CORRECTIONS CORP AMER CXW S W
June 18, 2016 - 10:31am EST by
value_31
2016 2017
Price: 33.90 EPS 1.82 1.96
Shares Out. (in M): 118 P/E 18.6 17.3
Market Cap (in $M): 3,983 P/FCF 0 0
Net Debt (in $M): 1,352 EBIT 0 0
TEV ($): 5,334 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • Prisons
  • REIT

Description

COMPANY SUMMARY

 

Corrections Corporation of America (“CXW”) is the largest provider of prison detention and corrections services to governmental agencies in the United States.  The Company owns correctional and detention facilities and is organised as a REIT. 

SUMMARY THESIS

(1) Prison population is falling (fiscal & policy reasons driving this) – prison population peaked in 2009 & has been falling since 

(2) Private Prison Operators are the ‘swing capacity’ in the system – private prison operators captured a disproportionate share of the growth in inmate populations (up to 2009).  As populations fall it’s easier to cancel contracts with private operators vs. closing government owned facilities (government employee redundancies, union issues, etc.)

(3) You can see this dynamic ‘in the numbers’.  For CXW since 2009:

  • 'Managed Only’ Facilities:  # of facilities managed has fallen from 21 (~25k beds) at 31-Dec-09 to 11 (~14k beds) at 31-Mar-16.  This is predominantly contract expiry/cancellation
  • ‘Owned & Operated’ Facilities: headline numbers show % occupancy has fallen from 88% during 2009 to 72% during Q1’16.  CXW currently has 9 owned facilities (out of 60) that are idle.  There are a further 2 facilities that were impaired (and thus are no longer reported) in Q1’15 (i.e. now no longer counts in the denominator for the calculation of utilization) (note: there were zero idled facilities in mid-2008)
  • Recent facility lease in Oklahoma indicates the challenged state of the market:  In May CXW announced a 5 year lease agreement for the North Fork Correctional Facility.  The structure of this lease provided the counter-party a ~1.5 years rent free period at the beginning of the lease (i.e. 1.5 years out of 5 years);

 

(4) Contracts are typically short duration – a very large percentage of contracts expire over the next 2-3 years.  Historically renewal rates have been high (as populations grew & private populations grew disproportionately).  This has changed recently.  If the structural decline thesis is correct the short duration contracts are the mechanism through which it get transmitted (& potentially quickly).  Also note counterparties have the right to cancel contracts unilaterally before expiry in certain circumstances (e.g. failure to secure sufficient budget appropriations);

(5) This is a largely fixed cost business – minimum staffing & other fixed costs mean the operating leverage from lost revenue (declining utilization) is significant.  There is financial leverage in addition to the operating leverage

(6) There is no alternative use for the real estate – For example CXW has had facilities idle since 2008. They just sit there empty.  Any ‘real estate value underpinning the downside’ thesis seems unlikely;

(7) Dividends exceed free cash flow – e.g. since REIT conversion CXW has consistently paid higher dividends than actual FCF (FFO & AFFO reported by the company are inflated).  This has gotten progressively worse as operations have deteriorated

(8) CXW has given counterparties a number of options to purchase facilities at or below book value – CXW currently trades at ~2.8x P/BV.  ~20% of BV is represented by facilities that either (i) automatically revert to counterparties at the end of the lease (in 2017); or (ii) where counter-parties have the option to acquire the facility at or below book value; or (iii) are currently idle;     

MORE DETAIL ON EACH OF THE THESIS LIMBS

(1) Prison population is falling 

  • The United States has the largest prisoner population in the world[1] and the highest incarceration rate of any large country in the world[2].  For perspective, the US prisoner population is larger than the aggregate total prisoner populations of the other G7 countries + China
  •  Total State + Federal populations in the US peaked in 2009 and have been falling since – A combination of policy & fiscal reasons are driving this
  • Even though aggregate federal prison population numbers are smaller than state population for private prison operators’ federal populations are more important than state populations. For example CXW generates more than 50% of its revenues from federal customers
  • There are a number of changes that have occurred or are slated to occur that will continue the downward trend
    • Sentencing guideline changes for drug crimes – ~1/4 of inmates impacted; sentences estimated to be reduced by 19% on average; offenders commenced being released from November 2015[3]
    • Bipartisan proposed changes to the Sentencing legislation[4]

