CoreCivic: Potential Policy Tailwinds, Not Enough To Move The Needle

seekingalpha11-23

CXW's potential upside hinges on new US government policies, particularly increased funding for ICE, which could boost revenues despite the Private Prison EO.Current valuations reflect market optimism...

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Pgiam/iStock via Getty Images  Investment Thesis Businesses in the correctional facilities market, otherwise known as “prison stocks” in our dusty chambers, have caught a bid in recent weeks following the outcome of the US presidential election. Whilst I am acutely aware this may be of a speculative nature, there also may be some merit in the repricing of these stocks if fundamentals are to change. Whether the newly announced “border czar” from President-elect Donald J. Trump will have any major effect on the domain is yet to be seen. But, there is talk among investor circles that the so-called deportation plan will require the use of facilities these businesses tend to operate. Whether they are in the right place at the right time, or we are about to witness a structural shift in certain factors of the economy, I cannot dare to speculate. What can be done is a thorough analysis of businesses presenting as potential opportunities in this space, to understand whether or not the economics are attractive enough to warrant long-term investment of large amounts of capital (relative to net worth). This has brought me to analyzing the prospects of Corecivic (NYSE:CXW). Founded in 1983, CXW is the largest owner of correctional and detention facilities in the US. It is also one of the largest private prison operators in the nation. It operated 42 correctional and detention facilities as of September this year, with a total capacity of roughly 62,000 beds. It operates through 3 segments, namely safety, community, and properties, each providing solutions to the government and public sector via corrections and detention facilities. This extends to its network of re-entry centers for those post prison life, alongside a number of Real estate contracts with the US federal government. These have extended for >40 years since the business was founded. Its re-entry centers, have a capacity of ~4000 beds, in addition to the properties segment which has ~10,000 bed capacity. The argument for investment towards businesses in this space centers around the distribution of potential outcomes following the US election. Specifically, the role of the US Immigration and Customs Enforcement (“ICE”) and the Department of Justice (“DOJ”) in regulating immigration status in the nation. An important note to consider here is that the Biden administration signed into effect in 2021 the Private Prison Executive Order. This specifically directs the attorney general not to renew any contracts between the DOJ and private prisons, \"phasing out the Federal Government's reliance on privately operated criminal detention facilities\". Critical to the investment debate, is that ICE facilities are not included under the EO because it is considered to be part of the department of homeland security – not the DOJ. Consequently, if there is to be more authority and funding handed to the agency, there are potential tailwinds that could benefit CXW into the coming years. YTD sales from ICE accounts made up ~21% of the top line, and revenues from the United States Marshall Service (“USMS“) made up ~30%, clipping $304mm and $400mm respectively. Running the scenario where these percentages are increased due to the new administration's policies doesn't do much in my eyes. It is still too early to predict the outcome of what impact these may have on the business economics and compounding ability of the market. My initial presumptions are that an uptick and revenue will result in higher sums of freely available cash flow after all CapEx + reinvestment requirements considered. These are companies where the balance sheet is entirely employed into tangible assets, and the runway to retain and then reinvest earnings into additional centers is severely hampered. It is hampered both from regulatory perspectives and the fact that prisoners are not exactly like fast food restaurants – demand is highly uncorrelated to any consumer preference. Revenues are typically contractual and are not negotiable to the upside (don't forget it's the government here). But operating costs do rise over time in keeping with the general increase in the cost of things. Here you're left with an eroding operating margin, exacerbated by the largely fixed cost base. On the upside, this also provides operating leverage with sales growth. As a result, what we need to see is a business 1) producing exceptionally high returns on the net tangible assets required to operate, and 2) that require little sums of capital reinvestment to maintain their competitive position or even just to function as a concern. In this report I will share my critical findings on CWX, its business economics and what a potential uptick in revenues means for the corporation. My view is the business is fairly valued today, and the market has done a great job at capturing any potential value unlock as a result of the new government policy in recent price action. Net-net, I initiate coverage with a hold rating, acknowledging the fact there is a universe of more abundantly profitable ideas in my opinion. Figure 1. Tradingview Why CXW is a challenging