct marketing expenses.
Primarily as a result of the increase in Membership fees, total revenues increased to $247.7 million for 2000 from $192.9 million during 1999, an increase of 28%.
Membership benefits totaled $70.5 million for 2000 compared to $51.8 million for 1999, and represented 33.5% and 33.0% of Membership fees for 2000 and 1999, respectively. This Membership benefit ratio (Membership benefits as a percentage of Membership fees) should remain near 35% as substantially all active Memberships provide for a capitated benefit.
Commission expense was $51.9 million for 2000 compared to $36.9 million for 1999, and represented 24.7% and 23.4% of Membership fees for such years. Commission expense, as a percentage of Membership fees, should remain at or near 25% of Membership fees based on the existing commission structure.
General and administrative expenses during 2000 and 1999 were $23.4 million and $21.4 million, respectively, and represented 11.1% and 13.6% of Membership fees for such years. Management expects further gradual decreases in general and administrative expenses when expressed as a percentage of Membership fees as a result of certain economies of scale.
Associate services and direct marketing expenses increased to $23.0 million for 2000 from $16.0 million for 1999 primarily as a result of Fast Start training bonuses paid of approximately $8.9 million during 2000 compared to $7.5 million in 1999. Additional costs of supplies due to increased enrollment of new associates, purchases by associates and higher staffing requirements for associate related service departments also contributed to the increase. These expenses also include the costs of providing associate services and marketing costs other than commissions that are directly associated with new Membership sales.
The provision for income taxes increased during 2000 to $23.3 million compared to $21.0 million for 1999, representing 32.8% and 35.0% of income before income taxes for 2000 and 1999, respectively.
Membership fees totaled $157.2 million during 1999 compared to $110.0 million for 1998, an increase of 43%. Membership fees and their impact on total revenues in any period are determined directly by the number of active Memberships in force during any such period. The active Memberships in force are determined by both the number of new Memberships sold in any period together with the renewal rate of existing Memberships. New Membership sales increased 34% during 1999 to 525,352 from 391,827 during 1998. At December 31, 1999, there were 827,979 active Memberships in force compared to 603,017 at December 31, 1998, an increase of 37%. Additionally, the average annual fee per Membership has increased from $229 for all Memberships in force at December 31, 1998 to $238 for all Memberships in force at December 31, 1999, a 4% increase, as a result of a higher portion of active Memberships containing the additional pre-trial hours benefit at an additional cost to the member together with increased sales of the Business Owners' Legal Solutions plan.
Product sales declined 79% during 1999 to $5.9 million from $27.8 million in 1998 primarily due to the concentration on Membership sales as opposed to the sale of goods and services following the TPN acquisition. The trend of declining product sales is expected to continue as the array of goods and services previously available for sale through TPN is dramatically narrowed and sales efforts are more closely focused on the sale of new Memberships and the recruitment of new sales associates.
Primarily as a result of the increase in Membership fees, total revenues increased to $192.9 million for 1999 from $157.9 million during 1998, an increase of 22%.
Product costs declined more than $13.7 million, or 77%, during 1999 to $4.2 million from $18.0 million for 1998 in conjunction with the 79% decline in product sales. Product costs as a percentage of product sales were 71% for 1999 compared to 65% during 1998. Product costs are expected to decline proportionately as product sales decline as more emphasis is placed on Membership sales rather than the sale of goods and services.
Other expenses decreased 29% from $1.6 million to $1.2 million for 1999 primarily due to an increase in Membership lapse fees and interest income for 1999 of $865,000 to $3.4 million from $2.6 million for 1998. Membership lapse fees increased primarily as a result of increased commission advance receivables, which, under certain circumstances, incur a fee. Fee income on commission advance receivables was $1.0 million in 1999 and $500,000 in 1998. At December 31, 1999 the Company reported $37.4 million in cash and investments (after utilizing more than $29.4 million to repurchase approximately 1.2 million shares of its common stock) compared to $50.1 million at December 31, 1998. Depreciation and amortization increased from $2.9 million for 1998 to $3.1 million for 1999. This increase was primarily due in part to increased amortization of production costs by $425,000.
