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By Henry Hoffman

Prison Industry Overview

The US prison population continues to increase and that’s good news for private prison operators. Currently, one in every hundred Americans is behind bars, the highest rate in the world and trends in the court system point to more jail sentences for longer durations. In fact, two-thirds of released prisoners are rearrested for a new offense within three years. Unsurprisingly, government run prisons, which control 93% of prison space, are overcrowded. State prisons are already at 97% of their highest capacity level and the federal system is at 137% of capacity. Demand for prison beds is increasing at a rate of 24,000 beds annually and supply projections significantly lag - further tilting the imbalance. State budget concerns, considerable lead times to build new prisons and increasing costs to accommodate prisoners all beg for ways to meet the growing demand. The private industry seems to be both the short term and long term solutions. Immediate demand can be met with currently available beds at private operators while stable cash flows generated by these companies can self fund building for future capacity. This all suggests higher occupancy rates and strong growth for the private prison industry.

Private Prison Operators

Founded in 1983, Corrections Corp of America (NYSE:CXW) is the largest private prison owner and operator in the United States with 87,000 beds spread among 65 facilities, giving it 45% of the US private prison marketplace. The number two player is Geo (NYSE:GEO) (24% market share) which recently acquired Cornell (CRN) (8% market share) transforming the current oligopoly to an effective duopoly for private operators. Going forward, CXW and GEO will comprise 77% of the private prison market. With only two noteworthy private players in the market, there is incredible room for growth as the private prison system makes up only 9% of the $65 billion detention and corrections market in the US. This trend is nothing new though, as private beds have been growing at a 16.3% compounded annual growth rate since 1990.

The private prison industry operates in three business segments; an owned and managed model, a leased structure, and a managed only business. In the owned and managed segment the private company typically owns the land and building, whereas in the managed only business the private operator only manages the facilities for a government agency. The managed only structure is more competitive, leading to lower margins than the owned and managed business. While all private operators are moving towards the higher margin owned facility model, Corrections Corp is ahead of the curve. GEO and CRN are mostly managed operators, but CXW already has two thirds of its capacity in its owned business. Also, CXW is focused on the US versus GEO which has prisons around the world, adding local political risk and uncertainties to future revenues and margins. For these reasons, along with valuation, we believe Corrections Corp is the company to own.

Table 1: Valuation Multiples for Private Prison Operators

Price/

Price/

Price/

Price/

Price/

Price

Mkt Cap

2010 EBITDA

2011 EBITDA

2012 EBITDA

2010 EPS

2011 EPS

CXW

19.84

$2,257

5.6x

5.4x

4.9x

16.3x

15.5x

GEO

21.29

$1,041

5.5x

5.3x

4.2x

14.9x

13.4x

CRN

27.53

$411

5.3x

4.5x

4.3x

24.1x

16.1x

Corrections Corp of America

Corrections Corp of America has many advantages over publically owned and run facilities. The company’s average length of construction of new facilities is 1 to 3 years vs 3 to 7 years for government agencies. Furthermore, the average cost per bed for its largest competitor ranges from $80,000 to $250,000 versus costs of $55,000 to $65,000 for Corrections Corp and operating costs are as much as 15% less for the private operator. These factors all make CXW a leading choice to meet both current and future demand for prison beds.

CXW has a strong balance sheet with low leverage (2.9x Debt/EBITDA) and no near term debt maturities allowing it flexibility to grow profitably. The company also has a predictable revenue stream from multi-year contracts on inmates and resulting stable cash flows. Its higher margin owned and managed business has 35% EBITDA margins and accounts for 92% of total EBITDA compared to its managed only business which only has 15% EBITDA margins. Furthermore, the company has been able to effectively put cash flows to work; over the past few years it has generated 13-15% returns on invested capital, and continues to guide for such rates as a minimum unleveraged target return for new bed development going forward.

Generally, CXW lacks major near term catalysts to push shares higher and is primarily a long-term story for more patient investors. However, in the intermediate term, CXW has an inventory of available beds to soak up immediate demand. The company estimates that filling the existing bed inventory alone would add $0.47 of EPS annually. Additionally, the company still has $200M of buyback authorization which should provide support to shares while investors wait. Shares currently trades at 5x 2011 adjusted cash flows, which we believe offer substantial upside as the market is under pricing a market leader with many advantages over its publically run competitors in a secular growth industry.

Valuation:

Corrections Corp trades at 15.5x next year’s consensus earnings estimate, which we believe is cheap given the high revenue visibility and strong secular tailwinds for the industry. Furthermore, earnings are artificially depressed as depreciation is overstated considering a prison’s asset life of 75 years- due to the durability of steel and concrete, versus the 40 years used under GAAP. However, we believe cash flows are the best way to value the prison operators.

Running various scenarios through a discounted cash flow model we model a range of valuations. We use a discount rate of 7.5% over the next 10 years, a 13x terminal multiple on cash flows and subtract out net debt. On the low end we obtain a valuation of $18 if the company is unable to expand margins going forward and is incapable of growing revenues faster than GDP. In a more positive scenario, we arrive at a valuation of over $40 if the company continues to grow at a similar rate to the past 5 years and expands EBITDA margins to 25% over the next few years. We believe even more aggressive assumptions are well within reason given the current macro environment and managements focus on higher margin owned facilities segment.

Additionally, CXW’s assets offer downside protection. CXW has a young portfolio of owned facilities. By CXW estimates, each bed costs about $60,000 to replace. They currently own 61,149 beds giving its assets a replacement value of $3.7 billion. After subtracting $1.1B in net debt and awarding no value to the managed business, CXW’s replacement value of real estate assets is $22.80/share. At the government’s replacement cost of $165,000/bed on average, CXW’s real estate would be worth around $79/share.

Figure 1: Discount Cash Flow Model Assumptions and Results

Inputs:

30 Year Bond Rate

4.00%

Equity Risk Premium

3.50%

Discount Rate (Bond + Risk Prem.)

7.50%

Terminal Capitalization Rate

7.69%

Long-Term Growth Assumption

5.00%

Calculation:

NPV of Cash Flows

2,271

NPV of Terminal Value

3,484

Cash

47

Debt

(1,149)

NPV

4,654

Shares Outstanding

110.5

Output:

Intrinsic Value Per Share

$42.12

Current Stock Price

$20.00

(Overvalued)/Undervalued

$22.12

% overvalued/undervalued

111%

Disclosure: Author long CXW

Source: Corrections Corp. of America Can Help Right Your Portfolio