The Political Walls Might Be Closing In On This REIT: CoreCivic

Summary

• The political environment has been especially harsh on private prison owners like CXW.
• The stock has taken a beating and by some valuation measures looks very cheap.
• With so much political uncertainty and a dividend quality score that is deteriorating, we suggest holding off on this 11% yielder.
• This idea was discussed in more depth with members of my private investing community, The Income Strategist. Get started today »

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The political environment is one of the key factors that impacts the REIT industry and the policies of the existing Trump-led Republican government have led to the emergence of winners and losers amongst REITs. The prison REIT subsector is a segment that has benefitted immensely from the government’s uncompromising stance on illegal immigration and deportation. Over the last two years, a surge in illegal border crossings and arrests from raids have led the U.S. Immigration and Customs Enforcement (ICE) agency to rely heavily on private prison companies to expand capacity. The number of people detained by ICE reached a record high in FY 2018 and the agency reported a record number of apprehensions along the southwest border in May 2019.

Source: US Customs and Border Protection

The heightened enforcement and increased border arrests have benefited private prison companies such as CoreCivic (NYSE:CXW) whose 46% of revenue is derived from ICE and US Marshals Service. CXW has emerged as a popular dividend stock that has delivered 10% dividend growth per year on average over the past eight years. Despite having a high dividend yield of 10.18%, this ‘high-yield stock’ continues to give jitters to investors as it remains exposed to political uncertainties and social risks that can affect the company’s future prospects.

Business Risks

CXW’s stock has had a tumultuous trajectory in the past few years due to its severe exposure to political uncertainties. These uncertainties arise from conflicting viewpoints that the Republicans and Democrats have about the country’s prison system. CXW’s stock plunged more than 40% when the Obama administration issued an order to phase out the federal use of private prisons. Later, the stock rebounded when the Trump administration decided to rescind the order and tighten security along the southwest border.

Along with immigration policy, the question of private prisons is turning out to be a key issue in the 2020 US elections as many leading presidential hopefuls from the Democratic party are calling to abolish the private prison system. Besides accusing private prisons of abetting unjust immigration policies, the Democratic candidates are mercilessly attacking REITs like CXW for causing security problems, abusing inmates, profiting from human suffering, and separating undocumented minors from their adult parents. It is clear that the election of a Democratic candidate as a future President poses a significant threat to CXW.

A huge public outcry against the private prison system is another risk that is impacting CXW. For years, activists have been protesting against private prisons that benefit from the mass incarceration and the detention of immigrant families. The movement has now gained momentum and there is mounting pressure on banks and pension funds to stop financing private companies that own a vast network of immigration detention centers. In response to deep public sentiment, a number of major banks like SunTrust (STI), JPMorgan Chase & Co. (JPM), Wells Fargo (WFC) and Bank of America (BAC) have announced their decision to stop financing private prison companies. The banks’ decision to divest from private prison companies hasn’t been well received by investors as CXW’s stock plunged by more than 50% after it became known that prison REITs stand to lose about $1.9 billion of their private financing.

From CXW’s perspective, all the noise against the use of private prisons is a politically motivated attempt to spread misinformation. However, the REIT does acknowledge that its future is riddled with uncertainties and it is already taking necessary measures to confront the challenges. While the REIT continues to focus on its core business, it is also undertaking ways to leverage its core expertise and diversify its portfolio by penetrating new segments like re-entry centers and government-leased non-corrections assets.

To serve its growth objectives, CXW now operates in three business segments: Safety Segment, Property Segment and Community segment. At the end of Q2 2019, the Safety segment included 51 correctional and detention facilities, the Property segment included 27 government-leased buildings and the Community segment portfolio comprised of 27 re-entry facilities. CXW’s diversification strategy is built upon several trends that are affecting US’s correctional system.

Positive Trends

Until now, private prisons have benefited from state-level policy choices which have remained the largest drivers of the country’s high level of incarceration rates. Within the US, about 57% of inmates are imprisoned in state prisons while only 27% and 10% are confined in local jails and federal prisons, respectively.

