- ---------- (1) Weighted average shares outstanding gives effect to dilutive effect of outstanding common stock equivalents and other potentially dilutive securities. See Note 1 of Notes to Consolidated Financial Statements of the Company. (2) The loss ratio represents Contract benefit costs as a percentage of Contract premiums. The expense ratio represents the total of commissions, direct marketing expenses, general and administrative expenses, premium taxes, interest and certain other normal operating expenses as a percentage of Contract premiums. The combined ratio does not measure total profitability because it does not take into account all revenues and expenses.
Contract benefit costs vary depending on the type of Contract. Closed panel plans provide the Contract benefits only through a designated provider attorney with whom the Company has arranged for the services to be provided in a particular geographic area. Provider attorneys receive a fixed monthly payment for each member in their service area and are responsible for providing the Contract benefits without additional remuneration. The fixed cost aspect of closed panel plans provides significant advantages to the Company in managing its claims risk. Under closed panel plans, the Company has the ability to more effectively monitor the quality of legal services provided and, due to the volume of claims that may be directed to particular provider attorney law firms, has potential access to larger, more diversified law firms. At December 31, 1996, approximately 88% of the Company's Contracts were closed panel plans.
Contract benefit costs relating to open panel Contracts, which constituted approximately 12% of Contracts in force at December 31, 1996, 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 periodically reviewed 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.
Prior to January 4, 1997, the Company's advanced commissions at the time of sale of all new Contracts. Effective January 4, 1997, the Company implemented a policy whereby the associate receives earned commissions on the first three sales unless the associate has successfully completed the new training program which was implemented at the same time. For all sales beginning with the fourth membership or all sales made by an associate successfully completing the new training program the Company currently advances commissions at the time of sale of a new membership Contract. 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 three years commission earnings. Although the average number of marketing associates receiving an advance commission payment on a new membership is ten, the overall initial advance may be paid to more than twenty different individuals, each at a different level within the overall commission structure. This commission advance immediately increases an associate's account with the Company and represents prepaid commissions on active memberships.
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 persistency. The Company closely monitors such commission advances to ensure maximum recoverability and maintains a recoverability reserve which at December 31, 1996 and 1995, was $3.4 million and $2.7 million, respectively.
Income Tax Matters-Net Operating Losses At December 31, 1996, the Company had net operating loss carryforwards ("NOLs") for Federal regular and alternative minimum tax purposes of approximately $11.9 million and $11.5 million, respectively, expiring in 2012 and 2013, respectively. In addition, the Company had general business and rehabilitation tax credit carryforwards of approximately $325,000 expiring primarily in 1998 to 2001, and an alternative minimum tax credit carryforward of $366,000 which does not expire. A valuation allowance has been established for deferred tax assets representing pre-1996 carryforwards except as related to the AMT Credit carryforward (which is considered to be fully realizable) as the Company does not believe it is more likely than not that the tax benefits of such carryforwards will be realized. The Company generated a tax loss for the year ended December 31, 1996 of $2.8 million. The Company believes it will realize the approximate $1.0 million tax benefits from this tax loss and has appropriately not provided a valuation allowance against this amount. The Company accrued tax expense for 1996 and 1995 at the applicable statutory rates and expects to continue such accrual for 1997 since it does not expect to be able to utilize available tax benefits from its existing carryforwards. However, if the level of tax deductions for commissions is less than expected in 1997 (as a result of new Contract sales being less than expected or for any other reason), the Company may have taxable income. In such case, the Company's tax expense for 1997 would be reduced to reflect any actual or anticipated future utilization of deferred tax benefits through reduction in the current valuation allowance.
Due to property and equipment additions during the later part of 1995 and the year ended December 31, 1996, depreciation increased from $477,000 for 1995 to $533,000 for 1996.
General and administrative expenses during 1995 and 1994 were $4.3 million and $4.3 million, respectively, and represented 14% and 19% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $55,000 during 1995, these expenses, as a percent of Contract premiums, decreased 5%. 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.
Dividends paid on outstanding preferred stock decreased to $125,000 for 1995 from $465,000 during 1994. This $340,000 decrease is attributable to the automatic conversion of preferred stock to common stock pursuant to its terms on February 27, 1995.
