Core Civic (CXW) is the largest private prison company in the USA. CXW owns roughly 70k beds and primarily provides and/or manages facilities for ICE and USMS detainees, and state prisoners. This is not an article on the ethical merits of private prisons, but one on the fundamentals of the private prison business.
Before delving into Core Civic, a primer on the USA jail system is helpful. There are three types of correction or incarceration facilities: federal, state, and local jails. Correctional facilities are concrete and steel structures that typically house between 100 to 2,000 inmates. In the United States, there are about 140k federal prisoners, 950k state prisoners, and 500k county detainees. Federal prisoners are prisoners under the purview of the DOJ. There are also ICE detention facilities primarily for detaining illegal immigrants until they are deported back to their country of origin. County jails normally house persons awaiting sentencing or persons serving sentences less than a year. With the media attention the prison industrial complex gets, it is surprising to learn that private prisons make up about 150k “beds” in the prison system or less than 10% of the total number of prison beds. Equally surprising is that the number of incarcerated Americans has declined almost 30% since 2010. This is primarily due to more lax drug possession laws since the “War on Drugs” as well as reduced sentence terms.
Given a declining prison population trend, a recent executive order prohibiting the renewal of private prison contracts (by select government agencies), and the rise of ESG investing, prison REITS were the worst performing sector over the last decade. This is even though CXW has returned over 2x its market capitalization in dividends since 2010. Meanwhile, its share price has dropped by more than 50%. However, we believe CXW’s business model to be highly resilient. Coupled with CXW recently converting to a C Corp, we believe CXW could generate significant returns in the near term. Because of this transition, CXW can now allocate capital to reducing debt and share buybacks(before the majority of earnings were distributed via dividends to shareholders). With continued share buybacks and a reduction of leverage, CXW has roughly 100% upside from today’s level.
CXW owns 70k beds or about 43% of the private prison beds in the USA. CXW has seen occupancy rates fall from 85% in 2013 to about 71% in 2021(including idled prisons). However, most of this drop was from 2020 onwards due to COVID as health actions were taken to safeguard prisoners. These were orders such as ceasing the transfer of county prisoners to state prisons, setting upper limits of occupancy rates to 85%, along with the enactment of Title 42 which prohibited detaining illegal immigrants, instead expelling them back to their country of origin due to the potential health hazard they posed.
Although CXW’s occupancy rate has dropped by 15% since 2013, CXW’s revenue has been constant. This is because CXW’s revenue per bed has increased enough to offset the decline in occupancy. About half of CXW’s revenue is derived from detention facilities that house either illegal immigrants or detainees awaiting sentencing. The other half of CXW’s revenue is from state prisons primarily located in the sun belt: Arizona, Texas, Oklahoma, Georgia, and Tennessee. The number of prisoners and the condition of prisons varies significantly state to state. CXW has prisons primarily in states that should provide stable revenues for the next decade. The reason for this is that most of these states either do not have enough jail capacity or are shuttering older jails (>50 years old) in which the prisoners then get transferred to private prisons as there is no spare capacity.
To illustrate the magnitude of the problem some states have with dilapidated jails we examined Georgia’s prison capacity. Georgia has roughly a 47k prison bed capacity in its state with about 43k of those occupied. 20k beds are in prisons over 40 years old and in some instances over 100 years old! Past 40 years, jails need costly infrastructure and technological upgrades. It is easier to either contract/lease with a private prison with spare capacity or to outright acquire the prison at a discount to replacement cost. CXW has done all three of these types of transactions with different states.
With the continued shuttering of older prisons, the potential for increased political and societal volatility ahead, CXW is poised to benefit in an outsized manner given the ratio between aggregate prison bed capacity to private prison capacity. Currently, there is an almost 10:1 ratio split between the two. A ten percent reduction in jail capacity would equal the entire private prison bed capacity. Another recourse is that CXW can directly sell its facilities to state and federal agencies. CXW has recently completed the sale of its McRae Facility to the BOP for $130mm. This comes out to about $66k per bed which if extrapolated to CXWs prison beds would yield $4.6B. After netting out debt, this comes out to be 3x CXW’s current valuation. Although the extrapolation might be a stretch as not all prisons are equal, the disparity illustrates the mismatch between market perception and the value of CXW’s assets.
