BusinessWeek Online October 21, 2003 STREET WISE By Eric Wahlgren Investing in Crime and Punishment Stocks of prison builders and operators are climbing as inmates' numbers swell. And the top players may still have some upside left Like it or not, these are boom times for publicly traded companies that build and run prisons. Part of the reason is a shift in national policy. Tough-on-crime state and federal sentencing laws keep offenders locked up for a long time. Current demographics are also bullish for the corrections industry. Convicted criminals 18 to 24 years old make up a big percentage of new inmates, and that number is swelling as the children of baby boomers -- baby boom "echoes" -- reach adulthood. The number of state and federal prisoners in 2002 grew at its highest rate in three years -- 2.6% -- to 2.17 million. New convicts don't have enough beds: The federal system was 33% overcapacity last year, according to a U.S. Justice Dept. study. And with states and the federal government financially strapped, the public prison-building spree of the 1990s is a thing of the past. Enter private-sector corrections outfits, which can run prisons for 10% to 15% cheaper than the government can, analysts say. "There's a lot of opportunity for the private sector to fill up existing beds and to begin new projects," says Andrew May, analyst at Jefferies & Co. TAINTED MOTIVES? Investors have taken note, driving stocks of three big players sharply higher in 2003. Corrections Corp. of America (CXW ) is up 48%, to $25.46; Cornell Cos. (CRN ) has risen 74%, to $15.70; and Wackenhut Corrections (WHC ) is ahead 81%, to $20.07. Many analysts say the run isn't over yet and are maintaining buy ratings on these stocks. "There's a lot of wind at the backs of these companies," says Jeff Kessler, a Lehman Brothers analyst in New York. Looking ahead, May sees the trio cranking out 10% annual revenue growth and 15% profit growth. That's pretty good compared to companies in many other industries forced to eke out higher earnings by shrinking costs rather than expanding top lines. Prison stocks might not be for everyone. A long-running controversy simmers over whether corrections should be a for-profit business at all, where management's primary duty is to shareholders rather than to society's benefits. "When you have a profit motive, it encourages the proliferation of the use of prisons as punishment," says Kara Gotsch of the American Civil Liberties Union in Washington, D.C. The ACLU and others believe cheaper and more effective ways of punishing criminals exist, such as mandatory treatment programs for drug offenders or home electronic surveillance for nonviolent offenders. DIFFERENT NICHES. The industry counters that it's not in the punishment business. Says Irv Lingo, Corrections Corp.'s chief financial officer: "We're in the business of providing capacity to state and federal agencies," he adds. In any event, demand for that capacity is increasing, which makes these stocks attractive from an investing perspective. Each of these three players has a different niche in the prison business. The biggest is Corrections Corp., with some 59 facilities (about 59,000 beds) and revenues of $963 million in 2002. The Nashville (Tenn.) outfit specializes in running adult corrections facilities and prisoner-transportation services for the federal government. It stands to gain the most from the feds' crackdown on illegal immigrants and from other homeland-security initiatives, analysts say. On Oct. 2, Corrections Corp. said it won a new U.S. Immigration & Customs Enforcement agency (formerly the Immigration & Naturalization Service) contract to more than double the capacity at a detainee processing center in Houston to 905 beds. "There's a lot more upside to the potential earnings numbers from the company," says Kessler, who rates the company a buy. (Lehman has ties to Corrections Corp. and Cornell.) THE YOUTH MARKET. May says Corrections Corp. is "in some ways the best company in the group" for its business model. But he rates the stock a hold on valuation concerns. If it declined to the $21-a-share level, "we would love it," he says. (Jefferies has also done investment banking with Corrections Corp. and Cornell.) Cornell, on the other hand, is well positioned to profit from the echo "boomlet." A big chunk of its business -- about 45% of 2002 revenues -- is focused on juvenile services, including incarceration and drug and behavior treatment programs, says analyst Sheryl Skolnick with Fulcrum Global Partners in New York. "These services have historically been outsourced," she says. May rates the Houston company, which raked in $275 million in revenues in 2002 from some 70 facilities (service capacity of 16,514) a buy, while Kessler rates it an equal weight. Of the three, Wackenhut Corrections is the only outfit with significant operations outside the U.S. This offers Wackenhut an opportunity to "export the U.S. model of corrections," Skolnick says. The Boca Raton (Fla.) concern has 48 facilities in the U.S., Australia, South Africa, New Zealand, and Canada, with a potential capacity of 36,000 beds. May -- one of the few analysts who cover Wackenhut Corrections -- has a buy rating on the stock. "A DISASTER." Of course, this industry has its challenges. Skolnick would like to see Corrections Corp. lower its long-term debt of $1 billion or so rather than refinance it. Counters CFO Lingo: "We think the debt level is very comfortable right now." For Cornell, analysts are eager for management to unveil its plan for the New Morgan Academy, which has cost the business about $200,000 a month since it shut down last year. The youth treatment center in Pennsylvania was forced to close its doors after questions arose over the handling of its young detainees. "It was a disaster," Skolnick says. Paul Doucette, Cornell's vice-president for business development and public affairs, says it plans to resolve the issue by yearend. Wall Streeters are also keeping a watchful eye on Wackenhut, which only recently became less closely held. Company spokesperson Pablo Paez says the outfit bought back all 12 million of its shares owned by Group 4 Falck, a Danish concern, on July 9. Analysts like the idea that management now has more freedom to pursue its own strategy, but that brings its own risks, too. MORE INMATES NEEDED. Furthermore, an outside chance exists that recent trends, which have been such a boon for this industry, could reverse, leading to a decline in inmates. The public could get sick of sticking people in the slammer and embrace a more rehabilitative tack, May says. Or demographics could change, and the crime rate could fall. "You have to have inmate growth to have industry growth," May says. For now, though, the U.S. penal system continues to put away more people than it has room for. With private corrections outfits around to fill this gap, their stocks could continue to provide some steady returns for investors for a while. Wahlgren covers financial markets for BusinessWeek Online in New York Edited by Beth Belton Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.