Description

GEO Group (GEO), the second largest private prison company in the US, went through a REIT conversion which effectively concluded in January of 2013.  This made it a great stock to own since the REIT conversion process began last summer.  The stock has currently stalled at the $33 level as those that made a lot of money in the name have chosen to take profits as they believe that with the passing of the REIT election there is little upside remaining in the stock.  While I would agree that the low hanging fruit has definitely been picked in this one, we think that GEO still has substantial upside.  GEO is in the process of increasing its dividend payout ratio and it also has a fairly clear path to AFFO growth from the utilization of a portion of its idle bed inventory in 2013 that could drive the current $2.00 per share dividend to the $2.40 to $2.50 by this time next year which could put the stock in the low $50 range if, as we expect, the dividend yield on the stock compresses to something closer to the non-mortgage REIT average.  In addition, there will be REIT index fund buying that will support the stock over the course of the next month.

• The current 6% dividend yield should compress over time.  The average non-mortgage REIT trades at a median dividend yield of 3.6%.  Given the stable nature of the private prison business with its diversified government customer base, long-term contracts, 90%-plus customer retention, high occupancy rates and low maintenance capex requirements we think a 250bps spread to the average dividend yield is too high and should contract.  We think that in the near term GEO’s dividend yield should be closer to 5% and over time as REIT investors gain an understanding of the stable attributes of the private prison business, dare I say, the yield could approach the REIT average.  The following is a quote from George Zoley, GEO CEO speaking on the 4Q12 earnings call, “Well, I don't know that we've had a lot of interaction with REIT investors as yet. I think that's going to come very shortly in the next 30 to 60 days as we get on these different indexes.”  In the meantime, we believe a 6% dividend yield provides solid downside protection and decent compensation while we wait for REIT investors to come up to speed.

• GEO management intends to increase the AFFO payout ratio to the 80%-85% range.  GEO’s current dividend payout ratio to AFFO is in the 70% range.  GEO, as with most other REIT conversions, followed the standard mantra with respect to its initial dividend which is, “start it low so it can grow.”  GEO has said as recently as its latest earnings call that it intends to increase its payout ratio.  We believe company’s target payout ratio is in the 80%-85% range.  The company is currently in the process of refinancing is senior credit facility which will give it the flexibility to increase its payout ratio by increasing the company’s cash available for distribution by lowering required amortizations on its CF.  The following quote is from Brian Evans, GEO CFO from the 4Q12 earnings call transcript, “Well the main piece that we would be focused on refinancing right now would be the senior credit facility. So I think the interest rate environment we're going to get consistent margin spread, consistent terms, but it's a change in the covenants in the senior credit facility, which will allow us to continue to pay dividends as a REIT at much higher payout ratio than the current credit facility envisions or builds capacity towards.”  Assuming GEO goes from a 70% to an 82.5% payout ratio, the 2013 full-year dividend would be in the $2.37 range based on the current 2013 AFFO guidance.  Assuming a $2.37 per share dividend, at the current 6% yield, the stock would be at around $40 and at a 5% yield, the stock would be at $47.

• AFFO growth from utilization of idle beds.  GEO has 6,000 beds that are currently idled and we think that approximately 2,400 of those idled beds will be utilized by the end of 2013.  The following are comments from the 4Q12 earnings call made by John Hurley, SVP/Pres US Detention for GEO, “In California, the Department of Corrections and Rehabilitation issued a bed utilization plan last April that would increase the use of 1,200 additional community correctional facility beds in the state for the later part of this year. The plan also calls for increased use of community supervision programs. We currently have more than 2,200 community correctional facility beds in inventory in California and we will continue to monitor the state's proposed plan. In Michigan, the state Legislature approved language directing the Department of Corrections to issue an RFP for 1,750 in-state beds.  The Department has initially issued an RFP for approximately 1,000 beds.”  Regarding the California beds, we believe that the CA Governor has requested the funding for 625 of those 1,200 CCF beds but based on our research we think the number of beds that California could actually need this year will be in the 1,200-1,500 range.  Regarding the Michigan RFP for 1,000 beds, GEO’s 1,750-bed North Lake Correctional Facility in Baldwin, MI is the only private prison in the state so they are highly likely to get this business.  Based on our calculations ($60 per diem x 2,350 beds x 365 days x 30% margin / 71.5mln shares), the reactivation of the CA and MI beds could add approximately $15.5mln to AFFO ($0.22 per share).  As a check against our math (and as additional upside), according to the CEO on the 4Q12 earnings call, the reactivation of all of GEO’s idled beds would add about $0.60 per share to AFFO.  While the reactivation of 100% of GEO’s idled beds is a possibility over time, we are only assuming that the CA and MI beds are reactivated in the near term in our analysis.  Increasing AFFO per share by $0.22 to $3.09 and assuming an 82.5% payout ratio would put the dividend in the $2.55 range which at a 5% yield would put GEO’s shares at around $51.

• GEO is being added to the major REIT indices.  GEO will be added to the MSCI US REIT index (RMZ) on February 28, 2013.  As a result of the addition to the RMZ, approximately 4.0-4.5mln GEO shares must be bought on that date.  Then, in late March, GEO will very likely be added to the FTSE NAREIT and the Dow Jones US Select REIT indices which will require index funds to buy and incremental 2-3mln shares.  While not the cornerstone of our thesis, the incremental buying by index funds will certainly provide some downside protection over the course of the next month.

What’s it Worth?

What does this all mean for GEO’s share price?  We think the impact of the items discussed above could be a significant driver of GEO’s share price this year.  Note that we only discussed what we believe are high probability idle bed utilization opportunities.  The company outlines many other opportunities for AFFO growth on their recent earnings call.  We’ve simply chosen not to include those opportunities in the interest of being conservative.

*Current values

Catalysts

• REIT index fund buying over the course of the next month.
• Management going on the road over the month or two to get in from of REIT investors.
• Refinancing of GEO’s credit facility should be done by mid-year if not sooner.
• Decision on Michigan RFP.
• CA legislature authorizes funding for additional CCF beds in the summer.

Catalyst

• REIT index fund buying over the course of the next month.
• Management going on the road over the month or two to get in from of REIT investors.
• Refinancing of GEO’s credit facility should be done by mid-year if not sooner.
• Decision on Michigan RFP.
• CA legislature authorizes funding for additional CCF beds in the summer.