 

 

(2) Private Prison Operators are the ‘swing capacity’ in the system

  • While prisoner populations (and especially federal populations) were growing private prison operators captured a disproportionate share of the growth in inmate populations[5]
    • Prison populations in private facilities increased from 5.9% of total in 2001 to 6.8% of total in 2009 (increase from 8.1% to 16.4% for federal prisoners)
  • As populations fall it’s easier to cancel contracts with private operators vs. closing government owned facilities (government employee redundancies, union issues, etc.)
  • In general where the prisoner populations have fallen, private operators have suffered.  For example:
    • Texas: Because offender populations were declining, the Legislature reduced appropriations for contract prisons, privately operated state jails, and residential pre-parole facilities by $97.3 million to reduce correctional bed capacity, resulting in the closure of the Mineral Wells Pre-Parole Transfer Facility and Dawson State Jail
    • Kentucky: Citing a declining prison population and recent criminal justice reforms, Kentucky officials opted in July 2013 not to renew the state’s last remaining private prison contract with Corrections Corporation of America to house nearly 800 inmates in the Marion Adjustment Center.  The state chose not to renew private prison contracts at two other facilities in 2010 and 2012.  “Our decision wasn’t based on an opinion of private prisons,” Kentucky Justice Secretary J. Michael Brown told The Courier-Journal in September. “CCA was a great partner. We could not have operated without that partnership while our (inmate) population was trending up.”
    • California: In 2011 the US Supreme Court ruled that overcrowding in prisons was in breach of the US constitution (cruel & unusual punishment).  As a result CA decided to send a number of inmates out-of-state.  They have subsequently built more in-state prisons & reduced the overall population.  As a result the use of private facilities has reduced significantly  

 

 
(3) You can see the impact of reduced populations in CXW's operational performance

'Managed Only’ Facilities:  

  • # of facilities managed has fallen from 21 (~25k beds) at 31-Dec-09 to 11 (~14k beds) at 31-Mar-16.  This is predominantly contract expiry/cancellation.  Additionally capacity utilisation has fallen
  31-Dec-09 31-Dec-10 31-Dec-11 31-Dec-12 31-Dec-13 31-Dec-14 31-Dec-15 31-Mar-16
Number of Facilities (#) 21 21 21 20 16 12 11 11
Average available beds (#) 25,101 24,285 26,390 25,324 21,306 16,763 15,048 13,898
Average compensated population (#) 24,238 23,287 25,269 24,340 20,575 15,944 14,104 12,980
Average compensated occupancy (%) 96.6% 95.9% 95.8% 96.1% 96.6% 95.1% 93.7% 93.4%
 
 

Owned & operated Facilities:

  • % occupancy rate has fallen from 88% during 2009 to 72% during Q1’16
 

 

 
  31-Dec-09 31-Dec-10 31-Dec-11 31-Dec-12 31-Dec-13 31-Dec-14 31-Dec-15 31-Mar-16
Number of Facilities (#) 44 45 46 47 49 49 60 60
Average available beds (#) 61,051 62,518 63,797 66,538 67,588 66,179 65,073 71,296
Average compensated population (#) 53,893 55,033 55,746 56,722 55,123 53,292 52,007 51,004
Average compensated occupancy (%) 88.3% 88.0% 87.4% 85.2% 81.6% 81.0% 79.9% 71.5%
 
  • At 31-Mar-16 CXW had 9 owned facilities (out of 60) that are idle - a total of 9,650 beds.  There are a further 2 facilities that were impaired (and thus are no longer reported) in Q1’15 (i.e. now no longer counts in the denominator for the calculation of utilization).  These two facilites represent a further 2,953 beds.  Importantly, there were zero idled facilities in mid-2008
 
