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Privatization picks.

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.

Other, more traditional corporations, are tapping the privatization mother lode, but may not represent a pure play on the phenomenon. It's important to remember that the strength of any company as a whole may well be far more important than its foray into privatization.

State-of-the-art communications are a direct result of the government's commitment to space technology. Since 26 percent of Motorola's business comes from the communications sector, it made sense for the company to finance the Iridium Project - whose goal is to provide telephone service anywhere in the world through a satellite network by the end of the decade.

While most investors won't select Motorola solely for its Iridium business, they will have some assurance that their investment is in safe hands. As an entity, Motorola is a safe buy. If the Iridium Project falls short of expectations, the company is well-prepared to absorb the blow; however, Iridium's ultimate success could give Motorola's price a hefty boost. Recently selling around $55 3/8, the Schaumburg, IL-based company posted earnings of $81.7 million for the first nine months of 1994, up almost 11 percent from the comparable period in 1993.

Opportunities for privatization exist abroad, too, especially in Eastern Europe, as governments strive to meet the growing demand for infrastructure, including utilities and communications networks. Denver-based US West derives over $100 million in revenue in Hungary alone, where its Westel venture has a 49 percent stake in the Hungarian Telephone Co. Similarly, in a joint venture with Bell Atlantic, US West has a 49 percent stake in the Czech Republic's cellular network.

Flat earnings led to a drop in US West's share value last year. The increase in long-term rates also has taken its toll on the company. US West, selling at about $34 3/4, posted operating income for 1994 of $1.92 billion - $944 million after extraordinary items - up from $212 million in 1993.

Buying into global privatization through a well-run company such as US West makes sense. As with Motorola, the downside risk in US West is minimal: If the privatized venture proves disappointing, the investor has hedged through a bet on the rest of the company's business success.

Reflecting another facet of privatization, Michigan Governor John Engler recently awarded the Great Lakes State's workers' compensation fund to Blue Cross Blue Shield of Michigan; other states, cities, and municipalities likewise have solicited bids from private industry to manage government services as well as finances.

It's not just giant companies that can succeed at privatization. In a surprise move, American Water Works, a 59-year-old company in Voorhees, NJ, is attempting to take over the publicly controlled Santa Margarita Water District from Orange County, CA, which recently filed for Chapter 11. With common stock selling at $25 5/8, American Water Works posted net income for 1993 of $71 million, up 9.9 percent from the year before. Another relative unknown is Rural/Metro, a Scottsdale, AR, municipal services company winning contracts to run fire and emergency medical services departments.

Certainly, the grand-daddy of privatization is Federal Express. Founded on the intuition that a private company could deliver mail the next day, albeit for a hefty price, corporations and individuals soon recognized the value of overnight delivery. Another fillip for Federal Express: Pro-business Republicans may push to allow package carriers to compete for first-class mail delivery. Many customers - and investors - would find a company capable of reducing postage costs by 25 percent extremely appealing.

With stock currently trading around $54 1/2, FedEx's earnings almost doubled in 1994 to $204 million from $109.8 million in 1993. But margins have been squeezed, as the demand for overnight delivery softens: Federal Express averages profits of $9.23 on two-day deliveries, compared with $16.37 on priority overnight service.

Of course, the goal of privatization is to earn profits and improve efficiency. Whatever the industry, when a better product or service can be built or provided privately, the government should cede ground to the private sector. Ultimately, insightful, calculating investors stand a chance to share the benefits.

Merry Sheils is president of First New York Equity, a registered investment advisory and financial-services firm.
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Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Wealth Builders
Author:Sheils, Merry
Publication:Chief Executive (U.S.)
Date:Jan 1, 1995
Words:1539
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