When investors think of "sin stocks," they usually think of tobacco, alcohol, or gambling stocks. However, one other category of sin stocks investors often overlook is the private prison industry. There are only two major publicly traded companies in this sector -- The GEO Group (NYSE:GEO) and Corrections Corporation of America (NYSE:CXW).

Let's take a closer look at GEO, which is the smaller of the two companies, to better understand how the private prison industry works, and if its stock is a worthy long-term investment.

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Source: Wikimedia Commons.

Strengths and opportunities
The private prison industry grew out of the "war on drugs" in the 1980s, which caused a higher number of people to be incarcerated for the possession (as opposed to the distribution) of drugs. Those tighter drug laws have caused the U.S. prison population to rise around 700% since 1970, making America the world's largest jailer, with 25% of the world's prisoners, but only 5% of the world's population.

To deal with overcrowding, several states signed contracts with private prisons like GEO and Corrections. Many of these state contracts guarantee private prisons occupancy rates between 90% to 100%. GEO and Corrections have dominated the market by securing contracts with the U.S. Marshals Service, Bureau of Prisons, and ICE, which erect major competitive barriers against other potential competitors.

GEO's annual revenues have risen 146% from $617 million in fiscal 2004 to $1.52 billion in fiscal 2013, while its annual earnings per share climbed 69%. To attract new investors, GEO converted itself into an REIT (real estate investment trust) in 2013. This means GEO doesn't have to pay corporate taxes, but it must distribute at least 90% of its taxable income back to shareholders as dividends. This change gives GEO an impressive annual forward dividend yield of 6%. Corrections Corp, which also converted itself into an REIT, pays out a forward yield of 5.7%.

Weaknesses and threats
The main weakness with GEO's business model is that the prison population in America peaked in 2009 at 1,615,487 prisoners. That figure hit a five-year low of 1,571,013 in 2012, before inching up again last year to 1,574,700 prisoners, according to the U.S. Bureau of Justice.

The Mexican border crisis, which some analysts believed would fuel higher demand for private detention facilities along the border, abruptly ended in August, presumably because of higher security measures in Mexico. Meanwhile, the legalization of marijuana in Colorado and Washington, with other states likely to follow, could cause a sharp decline in marijuana-related arrests and incarcerations. Approximately 40,000 people are currently incarcerated in the U.S. on marijuana-related charges.

Hundreds of lawsuits have also been filed against GEO by prisoners and employees, which include allegations of inmate death, abuse, medical neglect, and employment discrimination. In 1999, the State of Texas terminated a contract with GEO over accusations of 12 prison guards sexually assaulting female inmates. Last year, the American Civil Liberties Union investigated the East Mississippi Correctional Facility, which GEO ran between 1999 to 2012, and reported that prisoners were "underfed" and held in cells "infested with rats" with "no working toilets or lights."

In other words, bad PR suggesting that GEO is cutting corners to protect its bottom line could undermine its ability to secure new contracts with state governments.

Valuation vs. Corrections Corp
Last but not least, we should compare GEO and Corrections Corp operations and stocks on a fundamental level.

Corrections has 84,500 beds in 52 correction and detention facilities and 12 government partnered facilities, while GEO has 78,500 beds in 98 directly owned or managed facilities. Investors should also note that Corrections is more of a pure play on prisons, while GEO also runs youth services and community-based centers.

 

Forward P/E

EPS Growth (mrq)

Rev. Growth (mrq)

Profit Margin

Dividend (Forward)

YTD Price

Corrections

18.2

172.8%

(3.4%)

12.4%

5.7%

10%

GEO Group

11.7

13.7%

8.2%

7.9%

6%

17%

Advantage

GEO

Corrections

GEO

Corrections

GEO

 

Source: Yahoo! Finance, Oct. 27.

GEO seems to be a cheaper stock than Corrections, although Corrections has done a better job of protecting its bottom line. However, GEO has shown a remarkable ability to keep its top line growing even as industrywide occupancy growth remains weak. In my opinion, both GEO and Corrections aren't bulletproof sin stocks, but they're relatively stable income generators that could be fairly well insulated if the broader market crashes.

Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.