Description

We think the recent sell off in TH shares provides an attractive entry point. While the recent headline news optically seems bad, a closer look at government filings, company filings, and news coverage over the last 3 years suggest the exact opposite. Potential upside is 80-100%.

Summary:

• Title 42 will likely be lifted. This will result in a flood of refugee encounters, including unaccompanied children, at the southern border. The government already does not have enough housing capacity for unaccompanied children who are waiting to be processed by immigration. The govt will be in an even more desperate state by this summer. The government might need 60-130% more beds than it currently has today. That equals several facilities that are the size of TH's current 2k Pecos facility.
• TH is currently operating under a 1 year contract framework with HHS/ORR to provide housing services for unaccompanied children. All signs and historical precedent point to a high likelihood of contract extension to 10 years, with possible news as early as mid spring 2023.  
• The combo of structurally higher UC encounters, TH’s transformation from swing capacity to baseload capacity, and contract extension could see a structural re-rating in TH’s 5x EBITDA multiple.
• The concern last week about no UCs currently at TH's Pecos facility is overblown. UC volumes are seasonally low so the facility is temporarily warm stacked. Once UC volumes come back, the warm stack status will change to active status within a week. The government continues its process to sign up new housing capacity in anticipation of UC surge later in the year. 

Todd1123 did a great write up on VIC of TH in 2021 and continued to provide color throughout 2022. The write-up below seeks to go into depth on the government angle and give an update of the situation.

1. The end of Title 42 will likely bring a flood of refugee encounters at the border:

Title 42 will likely end soon. While there may be delays caused by legal complexities, the end is a matter of when not if. Under Title 42, many refugees are immediately expelled under the legal cover of pandemic protection. After Title 42 ends, the government will need to process asylum applications of those who had previously qualified for Title 42 expulsion.

The government is worried about the likely huge influx of encounters at the border. Many refugees are waiting in jam-packed shelters in Mexico for the end of Title 42.  We can see this below:

“Migrants have been waiting in anticipation of a major policy shift, expected in May, when the United States plans to lift a pandemic-era health policy that has allowed U.S. border authorities to swiftly expel many unauthorized migrants crossing the border from Mexico” https://www.nytimes.com/2023/03/28/us/mexico-border-migrants-shelters.html

“What we have in Tijuana and other Mexican border cities is a bottleneck,” said Enrique Lucero, director of the migration services office for the city of Tijuana, across the border from San Diego. “Thousands of migrants are waiting for the opportunity to enter the U.S., and more keep arriving.” The city’s 30 shelters can accommodate 5,600 people; as many as 15,000 migrants are currently in the city, he said.” https://www.nytimes.com/2023/03/28/us/mexico-border-migrants-shelters.html

While the case plays out in the court, officials and humanitarians in Tijuana are watching as they continue to manage a city where thousands of migrants have been waiting, some for years, to act on their right to ask the U.S. for asylum protections. “(Shelters) are at their maximum capacity due to this measure and the longer it takes for Title 42 to end, the lag will continue growing and the challenge will be greater whenever Title 42 truly ends,” said Enrique Lucero, director of migrant affairs for the city of Tijuana. https://inewsource.org/2023/01/04/tijuana-migrant-shelters-capacity-title-42-asylum-mexico/

“The intelligence memo, from the Homeland Security Office of Intelligence and Analysis, underscores the concern within the administration over an increase in arrivals after Title 42 ends amid mass migration across the Western hemisphere.”  https://www.cnn.com/2022/12/14/politics/title-42-migrant-influx/index.html

2. Post Title 42, the demand for unaccompanied children housing may 3x from current levels

Total refugee encounters on the southern border have averaged ~220k per month with Jan and Feb at seasonal lows of ~160k and ~230k for the rest of the year. Encounters are secularly growing.

The segment of the refugee population that is relevant to Target Hospitality today is unaccompanied children. The DHS apprehends unaccompanied children at the border. By law, UC may only remain in DHS custody for 72-hours following their apprehension, after which time UC must be transferred to the care and custody of HHS to accommodate UC. The UCs need to be processed by HHS and ORR before they’re placed with sponsor families. Other types of refugees (refugee families and single adults) are addressed by GEO, CoreCivic, and other temporary housing solution providers.

