Selected Consolidated Financial And Statistical Data 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.
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, 1995, approximately 80% of the Company's Contracts were closed panel plans.
Contract benefit costs relating to open panel Contracts, which constituted approximately 20% of Contracts in force at December 31, 1995, 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.
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, 1995 was $2.7 million.
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, 1995, the Company's annual Contract persistency rates, using the foregoing method, have averaged approximately 76%. The annual Contract persistency rates were 80.0%, 80.7% and 84.6% for 1995, 1994 and 1993, 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 1995 and 1994. 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.
Operating Ratios Two principal operating measures monitored by the Company in addition to Contract persistency are the loss ratio and the expense ratio. 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 Company strives to maintain a combined loss and expense ratio as low as possible. The combined ratio does not measure total profitability because it does not take into account all revenues and expenses.
Cash Flow Considerations Relating to Sales of Contracts The Company advances significant commissions at the time a Contract is sold. Since approximately 91% 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 more slowly as a result of the changes described above in the Company's commissions, the new commission structure may have an adverse effect on cash flow from operations depending on the number of new membership Contracts written and the composition of new or existing sales associates producing such Contracts.
Income Tax Matters-Net Operating Losses At December 31, 1995, the Company had net operating loss carryforwards ("NOLs") for regular and alternative minimum tax purposes of approximately $9.1 million and $8.7 million, respectively, expiring in 2001 and 2002, 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. The Company has established a valuation allowance for its deferred tax asset since the Company does not believe it is more likely than not that the tax benefits from its NOLs and other carryforwards will be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize these benefits before they expire, primarily as a result of tax deductions attributable to expected levels of commissions to be paid on new Contract sales. However, these benefits were used during 1994 and 1993 to offset current tax liabilities in periods in which the Company reported net taxable income. As a result, the Company's provision for income taxes for 1994 and 1993 was generally limited to taxes actually paid, which was significantly less than statutory rates. The Company accrued tax expense for 1995 at the applicable statutory rates and expects to continue such accrual for 1996 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 1996 (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 1996 would be reduced to reflect any actual or anticipated future utilization of deferred tax benefits through reduction in the current valuation allowance.
Associate Services The Company derives revenues from services provided to its marketing sales force, principally from a one-time enrollment fee of approximately $49 ($55 effective February 1, 1996) from each new sales associate and the sale of marketing supplies and promotional materials to associates on an ongoing basis. The Company enrolled 50,464 new sales associates during 1995 compared to 19,129 during 1994, resulting in significant increases in associate services revenues and costs. The Company's direct costs of providing materials and services to associates are reflected as costs of associate services. Amounts collected from sales associates are intended primarily to offset the Company's direct and indirect costs incurred in recruiting, monitoring and providing materials to sales associates and are not intended to generate material profits from such activities.
Interest income for 1995 increased to $1.3 million compared to $466,000 for 1994. Interest income increased primarily as a result of increases in the average investments outstanding. At December 31, 1995 the Company reported $18.3 million in cash and investments compared to $11.7 million at December 31, 1994.
Commissions were $7.5 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, should continue to decline as a result of changes in the commission structure for Contracts sold after March 1, 1995, and should not exceed 25% of Contract premiums during future years.
As a result of retirement of outstanding debt, interest decreased for 1995 to $10,000 compared to $320,000 during 1994. 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.
Provision for income taxes increased significantly during 1995 to $3.9 million, or 35% of net income before taxes from a 1994 benefit of $319,000. This $4.2 million change is attributable to the 1994 expense which reflected the benefit of net operating loss carryforwards, general business and rehabilitation tax credit carryforwards and alternative minimum tax credit carryforward. The Company has established a valuation allowance for its deferred tax asset since the Company does not believe it is more likely than not that the tax benefits from its NOLs and other carryforwards will be realized. The Company believes it is unlikely that it will generate sufficient taxable income to realize these benefits before they expire, primarily as a result of tax deductions attributable to expected levels of commissions to be paid on new Contract sales.
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, as described below.
Contract premiums totaled $22.9 million during 1994 compared to $19.2 million for 1993, an increase of 19%. 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 1994 were 45,893 compared to 34,294 during 1993. At December 31, 1994, there were 144,438 active Contracts in force compared to 133,121 at December 31, 1993. Additionally, the average annual premium per Contract has increased from $206 for those Contracts written in 1993 to $229 for Contracts written during 1994, an 11% increase, as a result of a higher portion of Contracts written during 1994 including the additional pre-trial hours benefits at an additional cost to the member.
