[1/17/01 6:00 PM EST] Conspicuously absent from Business Week�s recent review of key industries for 2001 is any mention of the prison management industry. Intuitively, prisons seem like a pretty good countercyclical play. As the �R� word has reared its ugly head recently, defensive stocks might be worth considering. In a soft economy, employment rates fall, tax bases erode and crime goes up. What better opportunity for those who profess to provide low-cost inmate processing? Wasn�t prison management once described as a hot sector destined for double-digit growth at least through 2001? These stocks don�t look like they�re in particularly good shape. What happened?
Part of the answer is best described by those in the media with a more sensational approach to reporting the news. Ramping up on the ol� industry learning curve apparently came with some physical and financial pain. Negative press on the subject includes stories about contract prisoner transportation drivers being kidnapped by their cargo, wholesale prison escapes through air ducts in motels-turned-prisons and other escapes right through the fences and concertina wire while guards played ping-pong. One wonders if Wile E. Coyote and his arsenal of gadgets by Acme couldn�t have done a better job of guarding the fort.
Prisoner of a Negative Trend
As a visual aid to this story, if you call up the price chart on the industry�s largest player, Corrections Corporation of America (NYSE: CXW), the trajectory of the price decline would suggest that either something has gone terribly wrong or the little device that draws lines on charts ran out of steam. How could things be so bad? What could be more universal and persistent than crime?
Indeed, in an industry where occupancy rates are between 115% and 125% of capacity, what gives? For one thing, the capital-intensive nature of this industry can become problematic. Standard & Poor�s recently removed CXW from its year-old listing on CreditWatch. The bad news is that the outlook is negative. S&P is concerned about the industry contract-negotiation process, described as lengthy and unpredictable. Perhaps the most telling aspect of this story is impaired cash flow due to the speculative overbuilding of new facilities over the past two years. We guess there�s too much room at the company�s inns.
Deciding that well-funded government budgets were going to be a drag on potential earnings, CXW�s management decided the future was in developing, owning and leasing properties to government agencies, rather than the old focus of managing prison operations. It seems they got a little ahead of the trend. As with any commercial real estate company in the same position, shame on it. Speculation is its own reward�often its only reward. Cash infusions from bottom fishers and recent management changes that include ousting the CEO and founder of the industry have not kept the stock from coming within $0.38 of extinction.
While certainly undervalued, other players in this sector did not take the same strategic direction and have not suffered the same outcome. The second-largest player is Wackenhut Corrections Corporation (NYSE: WHC), a diversified, international provider of corrections services and subsidiary of security giant Wackenhut Corporation (NYSE: WAK, WAKB). WHC operates in the United States, Australia and the United Kingdom. Its services run the gamut, and include management of adult facilities, juvenile facilities, community corrections, work programs, prison industries, substance abuse treatment facilities, mental health programs and geriatric facilities. Psychiatric health care, electronic home monitoring, prisoner transportation, correctional health services and facility maintenance round out the product offerings. The range of services offered could suggest that the company is not as caught up as CXW in needing just to fill beds. Social groups have been very alert to any urging from a strong prison industry lobby needing to fill beds.
Some believe an inherent conflict exists between making a profit and managing prisoners. Concerns about exploitation may limit just how successful�in terms of profits, at least�corrections companies can be. The industry comes laden with all the emotional issues you can imagine. Critics continue to assert that it is inappropriate for corporations to profit from the misery of others.
The conflicts of interest here are somewhat reminiscent of those in the health care insurance industry, but when it comes to prisons, the third-party consumer does not have any choice in the matter, which highlights the importance of accountability.
There is no question that exploitation has occurred. Poor management has invited organized protests and a general outcry. Indeed, negative press is a clear factor in the depressed valuations of these stocks�certainly CXW has had its share. Some situations have grown so bad that government agencies have taken over private facilities in response to dangerously inadequate management. The managements involved in these situations deserve the bad press, but this issue is easily addressed through attentive governmental oversight, certainly something we have seen in industries such as the electric utility industry. The prison management industry offers some oversight through facility accreditation from the American Correctional Association, and many companies compete based upon their reputation for quality and the success of their internal ethics and compliance programs.
Value Better than the Smell
Whatever your views on the ethical issues, not all privately run prisons are corrupt. And the stocks generally are undervalued. WHC, for instance, stumbling on the closure of a youth facility in 2000, is currently selling at an 8x multiple of estimated earnings while enjoying an outlook for 19% growth for FY01 and 18% five-year projected growth, according to consensus estimates. It might well be worth looking into.
Another name in this industry is Cornell Companies, Inc. (NYSE: CRN). While not as strong or consistent a performer as WHC, CRN is currently selling at a 50% discount to book value, something that must be driven in part by its large debt position, which is a product of its $200 million real estate portfolio. Although the size of its portfolio could be a red flag during soft industry conditions, the holdings are expected to be a source of investment capital through sale-leaseback transactions. CRN management asserts that it can sustain 20% earnings growth over the next five years with pretax margins that are the highest in its industry. Could this stock be worth more than its current 7x earnings multiple?
CRN recognizes that the public mood changes over time, so the company protects its revenue stream by being ready for shifts when they occur. Indeed, the company feels well positioned to capitalize on the current trend toward the rehabilitation of prisoners and away from the �lock them up and throw away the key mentality� of the past decade. The new trend is reflected in California�s Proposition 36 that sends nonviolent drug offenders to treatment facilities instead of prison.
A final name to consider is Correctional Services Corporation (Nasdaq: CSCQ), one of the nation�s largest providers of correctional services for youth, with 34 facilities and over 4,300 juveniles under management. This company also develops and operates adult correction facilities with an emphasis on niche operations such as parole violators, substance abuse offenders and pretrial detainees. All told, CSCQ has 16 facilities with 6,700 beds. While the wide array of treatment services offered suggests that this company is poised to benefit from a renewed focus on rehabilitation, third-quarter revenues are down when compared with the prior year, and it seems to be a member of the �waiting for better times club.� Recently selling at $3.00, CSCQ�s book value is around $5.00 per share.
Nearly as Sure as Death and Taxes
This capital-intensive industry has fallen prey to incompetence, the pains of rapid growth, overbuilding and negative press, but these companies still provide valuable services to a large and durable industry. The �get tough on crime� attitude is not likely to go away overnight. Annual outlays nationwide are about $45 billion a year in support of 2.11 million adult prisoners. CRN points out that this is 50% larger than the waste industry (an unfortunate comparison), where 90% of the business is outsourced vs. the 7% outsourced in this one. The addition of youth and mental health services brings the market total to $100 billion.
The number of juvenile offenders should spurt as the baby boom echo generation comes of age over the next 10 years. The youth population is projected to increase from 40 million to 45 million over that time. CRN expects 260,000 youths to be in privately managed beds by the end of 2001, compared with approximately 200,000 now and approximately 25,000 in the early 1990s. Additionally, federal contracts are due to increase over the next 24 months.
Critics question whether privately run prisons actually offer savings (the figure CRN offers is that they produce a 15% cost savings). But perhaps this issue will become less important should a conservative government with a bias toward reducing its own size bring renewed strength to this sector.
Shelley G. Reed, CFA, RedChip� contributing editor