Description

The Opportunity

Corrections Corporation of America (CXW) is an attractive "value with a catalyst" opportunity.  On Feb 10, 2009 (today), the Company announced fourth quarter and full year 2008 earnings which were slightly ahead of consensus expectations and in-line with historical trends for growth, margins, etc.  However, for reasons discussed below, management issued 2009 earnigns guidance of $1.10-$1.20, which was below Street expectations of $1.34.  In addition, during the evening before, a special federal judge panel ruled that the State of California would have to release ~50,000 prisoners over the next several years to relieve overcrowding.  In today's trading, CXW's stock tumbled 27% from $15 to $11 (an almost 5-year low).  This appears to be quite a strong over-reaction and presents an excellent opportunity to enter the stock.

Company Description

Corrections Corporation of America is the nation's largest owner and operator of privatized correctional and detention facilities and one of the largest prison operators in the United States.  The Company owns, operates and manages prisons and other correctional facilities and provides inmate residential and prisoner transportation services for governmental agencies. In addition to providing the fundamental residential services relating to inmates, the Company's facilities offer a variety of rehabilitation and educational programs, including basic education, religious services, life skills and employment training, and substance abuse treatment. These services are intended to reduce recidivism and to prepare inmates for their successful re-entry into society upon their release. The Company also provides health care (including medical, dental and psychiatric services), food services and work and recreational programs.  Currently, the Company operates 64 facilities, including 44 company-owned facilities, with a total design capacity of approximately 85,000 beds located in 19 states and the District of Columbia.

Business Model

The value proposition that CXW provides to federal, state and local governments is that the Company offers a cost-effective way to manage the growing prison population while enabling the governments to avoid the large capital expenditures associated with new prison construction.  CXW's business model is the following:  the Company gets compensated for operating and managing prisons and correctional facilities at an inmate per diem rate based upon actual or minimum guaranteed occupancy levels.  Operating expenses are predominantly fixed (63% are salaries and benefits).  Accordingly, CXW's cash flows have historically been very predictable.

Earnings Report

In its fourth quarter and full year earnings report released today, the Company provided earnings guidance for 2009 of $1.10-1.20 per share, well below Street expectations of $1.34.  On the Company's earnings call, management stated that they are guiding to conservative EPS estimates given the lack of visibility associated with government budgets and future spending by government customers, especially state customers, as they work to cut spending to balance their budgets.

It is possible, and this is the key, that CXW will have to accept lower "per diem" rates for inmates so that states can meet their budget constraints.  Given the operating leverage in CXW's business model, slight drops in per diem rates have a relatively large effect on the Company's bottom line.

Through analysis of management's guidance, it appears that they are assuming a potential decrease in the per diem rates of 2.5%.  This appears reasonable given that the per diem rates have typically advanced 3-5% per year over the past several years.  Although anything's possible and states are desperate to trim their budgets, imposing a more drastic per diem rate cut than this appears unlikely.  The relationship between CXW and its government entity customers is such that both need each other.  Clearly, the government entities have more power/influence at the negotiating table than CXW.  However, CXW provides a lower cost alternative to government constructed and operated prisons, so positions at the negotiating table are somewhat balanced.

To mitigate any potential decline in the bottom line, CXW management is currently working with several state customers regarding potentially reducing the service levels the Company provides so that CXW's operating costs can be decreased commensurate with any per diem rate reductions it might fact.  Accordingly, CXW's margins and bottom line performance may actually remain in-line with historical levels.  In the meantime, however, management is erring on the conservative side in providing its guidance.

