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the book value of the asset in question. For example, under this method an asset with a five-year
life and an initial cost of $100,000 depreciates $40,000 in year one ($100,000 — .4), $24,000 in
year two ($60,000 — .4), and so on.
2. P. Healy, K. Palepu, and R. Ruback, “Which Takeovers Are Profitable”Strategic or Finan-
cial?” Sloan Management Review, Summer 1997, find that acquisitions add value for approxi-
mately one-third of the 50 largest acquisitions during the early 1980s.
3. See Steven N. Kaplan, Mark L. Mitchell, and Karen H. Wruck, “A Clinical Exploration of
Value Creation and Destruction in Acquisitions: Organizational Design, Incentives, and Internal
Capital Markets,” working paper, (July 1997), Harvard Business School.
4. Accounting rules in the U.S., the U.K., Canada, and Germany require expensing R&D out-
lays. Expensing is the norm in Japan and France, even though capitalization is permitted.
5. E. Eccher, “The Value Relevance of Software Capitalized Costs,” working paper, 1998,
MIT, finds that the amortization of capitalized software development costs provides investors
with valuable information on management™s estimate of the future revenues for the software.
D. Aboody and B. Lev, “The Value-Relevance of Intangibles: The Case of Software Capitaliza-
tion,” 1998, working paper, University of California, Los Angeles, and New York University, find
that investors value capitalized software assets and changes in their values. They conclude that
management judgment in capitalizing software development costs does not adversely affect the
quality of reported earnings.
6. P. Healy, S. Myers, and C. Howe, “R&D Accounting and the Tradeoff Between Relevance
and Objectivity,” working paper, 1999, Harvard University and MIT, show that, even if managers
abuse reporting judgment by delaying writing down R&D assets, accounting methods that capital-
ize R&D and write-off costs of unsuccessful projects provide better information for investors on
firm values than do expense rules.
7. Defined contribution plans, where companies agree to contribute fixed amounts today to
cover future benefits, require very little forecasting to estimate their annual cost, since the firm™s
obligation is limited to its annual obligation to contribute to the employees™ retirement funds.
Expense Analysis

7-21 Part 2 Business Analysis and Valuation Tools

8. Consistent with this view, R. Jennings, P. Simko, and R. Thompson, “Does LIFO Inventory
Accounting Improve the Income Statement at the Expense of the Balance Sheet?” Journal of Ac-
counting Research 34, No. 1 (1996), find that LIFO earnings are more related to equity values than
non-LIFO earnings.
9. Research findings indicate that management™s inventory method decisions are related to tax
considerations, (see R. Hagerman and M. Zmijewski, “Some Economic Determinants of Account-
ing Policy Choice,” Journal of Accounting and Economics 1, 1979, and B. Cushing and M.
LeClere, “Evidence on the Determinants of Inventory Accounting Policy,” The Accounting Re-
view 67, No. 2, 1992), corporate governance (see G. Niehaus, “Ownership Structure and Inventory
Method Choice,” The Accounting Review 64, No. 2, 1989), and firm characteristics such as R&D
and labor intensity (see R. Bowen, L. DuCharme, and D. Shores, “Stakeholders™ Implicit Claims
and Accounting Method Choice, Journal of Accounting and Economics 20, No. 3, 1995).
10. See M. Scholes and M. Wolfson, Taxes and Business Strategy: A Planning Approach, En-
glewood Cliffs, NJ: Prentice-Hall, 1992, Chapter 10.
11. The Black-Scholes option-pricing model estimates the value of an option as a nonlinear
function of the exercise price, the remaining time to expiration, the estimated variance of the un-
derlying stock, and the risk-free interest rate. Studies of the valuation of executive stock options
include T. Hemmer, S. Matsunaga, and T. Shevlin, “Optimal Exercise and the Cost of Granting
Employee Stock Options with a Reload Provision,” Journal of Accounting Research 36, No. 2
(1998), C. Cuny and P. Jorion, “Valuing Executive Stock Options with Endogenous Departure,”
Journal of Accounting and Economics 20, No. 2; and S. Huddart, “Employee Stock Options,”
Journal of Accounting and Economics 18, No. 2.
12. P. DeChow, A. Hutton, and R. Sloan, “Economic Consequences of Accounting for Stock-
Based Compensation,” Journal of Accounting Research, Supplement, 1996, find evidence that
lobbying against SFAS 123 was motivated by concerns about reporting higher levels of executive
13. J. Francis, D. Hanna, and L. Vincent, “Causes and Effects of Discretionary Asset Write-
Offs,” Journal of Accounting Research 34 (1996), Supplement, find that management is more
likely to exercise judgment in its self-interest for goodwill write-offs and restructuring charges
than for inventory or PP&E write-offs.
14. Arthur Levitt, “The Numbers Game,” remarks at NYU Center for Law and Business, New
York, September 28, 1998. Consistent with this concern, J. Elliott and D. Hanna, “Repeated Ac-
counting Write-Offs and the Information Content of Earnings,” Journal of Accounting Research
34 (1996), Supplement, find evidence that the market reacts to unexpected earnings declines in
the quarter subsequent to large write-downs.
15. See Chapter 8 for a discussion of comprehensive income.
Pre-Paid Legal Services, Inc.

