The Profit of Prison
Norman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The privatized prison industry has garnered more mainstream awareness recently amongst investors as a result of increased media coverage and CNBC specials. This article digs deeper into the financials by focusing on fundamental analysis. While there are a number of players in the industry such as the Geo Group (NYSE: GEO) and the private Management and Training Corp, this research and analysis focuses on the industry leader, the Corrections Corporation of America (NYSE: CXW). CCA and CXW are used interchangeably throughout this article.
The Corrections Corp of America has some very interesting merits and strengths including their position as market leader within the privatized prison space, steady operating margin expansion in their most profitable segment, and the potential conversion to a taxable REIT subsidiary (TRS). I valued CXW at $25.33/share to $27.02/share using both perpetuity growth and EBITDA multiple methods. This valuation represents a roughly 10% downside to the current market price of $29.74/share. However this intrinsic valuation does not factor in the potential upside of the taxable REIT subsidiary (TRS) structure if the conversion follows through. At current levels, the market price per share does not allow for a margin of safety.
- Market leader with brand name recognition within the industry
- Operating margin expansion within the managed and owned segment
- Potential for REIT structure to unlock trapped value
- Occupancy and inmate population decline
- Legislation such as Fair Sentencing Act can reduce inmate sentences
- Contract renewal and re-bid win-rates
- State and federal budget reductions
The privately operated prison industry caters toward state, federal, and local authorities that seek to outsource either the management or also the housing of their inmates. Federal inmates originate from one of three major sources: The Bureau of Justice (BOJ), the US Marshal Service (USMS), or US Immigration and Customs Enforcement (ICE). Inmates are not necessarily incarcerated in a facility in their respective state and may be imprisoned in a different geographic region. For example, Hawaii has prisoners incarcerated at a facility owned and managed by CCA in Arizona. Some industry drivers are government budgets, legislation impacting term lengths for offenses, and the state of the economy.
Metrics that are relevant to companies within the industry are per-diem rates, bed counts, and occupancy rates. From a real-estate perspective, the cap rate is another important metric to consider. When a company bids for a contract with the government, per-diem rates per inmate are defined in the contract. For example, the CCA has an average per diem rate of $58.48 per man-day. The per-diem can be thought of as revenue per inmate per day. Contract terms can vary greatly across government authorities but most are between 1 and 5 years. The most favorable contract terms are those with “take-or-pay” clauses or those that guarantee the private prison a specified occupancy rate. Other contract terms may include giving the state the option to purchase the facility at either book value, fair market value, or present value of the remaining lease payments. Capacity in prisons is measured using a count of the number of beds. Occupancy can be calculated as the percentage of beds filled. Given the high fixed costs of an owned and managed facility, companies seek to maximize their occupancy rates to spread the fixed costs.
There are roughly 2.3 million inmates in the United States at any given time. While the number of incarcerated individuals has steadily grown over the past decade, recent trends indicate a decline in overall incarcerated inmates including 1.1% and 0.7% declines in 2010 and 2009, respectively.
A variety of factors are behind this recent decline including constraints in federal and state budgets, early release programs to alleviate crowding, and legislation to reduce term lengths of certain offenses such as crack and powder cocaine. Recidivism within 3 years amongst released inmates is 67.5% however, suggesting that declines in one annual period don’t necessarily presage a secular trend as released inmates may return to the prison system within a few years.
Privately operated facilities have grown as well, reaching a peak of roughly 129,000 inmates, or nearly 6% of the US inmate population. However, like the overall US inmate population, inmates in privately operated facilities have trended down recently.
CCA is the largest privatized prison operator in the US with 45% market share of the private prison market. CCA has a total of 66 correctional facilities under its operations with a total capacity of 91,000 beds. 735 or 4.4% of their 16,750 employees are unionized.
The business is segmented two ways: 1) Owned and managed and 2) Managed Only. Roughly 70% or 46 of its facilities are owned and managed and the remaining 30% or 20 facilities are managed only. Owned and managed facilities command both a higher per-diem rate and offer greater operating margins. Additionally it is less competitive than the managed only segment. However, the owned and managed segment requires significantly greater capital expenditure outlays due to the initial upfront CapEx to construct a facility and the ongoing maintenance CapEx for facility upkeep. Thus this segment is considered riskier than the Managed Only segment. The Owned and Managed segment has had both per-diem and margin expansion. In contrast, the Managed Only segment has had per-diem rates steadily increase but the operating margins have steadily eroded since 2004.
CCA management has given guidance in their most recent earnings call that they are no longer pursuing speculative build opportunities and instead pursuing build-to-suit opportunities. This reduction in spec building has led management to give guidance of $80-90M CapEx for the year. In the financial model, $90M is used as the CapEx and $115M for D&A for FY2012.
CCA has significant concentrations of their revenue in 4 select customers. Federal customers comprise 43% of their revenue and the California CDCR account has grown significantly from when they first signed on in 2006.
This concentration of revenue from 4 key customers is a significant risk to consider. For example, the state of California’s CDCR is set to reduce their inmate population to 137.5% of its current capacity or 110,000 inmates from 132,750 inmates. CCA has 9,300 inmates housed in California.
Recently, CCA announced a $0.20/share quarterly dividend in February 2012. CCA had a share repurchase program but only a fraction of the allocation could be used for share repurchases due to debt covenant restrictions. Ultimately, management ended the share repurchase program in February 2012.
Lastly on the most recent quarterly earnings call, CCA management announced that they were looking into possible restructuring as a REIT. This effort looks to be serious as management indicated that they have retained advisors like JPMorgan since 2011-Q4. Restructuring as a REIT would be a significant catalyst for the stock. The current 38% effective tax rate would effectively be eliminated under a REIT structure and the higher margin “Owned and Managed” segment could be separated from the “Managed Only” segment.
Using DCF analysis via the perpetuity growth method and EBITDA multiple method I valued CXW at $25.33/share to $27.02/share. At these intrinsic valuation levels, CXW is slightly overvalued by the market given that it trades at $29.74/share at the time of writing. I do not believe however that the market has priced in the possibility of the REIT structure conversion into the share price. The valuation of CXW with a taxable REIT subsidiary is beyond the scope of this article.
The DCF valuation relies upon several assumptions. The annual sales growth rate of 2.1% is a growth rate derived from Q1-2012 revenue results. SG&A as a percentage of sales is held constant at 5.2%. Management guidance for SG&A as a percent of sales was 5% on their earnings calls. The depreciation and amortization (D&A) expense of $115M is based upon management guidance given during the Q4-2011 and Q1-2012 earnings calls. Interest expense is forecasted to decline per the debt/interest schedule on pg. 68 of the 2011 10-K while bearing in mind the effective interest rate of 5.3% and average maturity of 4.7 years as a result of the debt refinancing in January 2012. The effective tax rate is held at 38% based upon management guidance and the CapEx is $90M for 2012, also based upon management guidance and the strategic direction to discontinue pursuing spec-build opportunities. These assumptions lead the model to forecast annual EPS at $1.61 for 2012, at the upper end of management’s expectations of $1.53 to $1.61/share.
DCF Sensitivity Analysis
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