Why I'm Dipping My Toe In Beaten-Down Corrections Corporation Of America

| About: Corrections Corporation (CXW)

Summary

On August 18, 2016, the Department of Justice instructed the federal Bureau of Prisons to cease renewing contracts with private correctional facilities.

While the federal Bureau of Prisons accounts for 11% of revenue for Corrections Corporation of America, the stock is down 40% since DOJ's directive.

The Department of Homeland Security has announced that it is evaluating the use of private immigration detention centers by the U.S. Immigration and Customs Enforcement agency.

Due to the market's extreme reaction to the DOJ directive and differences between ICE's and BOP's use of private facilities, CXW presents an intriguing value proposition.

Elevator Pitch

Shares of Corrections Corporation of America (NYSE:CXW) have been pummeled in the wake of an August 18, 2016 Department of Justice (DOJ) memorandum instructing the federal Bureau of Prisons (BOP) to "decline to renew" or "substantially reduce" the scope of contracts with private operators of correctional facilities.

After running my intrinsic value formula, I believe CXW is significantly undervalued at this time, based strictly upon the content and immediate implications of the DOJ memo itself.

However, the Department of Homeland Security (DHS) has now also announced that it will be evaluating its use of private contractors like CXW for detention centers utilized by the U.S. Immigration and Customs Enforcement agency (ICE). The results of this evaluation are supposed to be issued by November 30, 2016 - well after Election Day on November 8, 2016. And presidential candidate Hillary Clinton is already on record as stating the she favors ceasing the use of private correctional and detention facilities. This is important because the cessation of use of private detention centers by ICE would have a much bigger impact on CXW revenues than the DOJ memo will. Therefore, whether to invest in CXW is largely a bet on the outcome of DHS's current evaluation.

Now that its share price appears to have stabilized somewhat, I have opened up a small position in CXW, as I believe its shares are highly undervalued, and I am aware of and willing to accept the risk of DHS's current evaluation. Anyone considering buying CXW at this time should be aware and willing to accept this risk.

Company Description

CXW is the nation's largest owner of privatized correctional and detention facilities, and is one of the largest prison operators in the United States. It has been operated as a real estate investment trust (REIT) since 2013. Its customers are typically federal, state, and local correctional and detention authorities. As of December 31, 2015, CXW owned or controlled 66 correctional and detention facilities nationwide, and managed an additional 11 facilities owned by governmental customers.

Thesis & Catalyst

In assessing the value of CXW, it is helpful to put the DOJ memo into context, by examining its implications and comparing them to the recent stock price movement. Again, the DOJ memo instructs BOP to "decline to renew" or "substantially reduce" the scope of contracts with private operators of correctional facilities as those contracts near their termination dates. This chart summarizes CXW's revenues on a percentage basis going back to 2013:

Year

% of revenue from federal customers

% of revenue from BOP

% of revenue from ICE

% of revenue from USMS

% of revenue from non-federal customers

2013

44%

13%

12%

19%

56%

2014

44%

13%

13%

17%

56%

2015

51%

11%

24%

16%

49%

Click to enlarge

And, this chart summarizes CXW's revenues on a dollar basis going back to 2013:

Year

Revenue from BOP ($USD mil)

Revenue from ICE ($USD mil)

Revenue from USMS ($USD mil)

Revenue from other sources ($USD mil)

Total revenue ($USD mil)

2013

220.22

203.28

321.86

948.64

1,694

2014

214.11

214.11

279.99

938.79

1,647

2015

197.23

430.32

286.88

878.57

1,793

Click to enlarge

So, CXW's revenue from BOP, on both a percentage and dollar basis, was already in decline. This is no surprise. As reflected in the DOJ memo itself, due to changes in federal sentencing guidelines, the federal prisoner population has fallen relatively quickly since 2012. Between 2012 and 2014, the federal prisoner population fell from 217,815 to 210,567 - a decline of 3.3%. For the sake of comparison, over this same time period, total state prisoner populations fell from 1,352,582 to 1,350,958 - a decline of only 0.1%.

While I, like most value investors, do not fully subscribe to the efficient market hypothesis, I do subscribe to Mohnish Pabrai's conclusion that markets are reasonably efficient most of the time. If that is the case, then the trend of declining federal prisoner populations should have already been factored into CXW's share price to some extent. Moreover, it is notable that revenue from BOP accounted for only 11% of CXW's total revenues in 2015.

