Co-produced with Trapping Value
As the U.S. presidential elections draw near, it's impossible to not consider the ramifications of the different policies that might come into play during the next four years. Investors try and discount these ahead of time so as to prevent any surprises. These discounting mechanisms are, however, not always rational. In that regard, investor mood swings can range from unbounded optimism to hopeless paranoia. We identify one of the candidates today, where the sentiment is far removed from the underlying fundamentals, as a result of which, it represents a good risk adjusted play.
GEO, along with CoreCivic (CXW), make up about 70% of the for-profit prison market in the U.S. These publicly-traded REITs have been on the receiving end of relentless attacks from the Democratic Candidates as the election cycle has progressed. In this article, we will discuss GEO and tell you why we think it makes a good risk-reward investment at this price point.
GEO was formed about 36 years ago, in 1984, to provide secure corrections and detention management services as well as secure transportation services to state and federal governments in the U.S. and also internationally. GEO might have received attention over here, in the U.S., however, it's slowly but surely becoming a global player. GEO's international correctional and detention facilities include Australia, South Africa and in the UK.
GEO oversees the operation and management of approximately 95,000 beds globally. Of this, U.S. operations consist of 87,000 beds in 123 detention and correctional facilities.
Source: GEO Q4-2019 Presentation
These are divided among different customers as depicted in the table below with the U.S. Immigration and Customs Enforcement (or ICE) adding up to roughly 22% of the total revenue.
Source: GEO Q4-2019 Presentation
Looking at facilities that GEO manages on behalf of its customers, Australia comes on top in terms of revenue, with 9.5% of total revenues.
Source: GEO Q4-2019 Presentation
As it is evident below, GEO is dependent on ICE as its major customer, followed closely by various state and local governments.
Source: GEO Q4-2019 Presentation
In addition to owned and leased facilities and managed facilities, GEO also provides other key services to government entities. These include in-house secure transportation to federal, state, and local government customers in the US and internationally. Additionally, GEO operates residential facilities and 71-day reporting facilities which are key services to prison reform and inmate rehabilitation.
According to the Bureau of Justice, the U.S. has the highest incarceration rates of any developed country, based on data by the Bureau of Justice.
You have to go several steps down in that list to find a 'developed' country. Australia for example has about one-quarter of the incarceration rate as the U.S. This results in some extremely-lopsided statistics like the one that shows that the U.S., while having just about 5% of the total global population, also has 25% of the world's prisoners. Politicians love extreme statistics and this cycle has been no different with constant attacks on 'for-profit' prisons byDemocratic politicians. While these facts are not debatable, what's indeed debatable is the idea that private prisons are somehow contributing to this problem. While they have taken all the blame, the reality is that private prisons make up a very small portion of the total prison capacity in the U.S. They also have historically grown at a slower rate than the overall prison population.
Source: prisonpolicy.org
As we examine the political landscape and visualize the multiple possible outcomes, we think that the profitability and tangible asset value of GEO creates a very wide buffer, making it an attractive buy here. Even if the 'wrong' candidate came into power and tried to change this industry, we think it will work out for GEO. Currently state prisons are at 98% capacity and federal prisons at 140% capacity. Waving a (Democratic) wand and changing this overnight is not an option. Long-term measures may be put into place to change how prisons are run. Sentences may be lowered or the focus may shift over time to rehabilitation. This is assuming the “chosen one” has full support of the Senate and the House, and even then it will take years to change the logistics of the situation. The government can even claim a moral victory by buying these facilities and employing GEO in some shape or form to help. This might happen at the federal level (the states would likely not move much in this direction) and would work out really well for GEO investors as long as it gets anything close to fair value (see valuation levels below). Our base case though is for multiple less draconian measures, including external audits or requirement to meet certain standards for these REITs. An increased emphasis on rehabilitation by the government is where GEO could really increase its focus and shine as well. GEO already is moving in this direction by itself.
To strengthen its commitment to be a leading provider of enhanced in-custody rehabilitation and post-release services, GEO announced today that it has increased its annual expenditure commitment to expand the delivery of its GEO Continuum of Care programs from approximately $10 million to approximately $14 million in 2020. The GEO Continuum of Care integrates enhanced in-custody rehabilitation programming, including cognitive behavioral treatment, with post-release support services.
Source: GEO Q4-2019 press release
GEO guided for adjusted funds from operations (AFFO) of $2.62/share putting the company valuation at about 6.0X times AFFO.
Source: GEO Q4-2019 Presentation
This guidance is conservative and assumes no revenues from the California facilities being transitioned to ICE.
