Description

COMPANY SUMMARY

Corrections Corporation of America (“CXW”) is the largest provider of prison detention and corrections services to governmental agencies in the United States.  The Company owns correctional and detention facilities and is organised as a REIT. 

SUMMARY THESIS

(1) Prison population is falling (fiscal & policy reasons driving this) – prison population peaked in 2009 & has been falling since 

(2) Private Prison Operators are the ‘swing capacity’ in the system – private prison operators captured a disproportionate share of the growth in inmate populations (up to 2009).  As populations fall it’s easier to cancel contracts with private operators vs. closing government owned facilities (government employee redundancies, union issues, etc.)

(3) You can see this dynamic ‘in the numbers’.  For CXW since 2009:

• 'Managed Only’ Facilities:  # of facilities managed has fallen from 21 (~25k beds) at 31-Dec-09 to 11 (~14k beds) at 31-Mar-16.  This is predominantly contract expiry/cancellation
• ‘Owned & Operated’ Facilities: headline numbers show % occupancy has fallen from 88% during 2009 to 72% during Q1’16.  CXW currently has 9 owned facilities (out of 60) that are idle.  There are a further 2 facilities that were impaired (and thus are no longer reported) in Q1’15 (i.e. now no longer counts in the denominator for the calculation of utilization) (note: there were zero idled facilities in mid-2008)
• Recent facility lease in Oklahoma indicates the challenged state of the market:  In May CXW announced a 5 year lease agreement for the North Fork Correctional Facility.  The structure of this lease provided the counter-party a ~1.5 years rent free period at the beginning of the lease (i.e. 1.5 years out of 5 years);

(4) Contracts are typically short duration – a very large percentage of contracts expire over the next 2-3 years.  Historically renewal rates have been high (as populations grew & private populations grew disproportionately).  This has changed recently.  If the structural decline thesis is correct the short duration contracts are the mechanism through which it get transmitted (& potentially quickly).  Also note counterparties have the right to cancel contracts unilaterally before expiry in certain circumstances (e.g. failure to secure sufficient budget appropriations);

(5) This is a largely fixed cost business – minimum staffing & other fixed costs mean the operating leverage from lost revenue (declining utilization) is significant.  There is financial leverage in addition to the operating leverage

(6) There is no alternative use for the real estate – For example CXW has had facilities idle since 2008. They just sit there empty.  Any ‘real estate value underpinning the downside’ thesis seems unlikely;

(7) Dividends exceed free cash flow – e.g. since REIT conversion CXW has consistently paid higher dividends than actual FCF (FFO & AFFO reported by the company are inflated).  This has gotten progressively worse as operations have deteriorated

(8) CXW has given counterparties a number of options to purchase facilities at or below book value – CXW currently trades at ~2.8x P/BV.  ~20% of BV is represented by facilities that either (i) automatically revert to counterparties at the end of the lease (in 2017); or (ii) where counter-parties have the option to acquire the facility at or below book value; or (iii) are currently idle;     

MORE DETAIL ON EACH OF THE THESIS LIMBS

(1) Prison population is falling 

• The United States has the largest prisoner population in the world[1] and the highest incarceration rate of any large country in the world[2].  For perspective, the US prisoner population is larger than the aggregate total prisoner populations of the other G7 countries + China
•  Total State + Federal populations in the US peaked in 2009 and have been falling since – A combination of policy & fiscal reasons are driving this
  • You can find all of the data here: http://www.bjs.gov/index.cfm?ty=nps
• Even though aggregate federal prison population numbers are smaller than state population for private prison operators’ federal populations are more important than state populations. For example CXW generates more than 50% of its revenues from federal customers
• There are a number of changes that have occurred or are slated to occur that will continue the downward trend
  • Sentencing guideline changes for drug crimes – ~1/4 of inmates impacted; sentences estimated to be reduced by 19% on average; offenders commenced being released from November 2015[3]
  • Bipartisan proposed changes to the Sentencing legislation[4]

(2) Private Prison Operators are the ‘swing capacity’ in the system

• While prisoner populations (and especially federal populations) were growing private prison operators captured a disproportionate share of the growth in inmate populations[5]
  • Prison populations in private facilities increased from 5.9% of total in 2001 to 6.8% of total in 2009 (increase from 8.1% to 16.4% for federal prisoners)
• As populations fall it’s easier to cancel contracts with private operators vs. closing government owned facilities (government employee redundancies, union issues, etc.)
• In general where the prisoner populations have fallen, private operators have suffered.  For example:
  • Texas: Because offender populations were declining, the Legislature reduced appropriations for contract prisons, privately operated state jails, and residential pre-parole facilities by $97.3 million to reduce correctional bed capacity, resulting in the closure of the Mineral Wells Pre-Parole Transfer Facility and Dawson State Jail
  • Kentucky: Citing a declining prison population and recent criminal justice reforms, Kentucky officials opted in July 2013 not to renew the state’s last remaining private prison contract with Corrections Corporation of America to house nearly 800 inmates in the Marion Adjustment Center.  The state chose not to renew private prison contracts at two other facilities in 2010 and 2012.  “Our decision wasn’t based on an opinion of private prisons,” Kentucky Justice Secretary J. Michael Brown told The Courier-Journal in September. “CCA was a great partner. We could not have operated without that partnership while our (inmate) population was trending up.”
  • California: In 2011 the US Supreme Court ruled that overcrowding in prisons was in breach of the US constitution (cruel & unusual punishment).  As a result CA decided to send a number of inmates out-of-state.  They have subsequently built more in-state prisons & reduced the overall population.  As a result the use of private facilities has reduced significantly  

'Managed Only’ Facilities:  

• # of facilities managed has fallen from 21 (~25k beds) at 31-Dec-09 to 11 (~14k beds) at 31-Mar-16.  This is predominantly contract expiry/cancellation.  Additionally capacity utilisation has fallen

Catalyst

• Continued operational deterioration
• Dividend Cut