re-paid Legal plans are designed to help middle-income Americans
have affordable access to quality legal assistance.
Pre-Paid Legal Services Corporate Vision
Business Analysis and
Harland C. Stonecipher founded Pre-Paid Legal Services, Inc. (PPLS) in 1972 after
Valuation Tools
an expensive encounter with lawyers stemming from an automobile accident. PPLS sold
legal expense insurance that provided for partial payment of legal fees in connection
with the defense of certain civil and criminal actions. The company went public in 1979
and grew rapidly throughout the 1980s as an increasing number of Americans sub-
scribed to legal service insurance (see Exhibit 1). In 1998 the company had membership
revenues of $110 million, earnings of $30.2 million, and end-of-year book equity of
$101.1 million. In May 1999 it began trading on the New York Stock Exchange, and in
7 August 1999 its market capitalization reached $738 million, an increase of 101 percent
over the previous year.
Expense Analysis

Pre-Paid Despite its strong ¬nancial performance, opinions about the future of Pre-Paid Legal
Legal Servic- Services varied widely among U.S. equity analysts in the period late 1997 to mid-1999.
es The company was highly recommended by a number of analysts, but there was also per-
sistent short selling of the stock.1 Short sellers™ primary concern about the company was
outlined in a Fortune article in late 1997. The business publication alleged that the com-
pany was using an inappropriate method of accounting for sales commissions. As a re-
sult of this uncertainty, the company™s stock price ¬‚uctuated widely from a high of
$40.50 to a low of $13.50 between late 1997 and mid-1999.

PPLS offered its customers (termed members) a wide range of legal insurance. The most
popular plan, The Family Plan, accounted for 94 percent of all memberships in 1998.
This plan provided reimbursement for a broad range of legal expenses incurred by mem-
Professor Paul M. Healy and Teaching Fellow Jacob Cohen J.D. prepared this case as the basis for class discussion
rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1999 by
the President and Fellows of Harvard College. Harvard Business School case 9-100-03.
1. A short seller borrows stock certi¬cates from a brokerage ¬rm and sells the stocks on the open market. If the stock
price declines, the short seller can buy back stock, cover his loan from the brokerage ¬rm, and earn a pro¬t. Of
course, if the price increases, the short seller takes a loss.

Expense Analysis

7-23 Part 2 Business Analysis and Valuation Tools

bers and their spouses, including will preparation, document review and letter writing,
some of the legal costs associated with employment-related trial defense, traf¬c viola-
tions, and Internal Revenue Service audits.2 The Family Plan speci¬ed limits on the
number of hours of attorney time that a member was entitled to receive for many of these
services. It also provided a 25 percent discount on attorney rates for the purchase of any
legal services over and above those provided under the insurance contract.
PPLS™s membership premiums in 1998 averaged $19.08 per month (or $229 per year).
Premiums were typically paid on a monthly basis either by automatic charges to the
Pre-Paid Legal Services

member™s credit card or through employee payroll deductions. The premiums were gen-
erally guaranteed renewable and noncancelable except for fraud, nonpayment of premi-
ums, or upon written request by a member. The annual membership renewal rate in 1998
was high; 75 percent of members at the beginning of 1998 were still members at the end
of the year. At March 31, 1999, PPLS had 648,475 active members, and membership had
been increasing at about 40 percent per year.

