The City Limits 20

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When you hear the word “privatization,” do you think “corporate scheme to cheat the poor”? Do well-connected wastrels walking off with city contracts make you grit your teeth? Do you believe that lining private pockets with public money is wrong?

You’re so old economy.

Privatization is here to stay. While Democrats and Republicans may disagree on details, nobody in power questions the basic premise: that the private sector should take over a lot of the government’s job. Each year, federal and local governments shovel more and more cash into the hands of business-savvy for-profit social services providers.

With that in mind, we are launching the City Limits Privatization Index, a list of the top publicly traded companies that are making a killing–and generating juicy returns–off the public weal.

Why? It’s a great way to track the growth of this poorly understood sector. By watching the markets, we can see the real-world results of the shift from old-fashioned public works to new-style private contracts.

There’s an added bonus: In these days of market turbulence, companies that can count on government cash can be a great investing opportunity. In fact, our index is up 8.7 percent this year as of October 1–beating the pants off the S&P 500 (down 2.8 percent) and the NASDAQ (off 11 percent). Now you can see just what the return on your privatization investment could be–and start planning. After all, it’s not like the neighborhood nonprofit you work for is going to give you a big severance package when its contract gets handed over to Lockheed Martin.

PRIVX has been crafted through a combination of assiduous research and wholly subjective intuition. The index includes four major categories: educational services, government operations, waste management and security services. (That’s Wall Street talk for schools, welfare, trash and jails, respectively.)

And although we’ve set the list up as a tracking device, it’s also a blueprint for a truly cutting-edge investing strategy that doesn’t sacrifice either value or growth. With the City Limits 20, you get a piece of a small, hot firm like Edison Schools, as well as a powerhouse like Lockheed Martin. Plus, privatization stocks are bear-proof. Soft landing or hard, the need for garbage trucks and elementary school administrators stays constant–while the demand for welfare managers and prison guards can only grow.

Our picks might raise some eyebrows among short-sighted mutual fund managers, since a lot of these companies are not trendy on Wall Street right now. But the way we see it, this list is a preview of the future: You get a big promise at a cheap price, in industries that are guaranteed to grow. And if the Chris Whittles and the Ross Perots of the world are cleaning up from privatization, why shouldn’t you?

Jails

This market used to be a powerhouse. In the 1990s, annual growth for the prison industry was in the double digits, and private prison beds increased fivefold since 1993. But industry leader Corrections Corporation of America (CXW), which manages nearly 70,000 beds, has taken a big fall with financial and management problems, reporting losses in the hundreds of millions last year. And when Wackenhut Corrections Corp. (WHC) announced in September that it would be shutting down a problem-plagued Louisiana teen prison, its stock lost 15 percent the next day.

Since the big private prison firms are still unsteady, we threw in some smaller companies that provide offender services like health care or education. Notable New York newcomer Prison Health Services, a subsidiary of the America Service Group (ASGR), is now negotiating to take over health care at Rikers Island. According to ASG chief Michael Catalano, about 38 percent of the inmate medical care market is outsourced–and his company provides managed health care to 325,000 inmates, about a quarter of that market.

Private prison stock prices are still in the cellar, but there are some solid reasons to buy into prisons as a long-term investment. As Prudential Securities analyst James Thayer points out, the shrinking crime rate may have taken the edge off of jail overcrowding, but longer sentences keep demand for new beds strong. Another asset: the giant providers are beginning to regroup, and the competition is weak. Getting into the business requires both a strong reputation and good government ties. Three firms–Wackenhut, CCA and Cornell Companies (CRN)–do almost all the federal private prison work.

One bright light on the private prison horizon is the growing overseas market. While the U.S. is still a leader in for-profit prison management, other countries are hustling to catch up. The most promising market? South Africa.

Welfare

One thing’s for sure: Any economic softening will only be good news for the companies that manage government benefits programs. So even though some of the biggest welfare-management companies have had profit problems, we’re keeping an eye on these stocks.

