The Private Prison Industry: 10% Yields Don’t Justify The High Risks

Via Seeking Alpha

Summary

The private prison REIT industry has suffered from social and political concerns in recent months.

Some of the major banks have stopped financing the industry, driven by social concerns about maltreatment in private facilities. Some of them will still honor current arrangements until maturity.

This situation is unveiling opportunities for income investors, such as The GEO Group with its 11% dividend yield, and a possibility for capital gains if Donald Trump gets reelected.

Major risks include remaining banks withdrawing from the industry, socially concerned investors avoiding the stock, the inability to continue as a REIT, and the election of a Democratic president.

Source

If you are an income investor, you may appreciate income-generating securities with 10%-plus yields. Such returns are not common, especially when the economy is late in the cycle and most markets are expensive.

So when you find such a gem, the first question that pops into your mind is: Why is the price so low relative to the market?

Or one that I like better: What are the risks of the underlying asset? If the risks are acceptable, who cares why the price dropped?

Searching for the aforementioned yields, I found The GEO Group (GEO) and CoreCivic (CXW) (formerly known as Corrections Corporation of America, or CCA), the leaders of the controversial private-prison industry.

These two companies, which operate as REITs and are listed on the NYSE, have been shaken by political pressures and the moves of activists. It is believed that factors such as rates of homicide, suicide, and sexual assault are higher in these private facilities than in those run by the government.

As a result of these occurrences, some of the major banks have reported that they will stop doing business with the industry. But some will keep their commitments under current contracts until maturity.

The aforementioned stocks are yielding more than 10% in dividends, an effect of a roughly 30% plunge in the price of each. Past performance indicates that the dividend is sustainable, but will the future be more like the past or will it show a complete turnaround? There is no way to know for certain, but you should at least know the risks.

This article will focus on the risks and threats that the whole industry is facing, and on whether the high yields are worth such risks. I will be using GEO and CXW as representatives of the industry; other participants are privately-held and far smaller (except Management and Training Corporation).

The industry is full of social and political concerns

Many sources discuss about the need (or the lack of need) for private prisons. Some say that they are more expensive than those run by the government, while others say that the government can’t house the growing amount of prisoners (mostly from the border), so private operators complement the government.

The fact is that private prisons don’t create (extra) value for society, whether it pertains to saving money or to doing a better job with inmates.

In this Bloomberg article, Noah Smith explains why he thinks private prisons are a failed experiment. He mentions that there are no cost savings for the government as compared with public prisons. And that oftentimes private prisons cost more on a daily per-capita basis.

The article also states that most courts seem to incarcerate people in private prisons for longer periods, based on the belief that these facilities are cheaper for the government. Not only are these prisons more expensive, but they have higher rates of incidents related to safety and security, serious or systematic safety failures, and inappropriate cell conditions.

Noah also mentions that besides the high costs and low service quality, these prisons appear to have little to no effect on inmate outcomes after release, concluding that “private prisons should be seen as a failed experiment”, and that this practice should be banned.

According to this source, private prisons have more issues to take into account:

  • Inmates have less surveillance: one correctional officer per 6.9 inmates, compared with one per 4.9 in public prisons (cost-cutting?)
  • Higher rates of assaults between inmates, and between the staff and inmates, with staff uses of force also higher
  • Equal rates of fights and suicide attempts as public prisons
  • Gross abuse and misconduct by prison top authorities
  • Inmates suing operators for lack of access to medical care
  • And more

In my opinion, private prisons are not beneficial (on a net basis) to the government (or to taxpayers). The business has some conflicts of interest; for example, the more time you can host an inmate, the more revenue you can get, so there is an incentive to induce him/her into some violation, thus prolonging the stay.

I don’t think that ending the practice is a solution. The government would have to pay billions for the facilities, because it has nowhere to relocate those hundreds of thousands of inmates. In the past, politicians have tried to stop the business, but for some reason they haven’t succeeded.

These days, we have Elizabeth Warren with her plan to ban private prisons as president (if she gets elected). According to CNN, should the senator president in the next election, she would end all contracts that private operators have with the Federal Bureau of Prisons and US Immigration and Customs Enforcement.

Remember that this is part of an electoral campaign – something that can be used to attract votes.

Funding sources are under pressure

As REITs are required to distribute 90%-plus of earnings to its investors, they heavily rely on equity and debt-raising to grow, and sometimes to keep operations running.

Social activists know this, and are attacking the industry where it hurts the most: They are influencing banks and investment firms to stop financing it.

