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Justice Department decision not a death sentence for private prisons

The market is behaving as if private prisons have received a death sentence, but they may soon be out on parole.

When the Justice Department announced last week it would end its use of private prisons, investors abandoned their prison positions like escaping convicts, cutting 40 percent off two publicly traded prison companies in a few hours. Corrections Corporation of America and GEO Group are still down around 30 percent from that point, yet there is no reason to think they've lost that kind of value.

That's because the eventual end of the companies' nine Bureau of Prisons contracts account for only about 13 percent of their combined prison capacity, according to company filings and CNBC calculations. They make up about the same amount of the companies' total earnings before interest, tax, depreciation and amortization, according to analysts at Canaccord Genuity.

So the two companies will lose contracts for nine facilities out of more than 180. GEO will lose about 15,000 beds, representing about 14 percent of the company's annual operating revenues, according to the company. CCA will lose around 6,000 inmates, or about 7 percent of revenue, according to CCA.

So why is the market posting 30 percent declines?

When the cash flow of the facilities that will be affected is excluded, both companies are still trading at free cash flow yields near all-time highs, the Canaccord analysts noted. That means the market is pricing in the risk of further cancellations, perhaps from other customers of private prisons.

However, there is little reason to think that Immigration and Customs Enforcement, the U.S. Marshals Service or state prison authorities will follow the lead of the Bureau of Prisons.

The USMS does not have its own facilities, which need to be near courthouses, and is unlikely to cancel contracts, the analysts noted. Similarly, ICE — which is overseen by the Department of Homeland Security — owns no beds and is actively expanding its requests for outside prison services. States, too, don't have the infrastructure to abandon the private system.

Even if those groups decide they would like to avoid using private prisons in the future, they would probably have to purchase infrastructure owned by the private industry, making the assets owned by the two companies valuable.

"We see minimal near-term risk to the non-BOP contracts of both GEO and CXW, making the stocks very cheap in our view," Canaccord's Ryan Meliker and Michael Kodesch wrote. "Over the longer term, we believe investors will better understand the limited risk to the non-BOP contracts and the stocks should trade closer to their historical free cash flow yields."

The two companies may be losing contracts for more than 20,000 federal prisoners, but those contracts are only a small part of their overall business, and most won't even expire for several years. Even if every federal contract ended abruptly, CCA and GEO would lose only 30 percent and 44 percent of their capacities, respectively, according to CNBC calculations.

The Canaccord analysts said they expect to see some volatility in the short term as media coverage of the cancellations and the possibility of a dividend cut for CCA continue to suppress the stock.

Canaccord has a buy rating on GEO with a price target of $28 — about $5 over the current price — and a hold rating for CCA with a target of $21 — about $3 over. No other analysts have issued estimates on FactSet since the announcement.

Neither company seemed to be overly concerned about the canceled contracts. In fact, they seem to have anticipated the move before it was announced.

"While our company was disappointed by the DOJ's announcement, the impact of this decision on GEO is not imminent," a GEO spokesperson told CNBC. GEO Chief Executive George Zoley has also said that the announcement would not impact the company's financial guidance for the year.

Over overcrowding

The number of inmates over capacity at public federal institutions has been declining for years, and the number in private facilities has recently dipped. Both companies have anticipated that the department's gradual decline in inmates would eventually bite into Bureau of Prisons revenues.

"With that reduced pressure on their system, it was clear to us that their need for private sector beds was likely to be scaled back," CCA CEO Damon Hininger said in a conference call. "And to be honest with you, that is part of our value proposition where we provide customized solutions for our partners as they need them, and those solutions could be short term or long term."

The DOJ framed its decision to end contracts with private prisons as in the interests of prisoners and the taxpayer.

"They simply do not provide the same level of correctional services, programs, and resources," Deputy Attorney General Sally Yates wrote in a memo.

The companies dispute those conclusions. The announcement also comes at a convenient time: Prison populations, and overcrowding at public prisons, began to decrease around six years ago, thus reducing somewhat the BOP's need for extra beds.

Over the last six years, CCA's exposure to Bureau of Prisons contracts has fallen "dramatically," according to the company. As that revenue has been nearly cut in half, the company has successfully used that capacity to serve other customers.