General Consolidated net cash provided by operating activities was $942,000, $624,000 and $3.0 million for 1996, 1995 and 1994, respectively. Cash provided by operating activities remained relatively equal when comparing 1996 to 1995 due to the $5.2 million increase in net income, after an increase of $2.8 million in the impact of deferred income taxes, that helped to offset the $8.4 million increase in commission advances. The decrease of $2.4 million from 1995 to 1994 was primarily the result of increases in commission advances of $9.2 million which was partially offset by an increase in net income of $3.6 million and an increase in provision for deferred income taxes of $4.3 million.
During 1996, the Company had net cash provided by financing activities of $1.9 million as a result of the exercise proceeds of options to purchase common stock. In 1995, the Company had net cash provided by financing activities of $6.7 million as a result of the exercise proceeds of warrants to purchase common stock during May, 1995. The Company used $3.9 million for debt retirement during 1994. However, the cash used to retire debt during 1994 was more than offset by the $8.1 million of proceeds received as a result of new issuances of common and preferred stock primarily from the public offering completed in June, 1994 together with the exercise of other outstanding common stock warrants. Dividends on preferred stock of $465,000 together with the debt retirement, offset by the stock issuance proceeds, resulted in net cash provided by financing activities of $3.8 million for 1994.
The Company had a consolidated working capital surplus of $23.4 million at December 31, 1996 compared to a consolidated working capital surplus of $17.6 million at December 31, 1995. The $5.8 million increase in working capital during 1996 was primarily the result of the current portion of commission advances of $5.2 million.
Each warrant entitled the holder to purchase one share of common stock at an exercise price of $2.50 per share at any time until September 8, 1999. The warrants were redeemable at the option of the Company at a price of $.25 per warrant following the date upon which the last reported sale price of the common stock of the Company exceeds $3.75 per share (150% of the warrant exercise price) for five consecutive trading days. The closing price of the common stock exceeded that price level for the five consecutive trading days ended April 20, 1995.
The Company exercised its right to call the warrants for redemption and all of the 2.4 million warrants with an exercise price of $2.50 per warrant were exercised and resulted in net cash proceeds to the Company of more than $6 million. As a result of the exercise, the number of outstanding shares of the Company's common stock increased to 20,545,661 shares from 18,120,171. The proceeds from the exercise of the warrants have been invested in short term obligations of the U.S. Treasury and other government agencies and will be used primarily for the payment of commission advances upon the sale of new Contracts.
Consolidated Financial Statements - --------------------------------- Consolidated Balance Sheets - December 31, 1996 and 1995 Consolidated Statements of Income - For the years ended December 31, 1996, 1995 and 1994 Consolidated Statements of Cash Flows - For the years ended December 31, 1996, 1995 and 1994 Consolidated Statements of Changes in Stockholders' Equity - For the years ended December 31, 1996, 1995 and 1994 Notes to Consolidated Financial Statements
Consolidated Financial Statement Schedule - ----------------------------------------- Schedule II. Consolidated Valuation and Qualifying Accounts - For the years ended December 31, 1996, 1995 and 1994
We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related statements of income, changes in stockholders' equity, and cash flows each of the three years in the period ended December 31, 1996. 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, authorized 5shares; 5 shares outstanding; liquidation value of $84 ......................... 5 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, 32 and 45 shares authorized, issued and outstanding at December 31, 1996 and 1995, respectively; liquidation value of $430 and $605 at December 31, 1996 and 1995 respectively............................. 32 45 Common stock, $.01 par value; 100,000 shares authorized; 22,459 and 21,513 issued at December 31, 1996 and 1995, respectively ......................................... 225 215 Capital in excess of par value ......................... 41,039 37,757 Retained earnings (deficit)............................. 6,350 (6,105) Less: Treasury stock at cost; 747 shares................ (2,177) (2,177) ------- ------- Total stockholders' equity............................. 45,474 29,740 ------- ------- Total liabilities and stockholders' equity............ $57,532 $35,629 ------- -------
Year Ended December 31, ----------------------------------- 1996 1995 1994 -------- -------- -------- Revenues: Contract premiums.................... $ 50,582 $ 31,290 $ 22,852 Associate services................... 5,646 3,183 912 Interest income...................... 1,302 1,308 466 Other................................ 2,416 1,352 379 -------- -------- -------- 59,946 37,133 24,609 -------- -------- -------- Costs and expenses: Contract benefits..................... 17,609 10,574 7,990 Commissions........................... 11,476 7,708 6,788 General and administrative............ 6,227 4,315 4,260 Associate services and direct marketing 4,544 2,573 1,539 Depreciation........................... 533 477 410 Premium taxes.......................... 372 242 226 -------- -------- -------- 40,761 25,889 21,213 -------- -------- --------
Common Stock - $.01 par value, shares authorized - ------------ 100,000; shares issued and outstanding at beginning of year (21,513 in 1996, 14,216 in 1995, and 11,542 in 1994)............................................ 215 142 115 Shares issued during year: Conversion of Preferred Stock and convertible debentures (456 in 1996, 4,245 in 1995, and 1,191 in 1994)............................................ 1 42 12 Contributed to Company's employee stock ownership plan (51 in 1996, 20 in 1995, and 20 in 1994)....... - - - Exercise of warrants (891 in 1996, 3,032 in 1995, and 1,463 in 1994) ................................. 9 31 15 ------ ------ ------ Shares issued and outstanding at end of year (22,459 in 1996, 21,513 in 1995, and 14,216 in 1994)........ 225 215 142 ------ ------ ------