Judge Ruling

As mentioned above, on February 9, 2009, a special federal judge panel ruled that the state of California would have to release ~50,000 inmates over the next several years to relieve overcrowding.  Although the headline appears to be negative for private prison companies such as CXW, it's really a non-issue.  Of the 85,000 beds that CXW manages, 3,700 are in California (~4%).  So, even if all of the inmates of these facilities were released (very unlikely), it would not have much of an impact on CXW's bottom line.  Second, there are many arguments for why the release appears unlikely.  Prison release proposals, such as Governor Schwarzenegger's in 2006, have typically not progressed through California's state legislature as it is a difficult platform for a politician to "run on".  If anything, the judge ruling is likely a positive for CXW in that it might "spur" California into commissioning CXW to construct and manage additional facilities to handle the prison population.  

Fundamentals

Despite the near-term lack of visibility into federal and state budgets, the longer-term fundamental outlook for CXW is strong.  Prison populations should continue to grow as the population in general increases.  Further, prison populations are expected to increase near-term as a consequence of the weakening economy.  The Company's average occupancy for 4Q08 was 93%, down from 98% in 4Q07 primarily due to a 9.9% increase in the average available number of beds.  As CXW accomodates additional inmates, this translates into bottom line growth.  In addition, the Company has a good pipeline of new prison projects.   The Company is in the process of constructing several new facilities which will increase its total capacity from 85,000 beds to ~89,000 beds by the end of 2010, a 5% increase.  Specifically, the Company is in the process of completing a 1,020 bed expansion of its La Palma facility in Arizona, a 1,072 bed facility in Nevada, and a 2,040-bed facility in Trousdale County, Tennessee.  Of note, however, the Company has temporarily suspended the construction in progress on its Tennessee facility until there is more clarity regarding inmate accomodation needs.

The organic growth of the Company's facility base as well as its historical track record of increasing its per diem rates on inmates has translated into EBITDA growth from $217 million in 2003 to $394 in 2008, an attractive 12.7% 5-year CAGR.  Although 2009 and potentially 2010 may be "hiccups" in this growth trend, the underlying fundamentals of population growth and constrained state budgets suggests that growth in privately owned and operated prison facilities is sustainable over a very long period of time.

The Company's balance sheet is strong with total debt to LTM EBITDA of 3.0x and interest coverage of 6.0x.  The Company doesn't have any debt maturing until 2011.  The Company has plenty of cash flow as well as revolver capacity to fund its project pipeline, so liquidity is not an issue for CXW.

Financial Projections

Below I've included my financial projections for the CXW.  I have used the following assumptions in these projections:  (1) The "Revenue per Compensated Man Day" is lower in 2009 by 2.5% vs. 2008 to adjust for the potentially lower per diem rate tha CSW might have to absorb.  This is true for both the "managed facilities" as well as the "owned and managed facilities".  (2) Operating expenses were not lowered to reflect any decrease in services CXW might be able to negotiate in order to preserve operating margins. Anything they can negotiate represents upside from these numbers.  (3) Depreciation expense is higher in 2009 vs. 2008 to reflect the placing of expansion and development projects into service in 2008 (per management's guidance).  (4) The Company repurchases $28.0 million worth of stock each quarter through 2009 at an average purchase price of $18.00 per share (to exhaust the $112 million the Company has remaining in its share repurchase program).  Lower prices on share repurchases lead to upside on 2009's EPS.

Valuation and Price Target

Several different valuation methodologies indicate that CXW is undervalued.

Free Cash Flow Yield

With 2009E EBITDA of $392mm, maintenance capital expenditures (excluding newbuild/expansion capex) of $53.6 million, interest expense of $61.5mm and cash taxes of $84mm, CXW should generate FCF for 2009 of $192.9 million.  With a market cap of $1,355mm, this equates to a FCF Yield of 14.2%.  This is attractive on an "absolute" sense for the Company.  Trading up to a still-attractive 9% FCF Yield equates to a share price of $17.40, 58% higher than the stock's current price.

Current Valuation Relative to Historical Valuation  

CXW has traded over the past 3 years primarily above a 20x PE multiple.  Applying a discounted 15x multiple on the low-end of 2009E, management guided, conservative earnings of $1.10 generates a share price of $16.50, representing 50% upside from current levels.