For the sake of comparison, let us now look at what has happened to CXW's share price recently. On August 17, 2016, the day before the DOJ memo was issued, CXW closed at $27.22 on volume of 1.32 million shares. The day the memo was issued, August 18, CXW closed at $17.57 on volume of 39.9 million shares. After some further declines with a couple of minor rallies, as of the date I am writing this on September 15, 2016, CXW just closed at $16.20 - down 40% in the four weeks since the DOJ memo was issued. This is reflected in the following, rather ugly-looking chart:

Click to enlarge

The next section of this article will address the valuation of CXW more specifically. For the purposes of this section, however, I think it is safe to say that under most circumstances, an expected loss of 11% of revenue over the course of a couple of years does not justify an immediate 40% reduction in the share price of a company. Instead, the catastrophic drop in share price since the DOJ memo was issued suggests to me that Mr. Market is factoring the immediate loss of most federal contracts into the share price.

Therefore, the catalyst for this potential investment is that, if DHS ultimately determines that continued use of private detention facilities is appropriate, the share price of CXW should recover a significant percentage of the market capitalization it has lost since the DOJ memo was issued. If DHS ultimately determines that ICE should phase out use of private detention facilities, the share price of CXW will no doubt take a hit. However, because it appears that an immediate loss of a substantial percentage of all federal revenue is already factored into the share price, in the medium term, the decrease in share price may not be as large as one would expect. Notably, the DOJ memo was largely issued out of the blue, while DHS has announced its current evaluation of the use of private detention facilities. Therefore, in contrast to the DOJ memo's impact on BOP's use of private correctional facilities, the possibility of a substantial reduction in ICE's use of private detention facilities has already been factored into the share price. In the words of Mohnish Pabrai, this appears to be a potential "Heads I win, tails I don't lose much" type of scenario.

And, it is not necessarily a foregone conclusion that DHS will ultimately decide to end its use of all private detention centers, simply because DOJ instructed BOP to end its use of private correctional facilities. For one thing, as the previous revenue tables demonstrate, BOP's use of private correctional facilities had already been in decline, at the same time that ICE's use of private detention facilities increased significantly. Similarly, while approximately 16% of BOP's federal inmates are held in private correctional facilities, approximately 73% of ICE's detained immigrants are held in private detention centers. (Edwards, supra). While one could argue that the writing was already on the wall as to BOP, it would seem counter-intuitive for DHS and ICE to abruptly end use of private detention facilities, when such a large percentage of detained immigrants are already held in private facilities, and after having increased their use of such facilities so substantially in recent years.

And, there are qualitative reasons to support these numbers. For one thing, correctional facilities house BOP inmates for relatively long periods of time - sometimes several years - and have rehabilitation as a key goal. (Edwards, supra). By contrast, detention facilities are relatively transitory in nature, and the use of private facilities allows ICE to quickly and cost-effectively adjust to changes in immigration trends. (Edwards, supra).

Valuation

Over time, I have developed my own formula for calculating a fair, intrinsic value for a share of stock in a company. Before the DOJ memo was issued, this formula indicated that a share of CXW was fairly priced in the high-$20s (and again, the day before the DOJ memo was issued, CXW closed at $27.22). Accounting for the immediate impacts of the reduction of BOP's use of private correctional facilities, my formula indicates that a share of CXW is fairly valued in the mid-$20s. With CXW currently trading around $16 per share at the time I am writing this, to me, it appears that Mr. Market has already factored in a decision by DHS to cease its use of private detention facilities. Therefore, if DHS determines that continued use of private detention facilities is appropriate, shares of CXW could then rally back into the mid-$20s relatively quickly thereafter.

While it would be cumbersome and, frankly, boring to walk through my entire fair value calculation, there are simple metrics that support the conclusion that CXW is currently undervalued. For example, the lowest annualized price/sales ratio CXW has experienced going back to 2006 is 1.3, in 2008 and 2011. Reducing CXW's trailing 12 months' revenue of $1,819,000,000 by 11% and applying the conservative 1.3 price/sales ratio produces a target share price of $17.84 per share - 10% higher than the September 15 closing share price of $16.20. Of course, one would be foolish to invest based upon one simple metric like price/sales ratio, but again, it is consistent with the conclusion that Mr. Market has already priced CXW for the loss of most of its federal revenue, not just revenue from BOP.

Similarly, from 2013 (when CXW first became a REIT) through 2015, CXW had an average price/funds from operations (FFO) per share ratio of around 11.1. On a trailing 12 months basis, CXW's FFO is $302,439,000. Reducing that by 11%, and based upon the $16.20 September 15 closing price, CXW currently has a price/FFOPS ratio of 7.1 - considerably lower than the 11.1 average. Put another way, taking the lowest annualized price/FFOPS ratio since CXW became a REIT (10.5, in 2013) and applying it to $2.29 FFO per share ($2.57 trailing 12 months FFO per share reduced by 11%) produces an expected share price of $24.04 per share - 48% higher than the $16.20 closing price on September 15. Again, I am not suggesting that one invest based upon one or two simple metrics, but this is another indication that CXW has already been priced for the loss of nearly all of its federal revenue, not just revenue from BOP.

