Pop quiz: What's a $74 billion industry with a potential customer pool of 1.6 million users, a monthly membership cost of $1,500, and a retention rate that would leave Sirius XM or Netflix drooling? The answer: private prisons. However, a critical look at the failings and financial fudging of these corporations reveals several reasons why this sector is destined for destruction.

A history of private prisons, abridged
Private prison companies offer the public sector something very valuable: a buyout contract with immediate revenue in exchange for incremental long-term cost. Ready to hand over the keys, decision makers from police chiefs to the federal government are happy to wash their hands of prison management and enjoy some extra cash while they're at it. Private prison companies are sweetening the deal even more with campaign contributions and promises of new jobs.

From 2000 to 2010, the number of inmates kept in private prisons rose nearly 50%, from 87,000 to 128,000. While this amounts to less than 10% of all prisoners nationwide, it represents a serious trend toward privatization as budget-squeezed states look for ways to cut costs.

The wardens
Corrections Corporation of America (NYSE: CXW) and GEO Group (NYSE: GEO) hold half of all prison contracts and collectively pulled in $3.3 billion in revenue for fiscal year 2011. In an industry that lives by economies of scale, CCA enjoys a net profit margin of 9% -- nearly double that of GEO Group. However, both companies have seen decreases in net profit margins over the last four years, even as revenue has consistently risen. This is due in large part to decreases in prison occupancy rates. Like for Superman, less crime means less business for these companies.

In terms of stock price, CCA is trading about 25% higher than my purely quantitative calculation of intrinsic value. But a fundamental analysis of these companies and the industry at large shines an even brighter light on its dark future.

Bad news for prison blues
At a fundamental level, the mandate of a private prison is inherently different from that of a state-run institution. Whereas a state-run prison's motives center around ideals of rehabilitation and societal improvement, private prisons view inmates as a cost to society that should be minimized. While public prisons are no picnic, private prisons are known to consistently short-staff personnel, scrimp on guard training, shrink inmate medical-care services, and ignore facility maintenance.

A few tangible results from this economization include escaped felons, undisrupted gang violence, dysfunctional surveillance equipment, and cell-robbing, drug-dealing guards. In a period of 14 months at a CCA prison, there were 13 stabbings, two murders, and six violent escapes. The Department of Justice is investigating GEO Group for alleged staff sexual misconduct described as the "worst that we have seen in any facility anywhere in the nation." Now, remind me again who's supposed to be behind bars?

Cutting costs?
In an unprecedented 2010 report by the Arizona Department of Corrections, an "adjusted cost per capita" determined that private-prison costs are not significantly different in minimum-security prisons and are actually higher for medium-security prisons. "Adjusted" accounts for the fact that various private prison companies refuse to accept costly (i.e., violent, sick, and/or developmentally disabled) inmates. Looks like the bottom line just got a little fuzzy.

Source: Author, using data from Arizona Dept. of Corrections FY2010 Operating Per Capita Cost Report.

Did the prison bubble just burst?
In 2010, prison releases exceeded prison admissions for the first time since the Bureau of Justice Statistics began collecting data in 1977. Private-prison use has been falling since 2007 and has remained constant or negative over the past two years.

Source: Author, using data from Bureau of Justice Statistics.

A big increase in search-engine interest about privately managed correctional facilities suggests that the general public is paying attention, too.

Source: Author, using data from Google Trends.

And guess what the public owns? Stocks and votes. As public outcry continues to grow, contracts have already begun to flutter away. More than a third of CCA's contracts and approximately half of GEO's contracts expire in 2012, creating even more opportunities for governments to make their great escape. With no growth and no competitive advantage, it's only a matter of time until financial markets follow suit. Private prisons make neither sense nor cents, so make your break today.

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