Whether it's a blockbuster film like Erin Brockovich or the round-the-clock coverage of the Scott Peterson trial, Americans are fascinated by courtroom drama. For all the lawyer jokes out there, we must admit that we're a tad preoccupied with the law in this culture. Tapping into this enthusiasm, Pre-Paid Legal
Pre-Paid Legal's stock is near an all-time high, indicating its business model is gaining traction. In the second quarter, revenues were up, although net income was way down. How do we explain the latter development? Let's first consider the business in more depth.
Modeled after European legal expense plans, it has now signed up more than 1.5 million members, including American and Canadian families, as well as individuals. Perhaps the best way to understand its service is to think of an HMO. If you're insured under an HMO, you receive certain member benefits in return for your monthly fee. Likewise, subscribers of Pre-Paid Legal are paying a monthly fee for a range of legal services offered through a network of independent lawyers. Consultations for auto accidents and preparation of wills and living wills are just a couple of examples.
New memberships in the second quarter increased 28%, compared with the same period a year ago. So with memberships growing at a double-digit rate, why did its quarterly net income decline?
As a result of its commission-based compensation plan, Pre-Paid Legal has decided to expense (which means to 'designate as an expenditure' in accounting terms) these commissions in the first month of a new membership sign-on or service add-on. While it gets hit with these fees up front, thereby lowering current earnings, future earnings will increase as the revenues from these transactions are recognized, without the corresponding commission.
Because of this accounting method, Pre-Paid Legal's net income decreased 32% to $6.9 million, even though revenues for the period increased 10.7% to $105.6 million. During the past six months, it has earned $1 per share, below last year's level of $1.24 per share.
Shareholders may not like the sound of decreasing earnings, but they have to like what the company has been doing with its cash. It has put its cash flow to good use, buying back another 335,000 shares over the past six months. Overall, it has repurchased 9.4 million shares since 1999. It is also giving back to shareholders by paying out $12.4 million in dividends over the past two quarters. Despite these cash outlays, it still maintains a healthy balance sheet with $41.9 million in cash and equivalents, which far exceeds its debt.
The stock may be near an all-time high and the company continues to grow memberships at a double-digit rate, but the jury is still out regarding whether or not this is a good time to initiate a position. Trading at a forward-year price-to-earnings ratio (P/E) of approximately 23, Pre-Paid Legal will need to maintain healthy double-digit membership growth rates in order to support its valuation. At a minimum, this stock warrants further investigation.
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Fool contributor Jeremy MacNealy does not own shares in any of the companies mentioned.
