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3 prison stocks poised to break out
Thanks in part to overcrowding, governments are turning to private companies to build and manage prisons. Here's how to pick the right time to buy into the trend.
By Michael Brush
In what might be a revealing commentary on our country's state of affairs, the nation's private prison companies look like solid investments for the next several years.
The three big prison companies -- Corrections Corp. of America (CXW, news, msgs), The Geo Group (GGI, news, msgs) and even the troubled Cornell Cos. (CRN, news, msgs) -- have decent growth prospects for the following reasons.- Increased border patrols. The Intelligence Reform and Terrorism Prevention Act of 2004, signed by the president in December, calls for stepped up border patrols to improve domestic security. This makes it likely that more illegal immigrants will be caught. Lawmakers estimate that by 2010 the Bureau of Immigration and Customs Enforcement (ICE) will need another 40,000 prison "beds," as they say in the business.
- Governments are hard up for cash. "Because of tight budgets, there has not been a lot of new prison construction," says Irving Lingo, Corrections Corp. of America's finance chief. Instead, state and federal prison systems turn to private companies that build and manage prisons. In the 2005 federal budget, for example, Congress cut prison construction spending by 48%, says Patrick Swindle, an analyst who covers the sector for the brokerage Avondale Partners. Government prison systems turn to the private sector in part because costs are 10% to 15% lower.
- Government prisons are overcrowded and the prison population will keep growing. "Federal prisons are at 33% overcapacity, and more than half the states are at overcapacity," says Swindle. "There is a scarcity of beds, and companies in the private prison space are being asked to meet the demand."
Demand should pick up over the next decade for a simple demographic reason. The children of baby boomers, the so-called echo boom, are about to enter the 18- to 24-year old age group -- the years when people commit the most crimes. The Federal Bureau of Prisons estimates it will have a 36,000 bed shortfall by 2010, partly due to this trend.
The big-fish theory
These numbers may not seem like much. But it's a big deal for the tiny private prison sector, which houses only around 7% of the 2.1 million people in prison in the United States.
To see why, let's take a closer look at some numbers. The two federal agencies, ICE and FBP, will need 76,000 new prison slots over the next five years. That alone is more than the number of beds now run by the biggest private prison company, Corrections Corp., which houses about 70,000 inmates. And it doesn't even include increases in demand expected at the state level.
| Prison stocks | | Name | Recent price | Price earnings ratio* | Estimated 2005 earnings** | Market cap | Market share*** | Earnings estimate revisions | Comments | | Corrections Corporation of America (CXW, news, msgs) | $40.3 | 22.27 | $1.81 | $1.4 billion | 54% | Up | Market leader | | The Geo Group (GGI, news, msgs) | $26 | 14.61 | $1.78 | $246 million | 22% | Up | Lowest debt levels: expect acquisitions | | Cornell Companies (CRN, news, msgs) | $15.25 | 18.83 | $0.81 | $206 million | 12% | Down | Look for a pop from a change at the top |
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*Forward estimates based on consensus 2005 projections from Thomson Financial.
**Per share
***U.S. market
To be sure, much of this dynamic has already been priced into prison company stocks. Corrections Corp., for example, trades at about 22 times 2005 earnings estimates, at the low end of its historic 22 to 25 range. The Geo Group appears cheaper, with a forward price-to-earnings ratio of 14. But at $26, it trades at the 12-month price target recently set by one analyst. (As the leader, Corrections Corp. deserves a premium valuation.)
These stocks are still worth buying because of the long-term trends. But you'll need to be patient and have a long-term horizon. Troubled Cornell might just provide the most near-term upside, if new management comes in and gets earnings growth on track.
Why it pays to be cautious
One tactic might be to wait for any of the sector's risk factors to strike and push the stocks down to better levels for a purchase.
Last summer, for example, Corrections Corp. stock fell more than 17%, to $33 from $40, when the two chief risk factors hit. - Risk factor # 1: There was a riot at one of its prisons in Colorado last summer. Riots and escapes at private prisons pressure these stocks because of the accompanying media attention, even though their safety records are the same or better than those of government prisons, according to a Harvard Law Review article and industry studies.
- Risk factor # 2: Several contract bids were delayed. Even though this isn't unusual when dealing with the government, investors got scared nevertheless.
"Everybody wants everything to fall into quarterly buckets, and when you are dealing with government agencies it does not always work this way," says Lingo at Corrections Corp. "Government tends to move at its own pace, and private investors don't seem to understand that."
Sooner or later, governments get around to awarding contracts. So when prison stocks weaken because of contract delays, it's probably a good time to buy.
Founded in 1983, Corrections Corp. was the first company to privatize prisons in the United States. It's also the biggest, with 54% share in the private prison sector. So it's likely to get a big piece of the business from state and federal prisons trying to cope with overflows.
Unlike competitors, Corrections Corp. owns most of the prison capacity it manages, which means it has more stable revenue. The company also has about 8,000 unused beds now, which could give it an edge in contract bids. Filling those beds alone would bump earnings up to $2.40 per share, or 33% above the 2004 estimate of $1.81, says Avondale's Swindle. He's not predicting that will happen. But it shows the potential that lies ahead if the company gets even part way there.
Buying growth
The second-largest prison operator, Geo Group, has $84 million of cash and the lowest debt levels for the group. So the company is in a position to grow through acquisitions, says Jeffrey Kessler, who covers prison stocks for Lehman Brothers. Kessler started coverage of the stock in early November. It has already traded through his 12-month price target of $26. Conclusion: It may pay to wait to buy this one.
Thanks to what critics say has been a series of management missteps, Cornell stands out like a sore thumb. While the two other prison companies have been getting a steady stream of upward revisions to earnings estimates, a positive sign, Cornell's numbers keep getting cut.
What's wrong? The company has done things like overestimate what it would get paid for running a treatment facility, which it then had to close. And it has purchased or leased facilities it was unable to use because government contracts fell through.
All that may change if an activist hedge fund named Pirate Capital has any say. Since last summer, the Connecticut-based hedge fund has grabbed a 14% stake in the company. Now, it's using its weight to lob demands at the board for an overhaul.
"The common denominator in Cornell's consistent disappointments, downward revisions and delayed project completions is the current management team," Pirate Capital's Zachary George wrote in a recent letter to the board. To help fix things, Pirate Capital wants two board seats, a turnaround firm to replace management and an independent board committee to review takeover proposals.
A change is gonna come
Sheryl Skolnick, an analyst with Fulcrum Global Partners, agrees a change at the top might do shareholders some good. "We think there is a lot of value in the assets," says Skolnick. "The frustration is that every time we turn around, management has another reason why they can't get there this year." She puts earnings potential for the Cornell's facilities at $1.60 per share, or twice the current 2005 estimate of 81 cents.
Despite the attacks, Cornell management is hanging tough. It has several projects ramping up, including a federal prison in Pennsylvania, treatment and alternative education programs in Pennsylvania and Colorado and other facilities in New Mexico and Washington, D.C. These should boost revenue 30% by March 2006, says Cornell spokesman Paul Doucette. The company expects revenue to grow to $385 million by then, from $285 million in 2004.
Who's right? Shareholders can look forward to a showdown in early June, when the next board elections take place. Watch for Pirate Capital to launch its mutiny and make a move to get its representatives on the Cornell board. The hedge fund may get plenty of help from other would-be pirates. As many as a third of all votes were withheld in recent board elections to protest management, says Skolnick.
"By mid- to late-June we will have a very different Cornell," Skolnick predicts. Under better management, she says, the next stop for Cornell shares could be $21, for a 40% gain over recent levels of $15.
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