Description
Trading at 9.2X EBITDA vs. comps of 12-13X EBITDA, growing EBITDA 10-15% annually, CCA should be a $63-71 stock in 18 months. With average daily trading volumes exceeding 160,000 shares (and options) you can put real money to work here.
Corrections Corporation of America (CCA) is the largest private provider of correctional and detention facilities in the United States. In terms of size, they are second only to the federal government and four states. CCA operates a total of 64 facilities with a design capacity of approximately 65,000 beds. The company owns and manages 38 of these facilities and manages but does not own 26 facilities. The facilities are strategically located throughout the United States in 20 states and the District of Columbia.
History:
Many of you may remember CCA when their debt, preferred and equity were trading at distressed prices - and for good reason. The concept of for-profit prisons did not catch on as fast as CCA built prisons.
The idea behind private vs. public prisons is two-fold. First, there is the economic argument that the private sector is simply more efficient at most things and that costs could be reduced by having governments outsource at least a portion of their inmate populations. The general belief is that private prisons offer a savings of 10-25%. The second argument is that when governments are running deficits it is politically difficult to justify spending millions to build new prisons. It would appear then, that private prisons are a no-brainer from the government’s perspective, considering lower per day costs to house a growing inmate population, no upfront building costs, and the “Not in My Back Yard” complexity of building a prison.
Great idea, makes obvious economic sense, so what went wrong? While private prisons make perfect economic sense, socially the industry itself was attacked as just another injustice to the poor people that found themselves behind bars. In other words, it just isn’t right to allow a company to profit because someone made a mistake and is now in prison. Yes, believe it or not, there are people who think like that and unfortunately for the industry they have big mouths. Over time, these critics have (for the most part) been silenced, given CCA’s exemplary operation of their prisons.
What critics of private prisons managed to do was to slow the rate of growth of companies like CCA. The historical problem for CCA was that they saw this huge market potential, built prisons, and then were forced to endure years of critical bashing that slowed the acceptance of their product and limited the number of states that would allow outsourcing. With significant leverage and fewer beds filled than projected, the company suffered.
Fast Forward to 2004:
What industry do you know that can operate at over 100% of design capacity and does so consistently? You guessed it: prisons. During a recent speech, the Director of the Federal Bureau of Prisons, Harley Lappin stated, “The rapid growth of the inmate population has led to system-wide crowding of 37% above the rated capacity, with the most severe crowding at medium security and high security institutions (which are 60% and 53% above capacity, respectively).”
FYI, there are currently well over 2,000,000 people behind bars in the United States today and private prisons account for less than 5% of those beds.
With overcrowding at public prisons at levels never before seen, public prisons are being forced to outsource prisoners or face releasing dangerous criminals as courts deem overcrowding inhumane and against prisoners’ human rights. Given that CCA has a near-perfect record on the safe and humane treatment of prisoners, it is no surprise that their Average Compensated Occupancy increased from 90.9% at the end of 2002 to 95.4% at the end of 2003. Over this same period of time, Revenue per Compensated Man Days increased from $50.13 per day to $51.07 per day with operating margins expanding from 24.1% to 26.2%. Increasing occupancy, increasing margins: this is a company and an industry that is poised for significant growth in 2004 and beyond.
The Numbers:
I am going to make the argument that CCA should be looked at no differently than a REIT. In fact, the reason CCA doesn’t convert to a REIT is that they see so much growth opportunity that they think (and I agree) that they are better off using their significant free cash flow to reduce debt (which they have done) and expand some of their existing prisons than to be forced to dividend out the cash at this time.
CCA’s 4th Quarter EBITDA of $58MM is an annualized $232MM and their 4th Quarter FFO (for REIT analysis fans) of $39MM is an annualized $156MM. CCA now trades at 9.2X EBITDA and only 7.9X FFO.
Correctional Properties Trust, a 14 facility, 8,008 bed REIT, trades at 12X EBITDA and 14X FFO. CPT has more limited growth prospects than CCA as they only own and lease prisons but do not operate them. CCA has the benefit of being able to expand EBITDA and FFO through the management of prisons that are currently publicly managed. In December 2003, for example, CCA won 7 contracts to manage 8,315 beds for the state of Texas. During this same competitive bid process, CCA lost 1 contract for a net add of 6,314 beds, whose contracts began on January 15, 2004. (None of the incremental EBITDA from these contracts is in my annualized EBITDA or FFO numbers.)
