Conversion to REIT Status Could Mean Big Gains for This Little Known Stock

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Real estate investment trusts (REITs) have delivered strong gains recently as investors have been attracted to income producing assets while interest rates remain pegged near zero. Furthermore, many companies have joined the rush by applying for REIT status, although the IRS has become more scrupulous of this practice. Here, we’ll review four companies that have successfully or unsuccessfully made the switch and highlight the one which appears to be the best investment now.

How REITs work

In order to convert to a REIT, an applicant must satisfy two criteria: it must derive 75% of revenue from rent or real-estate investment income, and it must pay 90% of profits to shareholders as dividends. In return the company receives generous tax incentives and a lower cost of debt because REITs are considered to have lower credit risk. Thus, the converting company gets a double boost in efficiency increasing its earning power.

American Tower (NYSE: AMT) is one of the largest REIT conversions in the past several years. The company converted to REIT status in December 2011 and earned a return of 16.92% in 2011 and 33.09% in 2012, substantially outperforming the S&P 500 before and after the REIT conversion was publically known. Furthermore, American Tower already traded at a premium valuation of over 50 times trailing earnings at the end of 2011, but as profitability expanded the stock price appreciated.

One less successful attempt to convert to REIT status was undertaken by Iron Mountain (NYSE: IRM) and its share price was pummeled as a result.  The IRS has become more scrupulous in verifying applicants to dissuade companies from taking advantage of the tax code. Boston based Iron Mountain is a leader in information protection, providing shredding services, data recovery and storage for its mostly corporate client base.  In June of 2012, an application for REIT status caused significant expansion of Iron Mountain's valuation from 1.7 times trailing revenue in May 2012 to 2.3 times one year later while the share price more than doubled.  Due to the IRS inquiry the share price has fallen over 25% and interestingly the price to sales multiple has returned its valuation before the application. This demonstrates how highly the market values REIT status both from how high Iron Mountain's shares flew on news of the application and how far they have fallen since. 

Corrections Corporation of America (NYSE: CXW) is a compelling investment opportunity after their recent conversion to REIT status, which was completed around January. This investment isn’t going to give you a warm and fuzzy feeling; Corrections Corp. operates 67 detention and correctional facilities in over 20 states as well as the District of Columbia. However, if privatized prisons do not appeal to your sensibility, consider the durability of the business model. Given current prison overcrowding space is at a premium, furthermore, state and federal government have become more interested in utilizing the efficiency of the private sector to keep costs under control. The Geo Group (NYSE: GEO) is also a prison operator and gives a good sense of comparison within the industry.

The table below demonstrates just how cheap CCA is relative to the average REIT.  The trailing earnings and PEG ratios for GEO and CCA show both stocks are underpriced relative to the S&P 500.  The price/sales multiple shows that they both are very cheap relative to the average REIT, although margins are somewhat lower.  Furthermore, both companies have significantly greater expected future growth and past growth compared to the average REIT, with CCA having superior margins and ROE.

<img alt="" src="http://g.fool.com/editorial/images/49913/figure-1_large.png" />

Why further upside may be in store for Corrections Corporation of America

Further upside should be expected for CCA if the market has not yet fully discounted the increase in profitability that will accompany REIT status. While the stock has risen about 28% in the past twelve months a quick examination of CCA’s income statement reveals how significant the REIT conversion is.

<img alt="" src="http://g.fool.com/editorial/images/49913/figure-2_large.png" />

Income taxes will fall to nearly zero from $98 million, while the cost of debt for the company has declined substantially. In April 2013, two new debt issuances were completed for $675 million at an average rate of 4.375%.  Prior to the issuance, CCA was paying an effective interest rate of 6.70% ($75 million in interest expense on $1.112 billion in long-term debt). With 60% of its long-term debt at this lower rate, CCA will save 23% on its debt servicing costs . Therefore, the REIT conversion has lowered the cost of debt by $17 million per year while decreasing income taxes by $98 million per year, increasing the earnings power of the company by 71%.  Since the REIT application became public knowledge, CCA's price/sales multiple has expanded by 11% indicating that the significance of the REIT conversion may not yet be fully discounted.

The consensus earnings expectation for CCA is $2.01 per share for the upcoming 12 months. As shown above, when considering the effect of lower tax and debt costs and expecting flat revenue growth there appears to be substantial upside to the current analyst expectations. The top range of the company guidance is $2.16 per share, which also seems quite conservative.  Costs have risen and narrowing margins could be a concern, however, the company seems well situated to outperform expectations moving forward. 

The dividend will also be raised as a result of the REIT conversion. CCA is required to pay a minimum of 90% of its net income as dividends and Todd Mullenger stated on the most recent earnings call that $2.12 per share will be paid in dividends over the next year.  This corresponds to a 6.3% yield at the current market price and a 10% raise in the trailing dividend yield.

Conclusions

Over the past several months all income-producing assets have been under considerable pressure as the market has become concerned about the threat of rising interest rates. Correction Corporation of America has pulled back as well, however this most likely represents a buying opportunity.  Assuming fairly conservative earnings expectations of $2.20 per share CCA should have upside to $40 per share within the next 12 months by assigning the average multiple the company has received over the past 5 years.  If CCA receives a valuation even close to the average REIT the upside would be considerably greater.


Brendan O'Boyle is short CXW Jul-2013 $34 puts. 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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