At its current price, we believe that an investment in GEO Group presents a very compelling risk/reward profile. GEO was written up less than a year ago on VIC, and although the fundamentals of the company remain the same, the circumstances surrounding the company – as well the valuation of its shares – are quite different.

GEO closed on Friday at $18.22 – The stock has sold off more than 25% from its closing price of just over two weeks ago, and Friday’s close marked the shares’ lowest in two years. Of course, most everything has sold off precipitously over the last couple of weeks, and in this market 52 or 104 week lows are hardly infrequent. Nevertheless, we believe that GEO is a fundamentally strong company, and one which – with a small caveat – should remain entirely unaffected by both the credit crisis as well as the general economic malaise.

At its current price, GEO is trading at 14.7x adjusted 2008E EPS and 12.6x 2009E EPS; more compellingly, it trades at a 9.5% FCF yield on 2008E normalized FCF, and an 11.1% yield on 2009E normalized FCF. Moreover, as addressed in previous post on GEO as well as later in this report, GEO is a fast growing company that should deliver annualized EPS growth of 15%+ for the next 3-5 years. We believe that valuation is extremely attractive for a business with the following characteristics: 1) Recession resistant/proof; 2) Extremely limited competition (operates in a duopoly/oligopoly in an industry that does not have the supply to meet the demand) 3) Inflation protected; 4) Revenues/earnings derived from long-term contracts with government clients; 5) A very robust growth profile; 6) Various free options through a variety of operational enhancements. In this very uncertain economic environment, we believe GEO’s attractiveness is enhanced – it is a rare investment that we believe is almost entirely insulated (and in fact may benefit from) the turmoil in the nation’s economy.

We believe that on a base case scenario there is likely more than 50% of upside to the investment and a long-term basis limited risk of capital impairment.

 

This write-up will address the following: 1) The recent events which we believe which have contributed to the sell off; 2) Current valuation of GEO; 3) Near and intermediate term catalysts; 4) Risks to our thesis:

The report also includes a lengthy discussion various elements of the GEO’s business and the industry in which it operates. This information is useful for anyone unfamiliar with the business, although much has already been reported in previous VIC write-ups on the company. We have included this as an appendix following the core write-up.

 

 

1)       Motivated sellers: We believe that that at least two large holders of GEO have been selling the stock somewhat indiscriminately over the past couple of weeks.

 

Fidelity - FMR filed an amended 13G on September 10, 2008 showing that they had sold ˜2.1mm of the ˜4.8mm shares they owned as of June 30, 2008. From both an intuitive standpoint, as well as through discussions with GEO as well as sell-side analysts and traders, we believe the vast majority of those 2.1mm shares were sold during the three trading days of August 7, 8, and 11 2008, following GEO’s Q208 earnings release. As a later section in the report discusses, GEO slightly lowered FY2008 guidance on the earnings release, sending shares down on the day of the release to a 52-week low of $18.00. (Shares swiftly recovered over the subsequent two trading days and then rallied further). During those three days, more than 10mm shares traded hands, greater than 5x the average volume for GEO shares. Our reasons for believing Fidelity has been unloading the remainder of its position is based on 1) our view that Fidelity is unlikely to retain such a relatively small position in a company; 2) discussions with sell-side analysts and traders; 3) from the GEO’s own statements to us – including their recent discovery that the Fidelity PMs that formerly dealt with GEO are no longer at FMR. Whether for fundamental reasons or not, we believe Fidelity has decided to exit this position entirely and their large swathe of shares has been dumped on a market of nervous buyers.

 

Dawson-Herman Capital Management – As of June 30^th, Dawson-Herman held 1.65mm shares of GEO. On Thursday, we spoke with the GEO who related to us that they found out this past week that Dawson-Herman is liquidating its hedge fund. We have not been to independently confirm this statement, but neither do we suspect GEO is lying to us. If that is indeed the case, the large share blocks unloaded by Dawson-Herman would have had material implications on the share’s recent performance.

 

2)       Financing need: The company needs to expand it borrowing capacity sometime in Q408.

Integral to the substantial growth GEO will be experiencing over the next 12-18 months (and beyond) are large capital projects – i.e. constructions of prisons. Between the end of June 30, 2008 and the end of FY2009, GEO will be spending ˜$283mm to complete announced capital projects. As of June 30, 2008, the company had $41mm of cash on hand and $67mm of available capacity on its revolver, for a total of $108mm in existing financing. Additionally, GEO generated ˜$45mm in FCF (before growth CapEx) in H108. Assuming they continue that run-rate over the next six quarters (we believe it will be higher, meaningfully so in 2009), they will generate ˜$135mm in FCF through the end of FY2009. Accordingly, through existing financing and internally generated cash, the company has a total of $243mm available through the end of FY2009. Therefore, there is a ˜$40mm gap between financing available and financing required.