The entire REIT universe trades at an average FFO multiple of 13.6X 2003 FFO and 13.1X 2004 projected FFO. (Real Estate Weekly) CCA’s fair value, assuming no growth in EBITDA (almost impossible given all the contracts they have recently won), using CPT’s multiples of 12X EBITDA and 14X FFO on CCA’s annual run rate EBITDA and FFO gets you to a current share price of $53.5 and $62.3 per share, respectively. This analysis assumes multiple expansion, but no increase in run rate EBITDA or FFO.
CCA is obviously cheap when compared to REITs, but what is CCA worth assuming no multiple expansion, looking at just their growth prospects? The great thing about this company (and industry) is that not only is the overall prison population exploding, but the shift is clearly towards outsourcing the growing populations to companies like CCA, which are already approaching (if not at) design capacity.
CCA has about 6,000 empty beds. The way the industry works is that you could have a facility that is at 120% of capacity and a facility that is empty. The beauty of this is that you can fill up the empty prison with new contracts while keeping occupancy above 100% at the other facilities. A smaller CCA competitor, Geo Group (ticker GGI) increased their average occupancy in 2003 vs. 2002 from 97% to 100%, and is now also looking to exceed 100% occupancy in 2004.
The industry rule of thumb, according to Lehman analyst Jeffrey Kessler, is that 1,000 beds is worth about $6MM in incremental EBITDA. This means that CCA could grow the business by 36MM in EBITDA (6,000 beds at $6MM EBITDA per 1,000) before incurring any additional CapX. Assuming current multiples of 9.2X EBITDA, $36MM of additional EBITDA would be worth $331MM or almost $9.5 per share getting you to a share price of around $45. It will probably take 6-12 months for CCA to fill its remaining 6,000 empty beds. A few of CCA’s recent announcements:
January 5th: CCA announces a contract with the state of Vermont for up to 700 Vermont inmates. (These inmates are not going to be located in Vermont, or even in New England, but rather in space CCA has available in two prisons located in Kentucky). If you have a hotel in Vermont that is at 100% of capacity and one in Kentucky that is empty there isn’t much you can do about it. Given that a CCA customer (inmate) stays considerably longer at one of their “facilities” than a Marriott customer stays at a hotel, CCA’s empty beds even a thousand or more miles away from a state or agency needing capacity, can be profitably utilized.
March 5th: CCA announces a contract with the state of Arizona for up to 1,200 inmates. This time the lucky inmates will be traveling to CCA’s deluxe accommodations in Watonga, Oklahoma. This same facility currently houses prisoners from the states of Wisconsin and Hawaii.
Given the two announced contracts above, which total 1,900 beds, CCA has already filled over 30% of their empty beds in just two months!!!
To get a sense of the contracts that CCA will be bidding on in the near future, listen to both CCA’s and GGI’s latest conference calls. CCA tends to be very conservative and tight-lipped about what they are bidding on and growth prospects. GGI’s call is actually more informative about who, what and where is coming up for bid over the next 12 months. Given that it takes years to build a new prison and CCA’s competitors are at or approaching capacity, CCA (in the near term anyway) is in some cases the only alternative. This is why I am confident that CCA will be able to fill its 6,000 beds by the end of this year. Even if it takes them 2 years, CCA is cheap.
Filling CCA’s 6,000 empty beds is not the only way CCA will increase EBITDA in 2004. As mentioned above, they have already begun managing a net 6,314 additional prisoners for the State of Texas starting January 15, 2004. Obviously, none of the incremental EBITDA from these contracts is in CCA’s run rate EBITDA based off of 4th quarter 2003 results. There is no way to calculate the profitability of these contracts. CCA, for obvious competitive reasons, does not break down the profitability of their individual contracts. Assuming a ridiculously low profitability margin of just $1MM of incremental EBITDA per 1,000 additional prisoners gets you an additional $6.3MM. Assuming CCA’s current multiple of 9.2X EBITDA on $6.3MM of EBITDA gets you an additional value of $1.65 per share. If these contracts provide 50% of the profitability of Lehman’s assumed $6MM of EBITDA per 1,000 owned/managed beds, you get incremental value $5.00 per share. CCA has many more of these types of contracts (which require no CapX) that they are currently bidding on.