Facility First Idled

Beds    

  Notes
Shelby Training Center Aug-08 200   Tennessee Department of Children’s Services moved operations under its control
Queensgate Correctional Facility* Dec-08 850   Hamilton County, Ohio terminted the lease due to funding issues
Prairie Correctional Facility Feb-10 1,600   Minnesota and Washington had excess capacity and moved prisoners in-state
Huerfano County Correctional Center Mar-10 752   Arizona proposed budgets to phase out the utilization of out-of-state beds (moving in-state)
Diamondback Correctional Facility May-10 2,160   Arizona proposed budgets to phase out the utilization of out-of-state beds (moving in-state)
Otter Creek Correctional Center Jun-12 656   Kentucky moved prisoners to an in-state facility
MineralWells Pre-Parole Transfer Facility*     Aug-13 2,103   Texas did not renew due to a legislative budget reduction
Marion Adjustment Center Sep-13 826   Kentucky decided not to seek to renew contract
Lee Adjustment Center Jun-15 816   Vermont decided not to seek to renew contract
Leo Chesney Correctional Center Sep-15 240   Leased to GEO Group.  Contract not renewed
North Fork  Dec-15 2,400   Out-of State facility for California.  Re-let from July 2016

* No longer included on CXW's list of 'idled' facilities as a result of impairement that was completed in Q1'15

 

(4) Contracts are typically short duration 

  • CXW provides facility level disclosure quarterly, including details of contract counter-party and contract length.  A very large percentage of contracts expire over the next 2-3 years
    • >80% of CXW's 'managed only' contracts expire over the next 12 months
    • >75% of CXW's 'owned & operated' facilities contracts expire over the next 24 months   
  • Historically renewal rates have been high as populations grew & private populations grew disproportionately. This changed as prisoner populations started to decline (from 2009) as evidenced by the significant number of facilities that have been forced to idle (see above)  
  • If the structural decline thesis is correct the short duration contracts are the mechanism through which it get transmitted
  • Also note counterparties have the right to cancel contracts unilaterally before expiry in certain circumstances (e.g. failure to secure sufficient budget appropriations);

(5) This is a largely fixed cost business 

  • The nature of the business necessitates that fixed costs are high - e.g. the largest cost elements are labour (minimum staffing) and other non-variable costs
  • CXW's fixed costs (inc. depreciation) represent approximately 2/3 of revenues (the remainder is variable costs & profit)
  • The fixed cost base means operating leverage from lost revenue (declining utilization) is significant
    • Note: some of this has been offset to date as a result of mimimum guarantees contained in contracts.  This has offered CXW an element of margin protection to date however this cannot continue indefinitely if utilization does not improve (e.g. customers will either not renew contracts or renew them for smaller minimum guarantees)
  • In addition to the significant operating leverage CXW also has significant financial leverage - leverage has been increasing as a result of acquisitions & Dividends being > FCF (see (7) below for more details)

(6) There is no alternative use for the real estate

  • The nature of the assets mean there is no alternate use in the event they are empty
  • For example CXW has had facilities idle since 2008. They just sit there empty  
  • Any ‘real estate value underpinning the downside’ thesis seems unlikely

(7) Dividends exceed free cash flow

  • Since REIT conversion CXW has consistently paid higher dividends than actual FCF

 

  12 Mths 12 Mths 12 Mths 3 Mths Total Since REIT
(US$ Millions) 31-Dec-13 31-Dec-14 31-Dec-15 31-Mar-16 Conversion*
Operating Cash Flow $369.5 $423.6 $399.8 $120.3 $1,313.2
Working Capital ($42.1) ($70.6) ($0.1) ($26.2) ($139.1)
Normalized Operating Cash Flow $327.4 $352.9 $399.7 $94.1 $1,174.1
Investing Cash Flow exc. development & expansion capex ($61.3) ($111.1) ($86.0) ($4.6) ($263.1)
Development capex: Otay Mesa Detention Center# ($3.1) ($69.7) ($87.3) ($160.1)
Normalized Free Cash Flow b/f expansion capex $263.0 $172.1 $226.3 $89.4 $750.9
Acquisitions ($36.3) ($158.4) ($1.8) ($196.4)
Other development & expansion capex ($24.9) ($16.1) ($77.6) ($7.8) ($126.3)
Normalized Free Cash Flow $201.9 $156.1 ($9.6) $79.9 $428.2
           
Dividend Paid ($299.4) ($234.0) ($250.7) ($65.1) ($849.3)
           
