Up in Smoke? The Effects of Marijuana Legalization

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Does the move toward legalization of marijuana pose a threat to the for-profit prison industry?

On November 6th, voters in Colorado and Washington passed referenda legalizing the recreational use of marijuana. It is not clear yet how federal enforcement officials will respond to the new laws in practice, or whether the move toward legalization is the start of a larger trend. But if we see similar reforms gain traction in future elections in other states, it could affect the fortunes of several public companies. And not just Yum! Brands (YUM) and Pepsi (PEP).

For companies like Corrections Corporation of America (CXW) and GEO Group (GEO), the downside risk to marijuana legalization could be substantial. Recent reports from the analyst community make general mentions of policy changes as an ongoing risk factor, but make no specific mention of changes to drug laws. SunTrust cited the risk of "change s in state or federal policies and funding that reduce inmate populations," and a post-election report from Macquarie included similar language. Otherwise, analysts are very positive on the stock, and are focused mostly on the company's short-term plans to convert to a real estate investment trust. During the Q3 earnings call on November 8, an analyst asked about a referendum in California to reclassify some "three strikes" inmates, but no other policy changes were mentioned.

While changes in drug policy have not been a focus of industry analysts, CXW itself is more straightforward; each year's 10-K filing with the SEC includes the following in the "Risk Factors" section:

"The demand for our facilities and services could be adversely affected by the relaxation of enforcement efforts, leniency in conviction or parole standards and sentencing practices or through the decriminalization of certain activities that are currently proscribed by criminal laws. For instance, any changes with respect to drugs and controlled substances or illegal immigration could affect the number of persons arrested, convicted, and sentenced, thereby potentially reducing demand for correctional facilities to house them." **

That is, fewer people in prison because of drug charges would mean lower profits for companies in the prison business. As the largest private owner of prisons in the U.S., CCA operates 66 facilities housing 91,000 beds. The company manages 45% of the for-profit prison space under contract with state and federal governments. And while the company has some revenue from prison transport operations and from income related to its real estate holdings, the vast majority of revenues come from housing inmates.

Drug policy may actually be the key driver of profits for the prison industry. A study released in September from the U.S. Government Accountability Office found that growth in the federal prison population was outpacing prison capacity, and that the main drivers of overcrowding were the drug war and especially harsh federal drug sentencing. And marijuana-related charges are a big part of that picture: 2007 data from the Department of Justice showed that marijuana possession charges comprised more than 42% of federal drug charges (another 5% were for sale and manufacture), and that marijuana arrests were rapidly outpacing all other drugs.

fig. 1. Number of arrests by drug type, 1982-2007. Source: U.S. Department of Justice



Federal decriminalization or de facto enforcement changes would not entail an automatic release of existing inmates, but individual governors could entertain the prospect of mass pardons, and a sharp reduction in new inmates would be enough to affect the revenue of for-profit prison companies.

A secondary risk is that state and local budgets may be in better shape than they were in previous years. CCA is poised to profit when states get into trouble, since states running their own prisons can sell or lease those facilities to private companies, hire the companies to handle all of the operations, and record a one-time or short term cost reduction on their budgets. As the economy improves and tax bases firm up, states may face less budgetary pressure to rely on for-profit companies like CCA. During the Q3 earnings call, CEO Damon Hininger explained that the short-term issues surrounding sequestration and the federal budget had caused some uncertainty but said that he expected a resolution within the next few months such that CCA's contracts would not be affected.

From an investing standpoint, there is no reason to look for immediate downside in CCA. The company just announced a better-than-expected quarter and the stock is up 62% in 2012. If there are any investors on the sidelines because of questions about the federal budget, a political resolution might even be good for a short-term boost in the share price. But it also looks like the risk of a policy change to fit the changing demographics of the U.S. electorate is not being reflected in the price of the stock or its options. If voters continue pushing successfully for decriminalization, investors might find themselves needing something to help them relax.

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** CCA's own activities suggest some concern to ensure a favorable policy mix. In their 2011 letter to shareholders, the Chairman and CEO remarked that, "We do not work and have not worked to affect government policies that govern sentencing or detention policies. Staying out of the public debate on sentencing and criminal policies has been a long-standing corporate policy of CCA, and we believe it's the right policy." These statements appear to be plainly false, though. For some time, CCA executives co-chaired a legislative task force at the lobbying group ALEC aimed at influencing state lawmakers to pass pro-incarceration laws involving mandatory minimum sentencing, "three strikes" policies, etc. (The task force was disbanded after intense public pressure following the 2012 "stand your ground" gun law controversy, but appears to survive among ALEC's ongoing initiatives.) CCA was listed as a corporate member of ALEC in a 2011 research brief, and Laurie Shanblum, a senior director for business development, is listed as a member of the Executive Committee of the Private Sector for the lobbying group. Investigative reporting by a CBS affiliate in Arizona found evidence of CCA lobbyists and former lobbyists influencing the controversial SB1070 "show us your papers" legislation there; in a set of lucky circumstances for the company, legislators in receipt of political contributions from CCA in Pennsylvania, Florida, Tennessee, and other states have promoted similar laws. Perhaps the shareholder letter was partially correct: CCA has stayed "out of the public debate" on criminal policies because it has been able to work through private channels instead. No matter how we view the politics of these activities, none of this involvement seems suggestive of a company that is concerned to keep its distance from government policy. That is, the company's own concern to influence policy should make investors wary of adverse electoral outcomes.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

Jared can be followed on Twitter at twitter.com/CondorOptions.
At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.

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