The provision for income taxes increased during 1999 to $21.0 million compared to $11.1 million for 1998, representing 35.0% and 26.9% of income before income taxes for 1999 and 1998, respectively. The 1998 provision for income taxes reflects a $3.5 million benefit attributable to a reduction of a previously established valuation allowance due to the utilization of certain of the Company's NOL carryforwards.
The Company had a consolidated working capital surplus of $26.3 million at December 31, 2000 compared to $23.3 million at December 31, 1999. The $3.0 million increase in working capital during 2000 was primarily the result of an increase in the current portion of commission advance receivables of $12.7 million and a $1.9 million increase in Membership income receivable offset by an increase in deferred product sales revenue, Membership and associate fees of $12.2 million.
The Company believes that it has significant ability to finance expected future growth in Membership sales based on its existing amount of cash and cash equivalents and unpledged investments at December 31, 2000 of $41.3 million. The Company expects to maintain cash and cash equivalent balances on an on-going basis of approximately $30 million to $40 million in order to meet expected working capital needs and regulatory capital requirements. Cash balances in excess of this amount would be used for discretionary purposes such as stock repurchases. The Company continues to consider incurring indebtedness in order to continue or increase the rate of stock repurchases, including financing its new corporate headquarters in order to allow cash flow from operations to continue to be used to repurchase stock.
Our future results may be adversely affected if membership persistency or renewal rates are lower than our historical experience. The Company has over 20 years of actual historical experience to measure the expected retention of new members. These retention rates could be adversely effected by the quality of services delivered by provider law firms, the existence of competitive products or services, the Company's ability to provide administrative services to members or other factors. If the Company's membership persistency or renewal rates are less than the Company has historically experienced, the Company's cash flow, earnings and growth rates could be adversely affected.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 3 to the consolidated financial statements, the Company has changed its method of accounting for Membership commission advance receivables in 2000.
Nature of Operations Pre-Paid Legal Services, Inc. (the "Company") develops and markets legal service plans (referred to as "Memberships"). The Memberships sold by the Company allow members to access legal services through a network of independent law firms ("provider law firms") under contract with the Company. Provider law firms are paid a fixed fee on a capitated basis to render services to plan members residing within the state or province in which the provider law firm is licensed to practice. Because the fixed fee payments by the Company to provider law firms do not vary based on the type and amount of benefits utilized by the member, this capitated arrangement provides significant advantages to the Company in managing claims risk. At December 31, 2000, Memberships subject to the provider law firm arrangement comprised more than 98% of the Company's active Memberships. The remaining Memberships (less than 2%) were primarily sold prior to 1987 and allow members to locate their own lawyer to provide legal services available under the Membership with the member's lawyer being reimbursed for services rendered based on usual, reasonable and customary fees. Memberships are generally guaranteed renewable and Membership fees are principally collected on a monthly basis, although approximately 2% of Members have elected to pay their fees in advance on an annual, semi-annual or quarterly basis. The Memberships are marketed primarily in 28 states and the provinces of Ontario and British Columbia by an independent sales force referred to as "Associates".
Basis of Presentation The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("generally accepted accounting principles") which vary in some respects from statutory accounting principles used when reporting to state insurance regulatory authorities. The consolidated financial statements give retroactive effect, as a result of applying the pooling of interests accounting method, to the merger with TPN, which was effective October 2, 1998. The UFL acquisition, on December 30, 1998, was accounted for by the purchase method of accounting for business combinations. (See Note 2)
Commissions The Company has a level Membership commission schedule of approximately 25% of Membership fees. 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 fees generated by the sale of such Memberships. The Company currently advances the equivalent of up to three years of commissions on new Membership sales. In January 1997, the Company implemented a new policy whereby associates do not receive advance commissions on the first three Memberships submitted unless the associate successfully completes a Company training program, produces three Memberships and recruits three associates within 60 days from becoming an associate.