Early on in welfare reform, the data management divisions of huge companies like Electronic Data Systems (EDS), Lockheed Martin (LMT) and Citigroup (C) rushed in, eyeing two profit centers: welfare-to-work systems for local governments and “electronic benefits transfer” systems, the ATM cards that provide food stamps and other entitlements.

But it turns out it’s not that easy to make money on welfare. Low unemployment, plummeting welfare rolls and unexpected technical hitches have kept profits low, and companies have backed off a bit on their welfare-to-work business. Lockheed Martin, which handles almost half the country’s EBT and child support payment systems, has been looking to sell its government services division all year.

That leaves the field pretty much open for government specialist Maximus (MMS), which has rocketed to the top of the field on sales of more than $300 million in fiscal year 1999–up 30 percent from the previous year.

Running government programs is about 60 percent of Maximus’ business, and it does the job well; this little firm, voted one of Business Week’s top 100 growth companies, has been profitable for every one of its 25 years. “It’s still a solid company, one of the bellwethers in the human services area,” says BB&T analyst Tom Maher.

Better yet, Maximus is a good buy right now. Thanks in part to last spring’s New York City contracting scandal the company was trading at about half the price it had been a year ago, with a price/earnings ratio well below the S&P 500 average.

But while it waits for its $104 million New York City welfare-to-work contract to be reinstated, Maximus is also looking ahead: In October, it won a contract with the federal education department to collect on delinquent student loans.

Schools

Ten years ago, the idea of for-profit public schools was heresy. But charter schools have become the hottest trend in education. After all, it’s a $360 billion industry, and for-profits still have only a tiny piece of it–for now.

According to one analysis, privatization in the K-12 sector is growing at 15 percent a year. Profits for mid-size education companies are projected to grow by more than 300 percent in 2001.

New York City’s own Edison Schools (EDSN), a private manager of public schools, is hot enough on Wall Street that all six analysts that track Edison rate it either “buy” or “buy/hold”. And although the company still hasn’t turned a profit, Edison has a market cap of $1.3 billion.

Why the enthusiasm? Edison’s sales have nearly doubled every year since its founding in 1995. As of September, the company managed 108 schools. And soon, it may get a chance to seriously boost its portfolio by taking over up to 45 of New York City’s worst-performing public schools.

But there are other stars in this sky, including the powerfully profitable Advantage Learning Systems (ALSI), recently named as one of the top small companies by Fortune magazine. Advantage sells classroom software designed to improve students’ skills, diagnose weaknesses and help them prepare for standardized tests. More than 40 percent of all US schools now use Advantage products.

And, just in case vouchers overtake the charter school boom, we’re also tracking the old-fashioned industry titan: private schools. With enrollment topping 26,000, Pennsylvania’s Nobel Learning Communities (NLCI) calls itself the nation’s largest private school company. Unlike Edison, Nobel thinks big and makes money. In September, with some advice from the World Bank, it launched a deal with its private-school counterpart in China.

Garbage

Waste haulers have traveled some rough seas lately. The late 1990s saw a wholesale war over market share, won by trash giants Waste Management Inc. (WMI) and Allied Waste (AW). These two, along with the smaller Republic Services Group (RSG), now control about 40 percent of the waste hauling market. But the race for domination left both firms saddled with debt and merger-related internal confusion, and share prices are still depressed.

On the flipside: waste hauling is relatively recession-proof. This year, while tech stocks sagged, sanitation stocks were generally beating the market until the end of the summer, when worries about fuel and labor prices took hold. We’re bucking the trend here, but given the direction of the sector overall, we think these companies are worth paying attention to as good long-haul buys.

And now that the leading companies are shedding less profitable routes and focusing on improving operating margins, earnings should rise again. As Reed Conner & Birdwell chief investment officer Jeff Bronchick puts it in TheStreet.com, “there are some regional monopoly issues that can be turned to shareholders’ advantage.” With so few companies playing the field, hauling prices are bound to rise–and with them, profits.