We've been invested in Corrections Corp (NYSE:CXW), the largest private operator of prisons, since 2010. Sometimes we've had a large position and at other times not; we think the current opportunity is compelling. We've written about it before here.Around 9% of the U.S. prisoner population is housed in privately run prisons. CXW is the largest publicly traded operator -- Geo Group (NYSE:GEO) is the other. Private operators are, as you might expect, far more efficient than the public sector -- not least because their workforce is not unionized. This is most dramatically revealed in the case of California, where the state spends around $140 per prisoner per day compared with CXW's per diem rate of $67. Chronic overcrowding in California and other states as well as this cost advantage mean that the long run outlook is for increasing numbers of prisoners to be run in privately operated facilities.
The embrace of private solutions isn't seamless; prison guard unions are clearly opposed, and California itself represents 13% of CXW's revenues. Politics can sometimes intervene, but the trend towards increasing market share is robust. It's a business with limited economic sensitivity, reasonable barriers to entry and good growth prospects.
CXW was once structured as a REIT with the managed business as a tenant. They basically own and manage real estate. The REIT was overleveraged, was building prisons aggressively and had falling occupancy. This combined with the requirement common to REITS that they distribute at least 90% of their pre-tax income to their investors made it hard to fund their capex program, and they raised equity and restructured as a corporation. While this gave them more flexibility around managing cashflow, it also burdened them with a 38% tax rate once they returned to profitability.
We've long been intrigued at the possibility of the company returning to the REIT structure. As well as reducing their tax liability, splitting into a management company that operates prisons and a REIT which owns them would attract a REIT-type valuation on pre-tax income on the latter and lead to a re-pricing. It's not a bad investment as a corporation, but as a REIT we think it's mis-priced.
Eighteen months ago the company had told us they would never consider restructuring as a REIT. But in their 1Q12 earnings call they disclosed that such analysis had begun in the Fall.
CXW manages some prisons, and own/manages others. They break out the segment operating margins for both (13% and 36% respectively). Based on this and other information in their 10K, it's possible to construct an income statement for a new management company (we'll call it ManCo) and a REIT entity owning prison properties (call it NewREIT).
Assuming the 13% margins they earn managing prisons applies to those they own as well, it's possible to calculate pro-forma operating earnings for ManCo and net operating income for NewREIT.
CXW's market cap is $2.8BN. Their 13% operating margin on managing prisons applied to their total revenues of $1.7BN generates $228MM of operating income, $141MM after tax. A market multiple of 14X would value this at $1.7BN or 60% of their market capitalization.
We calculate NewREIT would generate $313MM of net rental income based on the 23% difference between their operating margins for each segment above, on the $1.36BN of revenues that come from prisons they own and manage. REIT cap rates vary from 8% for industrial properties to 6% for high quality offices and in some cases even lower. Their business is economically insensitive, clients are good credit, maintenance costs are minimal, and they have half the share of the U.S private prison market, so a 6% cap rate doesn't seem unreasonable [by comparison, Simon Properties Group (NYSE:SPG), trades at a cap rate of around 5% of Adjusted Funds From Operations (AFFO)].
Applying a 6% cap rate to this rental income values it at $5.2BN. We still have to deduct the market value of so far unallocated expenses such as G&A ($91MM) and maintenance cap ex (we estimate at 15% of net rental income or 3.5% of rent, $48MM). Applying a 14X multiple to these pre-tax figures and adjusting for their 38% tax rate deducts $1.2BN in value. The company has another $1.2BN in debt.
CXW Valued as ManCo and NewREIT
Managed only Business (ManCo)
13% operating margin as disclosed in 10K on managed business applied to entire revenue stream of $1,729MM and valued at 14X
Owned prisons housed within NewREIT
23% margin on $1,357MM revenue derived from owned/operated prisons, valued with REIT cap rate of 6%
G&A of $91MM, estimated maintenance capex of $48MM (3% of rent) is $139MM pre-tax, $86MM after-tax and valued at 14X
Implied Share Price
Current price $28
Source: CXW SEC filings, SL Advisors
The valuation is of course sensitive to the cap rate. An 8% cap rate reduces the value to $32 per share. And they may not convert to a REIT, although the company has hired JPMorgan and E&Y to do the analysis and has asked the IRS for a private letter ruling related to the conversion. We think their analysis is sufficiently far along that the company believes it's likely they will convert.