- Though the firm is the US' largest owner/operator of privatized correctional facilities, Corrections Corp's business is centered on real estate.
- The firm recently filed to become a REIT. In doing so, it raised its distribution significantly.
- We still believe the firm has strong dividend coverage. Let's have a look.
History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. This makes a lot of sense, as the strongest dividend growers are often the strongest generators of increasing cash flow. Corrections Corporation of America (NYSE:CXW) just raised its dividend in a big way after registering to become a REIT. But will its distribution keep growing? Let's have a look.
Let's first start with framing this analysis for new readers. Most dividend assessments tend to be backward-looking -- meaning the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Please don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30, or more years isn't much to write home about.
Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream, nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.
Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?
With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Dividend Cushion methodology. You have to read about the empirical performance of the Dividend Cushion here.
For those that may not be familiar with our boutique research firm, we generate a discounted cash flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments, and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.
The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based and driven from items taken directly off the financial statements. Let's take a look at Corrections Corp's investment highlights and then its dividend report to see how all of the analysis comes together.
Corrections Corporation's Investment Considerations
- Corrections Corp is the US' largest owner/operator of privatized correctional and detention facilities. It controls 40%+ of all private prison beds in the US. Unlike its consulting firm peers, the company's high fixed cost model is exposed to fluctuating occupancy levels.
- Governments continue to face rising inmate populations and overcrowded conditions, and the firm's inventory of beds positions it well to provide customers with immediate space. New prison construction by local, state, and federal agencies has generally been limited in recent years.
- Corrections Corp has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 21.7% in coming years. Total debt-to-EBITDA was 3.2 last year, while debt-to-book capitalization stood at 44.5%.
- Real estate is the core of its business, with the book value of land and buildings representing ~97% of fixed assets, including 14+ million sq/ft in 50+ owned facilities. Its facilities generate ~94% of net operating income. Revenue comes from the local, state, and federal level, and CCA enjoys a 90% contract renewal
- Corrections Corp has elected REIT status effective January 2013. The company's distribution has increased significantly. We expect continued growth in the distribution, but investors should be cognizant that it is now heavily dependent on the capital markets for funding (should exogenous events occur).
Corrections Corp's Distribution Report
Corrections Corp's distribution is nice, offering a ~6%+ annual payout at current price levels. The bottom right of the table below reveals our expectations for the firm's future pace of distribution expansion (~5% per annum). Please have a look.
Note: Corrections Corporation paid a $6.63 special dividend in 2013, which accounts for the somewhat lumpy track record thus far.
Let's now dig into Corrections Corp's qualitative ratings for dividend safety, dividend growth potential and risk of capital loss. The Dividend Cushion ratio not only informs our opinion of the safety of the dividend, but also its capacity for future growth. It tells us just how much excess cash flow the company will generate in covering the dividend, after considering the balance sheet.
Dividend Safety/Cushion -- GOOD/1.3
Corrections Corp scores a 1.3 on our Dividend Cushion™, which is GOOD. We assess the safety of a firm's dividend by adding the company's net cash (total cash less total debt) to our forecast of its free cash flows (cash from operations less capital expenditures) over the next five years. We then divide that sum by the total expected cash dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flows, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the ratio, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall.
Dividend Growth Potential -- EXCELLENT
We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track record. Corrections Corp registers an EXCELLENT rating on our scale, and we think the firm's annual dividend will be $2.48 per share within the next several years (by the end of fiscal 2018). This forecast is driven by our expectation of the dividend to expand at a ~5% compound annual growth rate. But why 5%?
Well, typically, we assign the actual dividend growth rates to firms on the basis of their qualitative Dividend Growth rating. For example, Corrections Corp has EXCELLENT dividend growth potential, which would put our estimate of the rate of future dividend growth in the high-single-digits. The scale we use is shown below.
Dividend Growth Potential Scale
Excellent: 8% or higher
Very Poor: 0%-2%
However, in this case, the firm has just made its transition to a REIT, and it has yet to define the growth trajectory. As a result, our best estimate is that the distribution will grow at a rate of ~5% (excluding currency fluctuations) -- more appropriately within the GOOD range. For all of the firms in our coverage, we evaluate recent growth rates and/or the dividend payout ratio to fine-tune the trajectory of the forecasts. For those interested in dividend growth forecasts for other companies, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe.
Risk of Capital Loss -- Medium
We assess the risk of capital loss based on our analysis of a firm's intrinsic value at this point in time. If the stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (excluding dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (excluding dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (ex dividends) is HIGH. Corrections Corp registers a score of MEDIUM on our scale. Though we generally prefer firms that are underpriced or have a LOW risk of capital loss, in this market environment, very few dividend growth firms are in this situation.
Wrapping It Up
We like Corrections Corp's distribution growth potential, and the firm pays a hefty 6%+ yield. We don't currently hold the company in the Dividend Growth portfolio, but we have plans to add it to the top 100 dividend growers report, the Dividend100. In any case, Corrections Corp's distribution growth potential is strong. Thanks for reading!
Note: For valuation purposes, dividends and distributions are interchangeable (both are accounted for in the cash from financing section of the cash flow statement). For tax purposes on the individual level, there are significant differences between the two. The following provides the definitions of the terms you may have read in the dividend report (image) above.