Unaccompanied children have historically been ~7% of total encounters.

When Title 42 ends, it’s highly likely that we will see much higher total refugee (and by extension unaccompanied minors) encounters. El Paso’s experience supports our view. El Paso sees about ¼ of total southern border encounters with refugees. In December 2022, El Paso officials estimated that border apprehensions in the city would more than double from ~2000 to 4500 a day once Title 42 is lifted.

It’s anyone’s guess but 300k+ per month of total encounters (35% increase vs. 2022) is a highly probable base case with potential of ~350k+ (60%+ vs. 2022) or more after Title 42 is lifted.  Huge increases in a short amount of time has happened before. Border encounters increased 140% from 75k a month in Q4 2020 to 180k+ by Q2 2021 after Biden’s election.

300-350k of total southern border encounters would imply 21-25k of unaccompanied minors vs. the 8k level in March 2023. There is not enough housing for this kind of UC volume.

3. There is not enough housing for 21-25k of monthly unaccompanied children

This is the current supply picture. Today, the nameplate capacity is 17.8k beds. The effective capacity is ~12.5k beds due to Covid restrictions.

Nameplate and effective capacity breakdown:

1. <13k state-licensed beds: There are <13k state-licensed beds (these care providers include group homes; long-term, therapeutic, or transitional foster care; residential treatment centers; staff-secure and secure facilities, and shelters). Call this nameplate capacity. Due to covid restrictions, effective capacity is 9.1k. Think of state-licensed beds as the baseload capacity.
   1. It’s difficult for the federal government to increase the number state-licensed beds. Many states do not want to offer licensed beds either due to political reasons or the need for prioritize local humanitarian needs. Some states like Texas and Florida even revoked many licenses for UC beds. The number of state-licensed beds has been stuck around 13.5k since late 2020.
   2. State-licensed beds get priority. If utilization of state-licensed beds is above 85%, then ORR can utilize other housing solutions like ICF, EIS, or other alternatives.
2. 2.8k ICF beds: Target Hospitality Pecos ICF has 2000 and Greenboro ICF has 800.
3. ~1.6k ICF beds to be closed: Fort Bliss ICF beds, to be closed in mid to late 2023. Note, Fort Bliss has a 5k capacity but it’s unclear how much is counted in the government’s assumption of maximum operational beds. I just used 1.6k as the plug.  
4. Total of ~17.4k beds of nameplate capacity. Given COVID restrictions, the effective capacity today is more like 12.2k

Future capacity (by summer 2023)

• 17.4k name plate capacity
• Minus 1600 Fort Bliss
• Equals 15.8k of name plate capacity or 11k of effective capacity

Assuming 2022 UC levels (i.e. Title 42 still in effect) of 10-11k monthly unaccompanied minors, monthly average utilization by summer 2023 will already be essentially 100%. Anything above 90% utilization is unrealistic. In short, the government desperately needs more capacity even without Title 42 rolling off.

If we assume COVID restrictions within ORR’s bed system remains, a spike to 21-25k monthly UC volumes would require 10-14k more beds (90-130% more beds). If we assume restrictions are lifted in the future, the system needs 60-90% more beds.

There are further data points supporting the view that the Government is desperate beds:

• As detailed below, Fort Bliss ICF was supposed to be closed by Sept 2022. However, the urgent need for beds forced the government to extend Fort Bliss’s operation until Sept 2023. In December 2022, the government explained its rationale for extending Fort Bliss from the original closure date of Sept 2022 to Sept 2023: “the Government has also been actively identifying potential new ICF sites; however ICF beds from new sites will not be available in time to meet ORR’s need for bed capacity before the ICF IDIQ beds come online. For these reasons, the Government has an unusual and compelling need to maintain the ICF bed capacity at the temporary Ft. Bliss ICF site to meet its statutory responsibility to provide care to UC.”
• Government’s original plans for new ICF sites in 2023 has hit roadblocks: The government originally intended to open a 1200-bed Carrizo Springs ICF in 2023. However, “after award of the contracts necessary to support the new Carrizo Springs ICF site, extensive building damage was discovered, which led to the termination of contracts.”