business I say the above with a grain of salt. I am acutely aware that managing a portfolio of equities requires owning businesses that possess a set of competitive advantages which can endure overtime and be reflected in higher carrying values of the stocks within the portfolio. At the same time, not all businesses can participate in the good fortune of the economy. The market for correctional and detention facilities is not in correlated to the expansion or prosperity in factors of gross domestic product, terms of trade, or national wealth and so forth. If it is, I haven't seen the statistics. It is a highly complex domain regulated almost entirely by the government and most of its revenues are tied up to public sector sources. As such, risks are that revenues can be clamped severely at the stroke of a pen– with nothing fundamental changing in the business. Ranting aside, there are several factors which mitigate against a sound investment calculus in this instance. For CXW, these factors will need to change moving forward, for institutional money to employee large sons of capital into its equity. Namely: Post tax operating earnings have been lumpy, and decreased from 2022 clipping $150mm in the last 12 months. The business has been shedding capital rapidly, via asset sales and working through net working capital, in this time. Management has done this to maintain profitability ratios of ~6% to 7% returns on operating assets. For instance, a total of $2.6Bn had been put into the business back in Q1 '22, earning ~7% ($182mm). Management had shed this to $2.2Bn last quarter, where it earned $150mm on this amount, otherwise 6.8%. The result is a business with $19.70 per share of capital at risk earning $1.34 per share, and throwing off $1.27 per share in freely available cash (~6% yield each). This is what you are buying today. Figure 2. Company filings  To give context on the economic value of these numbers, consider them benchmarked against a 12% hurdle rate (this is the long-term market averages; consider this the minimum accepted return a business must earn on its capital to create value above what an investor could achieve elsewhere). Management has rolled off anywhere from 600bps up to 700bps of earnings against capital deployed into operations for the last 3yrs. The minimum accepted return at 12% means it needed to earn $265mm from these assets in the last 12mo in order to meet this threshold margin. Instead of the business at $150mm, as mentioned. The prevailing economic loss is ~5% (6.8%-12% = -5%). Said otherwise, in a world where investors can reasonably expect to earn 10-12% on their money riding passive indexes, a firm that produces less than this amount on its own assets is considered an economic failure, as is the case here. The resulting losses in dollar terms equal ~$1.03 per share in the last 12mo, consistent with the last 2yrs range. Conceptually and practically, this makes sense. When you own stock of a business, you own a piece of its operating assets, in a pro rata amount. That is, a per-share amount. In other words, one share of CXW gets you roughly $19.70 per share claim on the business capital. You could go and buy units in the SPY at whatever price per share, giving you a “capital per share” amount as well. The difference here is that we can expect to earn 12%, based on the last 10–15 years of history. For CXW, we can expect to earn about 7% on the same terms. Why take on the extra risk in your capital account if this is the case? There are no dividends to speak of, with management ceasing these in recent years, and it is not buying back stock on a net basis. So where is the cash?  Figure 3. Company filings  As a positive, what we call cash conversion – that is, the ratio of free cash flow production to earnings - has generally been positive for this business. From 2022 to date, the average conversion has been $2.08 in freely available cash for every dollar of earnings produced (TTM values, Figure 4). This is a vote of confidence, ensuring that there is healthy free cash flow production to the firm. But again, the debate is more nuanced than on face value. While it generally produces a multiple of free cash flow to earnings, this has not been entirely due to the success of operations. Second, these cash flows have neither 1) been reinvested for incremental growth or 2) been valued highly in the market. It has completed asset disposals over the years, which have brought in additional cash flow whilst reducing the size of the asset base. When all factors are considered, the amount of freely available cash has been winding down substantially for the past two years as there is less capital at work to produce a given level of earnings. This was discussed earlier. The point is that it isn’t committing any growth in fact, the majority of CapEx I would consider as sustaining costs required to maintain a level of operations and competitiveness (and the level of operations is declining). I am not seeing value here, and I’m not sure how the specter of immigration policy changes these economics in a meaningful way.  Figure 4.   