Effective April 2001, the Company modified its compensation plan to consolidate the lower four levels of its compensation structure into two levels. At the same time, the Company implemented a two-year advance at the lowest commission level for associates who participate in the training program. Associates who do not participate in the training program receive only earned commissions until they meet the advancement qualification requiring them to produce 50 new memberships in their organization in order to advance to the next compensation level and qualify for up to 3 years commission advance.
Deferred Costs Deferred costs represent the direct incremental expenses the Company incurs in enrolling new members and new associates. Deferred costs for enrolling new members include the cost of the Membership kit and salary and benefit costs for employees who process Membership enrollments. Deferred costs for enrolling new associates include bonuses paid to individuals involved in recruiting the associate and salary and benefit costs of employees who process associate enrollments. Such costs are deferred to the extent of the lesser of actual costs incurred or the amount of the related fee charged for such services. (Refer to Note 1 - Revenue Recognition). Deferred costs are amortized to expense over the estimated life of the Memberships or the estimated average active period of associates, as applicable. At December 31, 2000 the estimated life of a Membership and the average active service periods of associates were 3.6 years and one year, respectively.
The Company charges a $10 enrollment fee to new members who are not part of an employee group. This fee is deferred and amortized to income over the estimated life of the Membership which at December 31, 2000 is 3.6 years.
Commission Advance Receivables Commission advance receivables represent a receivable from associates for the unearned portion of commissions advanced to associates on sales of Memberships. Commissions are earned as Membership fees are earned, usually on a monthly basis. Up to fifty-percent of commission advance receivables on lapsed Memberships are recovered from sales commissions due the associate on the sale of new Memberships. The remaining commission advance receivables on lapsed Memberships are recovered from earned commissions due an associate on remaining active Memberships. If there are no new sales made by the associate, 100% of the commission advance receivable is recovered from commissions due the associate on prior sales.
The Company charges associates a fee on commission advance receivables relating to lapsed Memberships. The fee is determined by applying the prime interest rate to the commission advance receivable balance pertaining to lapsed Memberships. The Company realizes and recognizes income only when the amount of the calculated fee is collected by withholding from cash commissions payments due the associate, because the Company's ability to recover fees in excess of current payments is primarily dependent on the associate selling new Memberships which qualify for commission advances.
Deferred income taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The Company records deferred tax assets related to the recognition of future tax benefits of temporary differences and net operating loss and tax credit carryforwards. To the extent that realization of such benefits is not considered more likely than not, the Company establishes a valuation allowance to reduce such assets to estimated realizable value.
Long-Lived Assets The Company reviews long-lived assets to be held and used in operations when events or changes in circumstances indicate that the assets might be impaired. The carrying value of long-lived assets is considered impaired when the identifiable undiscounted cash flows estimated to be generated by those assets are less than their carrying amounts. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that fair values are reduced by disposal costs.
Stock-Based Compensation Compensation expense is recorded with respect to stock option grants and restricted stock awards to employees and board members 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. For employee and board member stock options, the Company has adopted the disclosure requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") in preparing its financial statement disclosures.
Stock options granted to associates and other non-employees after December 15, 1995 are accounted for at fair value in accordance with SFAS 123.
New Accounting Standard Adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," ("SFAS 133") was issued in June 1998. This Statement, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. SFAS 133, as amended, applies to all entities and is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. The Company adopted SFAS 133, as amended, on January 1, 2001 as required. The Company did not hold any derivative instruments at January 1, 2001 and there was no effect on the consolidated financial statements upon the adoption of SFAS 133.
SEC Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements," ("SAB 101") was issued December 1999. This Staff Bulletin summarizes certain of the staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 was effective no later than the fourth fiscal quarter of the fiscal years beginning after December 15, 1999. The Company implemented SAB 101 in the fourth quarter of 2000, and has deferred the non-refundable $10 Membership and $47 of the associate enrollment fees and the related direct incremental costs associated with services provided members and associates in return for such fees. These deferred revenues and related costs will be amortized to income over the estimated life of the Membership or the estimated average active service period of associates which at December 31, 2000 were 3.6 years and one year, respectively. The deferred revenue and cost amounts at December 31, 2000 were $8.5 million. The implementation of SAB 101 did not result in a cumulative effect type adjustment in the consolidated income statement for the year ended December 31, 2000 since direct incremental costs of providing the services related to the enrollment of members and associates were equal to or greater than the fees charged for such services. These excess direct incremental costs are recognized in income as incurred.
