Description

Background

CXW will convert from REIT to C Corp in 2021.  It is an owner and operator of prisons and re-entry facilities.  It also owns a portfolio of office buildings leased to government agencies.  The office portfolio is non-core and will be sold to pay down debt.

Federal agencies (ICE, BOP, USMS) represent slightly more than half of revenue, with ICE being the biggest customer at 29% pre-COVID. State agencies account for the rest of the business.

Before the impact of COVID, prison accounted for 85% of net operating income (NOI), re-entry accounted for 5%, and office for 10%.

The business is leveraged to occupancy.  CXW is compensated on a fee per person per day basis and generally contracts come with minimum occupancy clauses. 

Prisons have high operating leverage and private prisons are the marginal supply.  In other words, public facilities tend to be filled up first before detainees are sent to private facilities.

Business Quality

High Barrier to Entry

Due to local opposition and NIMBYism, getting the required approval and zoning to construct a prison is very difficult.  It is harder for government agencies to build because their incentives are not purely economical. For instance, USP Letcher was first proposed in 2005 and it was canceled, after 14 years in negotiation, due to local opposition.

Another barrier comes in the form of existing relationships and track record.  Since the demand for private prisons primarily is to ease overcrowding, completing a project on time or having available capacity with short notice is very important.  Government decision-makers are comfortable with CXW as it has a track record that spans decades. It also has idle facilities that can be ramped up quickly.  New entrants face a chicken-or-egg first dilemma.

Cost Advantage

Due to inefficiencies and bureaucracy, government constructions are often delayed extensively and over budget.  CXW can build cheaper and in a timely manner.

Opportunity

CXW provides mission-critical services to the US government with high barriers to entry.  It is trading at a depressed multiple on near-trough earnings (6.9x LTM EBITDA).  

The last time it traded in the 6 - 7x range was before the last U.S. presidential election in 2016.  More specifically, the stock price was cut in half when then US deputy attorney general Sally Yates pledged in a public memo that private prisons would be eliminated in the federal system.

My bear case scenario assumes 8x trough EBITDA (additional 16% decline from 2Q20 EBITDA annualized) which implies the stock is worth $6.9 or 16% downside from $8.25.  

My base case assumes 10x normalized EBITDA (selling the non-core office portfolio at cost to repay debt, capturing half of the NOI lost due to COVID) vs GEO at 10.4x LTM EBITDA. My base target price is $20.2 or 145% upside. CXW should trade at a premium due to a better balance sheet and growth profile.

There is a near term catalyst less than 40 days away (election on Nov 3).  For those uncomfortable with the election, I suggest a pair trade - long CXW and short GEO - to hedge the headline risk.

Why does this opportunity exist?

There are three reasons that are transitory or one-time in nature: COVID, C-Corp conversion, and the presidential election.

First, COVID created a perfect storm.  It slowed down the justice system.  With courts closing which in turn postpone hearings, and loosening parole supervision (parolees checking-in on phones instead of face to face), admissions to prison plunged. Some prisoners were released to ease overcrowding.  Re-entry facilities were also temporarily closed.  

Furthermore, the US-Mexico border shutdown decreased ICE daily population from more than 37,000 in March to less than 21,000 in September.  As a result, prison and re-entry NOI declined $27mm yoy in 2Q20.

Second, management disclosed the company will convert back to a c-corp (it became a REIT in 2013) and suspended the dividend in June.  The unexpected dividend elimination caused many income-oriented and REIT investors to sell.

Third, pre-COVID, Trump was expected to win reelection given his strong record on the economy.  Nonetheless, the pandemic has made Biden the frontrunner.  The Democrats favor the abolition of ICE and private prisons. Sentiment on private prisons turned extremely negative in anticipation of a Biden administration.

Investment Thesis

CXW is a play on 1) post-COVID normalization, 2) replacement of obsolete facilities opportunity, 3) success in deleveraging and 4) improvement in occupancy driven by higher crime and hardening public opinion

Post-COVID Normalization

COVID dragged down ICE population due to closed border and prison population due to shutdowns of courts and social distancing in prisons which have a cascading effect on prison population. For example, prisons have stopped taking admissions from county jails.  As a result, compensated man-days were down from 5.9M to 5.3M year-over-year in 2Q20.

