The massacre at Newtown, Conn., last month brought
long-running debates about gun control back into the spotlight.
And with them came renewed volatility for gun stocks.
The two pure-play gun makers on the market,Sturm Ruger (
) andSmith & Wesson (
), were already teetering in early December. Both companies did
very well in 2012, as the possibility of re-election for
President Obama led to a surge in gun sales among fears of
tighter gun control legislation. Monthly tallies of federal
background checks required for buying guns, which analysts use as
a proxy for total gun sales, were running upwards of 20% higher
than year-earlier numbers.
Then some analysts began questioning the stocks'
On Dec. 7, after Smith & Wesson reported fiscal
second-quarter results, some observers thought the election trend
had peaked. Analysts like Rommel Dionisio with Wedbush downgraded
the stock from Outperform to Neutral.
"We believe many prospective consumers have already pulled
forward firearms sales this past year," he wrote in his report,
suggesting 2012's sales may have cannibalized 2013 demand. Smith
& Wesson's management, perhaps also anticipating slowing
industry demand, simply maintained FY13 guidance.
Both gun stocks began to slide in heavy trade. On Dec. 18, the
first trading day after the Newtown murders, they plunged in
While the stocks sold off, gun sales actually increased after
the mass murder. That fits the usual bang-bang pattern of gun
sales, say analysts; buying rises both with fears of gun control
and fears of crime in general.
Both Smith & Wesson and Sturm Ruger have recovered
somewhat in the last two weeks, though IBD's Security/Safety
group has backed out of the top 10 industry rankings, down now to
Trusts & Detention
There's much more to the group than gun stocks, however. A
less publicized driver has been private prison stocks. These
companies manage prisons by contract, mostly for state and local
governments in the U.S., which they claim they can do more
efficiently than the governments themselves.
Business is reportedly solid, although U.S. prison populations
did fall for two years through 2011, the latest year on record
with the Justice Department.
But what's really driven share prices lately is the fact that
the two leading players in the field,Corrections Corp. of America
) andGeo Group (
), are in the process of converting themselves into real estate
CCA has actually been a REIT before. It converted to its
present structure more than a decade ago. But according to Tobey
Sommer, analyst with SunTrust Robinson Humphrey, the calculus
changed recently when the two prison companies learned about
taxable REIT subsidiaries.
These subsidiaries, in which REITs own a controlling interest,
are allowed to offer more services to tenants than REITs
themselves. In its previous REIT incarnation, CCA had to run an
operating company separately from the property-owning
"The reason the TRS structure is advantageous is (that) it
does not require the company to technically have a change of
control -- it can stay one entity," Sommer told IBD. "And the
reason that avoiding a change of control is interesting is that
triggering a change of control would allow all of the customers
to renegotiate their contracts simultaneously."
Investors like REITs because the structure requires that 90%
of taxable income be distributed as a sort of dividend. So the
REIT news has cranked up both CCA and Geo to new highs. On Jan.
2, as CCA announced that it's completed the internal
reorganization necessary for the conversion, its stock hit its
highest point in more than 13 years. (The company is still
awaiting an approval from the IRS before it can complete the
The Overcrowding Opportunity
For the companies, REIT status provides a lower tax rate and
easier access to capital, which is important for the prison
industry since it's facing several challenges. The Freedonia
Group recently estimated that U.S. demand for private prison
management will grow about 5.8% a year through 2016. That's
healthy, but slower than the 8.1% rate it averaged between 2006
and 2011. (Total revenue for the sector in 2011 was about $34
billion.) Geo's revenue growth slowed to single digits last year,
and CCA's growth has been in that range for the last five
Sommer says the recession took a toll on state budgets,
leading both to less rigid law enforcement and a push for cheaper
contracts. The state of California, which has the largest inmate
population in the country, has also been involved in a legal
wrangle over how to handle prison overcrowding.
California's overcrowding problem has been a major source of
CCA's business, since it currently has some 9,000 inmates
outsourced to CCA facilities outside the state. But California's
governor has been pushing to bring the inmates back into their
home districts, while at the same time respecting legal limits on
population density. (The state reported the largest decrease
among state prison populations in 2011, trimming more than 15,000
inmates from its rolls.)
Still, the Golden State recently admitted that it's not going
to meet its June deadline for its goals, so CCA appears set to
keep its business in the near term. But the issue does point out
one of the major risks of these stocks -- they're just as
politically controversial as guns. In addition, their customers
are governments -- an added risk in periods of swift political
Nonetheless, Sommer believes budget-stressed governments are
going to have to come around, especially if convictions go
"There have not been states spending money on new facilities,"
he said. "So if inmate populations start to rise, then customers
are largely unprepared to deal with that themselves. Both
Corrections Corp. and Geo have idle capacity available if that
The Battle To Stand Watch
Another key driver for the security group has been the
spin-off ofADT Corp. (
) fromTyco International (TYC) in September. ADT is the U.S.
market leader in home and small-business security systems. With
25% share of a $13 billion market, it's six times the size of its
nearest competitor. Recent sales and profit growth have been
modest, but the share price has climbed around 28% since its
debut, leading to a Relative Strength rating of 92.
"We expect that ADT's industry-leading brand name, superior
scale, and expansive dealer network will allow this wide-moat
firm to outgrow the industry over the long run and generate
around 20% returns on invested capital in the process,"
Morningstar analyst James Krapfel wrote in a Nov. 29 report.
Freedonia estimates growth for the U.S. alarm-monitoring
sector is going to ramp significantly in the next few years.
Between 2006 and 2011 revenue crept up at 2.2% a year, but from
2011 to 2016 Freedonia expects 5.9% annual growth. The research
firm credits this to the housing recovery, since new security
contracts usually begin with new construction or renovations.
Nonetheless, Krapfel notes that ADT and other traditional
players are facing increasing competition from large
telecoms.Comcast 's (CMCSA) Xfinity Home andAT&T 's (T)
soon-to-be-launched Digital Life both offer interactive home
monitoring systems that not only watch out for invaders but allow
for remote control of such functions as lighting and temperature.
ADT is defending its turf with its new Pulse technology, which
boasts similar features.