The Long Case for Pre-Paid Legal Services

| About: Pre-Paid Legal (PPD)
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Robert RobottiNewsletter Value Investor Insight carried an interview August 25th with Robotti & Co. manager Bob Robotti (pictured left), whose fund focuses on small and microcap stocks and has generated an average net return of 17.4% per year since its launch in 1983, versus a 10.3% for the Russell 2000, according to Value Investor Insight. Here's the segment of the interview in which Mr Robotti discusses his position in Pre-Paid Legal Services (NYSE:PPD), which was trading at $36.77 at the time of the interview (chart here):

There no dearth of controversy around your last idea, Pre-Paid Legal Services (PPD).

BR: Our interest is primarily based on our conviction that they have a great product. For a monthly payment of around $25, you get access to certain legal services for free and to others at deeply discounted rates. We think that’s an interesting product offer for $300 a year, with applicability to even more people in the U.S. than for the tax-prep services of H&R Block. The model is actually similar to H&R Block – providing a level of service most people need on a more cost-effective basis.

Describe how the service works.

BR: You’re assigned a local law firm as your point of contact, which improves customer service. The first time I tried to use it was when I bought my co-op. The problem was they wouldn’t get involved until I already had the co-op picked out, but in New York you have to have your attorney involved earlier in the search process to get access to certain information. So it didn’t work there. Where it did work for us: we bought a $700 TV from Best Buy and it broke a month or two later and they wouldn’t take it back. For no additional cost, the Pre-Paid lawyer wrote a letter for us and we received a refund shortly after. A friend of mine, who also owns the stock, bought his house in Westchester County and used a Pre-Paid lawyer for his closing, paying less than half what every other lawyer wanted. He’s even used one of their lawyers for routine securities work, at one-fifth the cost I pay for the same work at my regular law firm.

Who is the target audience?

BR: The company says it’s not the top 10% or bottom 10%, but the 80% in between. The reality is they reach mostly middle- to lower-income people, which I think is more a result of how they sell than of who might benefit from the product.

A dreaded multi-tiered marketing system?

BR: Yes, they use a system just like Amway’s, which is one reason Wall Street hates the company. We agree that how it’s sold is a limitation, but not based on any elitist view of what’s appropriate. The first problem is that by selling to people you know, who sell to people they know, they don’t reach large parts of the population – namely higher income levels. The current system also isn’t adequately educating people on how to use the product and what a great value it is. The more people use and take advantage of the services, the longer they remain customers. We think there’s great untapped potential in promoting to a broader population base through advertising and more traditional marketing. They also should enhance customer-service efforts to connect more often with paying customers. The growth upside from doing both of these is tremendous – they win from dramatically increasing the customer base and from higher retention of the customers they already have. The founder, Harland Stonecipher, still runs the business.

What makes you think things will change?

BR: Management has been open to suggestions of certain long-time shareholders. Tom Smith, the managing partner of Prescott Investors, has been on Pre-Paid’s board since 2004. I’m sure he’s introduceing ideas that will continue to impact how they look at the business. We see it already in how they’ve started new programs to try to increase usage, in how they’re looking more carefully at the lifetime value of a customer. They have more than enough resources to invest in better marketing, and we think they will. We’re also optimistic about the identity- theft product they launched in 2003 in a joint venture with Kroll. It’s a relatively unique service that doesn’t just monitor for problems with identity theft, but also has a restitution part if something goes wrong. Kroll is a part of Marsh & McLennan and the entire company is quite sophisticated in how they sell their products. I believe this relationship can open new doors to Pre-Paid.

Is the competitive environment agreeable?

BR: The other main players – the Hyatt Legal Plans division of MetLife and a former Montgomery Ward business that’s now owned by General Electric – operate mostly in the corporate market, offering plans as employee benefits. Pre-Paid is by far the market leader with consumers. The short interest, nearly 55%, is about as high as it gets.

Why do so many investors loathe the stock?

BR: There have been lawsuits against the company alleging various damages, usually amounting to no more than a few hundred dollars each. One case, in Mississippi, resulted in a punitive-damage award of $9.9 million, which is now on appeal. Many business people would not consider an early negative verdict from a Mississippi jury as great cause for concern, and we agree. The Connecticut Attorney General also announced he was looking into the company’s sales practices, but nothing’s come of that since it was announced with great fanfare a year ago. There were accounting concerns, primarily over the company amortizing over three years commissions on new customer sales. Now those commissions are expensed immediately. Today, cash earnings slightly exceed reported EPS. With all this, we come back to the fact that we believe in the product – that it’s a proven, cost-effective service for consumers that has been around for 30 years. The “noise” has calmed down quite a bit, but sometimes a high short interest takes on a life of its own. As long as you’re comfortable with your work, you just can’t worry about that.

The stock has been stuck near its current level, around $37, since the beginning of 2005. Where do you think it can go?

BR: The shares currently trade for around 11x trailing earnings, if you adjust for the fact that the identity-theft earnings are temporarily lower because the start-up selling expenses are being expensed immediately. There’s no capital spending, so the earnings translate to free cash flow. Protecting the downside is that they have no debt and they’re using free cash flow to buy back stock. The company has gone from over 24 million shares outstanding to less than 15 million today, which has had a significant effect on EPS growth. I can’t give you a specific target number for the stock price. But if they can really get at the untapped potential I think this product has, the share price will be a multiple of what it is today.

Disclosure: Mr. Robotti owns each stock mentioned personally, and his fund owns over 1% of PPD.