May 04, 1999 PRISONS: WHY THEY'RE SECURE INVESTMENTS Bob Hirschfeld
Earlier this spring, the Department of Justice released a sobering statistic: 1.8 million Americans were behind bars at the end of 1998. That translates to one in every 150 citizens being behind bars, a rate only exceeded by Russia and South Africa.
The decade-long surge in the prison population is the result of stricter sentencing guidelines. At the end of 1997, federal prisons were at 119% of capacity and state-run prisons at 115% of capacity, according to J.C. Bradford's Michael Hughes.
Overcrowding, though, has been a boon to private operators of prisons, which now house 4% of the entire inmate population. 119,000 private beds are currently outsourced from the Government through 145 privately managed secure correctional facilities in the U.S.
The basic appeal is cost savings. Private systems, according to the Center for Policy Analysis, save 20% on construction and 5%-15% on operations, matters of no small appeal to budget-conscious states. Public and private advocates debate the cost benefits: the State of Texas figures that it saves $9.50 a day per inmate when it turns prisoners over to private operators. (The comparison, though, is not apples to apples, as the state has the costly task of housing all maximum-security prisoners).
In all, 33 states use private adult corrections facilities. Texas leads the way with 43 different sites. California, with 24 facilities, has also moved aggressively to outsource its prison business. The trend has not caught on as quickly east of the Mississippi, thanks to stiff opposition from labor unions and law-enforcement officials in those areas, says Bradford's Hughes.
In 1996, sociologist Charles Logan compared the quality of confinement in public and private prisons, and found that inmates prefer state prisons, while staff prefer private facilities. The tighter security of private facilities strongly appeals to staff.
Over 60% of inmates in the Federal system are doing time for drug violations, triple the rate of 15 years ago, according to the New York Times (in state and local, the number is 22%). During the 1980s, Congress and state houses passed laws requiring judges to issue mandatory minimum sentences that would put drug offenders, even first-timers, behind bars.
Crime has dropped precipitously in recent years, yet the inmate population continues to swell. 'We've got crime going in one direction and social policy going in the other,' says Dr. Allen Beck, a statistician with the Department of Justice.
Private prisons are not a new concept. In the mid-1800s, states awarded contracts to private entrepreneurs to operate several facilities including New York's Auburn and Sing Sing penitentiaries. But allegations of prisoner abuse, and the inappropriate use of convict labor put an end to that era of private prisons.
Corrections Corporation of America, which entered the market in 1984, was heavily criticized for allegedly understaffing its Youngstown, Ohio, facility. Though initially licensed as a medium-security prison, the company later transported in hardened, out-of-state criminals, including an estimated 600 murderers. Numerous stabbings and a pair of murders resulted. The furor prompted new legislation specifically requiring the Youngstown prison to limit its population to medium security inmates.
Adding concern: Ohio, Tennessee, and Texas have enacted or are considering enacting legislation to control private prisons. One possible regulation: prohibiting out-of-state inmates above the level of medium security. Another concern: Prohibiting private prison operators from speculative prison building, in which the private concerns builds a prison, then fills it with (often times out of state) inmates.
At the Federal level, a bill was introduced in March to prohibit Federal inmates
As a backdrop to all of the regulatory turmoil, several industry trends have quietly taken hold. For starters, REITs, or Real Estate Investment Trusts, are taking a greater role. Government(s) are choosing to offload the capital investment for new prison construction onto the private sector, notes Bradford's Hughes.
In addition, the market for facilities that house juveniles is swelling rapidly, and has historically been a greater focus of private operators. About 40% of juveniles in custody are held in privately run facilities (though these are often not-for-profits), versus abut 5% of adults in custody.
The Private Players
Prison Realty Trust (NYSE:PZN - news) is the largest private prison company, with 56% of the market. Prison Realty merged with the management arm of Corrections Corporation of America this past January 1999, in a $2.88 billion stock swap. Wackenhut Corrections (NYSE:WHC - news) is the second largest player with about a 21% share, followed by privately-held Ogden. Correctional Services (NASDAQ:CSCQ - news) , which controls 5.8% of the market, merged with Youth Services International (NASDAQ:YSII - news) in March. Cornell Corrections (NYSE:CRN - news) holds a 5.6% share.
Given its cost advantages, private sector prison growth is all but assured. Hughes projects growth of 20,000 to 24,000 beds per year going forward, adding that 'this type of bed growth should help most of the publicly traded companies sustain 20%-plus earnings growth over the next four to five years.'
Bradford's Hughes has developed a private corrections index based on the performance of six publicly traded companies. Since the beginning of 1998 through the end of March, the JCB index fell by about 15%, underperforming both the S&P 400 and the Russell 2000. Prior to that time frame, corrections stocks had appreciated smartly.
But the lackluster performance of these stocks masks continued strong growth of the sector. According to Brian Ruttenbur, of Sun Trust Equitable Securities, the adult segment of private corrections is expanding at 20% per year, and the youth segment at 30%. Overall prison bed growth is only about 4%-5%, indicating that the move to privatize will continue.
Given the efficiencies of the companies, bottom-line growth should expand more quickly. In a nutshell, huge top-line growth and highly efficient operations make the business model of the entire industry highly attractive.
What's more, current valuations are attractive, given that most corrections stocks have 'corrected' and now trade at serious discounts to the market multiple. PEG ratios (a ratio that measures PE ratios in relation to the company's core earnings growth rate), for instance, are low both on an absolute and historical basis. Given the recession-resistant nature of the business and above-average earnings growth, many analysts argue that such severe discounts are unwarranted.
Last fall, shares for the industry players started to come back. In the fourth quarter, the average correctional services stock gained over 30%. But shares gave back many of those gains in the first quarter of 1999. Correctional Services sold off over 30% on news of its merger with Youth Services International. Wackenhut Corrections declined over 30% on disappointing fourth quarter top line results. Shares of prison REITs also fared poorly: Prison Realty was down 12.5% and Correctional Properties Trust was off 17%.
Private corrections is an undervalued industry with virtually assured growth that plays to the theme of privatization and to the nations' appalling increases in prisoner population.