Contract benefits totaled $8.0 million for 1994 compared to $7.5 million for 1993, an increase of 7%. However, the loss ratio for 1994 decreased to 35% from 39% for 1993 as a result of non-recurring litigation fees included in contract benefits during 1993 of $550,000 (which was approximately 3% of 1993 Contract premiums) related to the termination of two previous provider attorneys.
Commissions were $6.8 million for 1994 compared to $6.1 million for 1993, and represented 30% and 32% of Contract premiums for 1994 and 1993, respectively. Commission expense, as a percentage of Contract premiums, should continue to decline as a result of changes in the commission structure for Contracts sold after March 1, 1995, and should approach 25% of Contract premiums during future years.
General and administrative expenses during 1994 and 1993 were $4.4 million and $3.9 million, respectively, and represented 19% and 20% of Contract premiums for such years. Although the total amount of general and administrative expenses increased approximately $500,000 during 1994, these expenses, as a percent of Contract premiums, decreased 1%. 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.
Direct marketing costs increased to $644,000 for 1994 from $527,000 for 1993 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. As a result of retirement of outstanding debt and aging of property and equipment, interest and depreciation both decreased for 1994 compared to 1993. Primarily as a result of the non-recurring contingency reserves established during 1993, the Company's expense ratio decreased from 64% for 1993 to 56% for 1994. These factors resulted in a combined loss and expense ratio of 91% and 103% for 1994 and 1993, respectively.
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 will result in savings of $831,600 per year in dividends.
During 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 $17.6 million at December 31, 1995 compared to a consolidated working capital surplus of $9.3 million at December 31, 1994. The $8.3 million increase in working capital during 1995 was primarily the result of increased cash and short-term investments of $6.1 million together with the increases in the current portion of commission advances of $2.4 million.
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, 1996. 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, 1995, the borrowing base was approximately $4.9 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, 1996. 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 1996.
As a result of the retirement of all outstanding debt during 1994, the Company has no outstanding material financial commitments.
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, 1995 ($15.5 million) and the unused revolving credit agreement availability of $4.9 million.
Parent Company Funding and Dividends Although the Company is the operating entity in many jurisdictions, the Company's subsidiaries serve as operating companies in various states which regulate Contracts as insurance or specialized legal expense products. The most significant of these wholly-owned subsidiaries are PPLCI and PPLSIF. The ability of PPLCI and PPLSIF to provide funds to the Company is subject to a number of restrictions under various insurance laws in the jurisdictions in which PPLCI and PPLSIF conduct business, including limitations on the amount of dividends and management fees that may be paid and requirements to maintain specified levels of capital and reserves. In addition PPLCI will be required to maintain its stockholders' equity at levels sufficient to satisfy various state regulatory requirements, the most restrictive of which is currently $3 million. Additional capital requirements of either PPLCI or PPLSIF will be funded by the Company in the form of capital contributions or surplus debentures.
Reports of Independent Accountants Consolidated Balance Sheets - December 31, 1995 and 1994 Consolidated Statements of Operations - For the years ended December 31, 1995, 1994 and 1993 Consolidated Statements of Cash Flows - For the years ended December 31, 1995, 1994 and 1993 Consolidated Statements of Changes in Stockholders' Equity - For the years ended December 31, 1995, 1994 and 1993 Notes to Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
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, 1995 and 1994, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles.
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. Prior to March 1, 1995 first year commissions payable on the sale of a Contract, and earned in the first contract year, were approximately 70% of annual Contract premiums while renewal commissions (payable as earned after the first Contract year) were approximately 16% of annual premiums.
Investment Securities In May, 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). SFAS 115 requires the Company to classify its investments in debt and equity securities into three categories as held to maturity, trading and available for sale. The classifications the Company utilizes determine the related accounting treatment for each category of investments. Investments classified as trading are accounted for at fair value, available for sale are accounted for at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of stockholders' equity, and held to maturity are accounted for at amortized cost. The Company adopted SFAS 115 effective January 1, 1994. Prior years' financial statements were not restated.
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. The Company has recorded an allowance of $2.7 million to provide for estimated uncollectible balances. Effective November 1, 1993, the Company imposed a charge of 1.5% per month on unearned commission advances made between November 1, 1993 and March 1, 1995. Effective March 1, 1995, and in conjunction with other commission structure changes, the Company reduced the charge from 1.5% to .17% per month for commission advances made after such date.
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. Neither series of Cumulative Convertible Preferred Stock are included in the weighted average number of common shares outstanding since they are not considered to be Common Stock equivalents. The Special Preferred Stock has been considered to be the equivalent of Common Stock from the time of its issuance in 1988 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 20,762,000, 12,460,000, and 12,407,000 for 1995, 1994 and 1993 respectively.