The Company completed its acquisition of UFL on December 30, 1998. UFL, based in Duncan, Oklahoma, was a subsidiary of Pioneer Financial Services, Inc. ("Pioneer"), which is a subsidiary of the Conseco group of companies. The Company paid $20.7 million in cash to Pioneer in exchange for all of the outstanding capital stock of UFL, which had assets and liabilities at December 31, 1998 with carrying values of $43.9 million and $24.0 million, respectively, which approximated their fair values. This acquisition was accounted for by the purchase method of accounting for business combinations. The accompanying consolidated statements of income include revenues and expenses related to this operating segment of the Company subsequent to its acquisition. The transaction has not had a material effect on the Company's operating results. As a part of the transaction, Pioneer Life Insurance Company, a wholly-owned subsidiary of Pioneer, entered into a 100% coinsurance agreement with UFL assuming all of the assets and liabilities relating to Medicare supplement and health care business written by UFL. UFL retained its existing life insurance business (2000 and 1999 premiums were $1.2 million and $1.0 million, respectively) and continues to provide claims processing for the coinsured Medicare supplement and health care policies and receives full cost reimbursement for such services. During 2000 and 1999, premium income and benefits expense for this coinsurance business (each of which were fully ceded to the coinsuring party) were $31.0 million and $22.5 million, and $33.1 million and $24.1 million, respectively.
A summary of the amortized cost, unrealized gains and losses and fair values of the Company's investments at December 31, 2000 and 1999 follows:
Amortized Cost Fair Value ---------- ----------- One year or less................................... $ 6,241 $ 6,223 Two years through five years....................... 9,942 9,963 Five years through ten years....................... 6,292 6,325 More than ten years................................ 7,016 6,820 ----------- ----------- Total.............................................. $ 29,491 $ 29,331 =========== ===========
December 31, ------------------------- 2000 1999 ---------- ------------ Certificates of deposit........................... $ 2,451 $ 1,774 Obligation of state and political subdivisions.... 130 100 U. S. Government obligations...................... 3,524 3,414 ----------- ----------- Total $ 6,105 $ 5,288 =========== ===========
Sales of investments during 2000 were not significant. Proceeds from sales of investment securities available-for-sale were $18,150,000 in 1999 resulting in gross realized gains of $700,000 and gross realized losses of $155,000. Proceeds from sales of investment securities held-to-maturity were $23,718,000 in 1998, resulting in gross realized gains of $17,500 and gross realized losses of $81,500.
Inventories consist of the following: December 31, 2000 1999 Personal and home care, and personal developement inventory.................... $ 198 $ 618 Jewelry inventory........................... 613 763 Sales and promotional materials............. 1,160 873 Less: Inventory reserve..................... (429) (812) ----------- ----------- Total $ 1,542 $ 1,442 =========== ===========
The Company examines, at the end of each quarter, on an associate-by-associate basis, the estimated recoverability of each associate's commission advance receivable by estimating the associate's future commission earnings. The future commission earnings are estimated based on each associate's active memberships at the end of the reporting period and the related future commission earnings expected to be derived from such active memberships. Each active membership is assumed to lapse in accordance with the Company's estimated future lapse rate, which is based on the Company's actual historical membership retention experience as applied to each active membership's year of origin. The data used is based on a 20-year history of membership retention rates, which is updated annually to reflect actual experience. The Company also closely reviews current data for any trends that would affect the historical data. The aggregate of all estimated future commission earnings for each associate is then compared to that associate's commission advance receivable balance.
The net carrying value of capitalized leased assets was $560,000 and $790,000 at December 31, 2000 and 1999, respectively.
