Damage Control at Prison Realty Trust

Investors are crying foul over a bailout of the REIT's management-owned operating company.
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The news that insiders at Prison Realty Trust (PZN) - Get Report have been forced to bail out their privately held operating company has sent investors in the prison REIT fleeing, helping drive down shares 40% over the past week -- from over 22 on May 11 to 13 today.

The plunge in the stock price stems from Prison Realty's disclosure it would increase the annual payments to its privately held operating company,

Corrections Corp. of America,

by over $65 million. The fact that Prison Realty insiders own a controlling stake in the operating company has many pondering the inherent conflicts of interest in this arrangement. Calls to the company were not returned.

The situation began last April after a complicated corporate shuffle produced a merger of Prison Realty and the then-publicly traded Corrections Corp. of America. The company would then contract its prison operations to a new company, also named Corrections Corp. of America, but which would be privately owned by some senior employees of Prison Realty. At the time the re-merger was announced, many were

skeptical of the company's motives.

But as recently as three weeks ago, the result -- Prison Realty -- seemed to be running on all cylinders, announcing solid earnings on May 5 that helped rally the stock. On the analysts' conference call, company Chairman Doctor R. Crants presented what one analyst termed a "very upbeat picture" of the company's future. Little did investors know that, the day before, the company's board had agreed to the increased payments to its operating company.

The increased payments include the "tenant incentive fee," which is paid to the operating company from the REIT for each new prison bed placed into service; the fee has been bumped from $840 per bed to $4,000 per bed.

The operating company will also enjoy a boost in the "project development fee," which the public REIT pays to the operating company for "oversight" of new facilities development -- from 5% to as much as 10%, and a new 4.5% new business fee paid when a new prison project is announced.

Although all of these new payments from the REIT to the operating company were approved by the board on May 4, and included in Prison Realty's 10-Q form filed on May 14 with the

Securities and Exchange Commission

-- no mention of any of these issues was made during the earnings conference call on May 5, or in the subsequent press release. Rather, the company waited until a special May 14 analyst conference call to alert analysts to the changes.

"Knowing the 10-Q was going to be released, it clearly seemed like company damage control," says Jerry Doctrow of

Legg Mason

who lowered his rating on the company from buy to market perform and increased the risk rating to speculative. (Legg Mason has provided banking services for the company in the past three years.) Adds Ritson Ferguson of

CRA Real Estate Securities

, "It was material and should have been disclosed."

The announcement is troubling on two fronts. First, it suggests the operating company has stumbled badly. "It looks like the operating company fell short by $80 million," says

Banc of America Securities

(formerly

NationsBanc Montgomery

) analyst Will Marks, "How could the company not have known about an $80 million shortfall is beyond me," suggesting Prison Realty management should have known and disclosed the problem much earlier. Marks lowered his rating from buy to hold. (Banc of America Securities has provided banking services for Prison Realty in the past three years.)

According to Doctrow, the company says it's an honest mistake. "They say they somehow forgot the operating company wouldn't be able to pay rent until the prisons were full," he says. Doctrow said the shortfall was exacerbated by the longer periods of time necessary to fill new prisons. In addition the operating company was not successful in winning new management contracts for other prisons, possibly a result of negative publicity about stabbings and other problems at Corrections Corp. of America-managed facilities.

"The Youngstown

violence problems did have a direct impact on Ohio and probably slowed occupancy at other facilities," says Doctrow.

More troubling, however, is the continued lack of candor on the part of management. "The way they disclosed the problem is very disappointing. It raises serious questions about the credibility of the management team," says Doctrow. Adds Banc of America Securities' Marks, "I don't know what to believe anymore."

CRA's Ferguson has expressed his skepticism from the beginning, based on the potential of conflicts between the REIT and the private operating company. "I cringed when the merger was announced," he says. Little did he know the conflicts would become so damaging to company investors.

While the slide in the stock price may attract bottom fishers, especially given the nearly 17% indicated yield, most analysts are taking a wait-and-see approach. "When things get this distressed, you just don't know what's next," says Ferguson. "Remember

Cendant

."

Doctrow, who estimates the company will have to borrow to maintain its current dividend, says the future of the company hinges on the completion of a $300 million high-yield debt offering and renegotiation of a $1 billion credit facility, both led by

Lehman Brothers

. Sources tell

TheStreet.com

the debt offering remains on track. However, no confirmation of the credit facility was available. "Is it a viable company going forward?" asks Doctrow. "That largely depends on the reception the company gets in the bond market."

For now, investors seem content to leave the company's stock in the slammer, without probation anytime soon. "People are debating whether these guys are incompetent, or thieves," said Doctrow.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, neither Edmonds nor his firm held any position in the stocks mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback at

invest@cjnetworks.com.