It appears to me that PPD is trading at well below intrinsic value. Here's the particulars: Become a Complete Fool
PPD has historically offered one main product, a legal service plan. Under this plan (of which there are several variants), the company agrees to provide a specified schedule of legal services to a customer in return for a monthly fee that averages ~$25. Services include toll-free access to a lawyer for questions, document review by a lawyer, a will, representation in a specified set of circumstances (mostly minor offenses; anything big would require an additional fee negotiated with the law firm), and a few other ancillary benefits. The legal plan has a benefit expense ratio of about 33%, which is paid as a monthly per capita to law firms around the country which the company has selected on the basis of their ability to provide services, on-going quality audits, minimum Martindale-Hubbell ratings, etc.
Recently (late 2003), the company has added an ID Theft plan. This plan is available as an addition to the legal plan at $10 a month or stand-alone at $15 a month. Benefits include access to a credit monitoring service, help in investigating cases of identity theft, and payments of up to $25k to compensate victims of ID theft. This plan is offered in conjunction with Kroll Inc. The plan appears to be a very timely product, and has been selling quite well. An interesting benefit is that a plan member can simply sign a couple of forms if their identity is stolen and Kroll's professional investigators will take over cleaning up the mess. The benefit ratio for this product is about 45%, but incremental administrative cost is small, as the company already has much of the necessary infrastructure in place.
PPD distributes via a multi-level marketing (MLM) structure, which has been much criticized WRT PPD and other companies. Used by Amway, Primerica and others, this structure has salespeople (PPD refers to them as "associates") who are independent contractors selling its products. Associates generate commission income by selling products and can also generate income by recruiting other associates. Typically, a recruiter gets a modest cash payment and a small share of the recruits commission income. In the best of all worlds, recruiters are also actively involved in the sale of products, and manage their recruits ("downline") as one would a business, giving support and guidance to recruits to help them sell more and increase the recruiter's ("upline") income. Some parts of most MLMs work this way. Other parts of most MLMs have some uplines that recruit and then do very little aside from siphoning off some commission money from their downline. New associates are charged a fee to cover training expenses which has varied from $99 to $249 in the past, but most of this fee is either used to provide training or given back to the associate in the form of bonus commissions on the first few sales.
I'm not thrilled about PPD's use of this structure, but it has allowed the company to expand without taking on a huge fixed cost distribution structure. In many ways, it is similar to the way life insurance and annuities are distributed, with an MGA-agent structure.
PPD also supports its associates by selling them promotional items, sales tools, etc. at cost or less (associate services attempts to break even, but often does not).
Commissions are typically paid at the time of sale, and associates may elect to receive a maximum advance or take a pay-as-earned cash flow. If a full advance is chosen, associates are hit with "charge backs", essentially debits to their future commissions, if a customer (PPD refers to them as "members") cancels before the advance has been fully earned. Not surprisingly, this has been the bane of many associates who generate business with poor retention characteristics. Although even a casual search will pull up lots of bitching on this score, I would point out that even highly respected companies have this problem (check out www.nmlcomplaints.com for example). Average commission on new legal plans has been about $150 to $160. Average commission on ID theft plans has been in the $60 range although this is a new product with limited (6 months) history.
Some allege that PPD is a Ponzi scheme and that most or all of the profit comes from bilking associates. I cannot possibly see how this is the case with PPD. Certainly associates account for a percentage of the block, but they also receive benefits for their payments just like any other customer. Associates services revenue is break-even at best, and initiation fees are largely used to train and incent new associates.
Persistency of business:
Persistency and retention of business have been less than impressive for the company's legal plan memberships. The most recent quarterly conference call indicated that rolling 12-month retention was a shade over 70% for the block, compared with something in the 85+% range for personal lines P&C insurance and 90 to 95% for typical life insurance products. The weighted average life of a newly sold membership is about 3.3 years, although the company's more seasoned blocks exhibit far higher persistency (as one would expect).
