Prison Stocks: The New Income Investment

Private prisons may have bad PR, but they have awesome cash flow.
For many years, private prison stocks were loaded with debt as they attempted to expand.  Their fates would ebb and flow depending on the situation with state and federal budgets, since it is the government that hires private prison companies to build and maintain prisons.
The upside is that governments make good customers. Sure, the funding may ebb and flow, but if a prison company has a good lobby (which it does), governments have very deep pockets over the long haul.  The trick is staying in the game, and private prisons have done exactly that.
There are also big secular trends in the prisons’ favor.  First, crime is always going to exist in this country.  There will always be criminals, and they will always require jails.  There is a never-ending supply of criminals.  That is what’s causing the second big secular trend: prison overcrowding.  Here in California, non-violent criminals are being released early on a regular basis.
Just like the hotel industry, there is more demand for new construction than supply. The influx of immigrants from Mexico, for example, created an opportunity for one company to make a deal with ICE.
Prison companies have since stabilized financially and have all that demand to meet.  That has put them on such solid footing that their cash flow is regular and robust.  That means they are now paying regular dividends, and will do so for a long time.  Income investors take note.
Corrections Corporation of America (NYSE:CXW) is the largest owner of US prisons, and its recent earnings report demonstrates why the secular trends are in its favor.  EPS was up 11.4%, FFO was up 6.3% to $0.67.  AFFO was up 4.8% to $0.66 per share.  Having converted to a REIT, Corrections Corp now pays out 90% of net income to shareholders.  That dividend yield is now a fabulous 5.5%.
The company remains in terrific financial shape.  It has $49 million of net cash.  It’s long term debt is only $1.2 billion, and only pays about $41 million in interest annually on that debt.  That’s an interest rate of about 3.5%.
That super-low debt service allows Corrections Corp to keep its cash working to build and maintain its prisons.  The company traditionally puts out about $80 million annually in capex, and every third year or so doubles that number.  Thus, in FY11 it had $180MM in FCF, in FY12 it was $204MM, and in FY13 was $290MM.
It is that great cash flow that allows it to pay its fantastic dividend.
CXW is on solid footing and is a buy.
The Geo Group (NYSE:GEO) is far more diversified, with prisons in the US, Australia, South Africa, the UK, and Canada.  It operates 100 facilities and about 70,000 beds.
Like CXW, the company transformed into a REIT and now pumps out a high yield of 5.7%.  Looking at cash flow, however, I’m not as crazy about GEO as I am about CXW.
Geo Group’s FY11 operating cash flow was $189MM but was offset by $222MM in capex, making it FCF negative. In FY12, operating cash flow improved to $264MM, and capex backed off to $107MM.  Of the resulting $157MM in FCF, $108MM was paid as a dividend.
Then, last year, operating cash flow fell back to $192MM and $117MM in capex yielded FCF of $75MM, but it paid $147MM in dividends.  That worries me, and the first half of this year saw FCF of $90MM with total dividends paid of $82MM.
My concerns with Geo Group is whether it can continue to cover the dividend with its free cash flow.  Part of this is due to its more expensive debt, about 5.5% on $1.5 billion in long term debt.  It also issued 5.875% Notes recently, so it continues to pay higher interest rates.
If you had to choose one, I’d go with Corrections Corporation.
Lawrence Meyers does not either security.

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