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Can this correction facility provide discipline to your portfolio?

Tuesday, June 28th, 2016

When building your portfolio, it is very important to make sure you have companies that provide diversification. You do not want to have more than a quarter of your portfolio in tech or financials, as different companies will go through different experiences over the course of time.

One company that will be sure to add some diversification to your portfolio is Corrections Corporation of America (CXW).

Corrections Corporation of America owns and operates prisons, jails, detention facilities, and residential reentry centers. Residential reentry centers (also known as halfway houses) provide assistance to those inmates who are nearing their release. They provide programs such as employment counseling, job placement, and financial management assistance to those inmates.

The company also leases their real estate to government-owned jurisdictions. This is beneficial to government entities from the federal level down to local municipalities, as high upfront costs to build and maintain prisons can be easily accumulated.

CXW is the fifth-largest corrections facility behind the federal government and three states.

The company has been in the process of expanding their business as of late, with a larger focus in the residential reentry centers.

In the most recent conference call, CXW listed aging government-run facilities around the nation and a growing U.S. population as factors that could aide in the growth of their company.

This company can provide diversification in two regards. First, CWX is run here in the U.S., meaning it is unaffected by global factors such as the recent Brexit. It is also recession proof. If the U.S. economy slips into another consumer recession, correctional facilities must still carry on.

It is important to note that this company operates under a different structure. They have structured their business as a Real Estate Investment Trust (REIT). These companies invest in real estate and trade on an exchange, like a stock. They provide investors a liquid method of investing in real estate. They must abide by various rules like investing 75% of their assets in real estate, cash, or U.S. Treasuries, having 75% of gross income must come from real estate, and maintain a dividend payout ratio of at least 90%.

It is crucial to understand the difference between private REITs and public REITS. Private REITs are much more complicated, as they do not provide the same transparency as public REITs. Your money may also be tied up for many years, and they are often accompanied by high commission and upfront charges.

This is why we prefer public REITs. If your advisor is in the process of selling you a private REIT, stop and ask how much he is making in commissions on the sale?

Just like we analyze the fundamentals for our traditional stocks, it is important that we do the same for these public REITs.

First we will look at the valuation ratios for Corrections Corp of America (CXW).

The current P/E for the last twelve months of earnings is 19.22, which is below the industry average of 27.26. Price/sales of 2.23 falls below the industry average of 2.93. Price/tangible book value of 2.86 compares favorably, as the industry average is not material.

There is also a small discrepancy between the price/book value of 2.79 and the price/tangible book value. This is important, as it shows us the company is not carrying a lot of intangible assets on the balance sheet.

Finally, price/cash flow of 10.76 is less than the industry average of 16.01. All the valuation ratios fell below the industry average, which is a major positive and indicates you are getting a good value for this company.

The company’s sales have increased 8.7% over the last twelve months. This compares favorably to the industry average, which saw an increase of just 2.6% during the same time period.

EPS has increased 4.9% over the last twelve months and also compares favorably to the industry average, as it saw a decline of 6.2%.

We would like to see more strength in the balance sheet, but the numbers look okay. The company’s current ratio of 0.92 falls below the industry average of 1.68. Traditionally, we are comfortable with a ratio over 1. Total debt/equity looks a little high at 97.2%, but it is below the industry average of 130.7%.

Due to the structure of the REIT, we evaluate our future target sell price by analyzing the estimated funds from operations (FFO) for December 2017.

In this case, the estimate of $2.79 gives us a target sell price of $46.04. This is an estimated return of 33 % over the current price of $34.59. CXW also has a current dividend yield of 6.2%, which is a nice added bonus to investing in the company.

The main difference of FFO and EPS is the exclusion of depreciation in FFO. This is an acceptable difference for REITs because of the large amount of property they hold on the balance sheet. 

Do you have a question or a company you would like us to take a look at?
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