In the past 18 months, the company appears to be trying to improve retention, in part spurred by a slowdown in membership sales and he in-force block essentially remaining flat over the past year or two. The CEO's compensation now includes a substantial incentive toward improving retention, the company has a dedicated retention analyst on board, and associates are now being incented if they generate business with better retention characteristics. The company has also greatly decreased the number of new associates recruited, which I believe to be partially an attempt to find better salespeople instead of taking any fool with the initiation fee. Although the company's business has many levers to improve its profitability, the singe greatest one is an improvement in retention. Even a 500 BP increase in retention would have very dramatic results on profitability and cash flow.
It is somewhat disappointing to see how belatedly management has turned to improving retention, but better late than never.
Regulation & Accounting:
PPD's products are considered insurance by a few state regulators, but by and large most states have left the company alone as far as insurance regulation goes. In the states that PPD has been regulated by insurance authorities, the company has formed insurance companies with some restrictions on dividend ability, etc. Associates in regulated states usually have to be licensed to sell the company's products.
A few years ago, PPD went through a major accounting controversy that ultimately resulted in the company changing auditors and re-stating its financials. In a nutshell, the company's old accounting practice was to capitalize commission advances and amortize them over the expected life of the membership, with tests for impairment. This was held to be aggressive by the SEC. Now the company expenses all commissions as cash is paid out.
While this treatment is more conservative and cash based, it ignores the fact that the company has exchanged cash for an actual asset (future cash flows arising from the membership acquired). If the company were selling, say, an insurance product, this treatment would be required by GAAP (check out the deferred acquisition cost balances on most life insurers' balance sheets). Really, this was a tempest in a teapot, since the best way to value this company is on a DCF basis.
FWIW, book value under the "old method" would be in the $12 to $14 a share range.
The company is currently entangled in a web of lawsuits, mostly stemming from allegations that the company's associates promised customers benefits not included in the plans. There are also some associates suing the company. To date, the company has either had all suits tossed out by the courts or settled them for a pittance. I believe that the major risk to the company stems from lawsuits in Alabama and (especially) Mississippi, both of which have a history of "jackpot justice". Frankly, I believe that these suits are the bogeyman of the market and are taken way too seriously. For valuation purposes, I have subtracted about $25MM from the company's valuation as a probable worst case scenario. Ultimately, I believe that the major cost of all this nonsense is likely to be the cost of defending against the suits rather than any actual award against the company.
Balance Sheet & Capital Structure:
PPD has historically been capitalized entirely by equity. However, in the past two years, the company has accumulated $38.6MM in debt on two bank lines. One line, accounting for about half of the total, was used to fund the construction of a new headquarters and operations building and is secured by a mortgage on the property. This is relatively low rate financing and is likely to remain on the books until it is amortized. The second loan accounts for about half of the total and was entered into last year for the express purpose of accelerating the company's stock buyback program. The line is in paydown mode (i.e. not eligible for further advances), and costs 300 BP over LIBOR. This loan has various covenants, including minimum retention levels, restrictions on further stock buybacks, etc. The covenants appear easily manageable, and the company carved out $1.8 million per quarter available to pay dividends, although PPD currently does not do so.
The company typically maintains at least $25 million in cash and equivalents in order to retain some financial flexibility and satisfy insurance regulatory requirements. In the early 1990s, PPD ran into a cash crunch as it wrote far more memberships than it had ready cash available. I believe that the institutionalized memory of this event has kept management more conservative WRT leverage up until very recently. Even with its current level of debt, PPD generates enough cash flow to pay off the outstanding stock repurchase line within a couple of quarters and ended the first quarter with more cash and equivalents than debt outstanding.
