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GEO GROUP INC GEO S
January 24, 2021 - 1:50am EST by
value_31
2021 2022
Price: 8.36 EPS 0.6 0
Shares Out. (in M): 121 P/E 13 0
Market Cap (in $M): 1,014 P/FCF 0 0
Net Debt (in $M): 2,805 EBIT 170 0
TEV (in $M): 3,765 TEV/EBIT 22 0
Borrow Cost: General Collateral

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Description

  • GEO equity is likely worthless and GEO credit is likely impaired
  • Near term catalysts exist – some are already in motion but not yet appropriately reflected in the company's valuation
  • If an outright short is not your preference this is a very attractive pair setup with CoreCivic equity (as a long) to isolate the idiosyncratic risks described
 
BUSINESS DESCRIPTION
GEO is an owner and operator of private prisons. Approximately ½ of the company’s revenue comes from the Federal government. The remainder is from state governments and a small international operation. In general, GEO owns the prison facility and has a contract with a government agency entitling it to compensation at a $/day rate per prisoner in the facility. Importantly, most of these contracts benefit from minimum payments from the government customer regardless of occupancy (more on that below) and in general the contracts are cancellable unilaterally by the government customer anytime without penalty.
 
WHAT’S CHANGED / WHY LOOK AT THIS NOW?
(1) BIDEN ADMINISTRATION POLICY
  • The policy: “Biden will end the federal government's use of private prisons, building off an Obama-Biden Administration's policy rescinded by the Trump Administration. And, he will make clear that the federal government should not use private facilities for any detention, including detention of undocumented immigrants. Biden will also make eliminating private prisons and all other methods of profiteering off of incarceration - including diversion programs, commercial bail, and electronic monitoring - a requirement for his new state and local prevention grant program.” (https://joebiden.com/justice/)
  • The practice (to date): 
    • Federal Bureau Of Prisons (BOP): non renewals of contracts have commenced
      • Moshannon Valley Correctional Facility (1,878 beds, $42 million revenue): contract terminated.  Will end in Mar’21 (see here)
      • Rivers Correctional Facility (1,430 beds, $43 million revenue): contract terminated.  Will end in Mar’21 (see here)
    • Immigration and Customs Enforcement (ICE): Biden signed an Executive Order ending a Trump directive that dramatically increased immigration enforcement
      • Under the Trump Administration ICE populations increased materially (see here). GEO was a large beneficiary of Trump policy seeing revenue from ICE increase by 35% from 2016 to 2019 
      • Acting Homeland Security Secretary David Pekoske issued a memo hours after President Biden’s inaugural Wednesday setting strict limits for arresting and deporting immigrants plus a 100-day moratorium on most deportations (see here)
  • Implications:  
    • Federal Bureau Of Prisons: GEO currently operates 15,676 prison beds for the BOP. All of these beds are at risk of non-renewal (see below). GEO’s revenue from BOP over the last 12 months was $326 million (approximately 14% of total revenue)
    • Immigration and Customs Enforcement: GEO currently operates approximately 19,000 beds for ICE. GEO’s revenue from ICE over the last 12 months was $519 million (approximately 22% of total revenue). GEO’s ICE revenues increased by 35% from 2016 to 2019 (i.e. under the Trump Administration). The Biden ICE policy suite will be worse for private prison operators than the Obama policy suite (i.e. GEO’s revenue will likely decline to materially below 2016). Additionally, it’s notable that ICE populations are down >70% vs. 2019 but GEO revenue from ICE is only down 5% as a result of minimum guarantees (i.e. GEO is materially overearning vs. pro forma). This creates significant downside risk to GEO rfevenue from ICE
 