Capital in Excess of Par Value - ------------------------------ Balance at beginning of year.......................... 37,757 30,770 22,990 Preferred stock offering............................ - - 6,486 Exercise of warrants................................ 2,225 6,567 790 Deferred income taxes related to exercise of stock options............................................. 997 - - Conversion of preferred stock and convertible debentures.......................................... 14 272 566 Stock contribution to employee stock ownership plan. 46 39 34 Other............................................... - 109 (96) ------ ------ ------ Balance at end of year ............................... 41,039 37,757 30,770 ------ ------ ------
Commissions Effective March 1, 1995 the Company implemented a level commission schedule of approximately 25% of annual premium revenue per year 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 consistent basis 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 the training program implemented by the Company at the same time, which includes an intensive one-day training seminar and the production of three memberships and the recruitment of 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.
Basis of Presentation The consolidated financial statements have been prepared in accordance with generally accepted accounting principles which vary in some respects from statutory accounting principles used when reporting to state insurance regulatory authorities. Certain reclassifications have been made to conform to current year presentation.
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 must subsequently be recovered through an associate's active memberships. At December 31, 1996, the Company maintains an allowance of $3.4 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.
Earnings Per Share Earnings per common and common equivalent share are computed by dividing net income applicable to common shares 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 it is not considered to be common stock equivalent. Special Preferred stock is considered to be a common stock equivalent and the number of shares issuable on conversion of the special preferred stock is added to the number of common shares. The 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 modified treasury stock method; those purchases are assumed to have been made at the average price of the common stock during the respective periods. Weighted average number of shares used in computing earnings per common and common equivalent share are 22,325,000, 20,762,000, and 12,460,000 for 1996, 1995 and 1994 respectively.
Earnings per common share - assuming full dilution are determined on the assumptions described above except that the purchases assumed to have been made upon the exercise of warrants and options are assumed to have been made at the market price at the close of the respective periods if that market price is higher than the average market price for such periods. Additionally, the $2.40 cumulative convertible preferred stock and certain convertible subordinated debentures are assumed to have been converted and the respective dividends and interest are included in determining net income applicable to common shares. Weighted average number of shares used in computing earnings per common share-assuming full dilution are 22,398,000, 21,778,000, and 15,772,000 for 1996, 1995 and 1994, respectively.
A summary of the amortized cost, unrealized gains and losses and fair values of held to maturity investment securities at December 31, 1996 and 1995 follows: December 31, 1996 ------------------------------------- Amortized Gross Unrealized Fair Cost Gains Losses Value --------- ------- ---------- ------ U.S. Government obligations.. $2,025 $ - $ 3 $2,022 Obligations of state and political subdivisions..... 414 1 2 413 ------ ----- ----- ------ Total........................ $2,439 $ 1 $ 5 $2,435 ====== ===== ===== ======
U.S. Government obligations.. $1,143 $ - $ - $1,143 Obligations of state and political subdivisions..... 412 - 9 403 ------ ----- ----- ------ Total........................ $1,555 $ - $ 9 $1,546 ====== ===== ===== ======
A comparison of the amortized cost and fair value of the Company's held to maturity investment securities at December 31, 1996 by maturity date follows: Amortized Cost Fair Value --------- ----------
One year or less............ $ 764 $ 765 Two years through five years 1,675 1,670 ------ ------ Total....................... $2,439 $2,435 ====== ======
The Company is required to pledge investments to various state insurance departments as a condition to obtaining authority to do business in certain states. The Company has investments pledged to state regulatory agencies as follows: December 31, ----------------- 1996 1995 -------- ------- Certificates of deposit................$1,822 $1,822 Obligation of state and political subdivisions......................... 300 300 U. S. Government obligations........... 650 644 ------ ------ Total $2,772 $2,766 ====== ======
Year Ended December 31, ------------------------ 1996 1995 1994 ------ ------ ------ Statutory Federal income tax rate..... 34.0% 34.0% 34.0% Tax exempt interest................... (.2) (.2) (.3) Benefit of operating loss carryforwards....................... - - (32.5) Benefit of AMT credit carryforward.... - - (10.6) State income taxes and other.......... 1.2 1.2 - ----- ----- ----- Effective income tax rate............. 35.0% 35.0% (9.4)% ===== ===== =====
Deferred tax liabilities and assets at December 31, 1996 and 1995 are comprised of the following:
A valuation allowance has been established for deferred tax assets representing pre-1996 carryforwards except as related to the AMT Credit carryforward (which is considered to be fully realizable) as the Company does not believe it is more likely than not that the tax benefits of such carryforwards will be realized. During the years ended December 31, 1996 and 1995, the valuation allowance increased by $147,000 and decreased by $239,000, respectively.
