Privatization picks - Wealth Builders

Chief Executive, The, Jan-Feb, 1995 by Merry Sheils

As government exits the business arena, companies participating in privatization may be a prudent investment.

At age 57, Jim Hindman is a grizzled, stocky man, a former college football coach who embodies the tough-talking discipline of Knute Rockne. But his rumbling baritone strains as he tells the story of a college-bound inner-city youth whose life ended several years ago with three bullets in his back. The teenager was a graduate of a reform school run by Youth Services International, a three-year-old publicly traded company in Owings Mills, MD, that has snapped up state-run programs nationwide. Hindman, YSI's CEO, considers the boy one who slipped through his fingers.

Ironically, the urban blight that contributed to the untimely death represents an opportunity for YSI and other companies, which are booting governments out of programs they don't run efficiently - including schools and prisons. Utilities, investment funds, and municipal services, too, are undergoing transformation. Even Washington won't be exempt, as pumped-up Republicans clamor to sell everything from air traffic control towers to printing shops. Overseas, a spate of U.S. companies is cherry picking in the telecommunications and energy sectors.

Privatization may well make solid business sense: CEOs of privatized companies, including Hindman, argue they are leaner and more motivated than their public-sector counterparts, partly because they focus on the bottom line and offer such employee incentives as stock-ownership plans. But potential investors in these companies must tread carefully. As with any prudent investment, the fundamentals must be sound, especially the earnings trend. Also beware of snags that aren't necessarily reflected in the balance sheet. Privatized companies frequently seek to replace union with nonunion employees - a major source of cost savings. As a result, many face the resistance of teachers, janitors, and administrators, and these companies are hamstrung in their attempts to operate autonomously.

The ongoing crisis in public education is recognized nationwide. But Educational Alternatives, the leader in education privatization, is focusing on the solution, rather than the problem. The eight-year-old Minneapolis-based company recently was awarded a contract by the Hartford, CT, Board of Education to manage the system's schools. The five-year, $1 billion contract could indicate straight A's for EAI, but not without some detention. Instead of being given a wide berth to cut costs and reallocate resources, the company has control over just a fraction of the Board's $171 million budget. This means EAI must work with the existing bureaucracy, which has admitted its failure to provide quality education. The difficulties EAI faces go even further. The opposition of entrenched interests makes it difficult for EAI to land new contracts. To succeed, the company has to work around the problems, rather than alleviate them. EAI will tinker with the curriculum, bring computer technology into the classrooms, and seek economies to effect needed change.

EAI, a spin-off of Control Data Corp., points to its success in Baltimore, where it presently manages 12 schools. The hope is for a 25 percent profit on that contract; however, based on the problems EAI has encountered, a 7 percent to 9 percent return may be more realistic. Once EAI can rack up more successes, it could prompt other school boards to follow suit.

EAI currently trades around $16 3/4, down from its historical high of $48 3/4. Earnings for 1994 show a loss of $236 million, a marked decline from 1993 earnings of $330 million. Nonetheless, EAI represents good value for the investor willing to ride a bumpy road for the near term.

Privatization also extends to prisons. Corrections Corp. of America, based in Nashville, TN, is the largest for-profit company to manage, finance, renovate, design, and construct prisons and other correctional institutions for government agencies in the U.S., Australia, and the U.K. CCA, with projected revenues of close to $120 million for fiscal 1995, recently signed a contract with the Florida Correctional Privatization Commission and expects $11 million in annual revenues from the venture. Earnings for the first nine months of 1994 reached $4.3 million, compared with $2.7 million for the same period in 1993. At a current price of about $15 1/8, CCA is an attractive choice in a growing market.

Youth rehabilitation is relatively new to the privatization market, and Jim Hindman's Youth Services International has made important strides. YSI develops and manages 10 residential and community-based educational and behavioral-change programs for more than 1,100 at-risk and adjudicated juveniles in seven states. Leveraging a 20 percent increase in the number of students in its programs, YSI posted record earnings of $2.1 million for 1994, swinging from a loss of $1.7 million the previous year. Recent acquisitions should add further to the bottom line.

However, higher earnings do not necessarily mean a higher share value; caution and patience are the required watchwords. YSI sells for around $7, down from a high of $10 when the company went public in February 1994. Like other small cap stocks, it took a beating in the recent market selloff, and it may be some time before the company returns to a double-digit share price.