4. The government learned its lesson from the 2020/2021 debacle. It was completely unprepared at that time.

Unaccompanied minors encountered at the border spiked 4x+ from 4.5k November 2020 to 19k March 2021. The government was caught completely off-guard as it had only 9000 beds. As a result, it had to race to open multiple “Emergency Intake Sites” to increase capacity to 31k beds.

Example of rationale for Fort Bliss EIS site from a government filing.

This was a policy and PR disaster. EIS sites were contracted to providers who specialized in setting up disaster relief sites for hurricanes and earthquakes. Refugees were living in tents without proper conditions and services. Subsequent government audits criticized the use of these EIS. The media had a field day.

As a result, many EIS sites were closed down and the government selected a few EIS operators for Influx Care Facility (ICF) conversions. These conversions turned makeshift tents/convention center type housing into housing solutions with a full range of services.

This focus on ICFs was the main reason why Target Hospitality won the right in 2022 (which resulted in a 4x in the stock price) to provide housing for up to 2000 unaccompanied minors in Pecos Texas.

5. Filings and other clues suggest the government is actively preparing for the Title 42 surge, a scenario where bed demand can increase 60-130% in a few short months.

In early March 2023, HHS issued a Request for Information. Specially it’s looking for a turnkey facility that can house 500 to 5,000 capacity with a minimum 10-year firm term ground lease with renewal options up to a total of 50 years. Interestingly, HHS wanted vendors who can build something within 14-30 days of the contract award.

The government in Dec 2022 said it expects at least 2600 additional beds to be awarded out fiscal year 10/1/2022 to 9/30/2023. Part of these beds might be awarded as part of a year-long multiple-award indefinite duration indefinite quantity IDIQ process. The IDIQ mechanism enables the government to have a longer multi-year solution as opposed to the 1 year or multi-month contracts it used for EIS contracts in 2021 and ICFs in 2022. This mirrors the shift in the government’s approach towards a longer term housing solution for UC refugees.

Regarding the IDIQ process, the government kicked off a one year search in February 2022 for a 10 year solution. This search has gone through multiple rounds of Q&A and interactions between potential vendors and the government. The final multiple-award IDIQ contracts are likely to be announced in Q2 2023 (original timeline was for March 2023).

In addition to the IDIQ process, there may also be other contract award processes for the 2600+ additional beds in 2023.

6. There are many clues that suggest TH’s Pecos government contract is likely to be renewed, either as part of the multiple-award IDIQ process or another contract process.

The IDIQ award process consists of two major phases: The first step is to create an indefinite delivery and indefinite quantity funding mechanism. This enables the government to actually sign long term contracts. The second step is the scope and economics of services provided. TH and its partner Endeavor have made significant process on the first step and details of the second step will be released within the next few months.

Endeavor, the contractor for Target Hospitality’s Pecos facility, has made significant process in locking in the renewal. On the last earnings call on 3/10/2023, TH management said Endeavor had recently been awarded an “indefinite delivery and indefinite quantity contract related to the extension of our humanitarian community in Pecos. This award consists of a base 5-year term with an additional 5 year option. This establishes the contracting vehicles required by the US government to appropriately fund multiyear contract awards. The IDIQ award to our non-profit partner is one of the final steps in the government’s contract award process prior to working through definitive agreements.”

Target Hospitality is Endeavor’s subcontractor for Pecos and will benefit from Endeavor. Target Hospitality signed a 11-year exclusive partnership with Endeavor in late 2022. Management said at the time: “The long-term agreement solidified our joint commitment to continue providing critical humanitarian services to the United States Government at this highly customized campus.”

The commentary above suggest that TH is very likely to be one of the ultimate recipients of the government’s upcoming UC housing contracts. If multiple vendors win as part of the multiple-award IDIQ process, there are two scenarios

• TH’s 2000 beds are split up among multiple bid winners
• TH renews its 2000 beds and multiple bid winners win incremental bed awards.