Why would states/federal agencies purchase twenty-year-old prisons from CXW rather than build a new one? Cost, time, and political risk. The cost to build prisons has continued to increase with costs going from $50k/bed in 1982 to about $100k-200k per bed today. Aside from the monetary costs of building out new prisons, the time a legislature needs to propose and pass funding to build (and then build) a new prison is no small hurdle. From a politician's perspective, there is a lot to lose and not a lot to gain. Taxpayers do not want their hard-earned money funding new prison builds.
The distribution of jails is also an important factor. About 4% of jails hold more than 40% of inmates! This is because these are larger jails that hold more than 1k inmates. In the states that CXW is most active in, roughly 25% of the largest prisons are over 50 years old. If these prisons are shuttered, this would represent ten percent of total prison capacity or the entirety of the private prison capacity. Private prisons only have about 20% capacity left. As CXW has high fixed cost leverage, an increase in occupancy rate would see a significant fall through to earnings. Variable costs make up about 25% of operating costs.
Recently, CXW was awarded the largest prison contract in over a decade as a result of Arizona shuttering one of its oldest and largest prisons down. Given the lack of excess capacity, the state had to contract out to CXW. This contract alone should increase the occupancy rate for CXW by three to five percent as it transfers the current ICE detainees to its other facilities to make way for state prisoners.
The use of private prisons is highly controversial due to the tension between ethics and the profit motive. One would think that private prisons dominate the US prison system however private prisons only make up less than 10% of nationwide prison capacity. It makes for great soundbites as it has become a heavily partisan issue with both parties playing proverbial regulatory ping pong.
The first major regulatory blow against private prisons came from Sally Yates, the AG during the Obama Administration. Her order banned agencies under the purview of the Department of Justice to use private prisons. Yates cited research showing that private prisons operated in a less safe and more costly manner than federally run prisons. The matter was contested as the paper was thought to have cherry-picked data. Reports have since come out also denouncing the state of federally run prisons. For clarity, the BOP and USMS fall under the Department of Justice. ICE and Custom and Border Patrol (CBP) fall under the Department of Homeland security. Yates’s order was then promptly reversed by Jeff Session, the AG during the Trump Administration.
The latest regulatory blow was an executive order by President Biden in January of 2021 prohibiting the renewal of private prison contracts by certain government agencies. These expanded on the previous Yates policy to include the US Marshals Services instead of solely the BOP. Given that about 50% of CXW’s revenue comes from federal agencies, namely USMS and ICE, it is important to understand the consequences of this order.
Effects of Regulation
Unlike the BOP, USMS and ICE do not have their own detention capacity. Without private prisons, USMS and ICE has to either contract with other state or local jails. USMS facilities are generally located near federal courthouses and provide detention space and services for pre-trial federal defendants. This is so detainees can participate in legal proceedings and be in close proximity with legal representation/counseling/family/friends etc. The USMS has about 60k people in custody with this being roughly constant for the last decade. Roughly half of these detainees are in county jails and the other half are in private prisons. The table below shows the breakdown of federal agencies and the number of prisoners/detainees held in local county jails.
For these reasons the USMS sometimes does not have any alternative than to use private prisons. So how are they supposed to abide by the executive order? A recent contract that came up for renewal provides the answer. USMS was using CXW’s facility in Northeast Ohio when it came up for renewal. However, seeing as there was no other capacity and being prohibited from renewing, CXW and USMS came to a creative workaround. CXW contracted the facility out to the county who then contracted it out to USMS. USMS is effectively a sub-leasee instead of a leasee. These workarounds and others such as solely leasing the jail instead of managing also acts to dampen regulatory impacts.
