Fitch Corrections Corp. (CXW) on Review for Downgrade
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Fitch Ratings has placed Correction Corporation of America's (NYSE: CXW) ratings, including its 'BB+' Long-Term Issuer Default Rating (IDR), on Rating Watch Negative. A full list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The placement of CXW's IDR on Rating Watch Negative follows the Federal Bureau of Prisons' (BOP) decision to amend the Criminal Alien Requirement XVI (CAR 16) solicitation by reducing contract beds to 3,600 from 10,800 in response to recommendations from the Department of Justice (DOJ) to reduce future reliance on privately operated prisons. The DOJ cited better performance at publicly run prisons, a decline in its prisoner population and excess capacity at publicly operated prisons as key reasons supporting its decision.
Key considerations to resolving the Rating Watch could include clarification of the positions on private prisons from CXW's non-BOP Federal Tenants, resolution around the company's near-term BOP contract expirations and the outlook for re-tenanting existing (and possible future) facilities following BOP contract losses.
Fitch places a high probability on CXW losing the majority of its BOP contracts (10% of EBITDA) at expiration, or following a temporary, short-term extension. Such a scenario would likely result in a one notch reduction of CXW's IDR to 'BB' from 'BB+', absent actions taken by CXW to offset the impact to leverage.
Fitch believes there are few attractive capital sources available to the company to de-lever. CXW's shares have weakened following the DOJ's announcement. The limited institutional investor appetites for prison real estate make a sale or joint venture unlikely. The loss of BOP income would effectively eliminate the company's small amount of retained cash flow after dividends, placing pressure on its adjusted funds from operations (AFFO) payout ratio, absent a dividend reduction. CXW reiterated its dividend policy commitment of paying out 80% of its AFFO.
Fitch estimates that the BOP comprises 7% of CXW's revenues and 10% of EBITDA, after adjusting for the (unanticipated) loss of its Cibola NM BOP contract earlier this summer. CXW has three contracts with the BOP that, at present, remain unchanged, but will be subject to BOP review as terms expire. CCA's Eden Detention Center, containing 1,422 beds, is included in the CAR 16 solicitation. CCA has two other BOP contracts with expirations in November 2016 and July 2017.
Fitch estimates that CXW's leverage will increase to 4.0x from 3.5x for the TTM ended June 30, 2016, assuming the loss of all BOP EBITDA and no replacement tenant. This is above Fitch's 3.5x negative rating sensitivity but within the company's targeted 3-4x leverage policy range. Fitch has previously communicated some tolerance for leverage to temporarily increase to 4.0x for a strategic acquisition but not due to a decline in fundamentals.
Fitch's rating case assumes CXW will generally operate with leverage closer to 3.0x. The company recently reiterated its comfort with operating at the high end of its range for an extended period, and some tolerance for taking leverage above 4.0x for a strategic acquisition, with the plan of returning leverage to within its policy target within two years. The company is looking at several smaller acquisitions of re-entry facilities
Fitch places a low probability on the near-to-medium term loss of contracts with CXW's two other Federal tenants - the U.S. Marshals Service and Immigration and Customs Enforcement (ICE). The U.S. Marshals (15% of revenues) is under the DOJ, which presumably places it at greater risk given the DOJ's view that publicly operated prisons perform better than private prisons. However, the Marshals Service generally does not operate its prisons, unlike the BOP. Therefore, it has few, if any viable near-to-medium term alternative publicly controlled facilities to replace its private prison contracts, notwithstanding perceived quality differences by the DOJ.
ICE (25% of revenues) is housed under the Department of Homeland Security and, therefore, is not subject to direct DOJ oversight. Like the U.S. Marshals, ICE also has essentially no internally run prisons and therefore no excess capacity that represents a viable alternative to private prisons for its inmate population.
The loss of U.S. Marshals Service, combined with the loss of most or all of its BOP contracts, contracts would likely cause CXW's IDR to migrate towards the low 'BB' or high 'B' category. Fitch would likely reduce CXW's IDR to the 'B' category in the event that ICE transitions to a publicly operated prison strategy. Fitch views both outcomes as improbable, albeit the U.S. Marshals Service contracts are arguably the more 'at risk' of the two given DOJ oversight.
Fitch's key assumptions within the rating case for the issuer include:
--1.5% same-store NOI growth annually 2016 - 2018;
--No debt or equity issued through the forecast period;
--$53 million cash adjustment for depreciation and interest expenses in 2016 related to South Texas Family Residential Center, $49 million in 2017, and $34 million in 2018;
--$58.5 million in annual maintenance and technology capital expenditures from 2016 - 2018;
--$32.5 million in development expenditures related to Red Rock Correctional Center expansion in 2016;
--Dividends of $0.54/share in 2016, $0.56/share in 2017, and $0.58/share in 2018.
Key considerations to resolving the Rating Watch could include clarification of the positions on private prisons from CXW's non-BOP Federal Tenants, resolution around the company's near-term BOP contract expirations and the outlook for re-tenanting existing (and possible future) facilities following BOP contract losses. Fitch will weigh these factors against any actions taken by management to offset the possible leverage increase from lost income.
Considerations for downward pressure on the IDR/Outlook include:
--Fitch's projection of leverage sustaining above 3.5x coupled with continued fundamental business headwinds. Should operating fundamentals improve, indicating current operating weakness is more cyclical than secular in nature, leverage sustaining above 4.0x would be considered for downward pressure on the IDR or Outlook;
--Increased pressure on per diem rates from customers;
--Decreasing market share or profitable contract losses;
--Material political decisions negatively affecting the long-term dynamics of the private correctional facilities industry;
--A holistic change in the Federal Government's sentiment towards privately operated prisons.
Although positive rating momentum is unlikely in the near-to-medium term, considerations for an investment grade IDR include:
--Increased privatization of the correctional facilities industry;
--An acceleration of market share gains and/or contract wins;
--Adherence to more conservative financial policies (2x leverage target; 4x minimum fixed charge coverage);
--Increased mortgage lending activity in the private prison sector.
FULL LIST OF RATING ACTIONS
Fitch has placed the following ratings on Negative Watch:
Corrections Corporation of America
--Long-Term IDR 'BB+';
--Secured revolving credit facility 'BBB-'/'RR1';
--Secured term loan 'BBB-'/'RR1';
--Senior unsecured notes 'BB+'/'RR4'.
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