Should You Invest In Private Prison Stocks?

One of my (foreign) economics professors always said that Americans are good at two things: gaining weight and human storage. Human storage was referring to the millions of Americans locked behind bars.

More than 2.4 million Americans currently call a jail cell their home, and the industry is booming. Thanks to a favorable legal environment and a trend toward privatization, private prisons are a booming billion-dollar industry.

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The Business Behind Private Prisons

The private prison business is relatively new in the United States; it wasn't until the year 1984 (fitting, huh?) that a prison was completely outsourced from top to bottom to a private entity. This launched the Corrections Corporation of America (CXW), currently the largest private prison company in the United States. Since then, the private prison industry has boomed – more than 100,000 people are locked up in privately-operated prison networks.

Here's why private prisons are a favorite privatization measure of state and federal governments:

1. 1. Non-Unionized Workforce – State, local, and federal governments are well known for their outsized pension deficits. Private prisons are able to operate at a lower cost in part because they are staffed by a workforce that is not unionized nor guaranteed a defined benefit retirement plan like most government workers.
   2. Profit Motive – Private prisons have incentive to keep costs down as the difference between revenues from governments and operating costs are the bottom line profit for prison management companies.
   3. Financing – Private prisons build, maintain, and expand many of the prisons they operate. Given the financial condition of most states and municipalities, this can be a huge incentive to outsource jails to a for-profit company.
   4. Talent and Insider Advantage – Corrections Corporation of America (CXW) isn't shy about telling the world about its talent. The company clearly has a firm hold on the key influencers in prison management and administration, hiring experienced wardens who had an average of 26 years in the correctional system to run its facilities. These wardens undoubtedly carry some political firepower when it comes time to negotiate a new contract. Private prisons can easily lure away talent in markets where salaries in public systems is set by rigid pay scales.
   5. Overcrowding – Private prisons can make inroads in working in areas with localized prison overcrowding, giving private firms an easy entry into new markets where cities may be delaying prison or jail expansion. Overcrowding in states like California continues to be a huge financial and safety issue for the state's residents.

Private prisons provide value to government in reducing costs and improving correctional facilities. They add to this by acting as a specialty financier and transferring the huge capital expenditures required to build and expand a prison onto their own balance sheet.

Making the Case for Investing in Prisons

There are several tailwinds that could propel private prisons to new heights: private correctional facilities house only a fraction of all inmates in the United States and the world, state and federal governments are more willing than ever to outsource prison management to a private company, and the number of incarcerated people continues to grow at a rate faster than the general population.

Furthermore, prison management companies are awarded long-term contracts spanning years and even decades, making them very similar to utility stocks in that the service is sold on subscription for years and years of guaranteed revenues. Additionally, local and federal government agencies are now guaranteeing minimum levels of occupancy in new jail contracts (private prisons are paid per inmate), which sets a minimum amount of profitability from quarter to quarter and year to year.

Let's Evaluate Some of the Challenges Facing Private Prison Investments:

1. 1. Private prisons are completely and totally dependent on government for revenues. Not only do governments pay private prisons for their services, but they also write the laws that would lead to positive or negative changes in the number of inmates that are incarcerated.
   2. Public opinion is gradually shifting against the use of private prison systems.
   3. A significant portion of private prison inmates are jailed for only a few crimes – illegal drug use, drug trafficking, and illegal immigration. Any changes in laws or minimum sentencing could vastly reduce the need for private prisons in the United States.
   4. A single incident could tarnish public perception of a single prison operator or the industry as a whole.

Historically, the trend is favorable for private prison companies. The number of incarcerated people has consistently grown year over year while the percentage of inmates in private prisons has also grown as a percentage of the total number of inmates.

Valuation and Predictability

A company's valuation should correspond with the predictability and reliability of its cash flows. I find prisons to be highly-valued: Corrections Corporation of America (CXW) sells for 18 times forward earnings while Geo Group, Inc. (GEO), which operates in the United States, Canada, Australia, the United Kingdom, and South Africa sells for just under 15x forward earnings estimates.

Corrections Corporation of America is expected to soon convert from a C corporation to a REIT, which would require the firm to pay out 90% of its earnings in the form of dividends. The stock seems to have advanced as this change is priced into the market.

While prisons can be seen as having similar economics of a regulated utility company with faster earnings growth, the inability to predict long-term shifts in the business model leads me to favor relatively pricier utilities, which provide roughly the same yield as CXW would if it converted to a REIT with much more predictability going forward.

Famous Investors Are Jumping On The Trend

Beyond the basics of private prisons, it appears famous investors like Michael Burry are also jumping on the trend of private prisons. Michael Burry, the Chief Investment Officer of Scion Asset Management, was one of the few who correctly predicted the housing market crash made famous in the movie the Big Short.

It was recently revealed this month that both GEO and CXW became the largest holdings in his fund - signaling that he is incredibly bullish on these companies to grow. 

What do you think? Are private prisons a bust, or a 21st century sin stock?