The main reason for illegal border crossing is income disparity.  As long as the incentives for illegal immigration remain intact, illegal crossing will resume and ICE detainee numbers will recover.  I also expect the economic disparity between the US and Latin America would become wider post-COVID. 

Courts were shut down due to COVID which created a backlog of unheard cases.  This drag is temporary as courts have now reopened, and the early release of prisoners due to social distancing is largely over. Admissions should normalize, driving up compensated man-days.

Replacing Obsolete Facilities 

Old facilities are more expensive to operate and maintain than newer ones.  Overuse causes excessive wear-and-tear and premature deterioration.  Public facilities have been over-utilized since the 1980s.  

Below is a chart of the age of BOP facilities.  30% of BOP capacity are over 50 years old.  The number is likely higher at state facilities due to tighter budget constraints at the state level.

According to the latest data available, public prisons had 1.35M detainees in 2018, not counting county jails.  Assuming conservatively that 30% of capacity needs to be replaced, this is a 405,000 beds opportunity.  CXW has 77,722 beds including idle facilities. 

The Lansing facility is the first ever private-owned, public-operated project pioneered by CXW.  Recall that private prisons are compensated for occupancy like hotels. The new structure is more like a traditional property lease in which CXW owns the property and is responsible for maintenance.  Government agencies enter into a long term lease with annual escalators and operate with their own staff.

The benefit for CXW is lower earnings volatility.  The benefit for government agencies is zero upfront payment and a better balance sheet for state budgets.

The Lansing project, which was completed early this year, replaced a 150 year old facility with 8 - 9% unlevered returns with 20 year lease term. It was a landmark deal.  CXW is in exclusive negotiation with Alabama for two facilities.

GEO cannot compete in this market with its current cost of capital. CXW is uniquely positioned to grow post c-corp.  Private equity cannot come in due to the barriers to entry.  I believe Mr Market has assigned zero credit to CXW and incorrectly priced GEO at a premium to CXW.

Success in Deleveraging 

There is a perception that CXW has trouble accessing financing as several banks pledged to cut ties with private prisons. First, I believe the banks are virtue signaling.  Given the amount of liquidity available, CXW has no problem refinancing its debt.  At worst, I expect CXW to pay 10-20 bps more than similar credits. Second, as shown below, CXW has enough liquidity at least until 2023.

Before the dividend suspension, the stock was trading below 5x FFO.  Clearly, the market isn’t giving them credit for the dividend.  It was effectively locked out from the capital markets because 1) borrowing more during a pandemic and when revenue is contracting is suicidal, 2) as a REIT, all earnings have to be paid out as dividends, and 3) cost of equity is prohibitively expensive and thus new projects are uneconomical.

Therefore, converting back to c-corp is the right move because it allows CXW to retain earnings.  Management has stated their first priority is to deleverage. 

Debt due before 2023 is $351mm, with $293mm due in 2022. The company has $364mm cash on hand and an office portfolio fully leased to government agencies that it paid $385mm for.  The office portfolio can probably be sold at a premium given the decline in 10 year treasury yield (150 - 250 bps contraction) relative to time of purchase.

Assuming $50mm maintenance capex, no improvement from 2Q20 EBITDA, and 21% tax rate, FCF to equity is $213mm/yr.  

Cost of equity should come down as CXW demonstrates it is not at the mercy of the debt market.  If the market does not give credit to the deleveraging, CXW can buy back 22% of its current market cap with FCF to equity per year.

Improvement in occupancy driven by hardening public opinion

Inmate populations peaked in 2009.  Population in private prisons peaked in 2012 and had outflows in all but one year since. The decline is due to lower crime, bail reform and gentler sentencing.

I believe the perception of criminal justice reform has inflected and the political wind has changed - many Americans feel the pendulum has swung too far.