 

Prima-facie, the $40mm should not be a problem. As stated in the company’s filings, GEO’s current credit agreement includes access to a $150 million accordion feature on the revolver and term loan. However, this is not a true accordion – at least in the sense most people would assume. Rather, as disclosed in the company’s 10Q, "…any such additional borrowings are not required to be made available under the terms of the Senior Credit Facility and would be subject to adequate lender demand at the time of the loans…We cannot assure that such borrowings or financing will be made available to us on satisfactory terms, or at all." In other words, in order to access the ‘accordion,’ the company will in reality have to essentially negotiate an entirely new facility. The company maintains that it will have no problem negotiating the facility during Q408, although it recognizes that it will be under terms less attractive than its current borrowing rates (currently, the company pays 150 bps over LIBOR for its term loan; 200 bps over LIBOR for its revolver). Management has stated that banks are approaching them as they never have before – tier one guys such as JPM and Bank of America are calling them up frequently. Given the security we perceive in GEO’s business model, it should come as no surprise that the banks are looking to get business rolling again with such a company. Nevertheless, in the present (i.e. last few weeks) environment, the company says negotiation of any credit facility is literally impossible under terms its regards as reasonable. They believe – as has been indicated to them by their banks – that with the passage of the bailout and restoration of some level of sanity to the credit markets, they will soon be able to negotiate access to the additional financing at a reasonable cost (for reference, GEO’s 2013 maturity 8.25% senior notes currently trade just under par; three weeks ago, before things got absurdly ugly, they consistently traded 2%-4% above par; accordingly, with their bonds yielding just around 9%, we think a bank facility at 200-250 bps less than that is within reason).

 

The company admits that delay of financing has created an overhang on the stock. For the past year, they have stated on their conference calls and in financial releases that in order to initiate and complete their announced projects on time, they will have to gain access to additional financing. In the current environment, nothing more scares the equity markets than the belief that a company’s survival is contingent upon access to financing. Critically, in the case of GEO, it is not at all a question of survival. Under no circumstances does the required financing imply either a solvency or liquidity problem. Rather, it is simply a matter of executing on schedule their robust growth pipeline (i.e. its only because the company has so many opportunities at its feet that this problem exists at all). Nevertheless, there is no question that awareness of the issue – but lack of full understanding of it – has contributed to a dearth of buyers willing to pony up as the aforementioned motivated sellers have been unloading their shares. [Lastly, GEO actually does have an alternative if, in what it considers the “draconian” scenario, financing proves unavailable through the balance of the year; simply, they can sign a phased release on their construction projects, instead of a full release. The result of the that would be somewhat higher construction costs, as well as the risk that the projects are not delivered on time. Again, while we and the company view that as a surely unattractive scenario, it does illustrate the nature of their financing need.]

Late last week, CA announced that they would need to borrow $7bn from the federal government in order to shore up the state’s finances. CA plays a meaningful role for GEO, with about 8% of GEO’s beds devoted to CA inmates (for competitor CCA, it is 10%). While the budgetary problems have the potential to cause delays in cash flow to GEO, it will in no way impact either recognized revenues or earnings. Nonetheless, insofar as the headline is perceived as significant vis-à-vis GEO, this has created a further overhang on the stock. As discussed later, we view the flip-side to this situation as illustrating CA’s dire budgetary situation, and serving as a potential catalyst to further outsourcing.

 

4)       Small company specific issues:

 

As discussed later in the report, company specific issues such as a loss of a contract or an issue at a facility can drag down the stock. Recently, the company lost a small managed only contract in Texas – resulting in the loss of $11mm in annualized revenue and about $.01 in annual EPS. Additionally, there was a story about a lawsuit directed at the company for a few year old occurrence at one of their facilities. We view both of these events as short term noise which has contributed to opening up the present opportunity in the stock.

 

 

We believe, due to the economics of the business, that normalized FCF is the best valuation method for GEO. Similar to the valuation of REITs on a FFO basis, we believe valuing GEO on FCF rather GAAP EPS captures better the true economics of the business. Like REITs, the most important element of the FCF story is the large delta between maintenance CapEx and D&A. For 2008, D&A is likely to be ˜$38mm while maintenance CapEx will be ˜$12mm. The delta is due to the substantial difference between taxable deprecation and real economic depreciation. While the delta certainly jumps out at us as being large, on two bases we conclude the number is reasonable: 1) on a per unit (i.e. cell basis, assuming two beds per cell), $12mm in maintenance CapEx implies ˜$500 per cell of maintenance CapEx per year; 2) quite simply, prisons are very simple and sturdy in design and, unlike facilities of other types, do not require to be maintained in pristine shape in order to keep occupancy rates high.

Currently, GEO is trading at 10.4x 2008 normalized FCF, and 9.0x 2009. We believe that is very cheap for a business with the characteristics we have described.