Source: www.prisonpolicy.org

Even though a growing number of states are planning to ban private prisons, the state prison system continues to face a plethora of problems related to overcrowding and understaffing. Many states are still relying on or are planning to contract with private prisons to meet significant infrastructure needs and to overcome budgetary constraints. So, it is very unlikely that a state prison system will hastily follow a federal directive to phase out private prisons because the state and the federal prison systems are governed by a different set of laws.

The problem of overcrowding in some states is so severe, in fact, that authorities are being forced to move scores of inmates to out-of-state private prisons with vacant spaces. Even states like Kentucky, which stopped using private prisons in 2013, are reluctantly contemplating the future use of private prisons to resolve the overcrowding problem. So, there will always remain geographical markets which will provide CXW with opportunities to sustain its core business. In addition, key government customers like ICE are continuously seeking CXW’s detention facilities because the rampant problem of unauthorized immigration still exists as indicated by the graph below.

Source: Pew Research Center

The ongoing demand within CXW’s safety segment was one of the factors that led to a 9% year-over-year revenue growth in Q2 2019. Lately, CXW's cash flow has been positively impacted by the seven new Safety contract awards, five of which are signed with state agencies and two of which are signed with federal agencies.

The REIT’s Safety business is perfectly complemented by its Community and Property segments which are playing a pivotal role in driving revenue growth. The Community segment reported a 24% growth while the Property segment reported 60% year-over-year revenue growth in Q2 2019. Both these segments are enabling CXW to develop new real estate solutions for government customers.

Source: CXW Q2 2019 Investor Presentation

New Solutions

Currently, there exists an ongoing demand for developing new facilities and expanding existing facilities because authorities are continuing to face challenges in maintaining old and dilapidated facilities. There are states like Kansas and Alabama that are building modernized prisons to expand capacity through build lease contracts. To grow its Property segment, CXW has been exploring the Private-Public partnership model to win such contracts for planning, developing and maintaining new facilities, which will add value to the portfolio. CXW is further fortifying its Property segment by acquiring mission-critical non-corrections assets that are leased to government agencies.

The REIT is particularly benefiting from the federal government’s tendency to increase discretionary spending and the funding of the General Services Administration (GSA) agency. At the end of Q2 2019, CXW’s Property segment comprised 27 properties and the REIT is striving to quickly grow the portfolio by acquiring properties that will appeal to high net worth (HNW) investors and medical practice investors. Recently, the REIT acquired a 36,520-square-foot property that is based in Detroit and which houses the Michigan Department of Health and Human Services (MDHHS).

Besides constructing new facilities, CXW is banking on its Community segment to take advantage of an emerging demand for re-entry facilities and rehabilitation services to fix the country’s recidivism crisis. An increasing number of states are vouching for community-based corrections to alleviate overcrowded prisons and to provide effective rehabilitation that will curb the recidivism problem. Moreover, the demand for residential re-entry centers has been fueled by the passage of the First Step Act which authorizes $250 million over five years to the Bureau of Prisons (BOP) to boost rehabilitation efforts. There exists a growing consensus that electronic surveillance, counselling sessions and therapies provided in community-based facility will play an important role in reducing crime and jail churn.

Taking cues from the evolving scenario, CXW has been quickly growing its network of community-based correctional facilities by making acquisitions over the last several years. By acquiring complementary businesses, the REIT has begun to offer behavioral therapies, supervision programs, and technologies for prison population management.

CXW is also in a good position to finance its acquisitions by relying on cash on hand and existing lines of credit. In the wake of the prevalent ‘private prison divestment’ movement, the REIT has also considered the option of borrowing funds from international banks that are immune to political risks.

Financials and Guidance

CXW has plenty of scope to grow its dividends due to its increasing cash flows and its low AFFO dividend payout ratio of 68% which is much less than the REIT industry average of 78%. CXW’s dividend appears sustainable in the long run as the REIT plans to scale up its payout ratio to 80% in the long run. However, the REIT’s management has no immediate plans to allocate additional cash flow towards increasing the current dividend level. Instead, the REIT intends to use its excess cash flows to create long-term shareholder value by reducing leverage and by funding its diversification strategy.

