Opportunity In Incarceration Provider REITs

Opportunity In Incarceration Provider REITs

By Paul Price

(Dr. Paul Price is a regular contributor to the LCP newsletter. To receive timely trade ideas from Paul, take a free trial here.)

When a stock gets hammered everyone knows it’s much cheaper than the day before. Traders who follow the company, and have a feel for its true worth, are the only ones with enough knowledge to evaluate if the drop is justified, or is an overreaction.

Corrections Corporation of America (NYSE:CXW) and The GEO Group (NYSE:GEO) are publicly traded incarceration providers. They work with Federal, state, local and immigration services typically providing facilities and services via long-term contracts.

Think about these firms like Netflix’s (NASDAQ:NFLX) Orange is the New Black, but taken much more seriously.

Thursday’s surprise announcement that the U.S. Department of Justice will no longer renew existing Federal agreements after they expire sent shares of both companies reeling.

Those massive sell-offs seem way overdone.

Existing contracts extend out as far as five years and the affected ones represent just small fractions of total revenues. Managements will have plenty of time to line up replacement customers. The situation reminds me of the “Brexit-Vote Blues” when the DJIA gave up about 1,000 points overnight before people realized there would be few short-term economic effects.

Both CXW and GEO now operate as REITs after converting to that legal status late in 2012. They pass income through to shareholders in the form of quarterly dividends. REITs are typically valued on a price to ‘funds from operations’ basis (P/FFO) rather than using P/E ratios.

Shortly after 3 PM, Corrections Corp. was trading at its lowest P/FFO since the start of 2012, before the IRS blessed the REIT conversion. Removing the corporate tax rate allowed CXW’s dividend rate to balloon from $0.53 in 2012 to a current annual rate of $2.16 per share.

CXW’s average post-conversion P/FFO has been 13.1x accompanied with around a 6.03% yield. Thursday’s ending quote left the shares offered at only 6.6x FFO. If nothing changes, at CXW’s 4:00 PM close of $17.57, shareholders will pocket 12.29% annually.

CXW’s three “should have sold” moments (red-starred below) kicked in at 13.7x to 16.1x multiples.

Outright purchase looks like a good choice for total return that could be quite significant. Even a sub-par valuation might support a 12-month rebound to about $32, a price that was touched or exceeded during each of the last five calendar years, including 2016 YTD.

Put writers collected huge premiums on Thursday for agreeing to stand ready to buy at well under CXW’s already marked-down price.

“If exercised” price points, based on actual most recent trades, dropped to $12.70 on the $16 strike, $13.40 on the $17 strike price or $14 on the deep-in-the-money $20 puts.

The best-case scenario on any put option sale would be keeping 100% of all premium received without ever needing to buy shares at all. The worst-case results for any of the listed trades mentioned would be forced purchase at prices south of where any CXW shares had changed hands since mid-2012 (excepting Aug. 18, 2016).

Follow-Up items on CXW:

On Aug. 18, 2016:

Correction Corp’s Insiders Traded on the Sell-Off:

CEO bought 2,870 shares @ $16.60 /sh. = $47,652

EVP Scott Irwin bought 300 shares $ 17.00 = $5,100

Director Mark Emkes bought 10,000 shares @ $17.19 = $171,889

Disclosure: I am/we are long CXW.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short CXW Mar. 2017 puts.