The Company generated a tax loss for the year ended December 31, 1996 of $2.8 million. The Company believes it will realize the approximate $1.0 million tax benefits from this tax loss and has appropriately not provided a valuation allowance against this amount. Because this 1996 taxable loss resulted primarily from reductions in taxable income generated by the exercise of stock options, the offsetting credit has been recorded in capital in excess of par value.
At December 31, 1996, the Company has net operating loss carryforwards (NOLs) for Federal regular tax and alternative minimum tax purposes of approximately $11.9 million and $11.5 million, respectively, expiring in 2012 and 2013. In addition, the Company has general business and rehabilitation tax credit carryforwards of approximately $325,000, expiring primarily in 1998 to 2001, and an alternative minimum tax credit carryforward of $366,000 which does not expire. The Company also has a capital loss carryforward of $1,800,000 which expires in 1997.
The Company's Chairman is the owner of PPL Agency, Inc. ("Agency"). The Company has agreed to indemnify and hold harmless the Chairman for any personal losses incurred as a result of his ownership of this corporation and any income earned by Agency accrues to the Company. The Company provides management and administrative services for Agency, for which it receives specified management fees and expense reimbursements.
Agency's financial position and results of operations are included in the Company's financial statements on a combined basis. Agency earned commissions during 1996, 1995 and 1994 of $130,000, $413,000 and $401,000, respectively, through its sales of insurance products of an unaffiliated company. Agency had net income for the year ended December 31, 1996 and 1995 of $56,000 and $599, respectively and a net loss for the year ended December 31, 1994 of $170,000, after incurring commissions earned by the Chairman of $18,000, $45,000 and $229,000, respectively, and annual management fees of $72,000 paid to the Company.
A former executive officer and director of the Company has a loan from the Company which was made prior to the time he became a director. The largest balance of this loan during the year ended December 31, 1996 was $281,000. The outstanding balance of this loan as of December 31, 1996 was $281,000. The loan bears annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year, and is secured by commissions due from the Company.
The former executive officer and director owns interests ranging from 10% to 67% in corporations or partnerships not affiliated with the Company but engaged in the marketing of the Company's Contracts and which earn commissions from sales of Contracts. These entities earned commissions, net of amounts passed through as commissions to their sales agents, during 1996, 1995 and 1994 of $54,000, $55,000 and $71,000, respectively.
The following table summarizes information about stock options outstanding at December 31, 1996 issued pursuant to the Plan:
The following table summarizes information about stock options outstanding at December 31, 1996 issued to marketing associates:
In accordance with Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS 123") , the Company recorded compensation expense related to the issuance of stock options to marketing associates of $318,000 and $76,000 during 1996 and 1995, respectively. The weighted average fair value of options granted that met the minimum exercise criteria during 1996 was $2.79 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 6.00%; expected life of 1.5 years; and expected volatility of 48.62%.
Earnings per common share - assuming full dilution: As reported............................. $ .56 $ .34 Pro forma............................... $ .55 $ .30
During 1988, the Company adopted an employee stock ownership plan. Under the plan, employees may elect to defer a portion of their compensation by making contributions to the plan. Up to seventy-five percent of the contributions made by employees may be used to purchase Company common stock. The Company, at its option, may make matching contributions to the plan, and recorded expense during 1996, 1995 and 1994 of $46,176, $39,150 and $34,027 based on contributions of Company stock of 51,000 shares, 20,000 shares and 20,000 shares, respectively.