Favorable Demand and Supply Dynamics Make This Stock Attractive

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Corrections Corporation of America (NYSE: CXW), one of the biggest domestic owners of partnership correction and detention facilities and prison operators, was converted to a REIT in January 2013.

Favorable demand-supply dynamics

Many of the federal and state prisons are overcrowded. According to 2011 data released by the Bureau of Justice , close to half of state prisons were operating above full capacity, while federal prisons ran at 138% of capacity. A recent presentation by the Federal Bureau of Prisons in April 2013 indicated that it is operating at 37% above capacity on average, with the problem even more serious at high security facilities, which are running at about 154% of capacity.

The Federal Bureau of Prisons also forecasted an addition of more than 5,000 inmates in 2013 and 2014, which represents a significant jump from an increase of close to 1,000 inmates in 2012.

Why private operators are the solution

There are basically two solutions to the overcrowding problem at federal and state prisons. The first method will be to increase the capacity of existing public prisons or build new ones. But this is not the best solution for a few reasons.

Firstly, with unfunded pension liabilities growing, there are competing public infrastructure needs for a limited amount of public funds. Secondly, the “not in my backyard” mentality puts a cap on the availability of sites for new prison construction. Last but not least, public prisons are not as cost efficient as their private counterparts, with unionized labor being a key contributor to higher costs.

The more viable alternative is to meet increased demand for available beds with private operators. According to a study done by Temple University in April 2013, private operators like Corrections Corporation of America offer cost savings ranging from 12% to 58%. The study showed that private prisons offer similar quality to their public counterparts at lower costs, with quality measured by the higher percentage of accreditation by the American Correctional Association for private prisons.

Asset quality and diversified customer base provide downside protection

Of the 67 facilities it operates, Corrections Corporation of America owns 51 of them, covering 14 million square feet with a capacity of close to 68,000 beds. There are two key indicators of the quality of any asset portfolio: the age of the assets and the maintenance capital expenditures needed.

According to its most recent earnings conference call, Corrections Corporation of America’s owned properties have a median age of 16 years and maintainence capital expenditure is reasonable at about 5% of net operating income. Also, as mentioned above, the “not in my backyard” mentality makes it difficult to get the necessary permitting and zoning approvals to build new prisons. This further enhances the value of Corrections Corporation of America’s assets, given the limited new supply of similar assets in the market. 

Government contractors that do business solely with federal agencies are exposed to greater risk, as one single rule change could impact their business negatively. Corrections Corporation of America’s customer base is diversified among various federal and states agencies, with individual states accounting for about 40% of revenues in total. In addition, the tenure of its contracts typically ranges from one to five years, providing stability to its revenue streams.

Peer comparison

Corrections Corporation of America’s peers include specialty REITs Geo Group (NYSE: GEO) and American Tower (NYSE: AMT).

Geo Group is the closest comparable for Corrections Corporation of America, being one of the largest providers of correctional, detention, and community reentry services to government agencies globally. While some investors might like Geo Group for its geographical diversity with operations in Australia, South Africa, and the U.K., Geo Group is not a pure proxy for the favorable demand-supply dynamics in the U.S. prison sector like Corrections Corporation of America.

While both offer attractive dividend yields above 5%, I prefer Corrections Corporation of America over Geo Group for its stronger balance sheet and domestic focus. In addition, Corrections Corporation of America is valued at a discount to Geo Group with a lower forward P/E of 16.5, compared with Geo Group which is trading at 19.3 times forward P/E.

American Tower, an owner and operator of wireless and broadcast communications sites globally, converted itself into a REIT in December 2011. Similar to Corrections Corporation of America, its assets are protected by strong regulatory barriers to entry, given the time and effort required to obtain approval from the Federal Communications Commission and the Federal Aviation Administration to build new towers. American Tower also enjoys stable recurring revenues from its long term contracts running with an initial term of five to ten years.

Despite this, I am negative on American Tower, given its high customer concentration and high gearing. American Tower has a gearing of 234% and more than 50% of its revenues are generated from its top five customers.

Conclusion

Corrections Corporation of America is a beneficiary of the trend of federal and state prisons turning to private operators to tackle the overcrowding problem at public prisons. Its strong asset quality and diversified customer base limits the downside risk. In addition, It sports an attractive dividend yield of 5.6%, making it a buy in my books.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends American Tower and Corrections of America. The Motley Fool owns shares of American Tower . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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