 
(2) PRISON POPULATION DECLINES
  • Incarceration rates in the United States are the highest in the world by a significant margin (see here)
  • After a spectacular increase in prison populations for 3 decades populations have been declining since 2013. The decline has been accelerating. 2019 saw significant declines in both federal and state populations
  • Private prison companies were disproportionately large beneficiaries of the increase in populations and (to date) has been disproportionate losers as populations have declined. Factors for this include: private operators providing marginal capacity (increase & decrease) and unionized workforces for government operated facilities making closure of those facilities disproportionately more difficult than private facilities
Federal Bureau of Prisons (BOP)
  • BOP populations fell by 14% or approximately 25,000 inmates in 2020. This decline exceeds the entire prison population currently housed in private facilities (i.e. there is ample capacity to transfer private populations into federal facilities)
  • In 2020 GEO’s BOP populations declined at a faster rate than overall BOP populations without any facillity closures.  GEO will experience multiple facility closures in 2021.  To date it has had three contracts terminated (see below).  It’s remaining contracts expire in 2021 and 2022 and look very high risk for termination (especially given Biden policy to eliminate private prisons and ample capacity in federal facilities to house these inmates)
  • GEO has benefited from minimum population guarantees under its contracts.  Therefore the decline in GEO's BOP populatins have exceeded the decline in revenues to date.  This will normalize as contract terminations roll through the financials 
GEO’s BOP Prison Contracts
 

Facility

Capacity

Population*

Utilization

Expiry

Comments

Owned

 

 

 

 

 

D. Ray James

1,900

3

<1%

Jan’21

Contract Terminated

North Lake

1,800

1,495

83%

Sep’22

 

Rivers

1,450

987

68%

Mar’21

Contract Terminated

Great Plains

1,940

1,508

78%

May’21

 

Moshannon Valley

1,878

1,640

87%

Mar’21

Contract Terminated

Big Spring**

1,732

1,456

84%

Nov’20

 

Flightline

1,800

1,518

84%

Nov’21

 

 

 

 

 

 

 

Managed

 

 

 

 

 

Reeves R3

1,800

1,496

83%

Sep’22

 

Reeves

1,450

1,061

77%

Jun’22

 
 
 
* Population at 21 January 2021
** Contract expiry as reported in September 2020 financial disclosures.  Updated information will be disclosed with December 2020 filings
 
 
 
Immigration and Customs Enforcement (ICE)
  • ICE populations fell by 62% in 2020 (or approximately 26,5000 detainees) and have fallen a further 6% YTD 2021
  • GEO’s ICE contracts benefit from minimum payments so despite populations having declined by almost 70% GEO’s revenue from ICE is only down 5%. This is not a sustainable situation (i.e. GEO’s run-rate revenue from ICE is significantly lower than currently disclosed). Approximately ½ of GEO’s ICE contracts expire by end-2021 and GEO will be renegotiating these contracts with near empty facilities and a new approach to immigration from the Biden Admininstration. GEO’s ICE revenue looks very high risk to decline materially
 
States
  • GEO’s exposure to any individual state is lower than its federal exposure but the states in aggregate are meaningful. A number of states GEO has larger exposure to have also seen large prison population declines in 2020. Specifically: 
 

State

% GEO 2019 Revenue

2019 Prison Population

Florida

4.6%

-15.6%

Arizona

3.6%

-10.1%

Oklahoma

1.6%

-13.1%

Georgia

1.2%

-14.7%

Texas

1.1%

-19.2%
 
 
(3) CALIFORNIA STATE LEGISLATION (AB-32)
  • California legislation (AB-32) was passed in 2019 and banned private prisons in the state of California including private prisons run for federal bodies (i.e. AB-32 bans private prisons for ICE, BOP and the US Marshall Service operating in California)
  • The Trump Administration and GEO litigated the legality of this legislation and mostly lost. The only point not lost was that USMS can operate private prisons (ICE and BOP cannot) (see here).  Importantly, the court refused to enjoin California from enforcing AB-32 against ICE contracts with GEO
  • AB-32 is very meaningful for GEO which has 4,400 ICE beds in California as well as over 1,000 beds managed for the BOP and CDCR
 
