Description

The Geo Group, Inc. (“GEO” or the “Company”) offers the opportunity to acquire a stable infrastructure-based business, in the midst of a REIT conversion, at a substantial discount to comparable publicly traded REITs and similarly situated REIT conversion plays. 

Company Overview

GEO operates private correctional facilities in (i) theUnited States(71% of EBITDA), (ii) internationally (4% of EBITDA), with private prisons intheUnitedKingdom,AustraliaandSouth Africa, and (iii) through the GEO Care segment (25% of EBITDA), which operates mental health and youth treatment facilities and provides electronic monitoring services.   As of July 1, 2012, the Company’s worldwide operations included the management and/or ownership of approximately 75,000 beds at 109 correctional, detention and residential treatment facilities. 

Basic company financials are laid out below:

GEO’s business is inherently lumpy, and industry growth is currently constrained by financial and political pressures, which force state and federal agencies to consider early release programs to reduce inmate populations.  As a result, sell side analysts do not build contract wins into their forecast, resulting in little to no estimated earnings growth.  GEO, however, has several near-term earnings catalysts that should drive AFFO growth including:

1. The California Department of Corrections and Rehabilitation (“CDCR”) announced a restructuring plan, entitled "The Future of California Corrections" in April 2012.  CDCR’s plan calls for the reactivation of 1,225 in-state contract beds by December 2013.  GEO currently has approximately 2.2k empty beds in CA, many of which were used by the state to house low level offenders through 2011.  We believe these facilities are in a prime position to be reactivated.  In 2011, GEO estimated that canceling a 1,573 bed contract reduced annualized revenue by approximately $33-$35 million and AFFO by approximately $0.10-$0.13 per share.
2. Michigan’s fiscal 2013 budget requires the state’s Department of Corrections ("DOC") to release a 1,750-bed RFP by 1/1/13.  GEO is in prime position to win the contract with its comparable cost advantage and vacant 1,740 bed North Lake Correctional Facility inMichigan.  Assuming a $60 per diem rate and 35% EBITDA margin, the annual accretive impact to revenues and AFFO would be $38 million and $0.13 per share, respectively.
3. In the United Kingdom, GEO’s international segment is competing on the Ministry of Justice‘s procurement to privatize nine public facilities that total approximately 6,000 beds.  Under the procurement, companies can be awarded long-term contracts to manage up to five prisons.  We estimate GEO would earn $30mm in revenue or $3mm in EBITDA for every 1,000 beds awarded.
4. GEO is also competing for an Electronic Monitoring contract for all ofEnglandandWales.   Based on our conversations with the Company,  we believe this contract could add $65mm in  revenue or approximately $16mm in EBITDA. 

The preceding list is by no means all inclusive, there are several additional RFPs outstanding including those issued by the Federal Bureau of Prisons andNew Hampshire.  We also note that GEO's earnings downside is limited as only 1.4k beds are scheduled to be re-bid next year and most of these are community contracts with limited competition.

REIT Review

Following Corvex Management’s and Marcato Capital’s April 2012 13D filing, pressing Corrections Corp. of America (“CXW”) to initiate a REIT conversion, GEO hired Skadden Arps, Bank of America Merrill-Lynch and Barclays Capital to review the impacts of a REIT conversion.  Recognizing CXW as GEO’s only genuineU.S.competitor, we believe GEO’s decision was primarily driven by management’s desire to avoid an operational / cost of capital disadvantage.   We also note that GEO’s management team is not unfamiliar with REITs.  The Company historically operated via an independent REIT, CentraCore Properties Trust ("CentraCore"), and a separately listed operating company that managed prisons as a tenant.  The OpCo / PropCo structure was imperfect, resulting in a number of operational and financial challenges that eventually forced Geo to acquire CentraCore in September 2006. 

While we are not real estate experts, our substantial due diligence and numerous discussions with legal advisors give us confidence in GEO’s ability to successfully overcome these challenges and efficiently operate within a Taxable REIT Subsidiary ("TRS").  On the most basic level, a TRS will give GEO a tax-efficient structure to operate its existing business while providing greater flexibility to pursue growth opportunities at a lower cost of capital.  Under a TRS, GEO will maintain its current strategic alignment, forming subsidiaries to provide impermissible real estate related services without jeopardizing the Company’s REIT tax standing.  In return, the REIT will be required to pay the subsidiaries an arms-length fee for the services provided. 

As neither CXW nor GEO has provided guidance on the impact of a REIT conversion on AFFO, we have estimated the cash flow impact below.  The most significant impact, as disclosed on GEO's Q2 2012 conference call, will be the amount of tax savings.   To estimate the taxable income generated by GEO’s TRS, we (i) include all managed only and service related revenue and expenses (excluding Residential Treatment Services, as discussed below), (ii) assume a 12.5% profit margin on a management contract relating to the Companies’ owned/leased facilities (CXW managed only facilities currently achieve a margin around 11%) and (iii) ascribe 85% of LTM G&A and interest expense.  Running these assumptions through our model, we estimate a 60% normalized tax savings for GEO, adding approximately $32mm in AFFO.

Note:  The Residential Treatment Services unit will largely need to be excluded from the TRS as health care facilities must be managed by an eligible independent contractor (IRC §§ 856(d)(8)(B) and 856(l)(3)).  We believe GEO is considering several potential arrangements that would allow it to retain up to a 30% interest in Residential Treatment Services, but for the sake of simplicity, the impact of this interest is not included in our analysis.

REIT Valuation

Given the infrastructure-like nature of prisons, we conservatively assume GEO will trade in-line with low growth health care REITs and therefore apply a 13-15.0x multiple, resulting in nearly 30-50% upside to current prices.  

Adding in the AFFO resulting from the completion of GEO's recent CapEx program and assuming the Company is successful in pursing some of the RFPs listed above we believe GEO's REIT AFFO will move above $200mm over the next several years adding more than $7.00 per share to our valuation.

Conversion Timing

In mid-July, after approximately three months of analysis, GEO and its advisors submitted a request to the United States Internal Revenue Service for a private letter ruling.  The Company is targeting a REIT conversion on January 1, 2013 requiring the receipt of a PLR in early Q4.  Our understanding is that Coresite received its PLR in 11 weeks, so a mid-July filing creates the possibility that conversion could occur by January 1, 2013.  However, given the short time frame, a REIT conversion may be delayed until the next available conversion date, January 1, 2014.   Should a conversion be delayed, we estimate GEO shares provide a 36% IRR (to a $40 price target) through January 1, 2014 (inclusive of $0.20 quarterly dividends), limiting downside.  

Conclusion

While it’s always possible that GEO will decide not to convert into a REIT, the Company has hired advisors and after conducting substantial analysis has asked the IRS for a private letter ruling relating to the conversion.  Management’s comments further imply that GEO believes it's more a question of when versus a matter of the Company’s ability to operate within a TRS.  Combining this with the competitive pressure leading up to the announcement of a REIT evaluation gives us confidence that GEO will be operating as a REIT in 2014, with its current share price more than compensating investors for waiting. 

Catalyst