The following banks have given in to these social activists because of reputational risks, but this could change with time, as I will explain later:

  • March 5, 2019, JPMorgan Chase (JPM): It halted future and current financing to the industry.
  • March 12, Wells Fargo (WFC): Same as JPM.
  • June 26, Bank of America (BAC): It halted future financing, but will meet its contractual obligations until maturity (it extended current loan facilities before the announcement) (source)
  • July 8, SunTrust Bank (STI): Same as BAC.
  • July 14, BNP Paribas (OTCQX:BNPQF): Same as BAC. GEO has around $1.7 billion in loans with BNP with five years to mature.
  • July 15, Fifth Third Bancorp (FITB): Same as BAC.

These announcements, along with the intentions of Sen. Warren, have caused GEO and CXW to plunge near 30% since early June.

I wouldn’t be so worried about the banks. For example, GEO amended its credit agreement with BNP to mature in May 2024, five years from now. I think that the management teams of BNP or BAC are not so worried about reputation. They are giving the people what they want while they (and their private-prison clients) gain some time to find a solution to their problems.

On the other side of the capital structure, social activists are influencing pension funds to stop investing in the industry.

Activists are targeting pension funds, asking managers to divest. Some have answered those calls, saying their goal is to generate the best possible returns, and that they’re not socially minded investors.

But other funds, such as the Canadian Pension Plan Investment Board, which manages around C$392 billion in pension funds, ended positions totaling $8 million in GEO and CXW.

According to this source, there are at least 20 U.S. pension funds with shares of GEO or CXW in their portfolios. Keep in mind that pension funds tend to favor REITs over normal stocks due to income stability inherent to real-estate-related assets.

These funds have at least $67 million currently invested in GEO or CXW (a small figure in my opinion – it must be a portion of the total investments from these institutions).

If these groups of activists succeed in their goals, these stocks will suffer a massive loss over time. This not only erodes your investment; it also reduces the possibilities for growth, as these companies will then find it hard to raise capital by issuing stock.

As pension funds are selling the industry, retail investors that care about these issues should sell as well, thus adding more downward pressure to the stocks.

Private prison stocks seem attractive at current valuations

GEO and CXW have lost 30% of their market caps since their highs of June to their multiyear lows as of late July.

GEO is yielding 11.6% with a payout ratio (using FY2018 AFFO) of 77%, while CXW is yielding 10.7% with a payout ratio (using FY2018 FFO) of 80%.

CXW revenue growth for the last five years is 2.75% while GEO’s is better at 8.35%. Earnings were flat during those years (less on a per-share basis due to dilution).

Under normal conditions (without Democrats and activists taking measures against them), these stocks would be a strong buy. What could change in the next five or 10 years? They would continue to steadily grow their revenues while keeping a nice FFO (or AFFO) to cover their dividends.

What are the risks of the opportunity?

The industry is facing key risks on the financing, legal and political fronts.

As explained before, six major banks have already halted (or partly halted) deals with private prisons. What could happen if the remaining banks follow that example? It would be catastrophic.

This is one of the less probable risks. See, some of these banks are keeping credit agreements with these companies until maturity. This grants some time for the industry to be able to fix this situation.

You may think that these REITs, without banks, can turn to the equity market and issue more of its shares, but this practice has a limit.

Socially concerned investors and funds could continue selling these stocks. If this happens, the ability to issue new stock will be minimal for these companies. The stock price will be depressed, and it will not make any sense to dilute in such conditions. Without available funding, these stocks are worth nothing.

A less-impacting (at first sight) risk would be the inability to continue operating as REITs. According to Bloomberg, Democrats Gregory Meeks from New York and Ron Wyden from Oregon tried to introduce legislation to take away REIT designation from private prison operators, but ultimately failed. This risk has low probability, but it indicates that there is political interest out there!

My last key risk is the election of a Democrat as president of the U.S. Many Democrats have shown interest in rolling back the practice in some way. Some want private prisons operate as normal companies paying normal taxes (Gregory Meeks), while some want to prohibit the activity entirely (Elizabeth Warren).

There is a good chance of Warren being elected. In such a scenario, these stocks will be worth zero.

As this is a quite binary risk, if Trump gets reelected, expect more than 50% of upside in these stocks.

My Takeaways

I think that there are many scenarios for downside and just one for upside. Besides, the downside here is zero value, a 100% loss, while the upside is as much as 100% profit, never more than that.

This reminds me of binary options, which are quite popular among some of my friends (outside the U.S.), but which have a negative risk-reward tradeoff (sometimes you get to make 80% in profits while risking to lose your entire position). I wouldn’t recommend such a setup.

In reality, this is more like a gamble. If Trump wins you have a stock with a 10% dividend and a one-time rebound of 50% to 100% – and then what? But if Trump loses, you will probably lose your entire investment, or at least have a huge loss – very risky to my eyes.

My recommendation is to hold, and to watch for changes in the business models of these companies toward the government running the facilities as the companies own the real estate and lease it. This could change lots of hearts, minds, and fundamentals.

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