The exercise of certain 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 are recorded in capital in excess of par value.
During 2000 and 1999, the Company's $3.00 Cumulative Convertible Preferred Stock, consisting of 2,133 shares and 111 shares, respectively, were converted into 5,609 shares of Common Stock and during 2000, 1,027 shares were redeemed for a value of $25,675. At December 31, 2000, all such shares had been converted or redeemed. Each share of $3.00 Cumulative Convertible Preferred Stock was previously entitled to receive cumulative cash dividends at the annual rate of $3 per share, payable quarterly, was convertible into 2.5 shares of Common Stock and was redeemable at the option of the Company at $25 per share.
The Company announced on April 6, 1999, a stock repurchase program authorizing management to reacquire up to 500,000 shares of the Company's common stock. The Board of Directors has increased such authorization from 500,000 shares to 2,000,000 shares during subsequent board meetings. At December 31, 2000, the Company had repurchased 1,748,209 shares under these authorizations for a total consideration of $48.3 million, an average price of $27.60 per share. The Board, at its January 16, 2001 meeting, authorized additional 250,000 shares to be repurchased.
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 and UFL is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits. At December 31, 2000, PPLCI and UFL did not have funds available for payment of significant dividends without the approval of the Oklahoma Insurance Commissioner.
Mr. Stonecipher and Shirley A. Stonecipher own Stonecipher Aviation LLC ("SA") and Mr. and Mrs. Stonecipher together with Wilburn L. Smith, President and a director of the Company, own S & S Aviation LLC ("S&SA"). The Company has agreed to reimburse SA and S&SA for certain expenses pertaining to trips made by Company personnel for Company business purposes using aircraft owned by SA and S&SA. Such reimbursement represents the pro rata portion of direct operating expenses, such as fuel, maintenance, pilot fees and landing fees, incurred in connection with such aircraft based on the relative number of flights taken for Company business purposes versus the number of other flights during the applicable period. No reimbursement is made for depreciation, capital expenditures or improvements relating to such aircraft. During 2000, 1999 and 1998, the Company paid $264,000, $276,000 and $279,000, respectively, to SA as reimbursement for such transportation expenses. S&SA was organized during 2000, and the Company paid $372,000 to S&SA during such year as reimbursement for such transportation expenses.
Wilburn L. Smith, President and a director of the Company, has loans from the Company made in December 1992, December 1996 and October 1998. The largest aggregate balance of the loans during the year ended December 31, 2000 was $515,000. The outstanding balance of the loans as of December 31, 2000 was $478,600. The loans bear annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year, and are secured by Mr. Smith's commissions from the Company. Mr. Smith also owns corporations or partnerships not affiliated with the Company but engaged in the marketing of the Company's legal service memberships and which earn commissions from sales of memberships. These entities earned commissions, net of amounts passed through as commissions to their sales agents, during 2000, 1999 and 1998 of $13,000, $14,000 and $39,000, respectively.
Randy Harp, Chief Operating Officer and a director of the Company, has loans from the Company made in December 2000. The largest aggregate balance of these loans during the year ended December 31, 2000 was $350,000. The outstanding balance of these loans as of December 31, 2000 was $350,000. These loans bear annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year.
David A. Savula, a director of the Company, is actively engaged as an independent contractor in the marketing of the Company's legal service memberships. During 2000, 1999 and 1998, Mr. Savula received from the Company $936,427, $815,460 and $651,215, respectively, pursuant to a previous agreement with the Company providing for the payment to Mr. Savula of override commissions and other fees with respect to commissions earned by, and new sales associate sponsorships within, the Company's multilevel marketing sales force, as well as amounts received pursuant to his individual associate agreement.
The Company also has notes receivable from certain marketing consultants who provide significant marketing-related services to the Company. Such notes aggregated approximately $2.6 million and $2.0 million at December 31, 2000 and 1999, respectively, and bear interest at the rate of 10%.