In general, it seems the market has historically valued GEO on an adjusted (excluding certain non-recurring expenses) GAAP EPS basis. The argument for doing so is likely that due to the company’s growth profile, ‘normalized FCF’ is not true FCF, and will not be until the company stops growing. While we believe GAAP (or adjusted GAAP) EPS belies the true economics of the business, we also believe that also on an adjusted GAAP basis (or even on a true GAAP basis), the company is cheap. Based on the midpoint of the company’s 2008 adjusted EPS guidance (excludes roughly $.08 of one-time start up expenses), the company is trading at 14.6x 2008 earnings. Based on the company’s announced pipeline of contracts that are currently rolling out and will continue to rollout through 2009, we believe $1.45 in adjusted EPS (including ˜$.10 in start up expenses) is very reasonable for 2009; at that, GEO is trading at 12.6x 2009E earnings. While we could see earnings impacted as much as $.05 due to a combination of a couple small contract losses and higher LIBOR rates (i.e. if they hold steady at current elevated levels), we could also see numbers coming in modestly higher than our projection (again, perhaps $.05) through multiple levers.

Especially in light of the company’s robust growth profile, we believe GEO’s valuation is very compelling. If granted a more healthy normalized FCF multiple of 15x on 2009 numbers, the company would be trading in excess of $30 per share (for nearly 70% upside). Given out belief that the company’s FCF should grow in excess of 15% per year for the at least the next 3-5 years, we believe that is a very reasonable multiple.

 

                As mentioned, GEO’s 2013 maturity 8.25% senior bonds currently trade just below par (offering yields of just about 9%). Only a month ago – before things got absurdly ugly in the credit markets – they consistently traded 2-4% above par. The case is similar for CCA bonds (offering yields of just over 7%). Given the extreme skittishness of the credit markets – illustrated by the fact that GE bonds trade at yields equal or above that of CCA’s (despite the huge rating disparity) – we believe the confidence the credit markets have in GEO and CCA’s business model is meaningful, and helps to further illustrate the attractive valuation of the company’s equity.

 

On the horizon for GEO are a number of catalysts which could materially positively impact the company’s earnings and FCF. The CEO described some of these potential new contracts as being “transformational” to the company, as combined they have the possibility to increase beds under management by anywhere from 20%-50%. At current prices, we believe we are paying zero for these options:

 

In general, the catalyst relate to any of the following:

 

1)       Announcement of contract wins for any of the company’s outstanding RFPs

2)       Announcement of facility expansions

3)       Demonstration of stability following hiccup related to prisoner transfer (see discussion later in the report)

 

Specifically, GEO will be bidding on and/or hearing about the following projects over the next 12 months:

 

1)       California RFI - is known within the private prison industry that CA has released an RFI for an undetermined number of beds. Due to the severe overcrowding in the state’s prison facilities and the near term need to remedy these problems, CA is under pressure by the federal government to provide a solution to its overcrowding. In November, a three judge panel will meet to decide if CA’s entire prison system will have to be taken under receivership due to the state’s heretofore inability to address the issue. Clearly, CA does not want that to occur. In response, in September the state released an RFI to the major prison contractors (GEO, CCA, and CRN, and perhaps MTC) asking for available capacity as well as ability to construct new prisons. Estimates for the number of beds CA will contract as a result of this RFI range from 8,000-20,000 (with the larger number perhaps materializing over time). GEO submitted its proposal to CA over a month ago, and anticipates that before the three judge panel meets in November, the state will negotiate with the contractors to ensure capacity. We see this situation as the flipside to the overhang of CA’s current budgetary issues. Namely, that as the fiscal straits in CA worsen, cost saving initiatives – especially those which relieve the state of large upfront capital outlays – will become more attractive and necessary.  

2)       The Federal Bureau of Prison has recently issued four procurements to address its criminal alien requirement - CARs 8-11

a.        CAR 8 and 9 – 4000 new beds; to be awarded in Q3/Q4 of 2009

b.       CAR 10 and 11 – 3800 beds; to be award by Q2 2009

3)       Immigration and Customs Enforcement – recently issued a pre-solicitation notice for approximately 2,200 beds in Southern California

4)       Virginia – GEO recently submitted a proposal for a 2,000 bed facility

5)       Florida – recently issued a procurement for a new 2,000 bed facility which will be financed using state-issued non-recourse bonds; to be awarded in December 2008

6)       International

a.        UK – Announced plans to increase prisoner capacity with a private developer of between 10,000 and 20,000 beds over the next several years; RFPs for these projects (multiple 2,500 bed facilities) could be issued by the end of the year

b.       South Africa – responded to solicitation for five 3,000 bed facilities (total of 15,000 beds)

7)       GEO Care – currently in discussions with several states and the company is hopeful GEO Care will win one or two contracts over the next 12 months. Specially, Georgia recently announced that it is likely to privatize seven of its state mental health facilities. GEO believes it has a “good shot” at winning this contract; if it does, it would effectively double the current size of the company’s GEO Care division. The company has also alluded to us of other potential near term contract announcements for GEO Care.

 

If you add it up, approximately 45,000-67,000 beds will be awarded through the end of FY2009. We believe GEO is in a good position to win at least its market share of these beds (especially for US beds).

 

 

1)       Political and headline risks – these risks are entirely unpredictable and no doubt scare investors. We recognize that such risks are the greatest threat to the privatized prison industry. While public and political sentiment has somewhat softened towards private prisons over the last few years (mostly out of necessity), a widely publicized incident could jeopardize that. Obviously, an ugly situation at a GEO operated facility is likely to pressure the stock for a short amount of time. A fundamental risk to the business model is revolutionary legislation that would dramatically reduce the number of prisoners in US correctional facilities. We view the odds of that happening as unlikely, but nevertheless within reason. We have seem some glimmers of that in California where, threatened by wildly overcrowded facilities, the state government has entertained the idea of house arrest and others methods of punishment for non-violent offenders (a proposition supporting limited movement towards such initiatives is on the ballot in the November election). On the most recent conference call, the company was asked whether it believed there would be any impact from an administration change (i.e. Obama). The company said not only does it not believe so, but its clients (i.e. state and federal prison bureaus) do not believe so either.  The truth is, we aren’t able to handicap these sorts of risks with any precision, but we do believe that relative to the risks faced by other operating business, they are minimal.

2)       Delays – from a company/operating specific perspective, the greatest risk in the business is delays. That is, after the opening and staffing of a facility, there are delays in the transfer of prisoners to the facilities. This risk obviously came to the forefront during the company’s Q208 earnings release. Related, there is the risk (especially with immigration detention centers) of sudden declines in occupancy levels, resulting in potentially material negative operating leverage. With regards to both of those concerns, preventing or remedying the situation is essentially entirely out of the company’s control.

3)       Contract Cancellations – Some contracts (especially the managed only contracts) may be cancelled by the customer at any time and for any reason. While historically this has not caused material problems for GEO – and the current industry dynamics give no indication that it should going forwards – this is a risk that does exist.

4)       Under followed by the Street – both GEO and CXW are followed by only a handful of firms, with Bank of America and Lehman Brothers the only major brokerage houses covering the names (however, the Avondale analyst is by far the best on the name and the industry in general). Given CXW’s $3.0bn market cap, we find that somewhat peculiar. The result is probably a certain level of investor ignorance of the companies, particularly GEO since it is often overlooked entirely in favor of CXW.

5)       Nature of the industry – Private prisons aren’t exciting stories, and a stigma certainly surrounds them. We would not be surprised if many money managers don’t want to invest in a prison stock out of decidedly non-economic/financial considerations.

 

 

 

 

 

 

APPENDIX: the following is a more in depth discussion of various elements of GEO and the industry in which it operates. It also addresses in further details issues mentioned in passing in the main part of the report. A good deal of this information had been addressed in previous VIC posts on GEO, but we have included here for the interested.

 

 

GEO Group is a provider of government-outsourced services specializing in the management of correctional, detention and mental health and residential treatment facilities – in other words, it’s a private prison company. The company manages roughly 50,000 beds both in the US and abroad. It’s presence in the US makes it the 7^th largest correctional system in the country, and the second largest private operator.

 

GEO is divided into four segments:

 

1)       US Corrections: GEO operates a range of correctional and detention facilities including: minimum, medium, and maximum security prisons; immigration detention centers; and minimum security detention centers. For all of these facilities, GEO provides a host of operational and management services: security; administration; rehabilitation; education; health and food services. The facilities the company operates are exclusively for adults and almost entirely for males.

2)       International Corrections: operation and management of correctional and detention facilities in Canada, the UK, Australia, and South Africa.

3)       GEO Care: GEO operates US based mental health facilities, providing care, programming, and treatment to the residents.

4)       Facility design and construction: GEO assists states in the design and fabrication of correctional and mental health facilities, with GEO lending its specialized knowledge and experience to the projects. However, the segment is not operated for profit; rather, its only purpose is to attract additional business to GEO.

 

 

GEO operates its corrections and mental health facilities through three different arrangements, each possessing varying financial and business characteristics.

 

1) Owned and managed:

Under this arrangement, GEO owns the actual facility which it manages. Funding for the construction of the facilities may be provided in one of two ways: 1) GEO puts up the financing, through a mixture of equity and debt of its own; 2) the state or municipality in which the facility is constructed raises financing through the issuance of bonds, resulting in the assumption of non-recourse debt for the company.

Under the latter arrangement, GEO gains access to very cheap financing (fixed rates on certain of the company’s non-recourse debt are as low as 3%) which is guaranteed by the state or municipality that issued it. A portion of the revenue GEO earns from the contract its services within the facility must go towards debt service, which GEO is wholly responsible for. After maturity and full repayment of the issued debt, title and ownership of the facility transfers to GEO. Obviously, we view this arrangement as extremely favorable to GEO, and see it as another attractive element to the story. However, the company does not currently believe it will be able to develop properties in the near future under such arrangements.

Under this arrangement, GEO provides the operational and management services to a correctional or detention facility which is owned by a state or federal government agency (all of the company’s International Corrections as well as GEO Care contracts are managed only).

                Under this arrangement, GEO leases a correctional facilities from counties who owns them.

 

                From a financial standpoint, the three methods of operations differ substantially. Owned and managed produces the lowest returns on invested capital (13%-15% cash on cash facility ROIC) but the highest facility EBITDA margins (better than 35%). Leased facilities generate ROIC of 13%-15% and facility EBITDA margins of ˜20%. Managed only facilities have essentially infinite return on capital, as it is a pure service business that requires no capital investment. However, facility EBITDA margins for managed only contracts are in the 10%-15% range.  

Although GEO does not break out facility margins between its owned and managed versus its managed only facilities, its primary competitor – Correction Corp. of America (CXW) – does. The data below presents a detailed picture of the cost structure and operating trends at CXW; we believe it is a very good proxy for GEO as well[1]. As the metrics show, across the board (inmate population; top line pricing; margins) trends are very solid.

 

	2006	2007					2008
	FY	Q1	Q2	Q3	Q4	FY	Q1	Q2
Owned and Managed Facilities
Revenue per Compensated Day(1)	$      61.03	$      62.28	$      62.37	$      63.83	$      64.08	$      63.16	$      64.67	$      65.49
Fixed Cost per Compensated Man-Day	$      30.72	$      30.67	$      30.14	$      31.58	$      31.00	$      30.85	$      31.81	$      31.14
Variable Cost per Compensated Man-Day	$      10.75	$      10.23	$      11.07	$      10.86	$      10.99	$      10.80	$      10.38	$      11.04
Total Cost per Compensated Man-Day (1)	$      41.47	$      40.90	$      41.21	$      42.44	$      41.99	$      41.65	$      42.19	$      42.18
Operating Margin per Compensated Man-Day	$      19.56	$      21.38	$       21.16	$      21.39	$      22.09	$       21.51	$      22.48	$      23.31
Compansated Man-Day Margin	32.0%	34.3%	33.9%	33.5%	34.5%	34.1%	34.8%	35.6%
Avg. Compensated Occupancy Rate (%)	93.9%	98.9%	99.6%	97.8%	98.3%	98.3%	98.3%	97.3%
Average compensated population	43,119	46,262	47,322	47,878	49,034	47,625	50,278	51,121
Average Available Beds	45,944	46,777	47,512	48,955	49,882	48,282	51,148	52,540
Managed Only Facilities
Revenue per Compensated Day(1)	$      38.30	$      38.68	$      38.64	$      38.93	$      39.05	$      38.83	$      39.25	$      39.26
Fixed Cost per Compensated Man-Day	$      24.27	$      24.62	$      24.31	$      25.32	$      25.15	$      24.86	$      25.64	$      25.46
Variable Cost per Compensated Man-Day	$        8.41	$        8.11	$        8.71	$        8.37	$        8.92	$        8.53	$        8.90	$        8.63
Total Cost per Compensated Man-Day (1)	$      32.68	$      32.73	$      33.02	$      33.69	$      34.07	$      33.39	$      34.54	$      34.09
Operating Margin per Compensated Man-Day	$        5.62	$        5.95	$        5.62	$        5.24	$        4.98	$        5.44	$        4.71	$        5.17
Compansated Man-Day Margin	14.7%	15.4%	14.5%	13.5%	12.8%	14.0%	12.0%	13.2%
Avg. Compensated Occupancy Rate (%)	97.0%	96.5%	97.9%	98.6%	97.3%	97.6%	96.5%	96.5%
Average compensated population	24,714	24,961	25,393	26,004	25,903	25,572	25,815	25,815
Average Available Beds	25,863	25,866	25,938	26,373	26,622	26,200	26,751	26,751

 

              Aside from the economic differences between owned and managed model versus the managed only, there are other differences as well. As the above data shows, while margin trends are clearly positive for owned and managed facilities, they are meaningfully weaker for managed only.

The decline in margins is primarily the result of increased competition in the space. While we believe that GEO has superb barriers to entry with regards to owned facilities and the management of larger facilities, smaller companies have been able to make inroads in managed only contracts, especially for smaller facilities (MTC has recently won managed only contracts from under both GEO and CXW through aggressive under bidding). As a result, price competition has intensified.

Formerly, GEO was much more reliant on managed only contracts than it currently is now. However, as the data shows, the relative percentages of the various arrangements have changed markedly over the years. Currently, ˜64% of total revenues and 82% of EBITDA is derived from either owned or leased facilities. Going forwards, we expect owned and managed to continue to grow relative to managed only (further demonstrating this was GEO’s announcement on August 7, 2008 of expansion and new construction plans for 2,145 additional owned and managed beds (on top of the already announced pipeline) to be completed by year end 2009).

The major strategic move that shifted GEO’s emphasis towards owned and managed facilities was GEO’s late 2006 acquisition of CentraCore Properties Trust (CPT). CPT was a publicly held REIT which owned 13 facilities, of which GEO leased 11. While prima-facie, the acquisition appeared expensive (12-13x EBITDA based on lease rates GEO was paying to CPT), it was strategically very positive. From a high level perspective, the CPT acquisition was a truly transformational move by the company – taking them from an asset light service oriented company, to an asset heavy quasi-REIT.

Related to margins and ROIC, there is a critical distinction between owned and managed versus managed only contracts. By their very nature, owned facilities generate sticker contracts. In order to cancel an owned and managed contract, the state must be prepared to transfer the entire population of the facility to another institution. Conversely, an existing management operation can easily replaced by another. The result is somewhat artificially inflated pricing power for owned and managed contracts, and competitively pressured pricing for managed only contracts.[2]

CXW has made it clear that they are not interested in actively pursuing further managed only contracts. While they will bid to retain the ones they currently operate, they do not believe it is a good use of resources. GEO, however, is intent on selectively growing their managed only business.[3]

While we are not particularly excited about the managed only business, we are neither much concerned about it; rather our conclusion is that for time being managed only is an effective method to grow the business without any capital investment. So while it is a lower margin and more competitive business, it is also certainly a profitable one. Additionally, managed only contracts are often critical in the development of client relationships. Many states are still wary of relinquishing greater control over the operation of their correctional facilities. For those states, private ownership of the facilities is currently out of the question. However, they will entertain outsourced management. Down the road, as those states confront pressing budgetary issues, they may realize the benefit in outsourcing ownership of the facilities as well. Accordingly, we view managed only contracts as gateways for states to experiment with full correctional facility outsourcing.

Both GEO and CXW state that their target pre-tax ROIC for new-build facilities is 13%-15% based on stabilized occupancy of 95%. Based on certain assumptions, we believe that translates into very close to 13%-15% after-tax return on equity as well. We recognize that in general, that range of after tax returns on equity – especially given the targeted ˜55% debt/total capital leverage – are not spectacular. However, given the following characteristics of the business, we believe they are extremely attractive: recession proof; great revenue and earnings visibility; tremendous growth prospects; minimal competition. Additionally, the private prison industry is a business in which large amounts of capital can be redeployed at equivalent rates of return for a long time in the foreseeable future.

Additionally, although targeted ROIC for new-builds are in the 14%-15% range, expansions on existing facilities offer much higher ROIC – often as high as 30%. Those high returns are the result of the marginal CapEx required to develop additional beds. In order to add the additional beds, often all that is needed is an additional wing or building constructed within an existing facility – something far less expensive on a per square foot or per bed basis than constructing an entirely new facility.

Moreover, it is important to note that GEO’s target ROIC is based on an assumed 95% occupancy rate. As we will discuss later, additional inmates added at peak occupancy rates add incremental profits at ˜84% margins. Accordingly, their impact on ROIC is tremendous, resulting in the possibility of ROIC meaningfully higher than 13%-15%.

 

We believe that the contract and cost structure of the business – specifically it’s nearly inflation proof profile – is a very attractive element to the story.

Firstly, these are long term contracts: typically, contracts have initial terms of 3-5 years with multiple renewal options. Contract renewal rates for GEO have historically been well in excess of 90%.

Regarding the structuring of contracts: In conversations with both GEO and CXW, we learned that contracts are structured by targeting the 13%-15% ROIC (at assumed 95% occupancy) for both owned and leased facilities. Importantly, both companies told us that the targeted ROIC is based off neither the original construction costs of the facility, nor the depreciated value of the facility at the time of the contract signing. Rather, the 13%-15% ROIC is based on replacement value of the facility assuming current construction costs in the area where the facility is located.[4]

All contracts are structured for annual per diem increases, though with varying structures. Some contracts come up for renegotiation every year; some contracts are based on a fix increase against the CPI; some contracts have pre-determined fixed (percentage) amount increases. In all cases contracts are structured such that annual per diem increases are at least at the rate of inflation. Importantly, due to facility margins, a 2.5% increase in per diem rates in fact covers inflation impacted expenses of up to ˜3.5%.[5]

 

Regarding cost structure: The largest component of operating expenses is labor, representing ˜65% of operating expenses. Both GEO and CXW admit that their greatest inflation risk is related to labor inflation costs. Indeed, in certain areas such as Texas where the economy has remained robust due to the strength of the oil and gas industry, they have felt some pressure recently. However, as a general rule, the companies are very well positioned against labor cost inflation. Many of their facilities are located in rural areas where opportunities for employment are limited and the local prison is oftentimes the largest employer.[6];[7]

 

There are three other major cost buckets:

       

1)              Food services: Despite rising food costs, both GEO and CXW say food inflation has not pressured them at all; rather, expenses (as a percentage of per diem revenues) have remained stable over at least the last five years. GEO explained that their ability to keep food prices down is a result of their flexibility – so long as they meet the nutritional requirements, it doesn’t matter what they serve the inmates. They don’t have to serve them corn or eve bread; if beans and turkey are cheaper, they will serve them that (GEO mentioned the company motto – “$1 a tray; $3 a day”)

2)              Medical services: Medical services are handled in a variety of ways depending on clients demands. In some arrangements, the company does not handle and is not responsible for medical services at all. In other arrangements, the company has full exposure to all medical needs of the inmate population. In arrangement where GEO does provide medical services, there are two types of cost exposure: 1) On site – these costs are easy to control as it relates mostly to basic first aid issues that on staff nurses, and perhaps a doctor or two, can cover. Those staff personnel are paid on a salary basis and the company faces no cost exposure risk. 2) Off site – off site expenses are incurred when an inmate requires medical attention that only a hospital or other off site medical professional can provide. These costs have the potential to be problematic if the company is fully exposed to costs incurred in such cases. However, in almost all of their contracts (with the exception of certain smaller ones), the company has either dollar or time based caps above which the client pays the bill. So while the possibility exists that the company will incur a catastrophic medical bill, that risk is small; additionally, the company believes the risk is mitigated by the increased per diem rates it charges clients in arrangements where the company is 100% exposed to medical costs.

3)              Utilities: The company believes it is well insulated from rising utility costs as it tends to lock up long-term (5-10 year contracts) and builds the cost structure of the utility contracts into the cost structure of the contracts with its clients. Both GEO and CXW say they have experienced no cost pressure impact from utilities expenses.

 

 

We believe a primary feature of GEO’s attractiveness as an investment is its extremely strong competitive advantages. Combined, CXW and GEO control almost 65% of the global privatized prison market (GEO – 26%; CXW – 37%; Cornell is the next largest at 7%). In the US, they control roughly 75%-80% (GEO – 30%; CXW – 50%; Cornell is again next largest at 10%) of all privatized beds. For adult corrections, CXW and GEO likely control upwards of 90% of beds in the US.

                While smaller companies are able to win managed only contracts on small facilities, we do not believe that states are willing to give contracts for large owned and managed facilities to any companies other than GEO, CXW. For large scale managed only contracts, occasionally occasional Management and Training Corp (MTC) will win a bid (as mentioned above).

                Accordingly, we view competitive threats as very low on our list of concerns. In discussions with CXW, we pressed them on whether they would view an extremely well capitalized but un-established entity as a potential threat. They said simply no: success in this business is not a matter of capital; it is purely a matter of reputation and experience. Such an entity could be successful only if they acquired an existing prison management company – CXW believes only GEO would be an absolutely viable option for such a model, although they said Cornell could be a much less likely possibility.

 

                Regarding CXW: there is no question that formally GEO and CXW are competitors. As a result, there is likely to be some overlap in the contracts they bid on. However, we believe that given the massive market opportunity that exists in the private prison sector, the competitive dynamics between the firms will be largely muted. In conversations with CXW, we were told that there is far more demand (both currently and projected) than even CXW, GEO, and Cornell combined are able to handle. This is a view wholly echoed by GEO as well. As a result, we believe that rationale pricing will continue to exist for the foreseeable future.

               

 

The following chart shows the breakdown amongst the company’s customers. A few important points: 1) Higher margin and longer term Federal contracts represent approximately 1/3^rd of total revenues; 2) The company has had over a 20 year relationships with the Federal government; 3) The company has relationships, on average, of 17 years with its top five customers.

 

In total, GEO has 31 government clients – 25 in the US; 6 International.

 

 Other significant business issues:

 

 

One of the problems with this business is the limited amount of visibility outside investors can gain into company performance. Therefore, management guidance – on an annual and even more so on a quarterly basis – is more important than in other businesses. GEO management has a reputation on the street for being conservative, and their strong track record of meeting or beating revenues and earnings gives should give us confidence in their projections. [that said, they have had a couple of downward revisions as the result of prisoner uptake delays, most recently in Q208.]

   

 

                Our preference for GEO over CXW (which we also believe is quite cheap), is based on two factors: 1) GEO’s significantly more attractive valuation; 2) GEO’s more robust growth profile. [Interestingly, CRN, the smallest company with the riskiest contracts, trades at a premium to both].

 

On all valuation measures, GEO is significantly more attractively priced than CXW:

 

	GEO			CXW				GEO at CWX Multiples
	2007A	2008E	2009E	2007A	2008E	2009E			2007A	2008E	2009E
Revenue	$      916.0	$      1,011.4	$      1,105.5	$   1,480.0	$   1,608.9	$   1,724.0		Stock price	$      38.87	$      39.62	$      40.58
y/y growth	16.4%	10.4%	9.3%	11.2%	9.0%	10.3%		CXW premium	113.3%	117.4%	122.7%
Multiple	1.5x	1.4x	1.3x	2.7x	2.5x	2.3x
EPS	$        1.05	$           1.24	$           1.45	$        1.06	$        1.21	$        1.42		Stock price	$      22.93	$      23.77	$      23.72
Multiple	17.4x	14.7x	12.6x	21.9x	19.2x	16.4x		CXW premium	25.8%	30.5%	30.2%
FCF	$        83.5	$           91.5	$         106.8	$      168.3	$      202.8	$      233.3		Stock price	$      28.01	$      25.45	$      25.83
Yield	8.7%	9.5%	11.1%	5.7%	6.8%	7.9%		CXW premium	53.7%	39.7%	41.8%
Multiple	11.5x	10.5x	9.0x	17.7x	14.6x	12.7x
EBITDA	$      143.9	$         156.3	$         183.6	$      347.6	$      395.9	$      456.4		Stock price	$      23.12	$      21.66	$      22.24
Multiple	9.8x	9.1x	7.7x	11.6x	10.2x	8.9x		CXW premium	26.9%	18.9%	22.0%

              

From a growth standpoint, we believe GEO’s more robust growth profile comes from two sources. Firstly, relative to its existing revenue base, GEO pipeline of projects in development is larger than CXW’s. Currently, GEO has more than 10,000 beds in development which will come on line between August 2008 and the end of 2009. Additionally, 1,320 beds began ramping up between February and May 2008. Combined, the 7,780 beds represent an additional ˜$155mm in revenues; including the 1,320 beds, the revenue total is ˜$185mm. Those numbers represent 16% and 19% respectively over LTM revenue. Secondly, we view International Corrections and GEO Care as engines of growth that CXW does not have and which we believe the market is not currently valuing. Although GEO Care has hit some bumps in the road and growth has slowed for the moment, there is good reason to believe that is has much potential.[8] The company’s International segment as well, although a new contract has not been announced for some time, has major prospects lined up which it hopes to deliver upon in the near future.

 

On August 7^th, GEO announced Q208 earnings. Although they delivered in line with guidance for Q2, the company revised downwards Q3 and Q4 guidance. Q3 from $.33-$.35 to $.32-$.34 and Q4 from $.39-$.41 to $.34 to $.36. Full year adjusted EPS guidance is now $1.23-$1.27. The revised guidance is due to revised ramp-up and intake schedules for the following facilities the company had scheduled to activate during Q3 and Q4 of this year:

 

-          Third quarter openings:

o    625-bed Northeast New Mexico Detention Facility (Clayton, NM)

o    1,100-bed Joe Corley Detention Center (Conroe, TX)

-          Fourth quarter:

o    1,500-bed Rio Grande Detention Center (Laredo, TX)

o    500-bed expansion of the 1,000-bed East Miss Mississippi Correctional Facility (Mississippi)

o    654-bed Maverick County Detention Facility (Maverick, TX)

 

Due to reasons entirely out of their control, the ramp-up and intake schedules for these facilities are being pushed out a bit. What that means, simply, is that prisoners are arriving later than expected. Compounding the impact of the revised ramp-up and intake schedules, is that a large number of the prisoners that will be moving into the new GEO facilities will be coming from other GEO facilities in the same region. The reason for that shift of populations is simply the desire on the part of the various Federal correctional bureaus to consolidate their inmates into the newer facilities (for various reasons: price, size, location, etc.). As a result, after the prisoners from the old facilities are moved into the new facilities, there will be a certain amount of vacancies in the old facilities; thus, until those spots can be backfilled by new inmates and detainees, occupancy in the facilities will be down. The company is confident the backfill will occur by the end of the year (and has received indications from the federal correctional bureaus of such). The financial impact of this whole shifting population situation is two-fold:

 

1)                            Certain amounts of revenues are pushed out to a later date until both facilities are operating at full capacity

2)                            There will be some amount of margin pressure while the facilities not operating at normalized occupancy levels

 

What needs to be stressed is that according to the company, this is absolutely and purely a timing issue. It is no reflection at all on the current demand dynamics within the industry. Rather, as the company has told us in previous conversations, the main risk to their operating model is delays on population transfers on the part of government agencies. These matters are out of their control and – from time to time – do impact their operating results. This comment from management on the conference call sums of their view of matters:

 

“In summary we view this as a timing issue and we continue to believe that demand throughout our industry remains strong. Our three announcements this morning regarding two expansions and the development of a new company-owned facility are further evidence of the robust demand dynamics in our industry.”

 

For better or worse, there is definitely a view in the investment community that the private prison companies ought to behave like machines with regards to their guidance and performance. By in large, that has been the case for both GEO and CXW. A salient question from a sell-side analyst on the call highlights this sentiment:

 

“I guess my general question is why isn’t this something that could have been anticipated by the Company, given the magnitude of the US Marshals Service contract, given the proximity, given all of your history in this space? I mean we understand I think the general investment community looks at this space as being on that has fairly good visibility on its earnings, not just quarter in and quarter out but king of looking out at least four quarters, given the nature of the business and the contracts that are in place. So, I guess I’m trying to understand why this came as a surprise to you guys regarding the backfill issue at this point in time.”

 

    Management responded to the question as follows:

 

“A very good question, you know, with a very simple answer – the planning by our clients is very contemporaneous planning. It’s not long-range planning. When they know a facility is going to open up a year from now, they are not particularly busy thinking about where are they going to get the prisoners to fill up that facility. Their planning probably begins in the weeks and a couple months before the opening of that facility, because they never really know what their situation is until they get that close. I think they would say that themselves.”

   

                In our conversations with the company, we believe the issue is under control and that management will do a better job of communicating with the investment community in the future.

 

 

 

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