Issues to think about:
1) Earnings overstate cash flow, and hence the PE is irrelevant. Operating cash flow takes a huge hit thanks to the 3yr commission advances. The advances get recorded on the balance sheet as an asset, bypassing getting expensed. To compensate, a deferred tax liability is placed on the balance sheet as well. This is an issue to be thought about. That asset keeps growing and growing. To PPD's credit they collect most of it over time, or at least they say they do - they don't give a specific number other than "majority." They keep a $4 million reserve just in case, but we don't really know specifically how much of that now-$65 million asset on the balance sheet will come back at us in the form of charges at some point. If management is to be believed, then it's only a minimal $4 million and we don't worry - or at least we try not to.
Still, Wall Street will never accept this accounting no matter how well it conforms to GAAP. The thing is, if they were more conservative and expensed the entire three-year advance right off the bat, they would still have a decent annual profit, this year to the tune of $20 million, which matches well with cash flow. Not surprisingly, it also matches better with the valuation of the stock. Looked at this way, the stock trades at nearly 40 times earnings, nearer its growth rate. And not many MLM's can claim even this cash flow.
2) New membership growth slowed last quarter. The company enrolled a whole bunch, but only just as many as the March quarter. Subtract this quarter's "new memberships" from the six month "new memberships" and you get basically the same number. This is critical because recruiting efficacy stinks. The company uses "persistency" to describe their member retention because it gives a good-looking number in the 73-74% range. A better one might be "recruiting efficacy": divide the net change in the number of memberships by the figure for new memberships added. This number is about 54.7%. For every 100 members added, 54 lapse. For the last four years going backward, the numbers are 54.7%, 53.7%, 53.4%, 46.2%. Keep up the effort, associates. You must. The upside is that they have the actuarial stuff down. The loss ratio has been steadily decreasing and very stable: from 35% in 1994 to 32.8% now.
3) Maybe no one would buy legal insurance if it were sold the traditional way. PPD's cooperative associations with big-name insurers have gone nowhere. Whether through lack of effort or lack of interest, it ain't happening. If it was a good stand-alone product, you would expect the traditional sales force (who get about the same level of commissions as associates) would be trying to sell it, and the customers would be buying it. Maybe management recognizes this, and that's why they've gone the MLM way.
4) About that 40X earnings number - it's iffy too. Adjusted for options issuance, 1998's net profit per share would have fallen 25% short of the reported number, all the way to the low 90 cent range - and that's before the adjustments mentioned in (1) above. It's in the 10K. Conservative accounting of commission advances paired to conservative accounting of options issuance would drop cash flow per share down quite a bit. Think 50X earnings.
50X earnings. Ah, there it is, nearer the growth rate. The stock has not been ignored by Wall Street. It's been studied, and the valuation has been appropriately corrected.
Note: In no way am I saying this is a short. 50X properly accounted earnings isn't even expensive for a fast grower in this market. And I actually own it for now. But I don't think it is prudent or proper to compare the growth rates to the PE's one can find in a common database and claim value.
Good investing all,
Mike |
