Private prison fundamentals shifting: Anonymous predicts demise of Corrections Corporation of America

An unlikely source - the computer hacker group Anonymous - has put out a report on Corrections Corporation of America (pdf) predicting near-imminent doom for their business model. (See also a blog post from the ACLU detailing highlights.) Grits has made many of these arguments myself and agree that the underlying, long-term fundamentals of the private prison industry are rocky. Still, Anonymous may have overstated their case just a tad.

True, incarceration in state prisons and county jails appears to have peaked and now begun to decline. And with US incarceration rates leading the world and far above historic trends, common sense dictates that the vast American gulag built up over the last three decades can't be sustained forever. But as long as private prisons can count on a) the War on Drugs and b) expanded immigration detention to provide them with inmates, the industry won't dry up and go away. Anonymous is overly optimistic about how rapidly drug reform might occur and, while acknowledging that immigration detention rates are likely to expand in the near term, seems to pooh pooh that countervailing trend, counting on the feds to employ alternatives to incarceration more than this writer thinks is likely.

That said, the Anonymous report provides a blue print for advocates to attack prison privatization by attacking each of their particular revenue streams. As Grits has written in the past, opposing mass incarceration means opposing private prison growth opportunities, so identifying which sectors are particularly weak provides important strategic insight for advocates.

Anonymous has correctly identified long-term trends but IMO overstated how quickly they may overtake the company's bottom line. I consider scaling back the war on drugs and reducing immigration detention a realistic opportunity over the next decade or two. But I'm not sure those developments will take down the private prison industry in time to benefit today's short sellers.

A final, interesting facet of the report - analyzing a recent development that's been little discussed among advocates - was its dissection and critique of the company's decision to become a "real estate investment trust" (REIT) as essentially a tax dodge. Find below the jump a substantial excerpt (citations omitted) from the report explaining CCA's REIT strategy and the implications for their business model, shareholders and taxpayers:

On 1 January 2013, CCA decided to effectively convert from a standard corporation to a Real Estate Investment Trust (REIT). By converting to a REIT, corporations can avoid paying federal taxes on their earnings as long as at least9 0% of those earnings are paid out to shareholders in the form of dividends. For dividend-hungry shareholders this is a win-win situation and one of the reasons that shares of CCA are trading up since April 2012, when murmurs of a REIT conversion hit the market. This corporate maneuvering to avoid paying federal taxes is yet another one of CCA’s questionable business practices. As a New York Times article explained:

“When [REITs] were created in the 1960s, they were meant to be passive investment vehicles, like mutual funds, that buy up a broad portfolio of real estate – whether shopping malls, warehouses, hospitals or even timberland – and derive almost all of their income from those holdings.

One of the bedrock principles – and the reason for the tax exemption – was that the trusts do not do any business other than owning real estate.

But bit by bit, especially in recent years, that has changed as the IRS, in a number of low- profile decisions, has broadened the definition of real estate, and allowed companies tosplit off parts of their business that are unrelated to real estate.”

Somewhere along the way, CCA and a host of other companies with fixed assets started takingadvantage of the designation by claiming that they effectively manage real estate, and thus fit thecriteria for REIT status. But while CCA owns prison real estate, common sense dictates that the Company doesn’t rent them out – it gets paid to run them. This distinction is an important one and certainly not lost on CCA’s silver-tongued lawyers.

For example, the Company’s 10 -K filing in 2011 (and prior) describe its business as: “We are compensated for operating and managing facilities at an inmate per diem rate based upon actual or minimal guaranteed occupancy levels.”

However, that wording was changed in their 10-K filing in 2012 to: “We are compensated for providing prison bed capacity and correctional services at an inmate per diem rate based upon actual or minimum guaranteed occupancy levels.”

It seems that this deliberate change in wording was a tortured attempt by Management to reinforce theidea that CCA rents out bed capacity instead of operating and managing facilities, making CCA appear more as a ‘land lord’ and less as an ‘operations and management’ service.
 
But it’s not just private prisons that are stretching the definition of “real estate”. Driving the absurdity even further, Penn National Gaming (PENN:NASDAQ) recently announced its plans to convert to a REIT. PENN is a gaming and gambling operator with a portfolio of real estate properties that house slotmachines, gaming tables, and race tracks.Now, how long do you think a gambling company can avoid paying its fair share of federal taxes before Uncle Sam cracks down on the entire REIT industry? The answer as it turns out, is not very long at all. Just this June, the IRS launched a review to define whattype of companies can qualify for REIT status. What the IRS review will mean for CCA and a host of REITimitators is anyone’s guess, but in a time of budgetary deficits and vitriol against corporate taxloopholes, growing abuse of the REIT structure was bound to get the attention of IRS and Congress.

In any case, this is not the first time CCA has dabbled with a REIT structure. An interesting facet to this story is that CCA used to actually operate as a REIT between 1997 and 2000. However, the Company’s first foray into the world of REITs was a short-lived disaster as overleveraging, overbuilding, and poormanagement nearly destroyed the Company.

By 1999, terms like ‘going concern’ were peppered throughout CCA’s 10-K filing. In fact, the only reason CCA avoided a total collapse in 2000 was becauseof a restructuring plan led by Fortress and Blackstone Investor Group.

But here we are again.As a new REIT, CCA will have to maintain a healthy dividend to keep and attract income investors.Today, the stock is yielding 6.0% and it’s hard to deny that CCA is stronger now than it was it first time around. But, even with a stronger balance sheet the Company is facing a multitude of the sameheadwinds that it once did, including overcapacity in its facilities, and diminishing demand.We find it doubtful that CCA will be able to maintain its current dividend payout given its dwindling financial position and deteriorating fundamentals, to say nothing of the fact that the Company isexpected to lose all of its California contracts in the next few years. This might explain why the two activist hedge funds that pushed CCA to convert into a REIT last year – Corvex Management and Marcato Capital Management – have since sold most of their combined 7% stake in the Company.

It’s first time as a REIT, CCA struggled to maintain its dividend obligation. We doubt this time will be any different.