The latter is much more likely. As will be mentioned below, the government already paid for TH 2000-bed facility’s capex and has shown a preference for incumbents in the past. Furthermore, as explained above, the desperate need for beds makes it more likely that the bed pie is enlarging and not remaining static.

The decision for the multiple-award IDIQ contract process is likely to be released within the next few months. In a government filing in December 2022, ORR said that “the government also planned for a competitive multiple-award IDIQ acquisition to meet ORR’s future ICF needs, with contract awards scheduled for Spring 2023. Furthermore, TH management on the 3/10/23 call said that the conclusion of the award should be “in the next few months. My point is you’re not talking about 6, 8, 9, 10 months here.”

7. Target Hospitality’s Pecos facility will likely be a major provider for the government’s long term UC refugee plan. This supports the view that TH’s Pecos facility has a high prob of contract extension.

1. Government has already shown its preference for TH through its selection of TH in the EIS to ICF conversion process. The government signed up dozens of vendors in its desperate race to ramp up housing capacity in early 2021. Once things settled down a bit, the government whittled down the vendors and selected only two for ICF conversion: TH’s Pecos and Rapid Deployment’s Fort Bliss. TH’s advantages vs. Rapid Deployment and other EIS vendors include: operational excellence, proximity of its facilities to the southern border, hard structures as opposed to tents.
2. Government paid TH for capex: The government paid Target Hospitality $194m as reimbursement for capital spending related to the conversion of Pecos from an EIS to an ICF. Why would the government spend that much money if they didn’t plan on continuing to use the Pecos facilities?
3. A removal of TH’s 2k beds from the system would be a significant detriment to ORR’s UC capacity. As mentioned above, by summer 2023, the government will effectively be operating at 100% utilization. In the event of a non-renewal and thus removal of TH’s 2000 bed from the system, the utilization would be 120%. Any utilization above 90% would be nonsensical and thus the removal of 2k beds, especially right before Title 42’s nullification, is highly unlikely.
4. TH’s solution is modular hard structure buildings, which is a better long term solution. This is a much more realistic long term solution vs. competitor Rapid Deployment’s Fort Bliss ICF. Fort Bliss’ units are mainly tents (some of which house up to 650 children!)

1. Eventual closure of competitor site: Rapid Deployment will see its Fort Bliss ICF mothballed soon. The government said in December 2022: “Operating an ICF on the Fort Bliss Army base is not part of ORR’s long range plans…”When ORR is able to bring additional bed capacity online, ORR intends to close and demobilize the temporary Ft. Bliss ICF site.” This removes 5000 beds from the market.
2. High cost of switching from an incumbent ICF provider:
   1. The government explained why switching providers is tough. To facilitate a change in contractor, Rapid Development has to dismantle the infrastructure. A new contractor would then be required to re-establish similar temporary infrastructure. “This would result in substantial duplication of costs to the government.”
   2. “Additionally, a new contractor would be required to recruit and hire staff. These new employees may be unfamiliar with the operations of an ICF site. The Government anticipates this learning curve could pose operational challenges and increases the risks of an overall decline in quality of care for children.”
   3. “There would also be substantial duplication of costs and programmatic efforts to re-establish the temporary ICF site at Ft. Bliss with a new contractor. There would also be increased program risk. Based on historical data related to bringing UC beds online in the Spring of 202. There are considerable programmatic efforts and contractor risks involved when new contractors provide beds for UC. To account for the risks and time needed for a new contractor to ramp-up to full staffing, the Federal Government would be required to deploy Federal detailees and federal resources to support operations during a transition period.”

8. Target Hospitality has a good chance of winning other government contracts and diversifying EBITDA.

TH has several warm stacked/utilized camps. These include a second Pecos camp, the Skillman Station Lodge (north of Mentone), the Delaware North Lodge (just north of Orla). TH just needs to go and win contracts to utilize its assets.