Financial Summary:
CCA’s 4th quarter annualized run rate EBITDA is $232MM. Realistically, they will add between $18MM and $36MM in 2004 from filling existing empty beds. I assume the company will hold their Revenue per Compensated Man-Day flat, even though they clearly have the pricing power to increase the margin, given their high level of occupancy and high level of demand for additional beds from their customers. CCA will also add EBITDA through managed contracts. In addition to the large Texas contract which has begun, CCA will clearly be the front runner for additional such contracts to be awarded later this year. EBITDA from managed but not owned facilities could add an additional $6-15MM in EBITDA to CCA this year and possibly double that for 2005 when they get the full EBITDA impact from contracts awarded this year.
CCA is clearly a growth story and, as such, should be awarded a growth like multiple of EBITDA, which it is currently not receiving. Over the next 12 months I would expect multiple expansion to at least 12X EBITDA. None of the calculations in this report take into account the significant growth in EBITDA that will result from added capacity which CCA has announced they will add opportunistically (mostly by way of additional beds to existing facilities) as they reach full capacity.
The way I look at this story is that growth in EBITDA in 2004 and 2005 will come from filling the 6,000 empty beds and additional managed contracts. Beyond 2005 EBITDA growth will come from capacity expansions (requiring CapX), managed contracts and possibly from fatter margins.
Stock Price Valuation:
Multiple expansion with no increase in EBITDA
$232MM EBITDA at 10X EBITDA = $40.5 per share
$232MM EBITDA at 11X EBITDA = $47 per share
$232MM EBITDA at 12X EBITDA = $53.6 per share
Increase in EBITDA with no multiple expansion
Low Case
$256MM EBITDA at 9.2X EBITDA = $41.4 per share
High Case
$283MM EBITDA at 9.2X EBITDA = $48.5 per share
Multiple expansion and increase in EBITDA
Low Case
$256MM EBITDA at 10X EBITDA = $47.2 per share
$256MM EBITDA at 11X EBITDA = $54.5 per share
$256MM EBITDA at 12X EBITDA = $61.8 per share
High Case
$283MM EBITDA at 10X EBITDA = $54.93 per share
$283MM EBITDA at 11X EBITDA = $63 per share
$283MM EBITDA at 12 X EBITDA - $71 per share
Base Case Returns:
I think the company will conservatively be able to hit the High Case 2004 EBITDA of $283MM for the full year 2005 and that multiples should expand to 11-12X EBITDA providing for a share price of $63-71 within 18 months.
Growth Prospects:
1. Filling existing beds
2. Managed Contracts
3. Organic growth which requires CapX (huge opportunity which I intentionally ignored but which will provide added growth of EBITDA in 2005 and beyond)
Holders:
Fidelity owns 9.55%, Courage Capital Management owns 2.6%, AW Asset Management owns 2.1% and Loeb Arbitrage owns 1.9%. No surprise, but all of these investors reported recently adding to their already significant holdings.
Down-side protection:
Unlike almost every other company/industry where there is real downside if another 9/11 were to occur, CCA should (for obvious reasons) be almost completely unaffected. The company is actually bidding on contracts for “detainees” as the result of improved security in the United States.
Home Run Scenario:
There has been speculation that CCA is ripe for a private market take-out. While there is no way to handicap such a transaction, solely for comparative purposes it is interesting to note that on Friday March 5th Blackstone announced the acquisition of Extended Stay America (a depressed hotel chain) for an estimated 11.9X 2005 projected EBITDA. Using the same multiple on CCA’s run rate EBITDA of $232MM and my projections of no less than $283MM in 2005 EBITDA gets you to a share price of $53 and $70 per share, respectively. Given that CCA is clearly in a better position than ESA to grow EBITDA, I would argue that if CCA were actually to be sold it would command an even higher multiple of EBITDA.
Catalysts:
Significant EBITDA growth from announced and future contract awards
At capacity pricing power to expand margins further
Multiple expansion from historical and projected growth in earnings
Improved analyst coverage (very little currently)
Reduced interest expense as high cost debt is refinanced
Large state and federal deficits preventing the building of public prisons
The further acceptance of private prisons which are not currently utilized by all states
Rapid growth in the overall prison population
Catalyst
Significant EBITDA growth from announced and future contract awards
At capacity pricing power to expand margins further
Multiple expansion from historical and projected growth in earnings
Improved analyst coverage (very little currently)
Reduced interest expense as high cost debt is refinanced
Large state and federal deficits preventing the building of public prisons
The further acceptance of private prisons which are not currently utilized by all states
Rapid growth in the overall prison population