Stock Buybacks & Short Interest:
For at least three years, there has been a large and vocal short position on the company. TSCM regularly hammers on the company, and Rocker Partners (short shop) has a very large short position in the company. The short thesis seems to have morphed over time. Initially it was focused on the accounting controversy mentioned above. Then I think the focus was on decelerating membership block growth. Now it appears to boil down to the idea that the lawsuits will bankrupt the company.
Against this backdrop, the business finally began to generate large and growing cash flow not needed to reinvest in the business. In part this was due to the sales slowdown. Management have long been substantial shareholders (the CEO is also the founder and has a ton of stock). Lacking business reinvestment opportunities, PPD began buying back stock very aggressively. In 1999, the company had close to 25 million shares outstanding IIRC. After spending over $150MM, the share count was down to 16.8 million as of the first quarter.
There now appears to be a stand-off between shorts and the company. Almost the entire float is shorted, suggesting that there may be some illegal loaning of shares to short more than once. The company had the highest days to cover on the NYSE in the April short interest report, at 89 days (!) to cover. The stock has been pretty volatile, and I get the impression that various hedge funds have been playing with the stock for some time.
Personally, I expect that if the short interest isn't squeezed away or doesn't otherwise drop, management will eventually try to take the company private.
Valuation of PPD is probably best done on a DCF basis. The cash flow pattern of the legal plan membership is a payout of about $155 up front, followed by monthly after-benefits gross margin of about $16.50. When I model these plans for valuation purposes, I load the monthly fee with overhead charges and assume that the monthly net margin is 55%, for after tax FCF of $26.81 per quarter. The legal plan I assume has a 50% net margin, and after tax FCF of $9.75 per quarter.
On this "fully loaded basis", I assume a three year life for the current block, a 12.5% discount rate on legal plan cash flows, and a 15% discount rate on ID theft cash flows (owing to their unproven and therefore more risky status). I then add $25 million of cash to the valuation (Q1 number was higher, but a lot of it goes to pay taxes, etc. early in Q2), and subtract the outstanding debt and a SWAG of $25 million for the lawsuits. I have ignored the value of the HQ building because it probably could not be sold for book value (how lively you think the office building market is in Ada, OK?), and I have ignored other assets and liabilities. Under these assumptions, I find a run-off valuation in the low $20s, just under current share price.
If the company simply were to expend enough commission dollars to maintain the existing block and retention rates were stable, I estimate that the block would throw off about $60 million in FCF, all in. Under this case, we can value the company as a $60 million per year annuity. Using a 13% discount rate, I get a valuation of about $27. This assumes that cash is simply paid out to shareholders.
The company appears to have a new opportunity in the ID theft memberships. I estimate the NPV of a new ID theft membership at $55, and the company appears to be on a pace to sell about 100k ID memberships per quarter this year. This year alone, such a pace would yield an NPV increase of $22 million. Per share, this works out to about $1.31 of added value in 2004 alone. If the company has the ability to add equivalent value every year going forward, these investment opportunities are worth about $10 per share.
If retention rises sufficient to add two quarters of average life to my assumed 3 years, the value of the in-force block and the reinvestment opportunities rises about 25%.
If the company manages to grow the in-force block of legal plans again, each incremental plan sale has an NPV of about $168 under my base assumptions. It isn't at all clear if/when this will happen, but I believe that sales efforts have been hampered by the company attempting to improve retention of new sales and the poor economy (I'd cut my monthly legal plan before the power bill, wouldn't you?).
My best guess as to the likely state of the company is that retention will likely improve slowly, the in force legal plan block will start to increase again, albeit likely at a 5% a year rate or so, and that ID theft plans will rise to about 500k block by EOY, then increase 100k memberships a year. This suggests a valuation in the $40+ range, and I believe that my assumptions are pretty conservative.
I'm not sure how to value the stock buybacks. I believe they are buying back stock at well below intrinsic value, so this must be adding something.
(NB I will X-post in Liquid Lounge and PPD boards).
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It appears to me that PPD is trading at well below intrinsic value. Here's the particulars:
Become a Complete Fool