Target extended its ABL facility on Feb 2023 to provide flexibility in bidding on new awards: “Target has identified several organic growth initiatives, including select opportunities to broaden its customer base across government agencies, as well as unique commercial diversification opportunities supporting domestic energy transition.  The Company continues to evaluate its expanding pipeline of strategic growth opportunities and seeks to allocate over $500 million of net-growth capital through 2027.  Target will continue to allocate capital to areas with the highest potential value creation and expects to maintain its industry leading cash-on-cash margins.”

TH put out a job posting for a VP of government affairs and VP of federal affairs in March 2023. Both listings were taken off within a few weeks and the company announced two hires. Both have deep government experience and connections.

https://investors.targethospitality.com/news/news-details/2023/Target-Hospitality-Advances-Growth-Strategy-with-Strategic-Government-Affairs-Hires/default.aspx

9. The right team, with the right incentives, is running the company

Recently, the company added a diversification EBITDA-based award to management’s compensation plan.

Last year, management updated their compensation plan early in 2022, right before they announced the Pecos contract that 4x’ed the stock.

TH also has 3 board members (out of 8) who have deep government connections. Barbara Faulkenberry was a 2 star Major General in the Air Force. Pamela Patenaude was deputy secretary of the Department of Housing and Urban Development. Linda Medler was a Brigadier General in the Air Force.

10. Why did the stock sell off on Friday?

The stock sold off because the Northland analyst drew attention to a 3/24/2023 filing. This passage stood out to bears:

On April 5, 2021, HHS opened an Emergency Intake Site for Unaccompanied Children at the Target Lodge Pecos North property in Pecos, Texas (Pecos). As of June 4, 2022, the site transitioned to an Influx Care Facility (ICF), which provided shelter for boys and girls, 13 to 17 years old. As of March 11, 2023, the facility was placed in warm status, which means a facility is not fully staffed and there are only minimal onsite facility management services, such as payment of utilities, infrastructure repairs, and fence, landscaping, and storm damage preparation. Currently, there are no children in care at the site and no reactivation date.

The initial takeaway for people who are not close to the situation is that the government no longer needs TH’s Pecos facility.

We think the market is misinterpreting the information.

Warm status:

As mentioned above, state-licensed bed utilization is first priority. Thus, in months where UC volumes are weaker, swing capacity like TH’s Pecos facility are temporarily placed on warm status. A site’s warm status can change within a week. If volumes start picking up next week, the government will notify TH to ramp up its Pecos facilities again.

Furthermore, as mentioned above, state-licensed beds need to maintain at least 85% nameplate capacity utilization. Once utilization is above 85%, then ICFs can take some of the UC volume.

The only thing that warm status tells us is that the seasonally low Feb and March volumes of ~8k result in a 75-85% utilization of the 13k state-licensed nameplate capacity. Thus, Pecos is temporarily not needed at the moment.

Furthermore, the Pecos facility was placed on warm status on March 11, 2023. On March 15, the government issued the multiple-award IDIQ to Endeavor/Target Hospitality and several other vendors. If the government did not need Pecos anymore and placed it on warm status, why did it go out and award multiple parties IDIQ contracts 4 days later?

Seasonally low period

As mentioned by TH, GEO, CXW management teams and an easy Google search, border encounters from Jan to March were low due to seasonality (given cold winter months) and delay in repeal of Title 42 (more refugees are choosing hold off border crossings).

We saw similar seasonality last year. Jan, Feb, March 2022 sequential growths of children under ORR care were -29%, 12%, and 3% vs. -31%, 6%, and ~MSD for Jan-March 2023.

Thus, the 8100 children currently under ORR care are at a seasonal low (vs. March to December average of 10-11k in 2022, with Title 42 still in effect). Remember, there are only 9k (13k x 70% due to covid restrictions) state-licensed beds.

Valuation:

~$280m of 2023 EBITDA (excluding capex revenue) + $150m of growth EBITDA (30% ROIC on $500m of growth capex) = $430m of EBITDA vs. TEV of $1.5bn. Current valuation is 5.5x 2023 EBITDA (excluding capex revenue and growth EBITDA) and 3.5x EBITDA including growth EBITDA.

Catalyst

News about the IDIQ contract process

New contract wins