Source: CXW Q2 2019 Investor Presentation

CXW’s EBITDA was reportedly $115.3 million in Q2 2019 and grew by 18% over the prior-year quarter. For Q2 2019, CXW’s normalized FFO per share was $0.69, which is a 21% increase as compared to the same period last year.

Source: CXW Q2 2019 Investor Presentation

Based on its recent financial performance, CXW has projected an improved outlook for the second half of FY 2019. The REIT now forecasts a normalized FFO per share in the range of $2.58 to $2.62, which represents a 13% increase over its normalized FFO per share for FY 2018.

CXW is positive about achieving further cash flow growth in 2020 due to the 512-bed expansion of its Otay Mesa Detention Center and also due to two new contracts. The two contracts will come into effect in the second half of FY2019 and they will deliver nearly $70 million in annualized revenue. To fulfill the requirements of the new contracts, CXW will be utilizing two idle facilities, namely 1422-bed Eden Detention Center along with its 910-bed Torrance Country Detention Facility. Together, the contracts and the expansion of the Otay facility will generate nearly $95 million in annualized revenue growth through the end of FY 2019. CXW expects an incremental cash flow growth in 2020 due to the high demand of multiple states that are actively pursuing additional capacity to alleviate pressures posed by overcrowding or staffing challenges. Growth opportunities will also be provided by the new 2,432-bed Lansing Correctional Facility which is being developed by CXW through a public-private partnership. The construction is scheduled to be completed in January 2020 and which will be leased to the State of Kansas for a 20-year lease agreement. The Lansing project is worth $16 million and it will generate annual lease revenue of approximately $15 million upon commencement.

Along with a robust cash flow, CXW’s low leverage plays an important role in fortifying its balance sheet. CXW’s cash flow growth has contributed to the decline in its debt leverage ratio which is already low in comparison to other REITs. The REIT has successfully achieved its long-term target of maintaining a leverage ratio between 3x and 4x. Investors can expect the ratio to further scale down towards the lower end of the range due to a strong demand for CXW’s inventory of 7500 idle beds in the Safety portfolio. As of now, CXW does not have near-term capital needs for achieving growth; hence its leverage will continue to remain substantially low in comparison to most of the publicly-traded REITs. Overall, CXW has the necessary financial prowess to take advantage of the favorable trends and drive its diversification strategy while braving the short-term disruptions caused by the sociopolitical environment.

Valuation and Dividend Quality

From a valuation perspective, the stock looks cheap and is paying a very attractive dividend.

But boy, if there isn't a whole lotta risk around this one. Can it recover and explode to give investors a hefty return? Absolutely. However, it carries considerable political risk and an uncertain future - one that might not become clear until we know who the Democratic nominee is or even after the election in November 2020.

As I've mentioned in the past and as I've outlined in The Income Strategist service, there are 4 factors that must be satisfied for me to invest in a company:

1. The Business Model has to be sound and the company's future prospects have to be attractive. There could be an attractive opportunity in this case, but there is a heightened level of uncertainty as well.
2. Financial Stability – the company is still financially stable and is generating adequate cash flow but the trend over the last year has been negative.
3. Earnings/Cash Flow – there has been a steady but very modest growth in revenues while AFFO has been declining over the last 3 years.
4. Valuation – the stock looks extremely undervalued but this could be for a very good reason.

It just about checks all those boxes, but if I could add one more, it's the extenuating circumstances box, which in this case, is a big red flag.

The stock currently pays a dividend yield of 11%, which is very tempting for income investors, but the political risk that could drive the stock down further makes me cautious. Not to mention, the deteriorating Dividend Quality Score that might indicate a dividend cut.

For the moment, I'd prefer to sit on the sidelines and see how the political situation evolves and give the company a chance to initiate new revenue streams that may be less tied to government policies.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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