In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 ("FAS 123"), "Accounting for Stock - -Based Compensation." FAS 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 FAS 123, the Company will continue to follow the provisions of Accounting Principles Board Opinion No. 25 for its stock-based employee compensation arrangements, and disclose the pro forma effects of applying FAS 123 for 1995 and 1996 in its 1996 financial statements.
A summary of the amortized cost, unrealized gains and losses and fair values of held to maturity investment securities at December 31, 1995 and 1994 follows: December 31, 1995 Amortized Gross Unrealized Cost Gains Losses Fair Value U.S. Government $ 1,143 $ - $ - $ 1,143 obligations Obligations of 412 - 9 403 state and political subdivisions Total $ 1,555 $ - $ 9 $ 1,546
The Company's investment securities are included in the accompanying consolidated balance sheets at December 31, 1995 and 1994 as follows. Remaining amounts recorded in these accounts represent certificates of deposit.
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, 1995 1994 Certificates of deposit........................... $1,822 $1,772 Obligation of state and political subdivisions.... 300 300 U. S. Government obligations...................... 644 - Total $2,766 $2,072
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, 1996. 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, 1995, the borrowing base was approximately $4.9 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, 1996. 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.
Year Ended December 31, 1995 1994 1993 Current .................................... $ $ 43 $ 29 Deferred ................................... 3,932 (362) -- Total provision (benefit) for income taxes $ 3,932 $ (319) $ 29
Year Ended December 31, 1995 1994 1993 Statutory Federal income tax rate ..... 34.0% 34.0% 34.0% Tax exempt interest ................... (.2) (.3) (8.7) Benefit of operating loss carryforwards -- (32.5) -- Benefit of AMT credit carryforward .... -- (10.6) -- State income taxes and other .......... 1.2 -- (4.1) Effective income tax rate ............. 35.0% (9.4)% 21.2%
A valuation allowance has been established for deferred tax assets representing 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, 1995 and 1994, the valuation allowance decreased by $239,000 and $1.7 million, respectively. The Company's net deferred tax asset as of December 31, 1994 is included in the accompanying consolidated balance sheet in other non-current assets.
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, 1995.
During 1995 the Company issued 3 million shares of Common Stock in connection with the exercise of existing warrants with an average exercise price of $2.19 per share.
At December 31, 1995, the Company had outstanding warrants and options to purchase a total of approximately 1.7 million shares of the Company's Common Stock at an average price of $3.52 per share expiring at various periods through December, 2005.
Aggregate rental expense under all operating leases was $28,000, $42,000 and $47,000 in 1995, 1994 and 1993, respectively. There are no significant operating lease commitments in effect at December 31, 1995.
In the normal course of its business operations, the Company is involved in various claims and judicial actions. The Company has established contingency reserves for potential loss in connection with certain proceedings which the Company believes to be adequate after consultation with its counsel in each such matter. Such reserves are based on the Company's current estimate of loss and are subject to change based on developments in each proceeding. Accordingly, it is possible that the Company may incur losses in excess of the amounts reserved.
Prior to March 1995, non-employee directors also received for each meeting attended options to purchase 2,500 shares of the Company's Common Stock at the closing price of the Common Stock on the date of the meeting as quoted by the American Stock Exchange. In December 1995, the Company's Option Plan was amended to provide for automatic grants of options to non-employee directors. Under the Stock Option Plan as amended, each incumbent non-employee director of the Company received options to purchase 7,500 shares of Common Stock on December 12, 1995, the date of adoption by the Board of Directors of the amendments to the Stock Option Plan. In addition, the incumbent non-employee directors and any new non-employee directors will receive additional options to purchase 10,000 shares of Common Stock on March 1 of each year commencing March 1, 1996. The options granted initially to the incumbent non-employee directors are immediately exercisable. The options to be granted on March 1 of each year will be immediately exercisable as to 2,500 shares and will vest in additional increments of 2,500 shares on the following June 1st, September 1st, and December 1st in the year of grant, subject to continued service by the non-employee director during such periods. Options granted to non-employee directors under the Stock Option Plan have an exercise price equal to the closing price of the Common Stock on the date of grant. Options granted to the non-employee directors under the Stock Option Plan are subject to the approval by the shareholders of the Company of the amendments to the Stock Option Plan providing for such grants. The amendments will be submitted to the shareholders at the Company's 1996 Annual Meeting of Shareholders. Outside director option activity during 1995 is shown below.
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 have been issued to qualifying associates at each month end since July, 1995 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 will cease March 31, 1996. Activity related to this plan was as follows during 1995: