Description

GEO Group is one of two for-profit prison operators in the US. I think the stock has a base case outcome of $12/share by 2024 assuming flat EBITDA and multiple, with an upside case of $18/share and a downside case of $6.50/share. The setup is highly skewed due to the significant cash generation at the business even post debt restructuring.

Since this stock was last written up here, the company has a) shut down its "construction & design" segment; b) completed a debt exchange that averted a possible bankruptcy and committed to paying down $200-250M debt/year (20-25% equity FCF yield); c) achieved record EBITDA despite continued federal contract cancelations from the growth in electronic monitoring and prudent cost management. Investors may be missing the fact that electronic monitoring business ($200M revenue and $93M operating income YTD) is now more than half of the contribution of the prison business ($705M revenue and $147M operating income YTD). Growth in electronic monitoring has more than offset the decline in the prison segment. 

The recent conversion to C-Corp from a REIT and the shut down of the construction business segment highlights what I believe is a transformational change in the business - a transition from a growth oriented company to a cash cow. In the past the company received significant negative press for actively supporting policies that would increase incarceration. The new GEO faces an entirely different set of incentives. Shunned by most investors and narrowly avoiding a debt maturity wall, the new GEO is going to be focused on managing its existing facilities, exiting non-core businesses, and focusing on debt paydown. The cleansing presentation filed by the management team in Jan 2022 showed EBITDA remaining flat at $411M through 2024 and debt reduction of $200 to 250M/year. Just two quarters later, the company has continued to post strong numbers, and the company is now guiding to $523M of EBITDA in 2022 (note that the previous forecast was arguably sandbagged as it was prepared for debt holders in a debt restructuring context, but I think the general assumption of flat revenue/EBITDA is still a reasonable base case).

The recent debt restructuring also highlights a perverse benefit of being a "anti-ESG" name - debt investors are unwilling to play hardball in a restructuring when they feel uncomfortable owning and operating prisons in the US. The completion of the debt restructuring commits the company into funneling all available FCF into debt reduction, which I view as a "feature" for equity investors. There is no risk of dilutive M&A or growth investments - this company will just focus on cost management and paying down debt. This focus also reduces the risk of the company get caught in more negative press events and is attractive for lenders, who are collecting 10% coupons with 10%/year forced amortization.

GEO is trading at 6x EBITDA, same as its nearest competitor, on what I consider to be trough political EBITDA. The Biden administration has been actively canceling contracts as they come up for renewal - although a number of those contracts were still renewed, as the government often does not have sufficient space in its own facilities. Although there is currently a desire to reduce the prison population in the US, half of the prison revenue is coming from states and not the federal government. Some republican states strongly believe in outsourcing prison management, and even some democratic states like California are suffering from severe prison overcrowding and may in the future utilize spare capacity in GEO prisons. 

In the downside case that the management produces $200M of FCF and EBITDA decreases from $523M to $411M by 2024, the company would have an EV of $2.5B (at 6x) and net debt of $1.6B. This would still leave a market cap of $864M or $7.00/share, a very attractive downside setup. The book value of land + buildings + improvements is $2.4B (plus $270M for idled facilities), so the downside case assumes liquidation at a fraction of the depreciated book value of the real estate, with no value ascribed to the go forward enterprise value or the electronic monitoring business. There are some notable asset divestitures in the works, and we note that the international business appears to be cash flow neutral. If it wasn't for extremely low cost non-recourse debt in Australia, GEO would have exited the business by now.

But even the base case of keeping EBITDA flat at $500M and paying down $250M/year of debt would leave the stock at $12/share, a 25% IRR. Notably the stock would continue to be attractively valued as the company is currently generating AFFO of $2.53/share. Although debt to market cap ratio is 2:1, the company is actually only levered 4.0x and is expected to be <3.0x leverage by 2024. No other company levered 4x would be called "distressed" but in this case the equity attach point is so low that investors are still benefiting from a high gearing ratio.

And the upside case is that there is a change in the political administration and/or continued growth in electronic monitoring solutions - a multiple expansion to 7x with EBITDA growth to $600M would result in a $20/share stock price. While not assured by any means, this case arguably requires a change of political tone to accepting that most "blue states" are terrible at managing their own prisons. Many of those prisons are so overcrowded and prisoners are unmonitored to the point that no rehabilitation is possible. GEO has long claimed that recidivism rates from its inmates are well below those from government run prisons (their claim - I have not verified it) and its prisons are contractually prevented from ever exceeding capacity. The political pendulum is currently at one apogee, and GEO stockholders are getting paid to wait until it slowly but inevitably swings the other way.

Catalyst

Exit from new facility construction and embrace of cash flow maximization / debt reduction in 2022.

Debt restructuring completed Aug 2022.

Forced debt reduction in 2023+2024 to grow market cap by 50% (assuming all things constant)

Potential political upside risk in 2024 and beyond.