Company filings Figure 5. Company filings Valuation insights The big talk on what might drive prices higher in this sector is on detention capacity. The argument is that the new administration plus the USMS + ICE could potentially remove any bottlenecks that would prevent them from using private providers, and this could lead to substantially higher sales on the back of this. Management has said that it has ~18,000 vacant beds in its network. It also noted that there were “a couple [house] bills” that talked of a 50,000 bed capacity. I’m not so sure, and I haven’t had anything concrete presented to me or come across my desk regarding the same, and we have been investigating this sector for some time now. But keep an eye out. Management has upgraded guidance anyway in anticipation for the higher revenues, giving some visibility into what trends to expect in the near term. It expects funds from operations of ~$185mm, up from $172mm previously. It calls for earnings of $0.75 at the upper end of the range, increased from $0.66 previously. The guidance assumes that federal populations will remain within “a stable range for the remainder of 2024”. There is some upside risk based on that fact. It hasn’t baked any increase in detention populations into its forecasts, and therefore I would be watching this closely to see what impact this might have the numbers start to trend higher.  Investors have also lifted the appraisal on CXW from a 1.1x EV/IC business to 1.5x at the time of writing. This does fit in with the nature of what’s happened recently, where investors value a dollar of capital in this business higher than previously based on the impeding growth trends. My numbers suggest it will need to reinvest about 15% of its post tax openings each year out to FY’26E, which only gets us to a valuation of $21.88 per share at present multiples. With the upside risk in place, whereby I bake in a 3% revenue forward growth rate, ~100bps ahead of consensus, the impact to valuation is minimal, getting us to $26 per share 2yrs out. So the valuation debate hinges more on generating higher sales relative to capital employed than it does for changes in operating margin (makes sense given the fixed cost base). For instance, in my estimates, lifting operating margins to 15% with the same growth estimates does not move the needle on valuation. However, at the same implied operating margin, 85% revenue growth rate gets us to $30 per share under the same circumstances. This makes sense to me; a business with high fixed assets, and a highly tangible operating nature empirically benefits most from an increased in capital efficiency/decrease in capital intensity, then it does buy an optic in operating margin.  Figure 6.    Author Finally, a start-up position of 1000 shares in CXW today costs $21,800, to receive earnings power of $1343. My numbers imply projected to $1367 in the next two years, or $1.$.47 per share getting us 1.8% compounding growth in earnings power. Box, the upside risk is a rapid increase in sales growth, that 3% annualized gets us up to 20% compounding growth in earnings power. This is an upside risk that must be considered. Figure 7. Author When balancing all the moving parts and contributing factors, my view is the margin of safety is not present and the ability for this business to compound capital attractive rates of return by earning decent returns on its operating base are quite limited. This is especially true when benchmarked against the universe of available opportunities that do fit within this core investment philosophy. Risks to thesis The major upside risk to the thesis is an increase in US federal detention capacity as a result of the new administration policies. Management has not baked this into its guidance, seen as there is no certainty. But it has acknowledged it. Furthermore, positioning a portfolio based on potential policy outcomes, versus more certain figures, does not align with a sound investment philosophy, one that looks too compound over very long periods of time whilst avoiding unnecessary drawdown. In my view, the market has done a great job at capturing the potential upsides for this business, with without baking any additional speculation of revenue growth into the calculus. If revenue growth does beat expectations, and my own internal expectations, there is risk valuations are under priced, and the stock could see further upside towards $30 a share in my scenarios. On the downside, the risk is that investors have got this wrong in lifting the multiple on invested capital, and a compression here could result in a poor investment, meaning the stock does not keep up with the growth of the business. Investors should recognize this set of risks in full before proceeding any further. In short CXW is at the precipice of an interesting juncture which could see its operating market well-positioned to capture a series of structural tailwinds brought on by US government policy. If this were the case, it would mark only a few times in history where we’ve seen similar results. The world is a different place however than in times gone by. Plus, objective factors that make a great business – and a great investment – cannot be overlooked either in the face of speculation. I often go by the historical record when establishing a view on where a company can head. Without the tailwinds mentioned in this report, the investment case for CXW is limited. And in my opinion, after crunching the numbers and potential distribution of outcomes, even a rapid uptick in sales revenue from these policies might not be enough to move the needle above investors could expect to receive elsewhere. Net-net; rate hold on fundamental grounds. Appendix 1.    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