Will Crime Pay Off for Prison Stocks?

Legendary fund manager Bill Ackman thought so. Here's why

   

Remember how Peter Lynch told us that it was a great idea to invest in distasteful industries, like garbage companies and mortuaries? I have to wonder if he would’ve liked the private prison business, because legendary hedge fund manager Bill Ackman sure does.

A few years back, state governments outsourced part of their incarceration system to save money. And like good capitalists, a few companies saw profit in a business that depends on crime, because society always has crime. And that means there will always be the building and management of jails — the one business always guaranteed to have customers!

Corrections Corp. of America (NYSE:CXW) caught Ackman’s attention in 2009. He noted that it’s the largest private prison company in the nation, with 48% of the market, and the fifth-largest prison manager. The big attraction, though, is Corrections Corp. owns the actual buildings and land at 90% of its facilities. That kind of hidden asset is what Ackman loves.

Prisons are so overcrowded, especially here in California, that officials are actually releasing criminals early. State prisons have a 96% occupancy rate, while federal prisons are at almost 140% of capacity. And the prison population growing at 5% annually. The market potential also remains huge, with only 8% of prisons privatized so far. Private prisons also operate as local monopolies, and all investors love monopolies.

Corrections Corp. carries $1.25 billion in debt, and it just refinanced its borrowing facility through 2016 at an incredibly cheap LIBOR + 1.5%. It used some of the proceeds of the expanded facility (from $350 million to $750 million) to redeem its 6.25% notes, saving millions in interest. Of that $750 million, 80% of it carries a fixed interest rate of about 6%.

When you add all of this up, it sounds great. Ackman’s analysis suggested that the stock could be worth between $40 and $54, versus its $24 currently.

So why did his fund sell out of the position in the middle of last year? There’s been no quotes to pull from, so my guess is that he sees bigger upside in his recent massive purchase of J.C. Penney (NYSE:JCP).

Is Corrections a buy for the rest of us? That depends. If you buy into Ackman’s thesis, the stock remains very undervalued. If you buy into the 15% annualized growth estimates over five years from analysts, then the thesis also holds together.

I’ll just spend a minute on the other public play in prisons, Geo Group (NYSE:GEO). I’m not crazy about this choice because it has serious cash flow problems. Where Corrections Corp. produces over $200 million in free cash flow, Geo Group is free cash-flow negative over the trailing 12 months, as it was in fiscal 2008 and 2009. A company needs to produce positive cash flow if it wants my love.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.


Article printed from InvestorPlace Media, http://investorplace.com/2012/02/will-crime-pay-off-for-prison-stocks/.

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