Marketing of Services
PPLS marketed its memberships through a multilevel marketing program that encour-
aged buyers to become salespeople. Members that sought to become sales associates
paid the company a fee, typically $65, to cover the cost of training materials, training
meetings, and home of¬ce support services. Registered sales associates sold the compa-
ny™s services to their friends and business associates. The most successful even recruited
and developed their own sales forces. In 1998 PPLS generated 76 percent of its annual
sales from the roughly 150,000 members registered as sales associates. The remaining
24 percent of sales were generated through arrangements with insurance and service
companies with established sales forces, such as CNA and Primerica Financial Services.
Sales associates were compensated on a commission basis (see Exhibit 2). Prior to
1995, associates that signed up a new member received a commission of 70 percent of
the ¬rst year premium, and a 16 percent commission for subsequent year renewals. First-
year commissions were paid in advance whereas renewal commissions were paid as
premiums were received. For example, if a new member signed up at a premium of
$229 per year, the associate responsible for the sale received a ¬rst-year commission of
$160 (0.70 — $229) at sign up. If the member renewed in subsequent years, the sales as-
sociate received a monthly commission of $3.04 (0.16 — $19).
After 1995 PPLS modi¬ed its commission formula to a ¬‚at 25 percent commission for
both initial year and subsequent renewal memberships. To retain and attract sales associ-
ates, PPLS advanced the sales associate three years of commission on every new member-
ship sold. If a membership lapsed before the advances had been recovered, PPLS deducted
50 percent of any unearned advances from future commissions to the relevant associate.
2. Legal services speci¬cally excluded from coverage included domestic matters, bankruptcy, deliberate criminal
acts, alcohol or drug-related matters, business matters, and pre-existing conditions.
272 Expense Analysis

Expense Analysis

Claim Cost Management
PPLS had historically offered two forms of legal services, each with very different im-
plications for managing legal claim costs. The ¬rst form of service, termed open panel,
allowed members to use their own attorney to provide legal services available under their
policy. Members™ attorneys were reimbursed for their services using a payment schedule
that re¬‚ected “usual, reasonable and customary fees” for a particular service and geo-
graphic area.

Pre-Paid Legal Services
The second form of service, closed panel memberships, required members to access
legal services through a network of independent attorneys that were under contract with
PPLS. These provider attorneys were paid a ¬xed monthly fee on a per capita basis to
provide services to plan members living within the state in which the attorney was li-
censed to practice. PPLS contracted with one large, highly rated legal ¬rm in each of its
36 major markets. These were selected after a detailed review by PPLS management.
Martindale-Hubbell, a legal rating ¬rm, typically rated PPLS™s provider attorneys AV, its
highest rating.
Average costs of membership claims in 1998 were 33 percent of membership
premiums, and management reported that these costs were expected to remain at around
35 percent in the future.

PPLS reported record ¬nancial performance in the period 1997 and 1998 (see Exhibit 3
for summary ¬nancial data). Membership revenues during this period grew by an aver-
age of 52 percent per year, net income grew by 61 percent per year, and operating cash
¬‚ows grew 270 percent per year. The ¬rm™s ¬nancial performance for the ¬rst six months
of 1999 continued to be strong. Membership revenues grew by 20 percent, earnings by
54 percent, and operating cash ¬‚ows by 138 percent (from $2.4 million to $5.7 million).
As a result of the company™s growth performance, a number of equity analysts that
followed the stock recommended it to their clients. For example, David Strasser of
Salomon Brothers issued strong buy recommendations for PPLS in August 1997 and
commented on the stock as follows:
We reiterate our Strong Buy recommendation on the shares of Pre-Paid Legal Ser-
vices, Inc. . . . We have recently increased our one-year price to $34 from $26. We
did this for several reasons. First, the company continues to demonstrate consis-
tent earnings growth, in line with Wall Street estimates, which gives us greater
visibility of our projected 36% growth rate. . . . We are also encouraged by the
company™s ability to generate positive operating cash ¬‚ow while still growing rev-
enues 53%. This positive cash ¬‚ow is indicative of the seasoned membership base
that generates cash in spite of the company™s policy of paying commission advanc-
es to its associates for new sales. We continue to believe that the company will an-
nounce an alliance with a major insurance company to sell the company™s
Expense Analysis

7-25 Part 2 Business Analysis and Valuation Tools

products. This would essentially double the size of the company™s productive sales
force and increase overall visibility of the prepaid legal product.3

Despite its strong ¬nancial performance, in late 1997 PPLS was a target of short selling.
On November 24, 1997, Fortune published an article titled “Will Pre-Paid Keep Grow-
Pre-Paid Legal Services

ing?” The article cited short seller Robert Olstein of Olstein™s Financial Alert Fund, who
explained that his concern arose because “PPLS™s accounting for commissions is unreal-
istic and not in accordance with economic reality.”4 The Fortune article noted:
Rather than record the commissions as an instant hit to earnings, Pre-Paid
spreads them out over a three-year period. Such deferrals, the shorts argue, make
today™s earnings growth look stronger than it really is. In the ¬rst half of this year,
for example, if the company had swallowed commissions when they were paid, it
would have shown little if any earnings growth”certainly not a level of growth to


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