The number of murders is up 28% in major US cities year-over-year. Reported violent crime is flat.  Since violent crimes and murders are highly correlated, this suggests underreporting of violent crimes because It is hard to hide a dead body/missing person.  But victims of other violent crimes might fail to report the crime due to distrust of police, depression related to lockdowns, or the increased prevalence of mob justice.

Furthermore, videos of people looting and engaging in violent acts in public, inflaming headlines such as “The feds can’t save New York from the insane no-bail law” and the alleged association of mob violence with BLM protests add credence to the “crime wave” narrative. 

According to Gallup, 8% Americans think Crime/Violence is the most important problem in September, up from <0.5% in May and double from 4% in August.

Biden and Pelosi have changed their tone drastically relative to August, publicly condemning violence which indicate their internal poll numbers show public opinion favors “hard on crime”.

What does this mean for prison population trends? 

New York State epitomized how quickly politics can change. There were about 20,000 detainees at the end of 2019.  Bail reform, which eliminated cash bail for most suspects, was passed in 2019 and implemented at the start of 2020.  It quickly reduced the number of detainees from about 20,000 to 15,000 within 3 months.

In February, the NYPD alleged bail reform is the cause of a rise in crime – before covid and George Floyd – and along with negative press coverage, turned public opinion.  Politicians reacted just as quickly, amended and tightened the reform law in April.

This is a turning point: Politicians cannot appear to be soft on crime.  They will respond to public opinion and take a tough stance against crime to endear voters. I believe the trend of prison population will bottom in 2020 and start growing in 2021.

Biden Presidency

If Biden wins, sentiment will turn more negative and stock will sell off.  In a worst case scenario, I assume Biden is serious in eliminating private operators from the federal system.  There are two separate implications: 1) USMS and BOP,  2) ICE.

USMS and BOP

While the headline is scary, the implication is actually positive. The federal government cannot confiscate private properties without compensation like Argentina or Venezuela. The detainees are arrested due to criminal offenses. 

This means there are only two options: 1) purchase facilities from CXW, or 2) convert federal contracts into the private-owned, public-operated model like Lansing.

For option 1, I expect the purchase price will be close to tangible book. The stock is trading at 0.72x.

For option 2, the stock will re-rate as 23% of revenue will become de-risk.  The multiple should converge with net lease companies with exposure to government like DEA which is trading at 19x EBITDA.

ICE

It’s important to note that “abolish ICE” is an idea endorsed by several candidates in the primary.  Biden never endorsed the idea.

He has vowed to stop detaining asylum-seekers, effectively reviving catch-and-release. The table above shows the average daily population (ADP) of ICE in September.  If Biden keeps his promise in the most progressive ways tomorrow, releasing ALL non-criminals detainees, ICE population will decline by 6,000.

CXW’s ADP from ICE was around 11,900 in 2Q20. The minimum guarantee from ICE is 8,600.  Even if CXW holds all the asylum seekers, an unrealistic pessimistic assumption, it would mean a decline of 28% compensated man-days from 2Q20 level.  In terms of revenue, the decline would be 7.8%

I estimate ICE-owned facilities can handle 5,000 ADP.  County jail held 7,000 ADP for ICE in the latest 12 months.  In a normalized year, there would be 22,000 criminals and suspects held by ICE, which means it would still need an additional 10,000 beds.  

Assuming CXW can capture 5,000 beds, compensated man-days would decline 58% from 2Q20 level.  CXW revenue would decline 16% from 2Q20 level.

Valuation

Upside to the base case

• Recapture more than half of NOI lost due to COVID 

• Office portfolio sold above cost basis; 10 year treasury yield is 150-250bps lower than the time CXW bought the properties.

• Reinvestment of retained earnings

• Occupancy increase driven by tougher on crime stance

• As CXW executes, it should trade at a premium to GEO due to lower leverage and higher organic growth.

Risks

State budgets will be in horrendous shape post-COVID; spending on correctional service can be cut as healthcare and education are higher priorities. 

Politicians continue to go softer on crime and prison population continues to fall. 

Catalyst

Presidential Election on Nov 3

Sale of office portfolio

Develerage

Closing the two projects (Elmore and Escambia) with Alabama Department of Corrections