Dividend Paid / Normalized FCF b/f expansion capex 113.8% 136.0% 110.8% 72.8% 113.1%
Dividend Paid / Normalized FCF 148.3% 150.0% n/m 81.5% 198.3%
           

# This expenditure is best thought of as maintenance capex.  Ownership of the San Diego Correctional Facility reverted to the County upon expiry of the ground lease in December 2015.  The Otay Mesa Detention Center is being constructed to replace the San Diego Correctional Facility and retain those prisoners (i.e. it's not an expansion).  Without this expenditure the cash flows from those prisoners would have disappeared.  CXW had not provisioned for this expenditure in its accounts and instead ran the expenditure through the investing cash flow line as 'expansion' capex. 

  • The company represents it's dividend relative to Funds From Operations (FFO) and Adjusted Funds From Operations (AFFO) but both of these numbers are inflated because 'maintenance' capex appears to be significantly understated
    • 'Maintenance' capex as presented in AFFO is 27% of depreciation of real estate assets (since REIT conversion)
    • 'Maintenance' capex as presented in AFFO is 29% of investing cash flow excluding development & expansion capex (since REIT conversion)
  • Adjusting AFFO for a more accurate representation of maintenance capex (i.e. depreciation) results in a dividend payout ratio of 111% since REIT conversion
    • Note: Since REIT conversion Investing Cash flow excluding development & expansion capex (i.e. cash capex) is broadly in-line with depreciation of real estate assets.  The difference between 'maintenance' capex as presented by the company and actual cash capex is ~$187 million
  12 Mths 12 Mths 12 Mths 3 Mths Total Since REIT
(US$ Millions) 31-Dec-13 31-Dec-14 31-Dec-15 31-Mar-16 Conversion*
Net Income $300.8 $195.0 $221.9 $46.3 $746.0
Depreciation of real estate assets $81.3 $85.6 $90.2 $23.3 $280.4
Other adjustments# ($87.4) $30.0 $5.3 $1.1 ($51.0)
Funds From Operations (FFO) $294.7 $310.5 $317.3 $70.8 $993.4
Maintenance capex ($21.0) ($25.5) ($26.6) ($3.4) ($76.4)
Stock based compensation $12.9 $14.0 $15.4 $3.8 $46.1
Amortization of debt costs & non-cash interest $3.5 $3.0 $2.9 $0.8 $10.2
Adjusted Funds From Operations (AFFO) $290.2 $302.1 $309.0 $72.0 $973.3
Capex Adjusted AFFO^  $229.9 $242.0 $245.4 $52.1 $768.5
           
Investing Cash Flow exc. development & expansion capex ($61.3) ($111.1) ($86.0) ($4.6) ($263.1)
Dividends Paid ($299.4) ($234.0) ($250.7) ($65.1) ($849.3)
           
Maintenance Capex / Depreciation of real estate assets 25.8% 29.8% 29.5% 14.4% 27.3%
Maintenance Capex / Investing Cash Flow exc. D&E capex 34.3% 22.9% 30.9% 72.2% 29.0%
           
Dividends Paid / AFFO 103.2% 77.5% 81.1% 90.4% 87.3%
Dividends / Adjusted AFFO 130.3% 96.7% 102.1% 125.2% 110.5%

# Impairment of real estate assets, extraordinary items, goodwill impairments, tax benefit from reversal of deferred tax
^ Represents AFFO + maintenance capex - depreciation of real estate assets

 

(8) CXW has given counterparties a number of options to purchase facilities at or below book value 

  • CXW currently trades at ~2.8x Price to Book Value
  • ~20% of Book Value is represented by facilities where value should be capped at or around book value, which implies the residual ~80% of BV is trading at very high premium
  • Specifically, the facilities that should be capped at or around Book Value:  
    • (i) Facilities that automatically revert to counterparties at the end of the lease (1 facility, 1,500 beds, $18m revenue; $1m book value) 
    • (ii) Facilities where counter-parties have the option to acquire the facility at or below book value (7 facilities, 11,336 beds, $368m book value); and 
    • (iii) Facilities that are currently idle (9 Facilities, 9,547 beds, $108m Book Value); 
The Company's 10-K has details of each of facilities above. 


 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

  • Continued operational deterioration
  • Dividend Cut
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