There are some companies that work in distasteful industries. Companies like payday lenders, mortuaries and waste management services just aren't the sexy companies people get excited about. Some even get on a soapbox and proclaim these businesses to be unethical and immoral. But the simple fact is that investors can earn outsized returns by investing in these businesses.
And who wouldn't want that? I know I would, and I know Peter Lynch hit several home runs doing the same thing, like with death service provider Service Corp International (NYSE: SCI) and garbage collector Waste Management Inc. (NYSE: WM).
A trend began many years ago when state governments began to outsource a part of their judicial system in order to save money, time and hassle. Several companies stepped in to fill the gap. These companies knew there were good profits to be made if they could provide their services more affordably than the government could. They also knew that crime never goes away. What could be better than a business that's guaranteed to have customers (willing or otherwise)?
I'm talking about jail -- specifically, the building and management of prisons.
One of these companies is Corrections Corporation of America (NYSE: CXW) and, as an investment, I think it's the best of the bunch.
The reason the company came on my radar was Bill Ackman, the hedge fund manager, who is pretty sharp at finding distressed assets and overlooked growth plays. He now owns 10% of the company.
Ackman likes Corrections Corp. for many reasons. For starters, Corrections Corp. is the largest private prison company in the nation, owning 48% of the market, and is the fifth largest prison manager. The company owns the land and buildings at 90% of its facilities, making it a real estate play as well.
The company has huge opportunities for growth. The nation needs prisons. According to Ackman, only 8% of prisons are privatized and the average capacity rate for state prisons is 96%, meaning many state prisons are overcrowded. Meanwhile, federal prisons are at 137% of capacity.
Corrections Corp. can deliver on this need. It takes the company an average of 18 months to build a jail, compared to five to eight years for a state. Prison populations have been growing at a +5% compound annual growth rate, and have historically increased after recessions.
Corrections Corp. operates in a sector with strong secular growth. And what's more, the company is financially positioned to take advantage of it.
The company carries $1.15 billion in debt, of which 80% is fixed at an interest rate of about 6%. Earnings have always vastly exceeded debt service, so there's no concern about default. Even better, the company's free cash flow in 2009 was $270 million. The company will be able to fund new prisons out of that cash flow
Considering that Corrections Corp.'s tenants are credit-worthy, has low capital expenditures for maintenance, enjoys local monopolies when constructing prisons and is part of an oligopoly in the sector in general, it all adds up to a compelling story.
Are there risks? Yes. Just about every state is going through budget nightmares right now. It's possible that building new prisons is something a state just can't afford. But nobody wants to be perceived as being soft on crime, so most legislatures probably won't cut private prison construction.
Nevertheless, anything that results in decreased prisoner populations is bad for Corrections Corp. In addition, if something really bad happens between now and when the company's debt matures in 2012, it may not be granted a repayment extension. There's also the bad press and backlash that occurs when local communities attempt to stop new prisons being built in their area.
Still, the risks are minor compared to the fact that this is a solid, profitable company operating in a sector with strong secular headwinds, with the support of a smart hedge fund manager.
Action to Take --> I see Corrections Corp as a buy and long-term hold. The company is extremely well-positioned to take advantage of the private prison trend. Between the company's operations and realestate value, the stock is worth between $40 and $54 a share -- at least double its current share price -- based on 2012 earnings and cash flow estimates.