GEO’s full-year 2020 guidance assumes no contribution from GEO’s 700-bed Central Valley, 750-bed Desert View, and 700-bed Golden State facilities in California, which will be transitioning during 2020 from California state corrections contracts to the previously announced new 15-year contracts, inclusive of option periods, which GEO entered into with U.S. Immigration and Customs Enforcement (“ICE”) on Dec. 20, 2019.
As GEO previously announced, the State of California completed the ramp-down of the Central Valley facility at the end of September 2019, and the Desert View and Golden State facilities are in the process of ramping down during the first half of 2020. The discontinuation of the California corrections contracts for the three company-owned facilities represents an annualized revenue loss of approximately $47 million.
While GEO expects that the three facilities will transition as facility annexes under the new ICE contracts during the second half of 2020, GEO has not assumed any contribution from these facilities in its initial financial guidance.
Source: GEO Q4-2019 press release
One other point from the guidance we would note is the dialing down of the overall capex. Growth capex is close to a $18 million annual run-rate, and this preserves a lot of cash flow for GEO. This also is the lowest run-rate we have seen in recent times.
Source: GEO Q4-2019 Presentation
The combination of this AFFO and the capex will position GEO very well to withstand any volatility in the sector. That is a fundamental reason for us turning bullish on its prospects as we believe the stock is pricing in a very bad outcome versus the more likely reality. We expect valuations to move be at least 8X AFFO, in addition to the steady dividends that will result in total returns close to 50% overtwo years.
The current dividend of $1.92 is very well covered by AFFO (73% payout ratio) and leaving significant room to reduce leverage and complete projects. The current yield is at 16%, which is one of the highest yields in the REIT sector that investors can find today.
Another reason GEO is highly attractive is because the tangible value of its real estate holdings significantly exceeds the enterprise value of the company. With a $4.6 billion of enterprise value, the cap rates of 14% are quite high for a resilient and business model that is very difficult to replicate.
While prison real estate are very unique and can hardly be used as a site for other purposes, new prison locations can take years to get approved, developed and put into operations. Therefore, existing locations command a high premiums. The 14% cap rate is discounting in many negative scenarios and even more. Even in case of a piecemeal liquidation, this will result in higher values and shareholder returns than what valuations are at today. This offers investors the opportunity to buy the stock at a highly-discounted price.
GEO management mentioned extending the revolving credit facility and it now matures in June 2024. Importantly, this extension came with no changes, suggesting that even though banks have publicly voiced their desire to move out of lending to private prisons, their actions have gone in the other direction, i.e. been resoundingly louder than their words. GEO does have significant maturities down the line in 2024.
Source: GEO Q4-2019 Presentation
However, with the amount of capital looking for a home and the large interest coverage that GEO's cash flow provides, we see no trouble in getting that financed when the time comes. In the interim, GEO continues to use excess cash flow to buy back its own debt at a discount.
During the fourth quarter of 2019, GEO repurchased approximately $22 million of senior unsecured notes due 2022, bringing the total debt repurchases during 2019 to $56 million at year-end.
Source: GEO Q4-2019 press release
We are today in a full-blown market correction. GEO has exhibited much less volatility than the general markets. We have noted in a previous report that this is a defensive and recession-resilient stock that's worth owning in times like today. Another reason why GEO has outperformed the general markets is that theFed has just slashed interest rates by 0.5%. Today, the 10-year Treasury yields are well below 1% which makes stocks like GEO even more attractive, and cheaper based on yield valuations.
We have seen just last month massive purchases of the stock by the CEO of the company, Mr. George Zoley, amounting to $8 millionworth of shares.
This is significant, and can be used as a good indicator that management believes that the stock is highly attractive at the current price.
GEO offers investors exposure to a unique asset class that's priced for its demise. At 6X adjusted funds from operations (or FFO) and at a high discount to its tangible net asset value, investors have a unique opportunity to the stock's very attractive valuation even in case of a slow liquidation. A liquidation is not what we believe will happen, but even if it did, it would work out well for investors buying today. Important to note too that GEO offers a resilient business model alongside a high dividend yield compensating us for buying this stock ahead of the election. GEO's international diversification also is a big plus. We expect about 40% upside in 24 months, in addition to a dividend yield of more than 16%. Upside could be substantially higher should the current president be re-elected.
With the current market turmoil and correction, GEO is one defensive stock that investors should own to hedge against both volatility and any future recession. GEO and CXW are today two of my largest holdings in my retirement account. Income investors should buy and hold for many years, earning a fat yield of 16% that insiders are loading up on. GEO has the potential to be the big winner in your income portfolio.
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Disclosure: I am/we are long GEO, CXW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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