Prisons are a strange concept when you think about it. They're groups of buildings designed expressly to hold people whom society would prefer not to have around for a while. The idea of shipping off undesirables is nothing new, of course. The British sent their naughty children halfway around the planet to an island called Australia. No fuss, no muss, no state bonds to pay for it all.
In America, for better or worse, somebody will always find a way to make money off just about anything. So it stands to reason that prisons would be yet another way. See, prisons are just another money pit for state and federal governments, another thing they would rather not have to deal with. If something bad happens in a privately run facility -- say, for example, a prison break or some claim of prisoner abuse -- the state isn't on the hook. The private operator's insurance picks it up. It's a good cost-saving measure.
Four major public companies currently deal in this unseemly business: Cornell Corrections (NYSE: CRN ) , Corrections Corporation of America (NYSE: CXW ) , Correctional Services (Nasdaq: CSCQ ) , and The Geo Group (NYSE: GGI ) . It's worth looking at these companies for one very unfortunate reason: There will always be crime. Just as there will always be car accidents. Just as people will always need food. Each of these businesses is different, of course, so before we incarcerate ourselves in a prison of our own making, we'd better check out the facilities first.
One of the problems with the prison industry is how revenues are generated. Generally, a company signs short-term contracts with state and federal agencies to run their prisons for them. Fees typically get paid to the company on a per-inmate basis, with certain price floors. The problem with this setup is that once a prison hits full capacity -- and many have done so -- the company has maxed out its revenue opportunities at that prison, unless it can negotiate higher fees upon renewal. That means prison companies must constantly be trying to secure new contracts, expand current prisons, or buy up and possibly have to renovate other prisons. That makes for a lot of cash flow drain.
The other issue is costs. Prisons are expensive to run, and the need to carry expensive liability insurance is a big part of that cost. There's a lot of overhead, too. Remember, prisons have to provide everything from linens and clothes to food and guards. In some ways, prison costs aren't too different from the costs a hotel must bear. Of course, hotels have higher profit margins and don't need people to patrol the grounds for escapees.
With the overhead and revenue concerns, it helps to be a big player. Corrections Corporation owns 50% of the beds in the industry, and in a business like this, reputation really does make a difference. When it comes to safeguarding the community, the state and federal folks like to stick with established prison operators that have not had problems, so Corrections is a good place for many governments to go to first. With almost 14,000 employees, an enterprise value of $2.4 billion, and a decent profit margin of 5.46%, Corrections looks good at first glance. Factoring in analysts' expected 16% earnings growth from this year to next pretties up the picture even more.
But, alas, the story doesn't end there. Although the stock trades at a price-to-earnings ratio of 24 -- a reasonable premium for the big player in the biz -- there's a problem on the balance sheet. Remember when I said this business is cash flow intensive? Corrections' free cash flow was negative $15 million over the trailing 12 months, although, to be fair, I should mention that those cash flows include considerable expansion capital expenditures. (Some analysts don't subtract expansion capital expenditures, which are optional expenditures, from operating cash flow when arriving at FCF.) With a billion dollars in debt and only $60 million in total cash on the balance sheet, this is not a company looking poised to pay off much debt anytime soon. I have reason enough to pass.
The Geo Group, the second-largest player with an EV of $437 million, has some slightly better metrics than Corrections Corporation. For one, the debt load is not as bad. It has $85 million in cash and $241 million in debt. Its trailing-12-month FCF is a very impressive $47 million. Earnings are set to grow 20% over the next year, according to analyst estimates, from $1.49 to $1.80. But with a stock price of $29.50, Geo sports a YPEG (year-ahead P/E and growth ratio) of 1.50. Too pricey for me.
What also caught my suspicion is a thin profit margin just north of 2% and a whopping $160 million in capital expenditures in 2002 ($6 million to $10 million might be a more normal figure based on the company's habits). But a good portion of that amount was due to a business transaction in which the company essentially bought out a partner in the business. (You may remember Geo Group as once being called Wackenhut.) All in all, I would keep my eye on Geo Group. I'd like to see what the next year brings to its expansion plans and contract renewals. It services international customers as well, and that opens up another whole arena to expansion.
Of some interest is Cornell Corrections, but not for reasons investors might like. The Securities and Exchange Commission just recently cleared the company of any wrongdoing regarding a restatement of its 2001 and 2002 earnings. Hedge fund Pirate Capital scooped up a 13% stake in the company and was a major factor in forcing out the CEO. According to the Nov. 22, 2004, issue of New York Metro, Pirate wants the company sold and thinks it can fetch as much as $20 a share. (It currently trades around $13.50.) Six other hedge funds are, according to the article, also circling the company.
Finally, we have teeny Correctional Services, which is so small ($25 million market cap) that no analysts cover it. It's showing just a small profit and a negative FCF from the trailing 12 months, so it doesn't appear terribly enticing, at least based on a cursory look.
The final lockdown?
If I had to choose one of these companies as my cellmate, well, I'd probably first ask to be moved to solitary. Corrections Corporation looks overpriced. Geo Group is worth watching. Cornell Corrections is perfect for the purely speculative investor. And for most investors, Correctional Services won't be worth watching for a while.
Despite the lack of compelling values in the prison industry, businesses arising from government outsourcing can be good things to keep tabs on. If you can find a business that takes advantage of government's generally deep pockets and weak fiscal restraint, it's worth your time to investigate it further.