Gun Makers, Prison Operators Face An Uncertain Year

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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 ( RGR ) andSmith & Wesson ( SWHC ), 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' price-to-earnings valuations.

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 massive volume.

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 No. 30.

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 ( CXW ) andGeo Group ( GEO ), are in the process of converting themselves into real estate investment trusts.

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 company.

"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 conversion.)

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 years.

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 change.

Nonetheless, Sommer believes budget-stressed governments are going to have to come around, especially if convictions go up.

"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 plays out."

The Battle To Stand Watch

Another key driver for the security group has been the spin-off ofADT Corp. ( ADT ) 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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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