Prison REIT Shares Get Thrown into the Dungeon

On August 18, in a memo issued by Deputy Attorney General Sally Q. Yates, the Justice Dept. ordered the Federal Bureau of Prisons (BOP) to take steps either to decline to renew contracts with private prison companies or to reduce the scope of those contracts in a manner consistent with the law and efforts to reduce the federal prison population. That action capped a six month period of heightened scrutiny of privately-run federal prisons that began with exposes in publications such as the Nation and Mother Jones and led to the issuance of a report by the Office of Inspector General of the Justice Department reviewing the Federal BOP’s monitoring of contract prisons.

In response to the Justice Dept.’s memo, the stocks of private prison operators, Corrections Corporation of America (CXW) and The GEO Group, Inc. (GEO) fell 35.5% and 39.6%, respectively. Both stocks bounced back sharply on the next day, Friday, August 19; but they are still down 29.9% and 26.6%, respectively, from Wednesday’s close.

Based upon the work that I have done so far, I see the Justice Dept.’s move as the first step in what is likely to be a long process for resolving what has become an untenable situation. The BOP initially entered into contracts with the private prison operators to handle rising volumes of aliens, illegal and otherwise, who were being sent to prison as a result of various infractions, including trying to get back into the U.S. after having been deported.

As the Washington Post has noted, the BOP apparently saw private prisons as a quick and relatively cheap fix for an immediate problem: rapidly rising prison populations. The private operators have been taken to task by The Nation and Mother Jones for failing to give seriously ill inmates the immediate attention that they needed. The Post points out, however, that the contracts between the BOP and the private contractors were deliberately vague in certain areas, such as health care, because if they were specific, the private contractors would have incurred the necessary costs and expected reimbursement. If the health care provided to these alien inmates has been substandard, the FOP may therefore bear some of the blame.

It is important to note that while the Justice Dept. memo cites the safety deficiencies uncovered in the OIG report, the OIG report itself does not recommend that the government cease doing business with the private operators. Although the report does note that privately-managed prisons scored lower (than Federally-managed prisons) in six of eight major categories – contraband, reports of incidents, lockdowns, inmate discipline, telephone monitoring and selected grievances – it said that many of these issues needed further study to determine the exact causes of those differences.

For example, the number of violent incidents has been higher at private prisons, but the operators – in letters filed as an appendix to the report – were quick to point out (convincingly in my mind) that the populations that they house are more prone to violence.

The report also cites the practice of many private operators of housing overflow prisoners improperly in Special Housing Units (SHUs) – e.g. solitary confinement – until space opens up in regular jail cells. Yet, the executive summary of the report begins by noting that the BOP was operating at 20% over rated capacity at the end of 2015.

Ms. Yates notes that the total federal prison population declined from 220,000 in 2013 to 195,000 today. Assuming that capacity was flat from 2013 to 2015 and that the prison population was about 200,000 at the end of 2015, the FOP was running at about 32% over capacity in 2013 and through the efforts of the Justice Dept., reduced that overcapacity to 20% as of the end of 2015.

Ms. Yates says that the Justice Dept. plans to reduce the prison population by more over time, but it is hard to see how it can justify closing any more facilities today, given the continuing overcapacity problem. In fact, the practice of housing overflow inmates in SHUs probably occurs because there is not enough prison capacity today.

The private operators are responsible for their SHU improprieties only if the Federal government agreed to pay them for capacity expansions that they failed to complete in a timely manner. The OIG report does not indicate whether this was the case.

I am not an expert in either the composition of the prison population or the efforts by the Justice Dept. to reduce it; but I think that if normal laws of nature apply, it is probably likely that the low hanging fruit (i.e. the ability to release prisoners who are incarcerated unjustifiably) has already been achieved. It will probably be difficult to reduce the prison population by a similar percentage in the future without changing the laws.

Indeed, resolution of the long-standing battle between the Obama administration and Congress to change immigration laws is an important piece of the puzzle here. (For example, legislators may need to reconsider whether a five-year prison term for attempting to re-enter the U.S. after being deported is appropriate, since it undoubtedly was a cause of the growth in the alien prison population in the years up until the peak in 2013.)

In the meantime, the OIG report will jumpstart the process of deciding what role, if any, private prisons should play in the management of the Federal prison system. The current two-tier system of high standard Federally-managed prisons for U.S. citizens and lower standard privately-managed prisons for aliens is probably untenable. Private prisons either need to be fully integrated into the BOP system or they should be dropped entirely.

With this action last week, the Obama administration has set the stage for a reduction and eventual elimination in the role of private prisons. Likewise, Hillary Clinton says that privately-managed prisons should be phased out because of the risk (or even the appearance of risk) that jail terms might be influenced by private interests.

The Republicans, on the other hand, are more likely to embrace and even expand the role of private operators in the management of the Federal prison system as an efficiency measure.

All of which brings us back to the plunge in the share prices of CXW and GEO. It is noteworthy that both companies are now REITs. Prior to last Thursday’s sell-off, both stocks had dividend yields of around 8%. With the sell-off, both now yield around 11%.

With yields so high (even before the sell-off), investors were obviously concerned about the ability of both companies to sustain their dividends. Annual payouts for both exceed earnings on a GAAP basis. Free cash flow, defined in this case as cash from operating activities minus maintenance capital expenditures, exceeds the annual dividend only for CXW, according to my analysis.

However, CXW has some unusual arrangements where it is supervising construction of facilities that it will lease from third parties. In those circumstances, what has been categorized as growth capex should, I believe, be included in maintenance (or mandatory) capex. So CXW’s free cash flow coverage of its dividend is probably lower than my preliminary calculations suggest.

It seems clear that both companies are betting that future growth in revenues and net operating income will allow them to maintain their dividends. With last week’s announcement by the Justice Dept., investors are obviously worried that the necessary growth will be even more difficult to achieve. That may be true, but both companies will probably not experience much of a decline in their earnings prospects near-term as a result of last week’s change in Justice Dept. policy. The risks are certainly there over the longer run, but it is also possible that the changes last week’s policy shift could conceivably work to the benefit of the private prison operators over time, if the two-tier prison system is eliminated and the Federal government decides that private operators should still be a part of the mix.

August 21, 2016

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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