Because the market has priced CXW for failure, it is also not taking into consideration other factors. For example, even if DHS comes to a similar conclusion as DOJ/BOP, the reduction in revenues will play out over time, not immediately, given the large percentage of immigrants detained in private (as opposed to government) detention facilities. Moreover, many of CXW's facilities with the federal government are located in states in which the state government also has contracts with CXW, such as Arizona, California, Georgia, New Mexico, and Texas, providing a potential opportunity to re-purpose and re-market those facilities. While the federal inmate population has fallen relatively quickly in recent years due to changes in federal sentencing guidelines (down 3.3% between 2012 and 2014), total state prison populations have remained relatively stable (down 0.1%) over the same time period. Indeed, CXW has been awarded multiple new and renewal contracts by the states of Arizona, California, and Idaho since 2012. To be fair, it is true that CXW has some facilities that have been idle since as far back as 2010, so one should not place too much weight on this possibility. But again, it is a potential ameliorating factor that does not appear to be factored into the current share price.

Risks, Downsides, & Disclaimers

Political, customer, and business risks. A very important risk to consider when evaluating CXW is whether other federal, state, and local customers will follow the DOJ's and BOP's lead in declining to renew contracts as their terms expire. This article has already discussed DHS's current evaluation of ICE's use of private detention facilities. Even though, from a fair value perspective, the market appears to already be factoring in continued loss of other major federal agency customers, there is little doubt that shares of CXW will experience additional substantial declines in the short- to medium-term if DHS decides to cease renewing contracts with CXW. Related to this is the risk posed by the relatively narrow line of business that CXW is engaged in. As opposed to some types of industries, CXW may have a limited ability to "pivot" to other lines of business.

Market risk. Many feel that the stock market is currently over-valued. If the broader market experiences a broad correction, even undervalued stocks will go down too.

Interest rate risk. REITs can be sensitive to increases in interest rates. While I am certainly not an expert on the Federal Reserve and express no opinion about whether the Fed will or should raise interest rates again sometime in 2016, it seems relatively certain that, given the current historically low interest rates, interest rates will increase over the long term. This could reduce returns from REITs such as CXW.

Dividends. CXW currently has a dividend yield of around 11%. While, generally speaking, dividends from stocks held within retirement accounts are not taxed, to the extent one holds CXW in a non-retirement account, those dividends are likely taxed as income.

The "Dylan" effect. Inevitably, immediately after I purchase a stock, it goes down. Thankfully, they do typically recover. However, for those interested in the short term, they should be aware of this well-documented phenomenon.

Summary/Conclusion

Based on all of the above, I have begun to build a small position in CXW. Given how precipitously CXW has declined, I believe it currently presents an intriguing value proposition, and I am fully aware of and willing to accept the risks. However, CXW is definitely not one of those types of stocks that you can buy and forget. Therefore, while I use stop-loss and stop-limit orders sparingly, I will likely employ those types of strategies here, particularly as the election and the November 30, 2016 deadline for DHS's decision approaches.

10/5/16 Update: There have been a few recent developments regarding Corrections Corporation of America. First, during the first Presidential debate on September 26, Democratic candidate Hillary Clinton stated that, "I'm glad that we're ending private prisons in the federal system; I want to see them ended in the state system. You shouldn't have a profit motivation to fill prison cells with young Americans." While Ms. Clinton was already on record as desiring to end the federal government's use of private correctional and detention facilities, the next day, shares fell over 7%. Second, on September 27, CXW announced a restructuring of the company's corporate operations and implementation of a cost reduction plan. The plan includes cutting 12 percent of the corporate workforce at headquarters, and the CEO volunteering to forfeit restricted stock units granted earlier in 2016. Third, the Federal Bureau of Prisons recently announced the renewal of a contract with the GEO Group Inc. (NYSE:GEO), the other major player in the industry. States have the legal authority to decide for themselves whether to use private facilities, and the recent contract renewal by the Bureau of Prisons suggests that federal cessation of private contracts may not be as precipitous as the market has assumed. I am therefore continuing to hold my small position in CXW.

11/13/16 Update: In the wake of the news that Donald Trump is the President-elect, shares of CXW went up 43% in one day on Wednesday, Nov. 9. In my opinion, this move took the stock from highly undervalued to slightly undervalued. For those wondering whether to take profits now or hold, one factor to consider is that ICE still has yet to formally announce whether it will continue to use private detention facilities. If ICE decides to continue to use private detention facilities, CXW could see another bump. Personally, I am continuing to hold my small position, though it would certainly not be unreasonable to take profits now.

Disclosure: I am/we are long CXW.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.