At December 31, 2000, the Company was committed under noncancelable operating and capital leases, principally for buildings and equipment. Aggregate rental expense under all operating leases was $49,600, $113,000 and $468,000 in 2000, 1999 and 1998, respectively. At December 31, 2000, minimum rentals for capital leases for the year ending December 31, 2001 is $224,000.
As of December 31, 2000, the Company recorded a charge of $1.5 million representing an amount negotiated on January 23, 2001 to settle a lawsuit involving multiple plaintiffs. This settlement offer was unexpectedly received in a settlement conference and management believed that it was in the best interest of the Company to promptly settle this matter.
Subsequent to December 31, 2000, the Company and various of its executive officers were named in multiple putative securities class action complaints filed in both the United States District Courts for the Eastern and Western Districts of Oklahoma seeking damages on the basis of allegations that the Company issued false and misleading financial information, primarily related to the method the Company uses to account for commission advance receivables from sales associates. These complaints have been transferred to Western District of Oklahoma where motions to consolidate them into a single proceeding are pending. As of April 20, 2001, these cases were in the preliminary procedural stages relating to selection of lead counsel and lead plaintiffs as required by the Private Securities Litigation Reform Act of 1995 ("PSLRA"). After the selection of lead plaintiffs and lead counsel, the Company expects that an amended and consolidated complaint will be filed. The Company expects to file a motion to dismiss the complaint. Under PSLRA, discovery is stayed during the pendency of a motion to dismiss. Costs of defense of these cases through the motion to dismiss stage are not expected to be material. While the outcome of these cases is uncertain, the Company believes these actions are without merit and will vigorously defend these actions. However, an unfavorable decision in this litigation could have a material adverse effect on the Company's financial position, results of operations and cash flows.
In January 2001, the Company received inquiries from the Division of Enforcement of the Securities and Exchange Commission ("SEC") requesting information relating primarily to the Company's accounting policies for commission advance receivables from sales associates. Also, in January 2001 the staff of the SEC's Division of Corporation Finance reviewed the Company's 1999 Form 10-K. The Division of Enforcement's inquiry is informal and does not constitute a formal investigation or proceeding. In subsequent discussions and exchanges of correspondence the staff of the Division of Corporation Finance of the SEC raised issues regarding the Company's accounting policies and requested additional information from the Company. The Company is cooperating with the staff of the SEC in providing the requested information and expects to continue to do so. As of April 20, 2001, these inquiries were proceeding. The Company is not able to predict what the outcome of these inquiries may be or when they will be resolved.
The Company also has other options outstanding. These grants were made to Regional Vice Presidents ("RVP") (marketing employees) of the Company and marketing consultants. The exercise price is equal to the closing stock price on the day the RVP was appointed by the Company or the date the options were granted to the marketing consultants. Effective December 31, 1999, the unvested portion of the outstanding RVP options (755,332 options with a weighted average exercise price of $28.53) were terminated.
Basic earnings per common share are computed by dividing net income applicable to common stockholders by the weighted average number of shares of common stock outstanding during the year.
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 and the Special Preferred stock are considered to be dilutive common stock equivalents for all periods and the number of shares issuable on conversion of the $3.00 Cumulative Convertible Preferred stock and the Special Preferred Stock is added to the weighted average number of common shares. At December 31, 2000 all such shares had been converted or redeemed. The weighted average number of common shares is also increased by the number of shares issuable on the exercise of options less the number of common shares assumed to have been purchased with the proceeds from the exercise of the options 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.
Following is a summary of the unaudited interim results of operations for the years ended December 31, 2000 and 1999.
Selected Quarterly Financial Data (In thousands) Effect of Net Income Change in as Accounting Previously Principle Net Income Revenues Reported (1) as Restated -------- ---------- ---------- ----------- First quarter... $55,933 $11,392 $(4,512) $ 6,880 Second quarter.. 60,200 12,659 (785) 11,874 Third quarter... 65,616 14,360 (729) 13,631 Fourth quarter.. 65,903 12,389 (1,162) 11,227
Depreciation and amortization, income taxes and capital expenditures for UFL are not significant.