My possible short position explained.
Let's go through it from the beginning.
1) Earnings overstate cash flow, and hence the price-earnings ratio 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 Pre-Paid'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 -if the asset discussed above is legit. Not surprisingly, it also matches better with the valuation of the stock. Looked at this way, the stock trades at 42 times earnings.
2) New membership growth has slowed the last few quarters. 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%.
While they have the actuarial stuff down - the loss ratio has
been steadily decreasing and very stable: from 35% in 1994 to 32.8% now - it remains a fact that for every 100 members added, 55 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.
And when economic times get difficult, what happens? That efficacy will fall off, associates will get charge-backs, and the company doesn't collect. That ends up being a write-off of bad assets if it is more than the company's 4.4 million allowance. And it would be the first bad news in a while.
3) Maybe no one would buy legal insurance if it were sold the traditional way. Or maybe at least it is part of discretionary income and will fall off badly in a Pre-Paid's cooperative associations with big-name insurers have gone nowhere. Whether
through lack of effort or lack of interest, it is not 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 multi-level marketing 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 60X normalized earnings.
All of sudden, there's not much room to maneuver - and no room for slowing growth. Forget about the insider buying -the two characters doing it all are just investment managers of unknown quality. The only significant insider activity ongoing occurred back in 1997 when Stonecipher, Grunebaum, and in-and-out leader Mildren sold stock like banshees. Mildren sold every last drop in the low 20s after he resigned as CEO and President in 2/97.
The board is packed with PPD cronies. The outside directors, of which there are but a few, are in bed with PPD anyway. Hail ($284,000 in 1998) and Savula ($651,000) are distributors of PPD products. Even Stonecipher, through PPL Agency, leeches this kissing sisters route ($47,000 in 1998). This should send up a red flag. Belsky seems respectable, but he's only gone so far as to buy 350 token shares, and his term is up this year.
While we're on compensation, Stonecipher pulled down a 1.8 mill
package assuming a share price of 36. Wilbur Smith, president, pulled down 1.2 mill. Harp the CFO got 670K. That's in addition to the money Stonecipher pays himself through his airline to transport PPD people around. Wil Smith also gets a .5 mill loan from the company which is growing yearly.
Now, let's be clear: PPD requires growth, because if growth stagnates, the poor persistence takes hold. Well, growth is slowing. The cash flows may be stagnating.
Lo and behold, here comes a registration for 100M additional common shares, and over 900,000 shars of two kinds of preferred stock. Is this in anticipation of capital needs in excess of operations?
Well, that's the short story. Remember shorts are great at analysis but have horrible timing. They can exacerbate the overvaluation by frequent panic covering. Ironically, it is when short interest dips after a long climb that a short signal is given, and a long-term top is near.
Good investing,
Mike |