 
FINANCIAL IMPLICATIONS
  • Using LTM as a starting point and adjusting: 
    • BOP: assume all contracts lost (seems likely). Assume gross margin of 30% on these contracts
      • BOP contracts are higher margin than average. GEO disclosures indicate D Ray James ($87/day); Big Spring ($52/day); Moshannon Valley ($61/day) and Rivers ($95/day) are all higher than the average GEO day-rate (which is in the low $40s/day)
    • ICE: currently running at <30% of 2019 and AB32 creates existential risks to GEO’s ICE operations in California. Assume 50% revenue decline from ICE at 35% Gross Margin (i.e. assume populations are higher than current which would imply at 70%+ reduction to revenue)
      • ICE contracts are much higher margin than any other GEO contracts. On average ICE contracts earn the company almost $80/day
    • Other: State populations are down 10-20% across the board. Conservatively assume 10% revenue decline for State operations at 20% Gross Margin (below the average company margin as these contracts are lower margin than ICE/BOP)
  • GEO starts with $2.7bn of debt and 7x Leverage (EBITDA)
  • Contract losses puts the company into a negative Free Cash Flow Position, increase leverage to unsustainable levels (>17x EBITDA) and leave it unable to meet debt maturities in 2022 & 2023.  In this scenario equity is worthless and the company’s debt is materially impaired
  • GEO will very likely need to eliminate its dividend completely as a pre-emptive measure
    • As contracts are lost EBITDA will decline and leverage will increase resulting in a breach of covenants under the company’s bank debt
    • Unlike a normal situation GEO’s ability to negotiate covenant waivers with its bank group is compromised by the fact that all of its lenders have indicated they no longer wish to lend to the company (see here)
  • GEO has already cut its dividend in half but will be required to eliminate the dividend completely 
    • GEo cut its dividend in Q3'20 and indicated it was sustainable.  It then cut its dividend again for Q4'20 and again is saying it is suistainable.  As the company suffers further contract losses and population declines it keeps reducing the dividend to a 'sustainable' level that leavs it will minimal positive free cash flow.  It seems likely this will continue until the dividend reaches zero
Pro Forma Financials
 
 
 
VALUATION AND COMPARISON TO CORECIVIC
  • GEO and CoreCivic (CXW) are the two largest companies in the Private Prison market. Broadly speaking, the two companies are exposed to similar market dynamics and historically the two stocks have been highly correlated
  • CXW currently trades at a discount to GEO – the primary reason for this appears to be CXW has eliminated its dividend (i.e. GEO’s dividend – which per above seems unsustainable – is causing the stock to levitate)
    • In June 2020 CXW announced it was eliminating its dividend and changing corporate structure from a REIT to a C-Cop. The reason for this is CXW’s concern about the industry fundamentals, ongoing access to capital and a desire to retain cash flow to de- leverage
    • As a reference point CXW is approximately 2-turns less leveraged than GEO 
  • There are a number of reasons why CXW is better positioned than GEO, including: 
    • Valuation => CXW currently trades at 7x EBITDA vs. GEO at 10x EBITDA 
      • Per above this is not based on fundamentals but instead on an unsustainable dividend. IF GEO were to trade at the same EV/EBITDA at CXW it would have zero equity value
    • CXW has already eliminated its dividend and changed corporate structure => there is no downside shock potential from these events (vs. GEO where both are yet to come)
    • CXW has minimal exposure to the Bureau of Prisons vs. 14% of total revenue for GEO => GEO will disproportionately suffer from Biden Administration policy in this area
    • CXW has a safer financial profile => CXW starts with lower leverage and a larger buffer under debt covenants. It is also using surplus cash flow (including proceeds from asset sales underway) to retire debt. GEO has much higher risk of creditors extracting value from equity holders when covenant breaches occur

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

  • Continued contract losses
  • Dividend cut
  • Debt covenant breaches and financial distress
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