Is There Investment Opportunity in the Prison Sector?

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While death and taxes are the only guarantees in life, it’s a good bet that crime will always be a fact of life, even if it doesn’t pay. According to the U.S. Department of Justice, the number of sentenced offenders per 100,000 residents was 492 in 2011, versus 500 in 2010. The constant stream of prisoners has led to overcrowding, with the federal government and 24 states recently reporting prison censuses that are above capacity. On the upside, the high demand for correctional facilities and services has created opportunity for businesses. So, how does an investor play the sector?

The prison network duopoly

Like other industries, prisons benefit from economies of scale in their supply chain, including purchases of food and medical supplies. The industry’s titans, like Corrections Corporation of America (NYSE: CXW) and GEO Group (NYSE: GEO), have spent the last decade consolidating smaller, less efficient operators. With overall occupancy levels that top 90%, the industry has reliable income characteristics across business cycles, which has led the top public companies to pursue REIT conversions in order to expand their investor base.

Corrections Corporation of America is the largest private owner of correctional facilities in the U.S., owning or managing nearly 45% of the privately-owned facilities in the country. In its latest fiscal year, the company reported mixed financial results, with a 2% increase in revenues but a 9% decline in operating income. Corrections Corporation’s top line benefited from small increases in both its compensated population and the per-day rates paid by government agencies. However, rising turnover and compensation costs for its correctional officers put a crimp in the company’s operating profit.

Looking ahead, Corrections Corporation is optimistic about the industry’s prospects, despite funding problems at the state level. The company has become more conservative in its capital allocation process, only erecting new facilities where it has long term management agreements in place that allow it to recover its capital costs.  Corrections Corporation also sees opportunities to acquire existing state-owned facilities, which provides cash windfalls for debt-laden states.

Meanwhile, GEO Group is currently positioned as the #2 owner of correctional facilities in the U.S., with 73,000 beds in 100 facilities. Compared to Corrections Corporation, GEO Group has created a more diversified revenue stream, with a large community services segment that manages the prisoner lifecycle, from arraignment to reintegration. The company also entered the remote monitoring area through the acquisition channel, including its purchase of Cornell Corporation in 2010.

In its latest fiscal year, GEO Group reported modest growth, with increases in revenues and operating income of 5% and 2%, respectively, compared to the prior year.  Like Corrections Corporation, GEO Group’s sales growth benefited from increases in its compensated population and stable pricing in its daily rates. More importantly, the company’s divestiture of its non-core healthcare assets, as part of its REIT conversion process, has improved its profitability and cash flow metrics.

An alternative security idea

Of course, a potential risk to the outsourced prison model is funding challenges at the state level, which currently constitute almost half of sales for the industry’s top two players. Some states have chosen to reduce prisoner populations rather than to increase the size of funding. For instance, California has reduced portions of its prisoner population at the state level through its realignment plan, which transferred prisoners to local jurisdictions.

As a result, investors may want to look at companies that provide electronic monitoring technology, which provides security without the expensive brick-and-mortar facilities. 3M (NYSE: MMM) is a leader in this field through its Elmo-tech and Pro-tech units, competing against Corrections Corporation’s monitoring segment. With $4 billion in annual segment sales, 3M’s security unit is one of its key areas for future growth.

In its latest fiscal year, 3M’s security segment reported flat sales due to economic weakness in certain geographies, but it still generated a 4% increase in operating income. In the security area, the company has pursued growth primarily via the acquisition channel, including recent purchases of electronic monitoring and biometric identification companies. With $5.3 billion in total operating cash flow in 2012 and an annual research and development budget of $1.6 billion, 3M has the financial strength to build or buy dominance in the security segment.

The bottom line

Prison operators are a good choice for income-oriented investors due to high yields from their pass-through income. However, growth investors need to find a technology angle as governments look to maintain security while cutting funding levels. With a strong focus on its security segment and healthy operating margins across its business units, 3M is one to own.

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Robert Hanley owns shares of Corrections Corporation of America and GEO Group. The Motley Fool recommends 3M and Corrections of America. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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