Valuation Relative to Peers

Based on the projections above, CXW is trading at 6.4x 2009E EBITDA of $392mm and 9.2x 2009E earnings of $1.19.  CXW is actually trading at a discount to its closest comp The Geo Group Inc. (GEO) which is trading at 6.5x 2009E EBITDA and 10.1x 2009E earnings (based on consensus projections).  This is despite the fact that CXW has significantly better margins (~24% EBITDA margins vs. ~16% for GEO) and identical leverage.  The only other publicly traded prison company of size is Cornell Companies (CRN) but is significantly smaller at only $225 million in market cap.

Discount to Asset Value

Although this is a far from exact methodology, it does provide some sense of the underlying asset value of CXW through a quick replacement cost analysis (based on recent construction prices).  CXW recently completed the construction of its 1,668-bed Adams County, MS facility at a total cost of $105mm.  This equates to $63,000/bed.  CXW is also close to completing the construction of its 3,060-bed La Palma, AZ facility at a cost of $205mm.  This equates to $67,000/bed.  CXW is also engaged (although the project has currently been put on hold) in the construction of the 2,040-bed facility in Trousdale County, TN at a cost of $143mm.  This equates to $70,000/bed.  The average construction cost of these facilities is therefore ~$67,000/bed.  Currently, CXW owns facilities with a total bed capacity of about 58,000.  Multiplying the 58,000 owned beds by the current construction cost of $67,000/bed equates to an asset value of $3.9 billion.   This is vs. the Company's current enterprise value of $2.5 billion.  Subtracting the net debt of $1.2 billion equates to an equity value of $2.7 billion, or $22 per share.  Note that this valuation DOES NOT include the value of the contracts that CXW has for managing the facilities that it doesn't own.  The $22 per share value represents 100% upside from current levels.

One could easily argue that construction costs have come down commensurate with the slowdown in the US economy and that the $67,000/bed figure is too high.  Even if you discount the figure, however, the underlying asset value of CXW is still much higher than its current trading value.

Based on all of these valuation methodologies (combined with where the stock traded less than 1 month ago), it is very reasonable to think that the stock should trade at a level of at least $16, representing 45% upside from its current price. 

Summary 

Overall, CXW represents an attractive "value with a catalyst", near-term opportunity with easily 45% upside from its current pcie.  Its a good company with an attractive valuation on several parameters, a strong balance sheet, and a business model that for the most part is non-economically sensitive.  Further, the catalysts listed below should provide near-term upward pressure on the stock.

Catalyst

 There are two main catalysts to drive CXW's stock upward near-term:

• Share Repurchases - First, the Company will likely be aggressively purchasing shares near-term (next 2-3 days) at these depressed levels. The Company has $112 million of capacity left in its share buyback program (the program was announced on November 14, 2008 and has $150 million in total capacity). From November through February 6, 2009, the Company repurchased 2.5 million shares at an average price of $15.16. If the Company was purchasing stock at $15 per share, the likelihood that they will be purchasing at $11 is very high. In addition, on the earnings conference call today, an analyst asked how long the Company would have to wait before "re-entering" the market as far as buying shares. Management stated that although there can be restriction periods in terms of buying back shares on a discretionary basis, the Company can work around those windows by having pre-determined buybacks in place. From management's body language and from talking with analysts who cover the stock, it seems management has a pre-determined period for buybacks already in place that will engage right after earnings. This should provide upward pressure on the stock.
• Strong Interest in the Stock - From talking with analysts who cover the stock, a lot of people are showing interest init. According to analysts,a lot ofinvestors were looking at the stock when it dropped to $12 in mid-November.It's "defensive", non-sensitive to the overall economy nature was driving the interest by investors trying to find some save havens toallocate capital. However, the stock quickly ran to $18 and people weren't able to build positions. From talking with analysts, all the people who missed it the first time view this as another chance to get in. The interest level appears to be high.