So how effective was the executive order introduced in January 2021? Roughly 70% of the beds the USMS contracted with CXW were renewed while 30% were outsourced to local jails. Extrapolating this for the rest of USMS contracts would amount to an 8% drop in revenue for CXW although it will be staggered as the various USMS contracts come up for renewal
How about ICE?
While USMS makes up about 20% of CXW revenue, ICE makes up about 30%. Unlike USMS, ICE was conspicuously missing from the executive order. This was due to several fundamental reasons. ICE facilities are unique in that they need to provide different services to immigrant detainees than what local or state facilities provide. ICE facilities are more labor intensive as they offer higher degrees of healthcare services, transportation support etc. These add-on services require roughly 30% more staffing than the average facility. ICE facilities also need significant flex in their capacity as they are subject to sudden and sharp swings in population. Numbers can fluctuate from 14k to 40k, as seen over the last several years. The capacity to handle such surges cannot reasonably be maintained solely through the use of county/state jails. The only remaining option is private facilities.
Below is an excerpt on ICE and the potential use of county jails from a Homeland Security report :
“The subcommittee emphasizes that it would not represent improvement to phase out private contractors if the result were heavier use of county jails. At least with regard to the capacity to respond to surges in migration flows, contracts with private contractors in general represent a better alternative”
Given that CXW is not facing existential risks, the next point is how value accrues to the shareholder. While CXW was a REIT, it distributed its earnings back via dividends (averaging 220mm per year for the last 7 years!) . Being a C-Corp, CXW now has additional optionality with share buybacks and reducing debt loads, although it now incurs an income tax. CXW currently has about $1.25B in net debt and a $1B market cap. By 2023 and in a more normalized environment, CXW should generate EBIT of about 220 mm/year.
CXW’s targets are to lower debt levels to 2.5x adjusted EBITDA and to be a continuous buyer of shares at these prices (around $10/share). CXW recently instituted a 225 mm share buyback (about 20% of shares outstanding) and has bought back roughly $50mm. If CXW only uses capital for those two purposes, it could theoretically reduce debt levels and share count to zero (assuming prices stay at these levels) in a little over a decade.
“I’d say, our goal is to consistently repurchase shares. We’re a long-term buyer of shares that these prices, and as we’ve discussed for the past couple years intend to return capital to shareholders once we accomplished our leverage targets, which we have done.” Damon Hininger CEO- Q2 2022 conf call
We believe that reducing debt while buying back shares is the optimal allocation of capital and would want to see continued progress in both. Given that the CEO is also a large shareholder (owns 750k shares, likely a good portion of his wealth), shareholder interests are aligned. Possible risks to capital allocation are acquisitions if CXW feels the imperative to diversify into other industries given the rise of ESG investing.
A myriad of regulatory restrictions, coupled with controversies around the ethics of private prisons has made investing in private prisons almost impossible. Pension funds have taken to lambasting several funds that own private prisons and calling to cease investing with them. The inability of institutional money to invest in private prisons presents a buying opportunity. As long as private prisons are fundamentally sound business models and return value to shareholders in a consistent manner, other factors are irrelevant.
Given USMS headwinds and sales of facilities, CXW will generate a normalized EBIT of 220mm going forward. It currently trades at about 10x EBIT/EV. Since converting to a C-Corp, CXW has reduced capex spending to solely maintenance (roughly half of capex spending or about $80mm per year), halted dividend payments, paid down 600mm in debt, and bought back roughly $50 mm of shares. Given disciplined capital allocation, we believe that CXW will be a double from here, however, we will wait to see continued sound capital allocation before increasing our position. We find their 8% bonds to be a good spot to park cash in the interim. CXW will continue to benefit from the continued shuttering of older state prisons, the resilience of current customer contracts, and the potential for increased political and societal volatility ahead.