Description

The GEO Group has just recently sold off 25%. It now trades at 10.8X on 2009 Adjusted Free Cash Flow, and 12.7X on 2008 Adjusted Free Cash Flow. We think that this is cheap for a company which is growing earnings north of 20% in a non-cyclical oligopolistic industry with good visibility. We believe it is a relatively safe investment in an uncertain economic environment. In fact its closest comparable (CXW) has rallied over the past month while the market has sold off. There are numerous catalysts (listed at the end).

I originally posted this idea in December of 2006 and given recent the huge sell-off, I thought it was a good idea to post an update in case anyone was following the name or looking at it for the first time. I would have posted this update as a message to my original post but this update is longer than 1000 words (messages are limited to 1000). Please review the initial write-up for a detailed background on GEO's industry and company specifics.

Why is it down so much?

GEO has sold off nearly 25% recently on lowered guidance for Q4, and management provided early 2008 guidance that was below analysts’ consensus. This was a big surprise given management’s history of beating and raising estimates.

The Q4 and 2008 guidance and why the sell-off is an overreaction.

GEO lowered Q4 guidance from 30-32 cents to 26-27 cents. The lowered guidance was the result of a seasonal decline in federal detainees (illegal aliens) at two facilities. While this seasonal slowdown has occurred over the years, the company did not budget for it this year because it did not occur last year but they will now do so in the future. The reason why there is a seasonal decline during the fourth quarter is that illegal aliens do not cross the border as much during the winter due to the holidays and lower activity in farming jobs. The decline hit the bottom line especially hard since they were in company owned facilities which carry high margin and a relatively fixed cost. In addition, Q4 guidance was hit by one-time costs of 4 cents. So Q4 will be a messy quarter, however the seasonal slowdown does not affect the supply/demand picture of prison beds related to illegal immigration. It is a timing issue. We do not think that illegal immigration is going to decline causing a reduction in demand for prison facilities. In fact, the US Border Patrol is expanding a program which extends the holding period and/or jail time for repeat offenders rather than just catch and release. This will serve to benefit GEO Group because it will increase total jail days. In fact, the Senate recently amended its proposed Appropriations bill for the Department of Homeland Security providing more resources for ICE's detention facilities. The amendments call for ICE to increase its detention bed space to 33,000 beds from the current 27,500.

GEO provided pro-forma 2008 EPS of 1.27 to 1.35 versus consensus of 1.35/share. The new consensus is 1.29 share. The difference from analysts’ expectations are primarily due to the seasonality which they are now budgeting for 2008, and a large amount of startup and business development costs. GEO management is also being conservative.  2008 will be a big investment year in which they will open a lot of new facilities and pursue numerous growth opportunities. On the positive side, much of the investment and additional costs in 2008 will contribute to earnings during 2009 and 2010.

The lower Q4 and weaker than expected 2008 guidance caused GEO to get hammered but the business fundamentals have not changed and at this price GEO presents a compelling opportunity. We think that GEO's 2008 guidance set a floor for 2008 earnings with only upside from here.

Valuation--Focus on Adjusted Free Cash Flow not GAAP EPS

As mentioned in my original write-up, Depreciation and Amortization far exceeds maintenance capital expenditures. This is why analyzing the company on GAAP EPS is not appropriate, and a value investor should look at Adjusted Free Cash Flow of the ongoing business.

My Estimates

	2008	2009
Revenue (ex: Construction)	1020	1140
Opex(*not inc. Startup Exp.)	770	857
Gen and Admin	67	71
Dep and Amort	41	47
EBIT	142	165
Interest	35	35
EBT	107	130
Tax (38.5%)	41	50
Equity Inc. from Inter. Affiliates	2	2
Net Income	68	82
Fully Diluted Shares	51.8	52.2
Pro-Forma EPS	1.31	1.57
EBITDA	185	214
Maintenance Capex	12	14
Free Cash Flow	97	115
FCF/Share	1.87	2.20

*In 2008, the company will undergo $11mm of startup and business development expenses which the company doesn’t capitalize which I add back to earnings from operations. These expenses are one-time in nature, and I view them as investment. While GAAP requires these expenditures to be expensed when incurred, most of the time these costs are recoverable during the course of the contract.

For 2009, much of the revenue growth is from contracts that are already announced and will not start up until late 2008 and 2009 so visibility is good.

Price Target

$33/share, which represents 15X 2009 Adjusted FCF of 2.20/share.

The Industry

The industry has not changed since my initial write-up last December, although if weaker State budgets occur, this will accelerate the use of private prisons to meet overcrowding because they are cheaper and faster to open than their public counterparts. Spending precious State tax receipts on building prisons is not popular even in good times let alone lean times.

For a good industry primer on the prison overcrowding issue from a neutral source try the Pew Charitable Trust:

http://www.pewtrusts.org/news_room_ektid29963.aspx

GEO's closest competitor is Corrections Corp.(CXW). CXW has rallied over the past month despite a brutal stock market because it is viewed as a defensive stock and it posted a solid quarter unlike GEO. We believe GEO will eventually trade higher as confidence is rebuilt. We think GEO represents far greater upside than owning CXW because GEO has international growth opportunities and Geo Care which carry high returns on investment, while CXW is limited to U.S. Corrections. CXW (which we think is cheap but not nearly as cheap as GEO) is currently trading at about 14X 2009 Adjusted FCF, and 17X 2008 Adjusted FCF.

As explained in my initial writeup, the industry only has a few major competitors and each one has moats around their business (both figuratively and literally). A new competitor cannot enter the market because experience and track record are important. In addition, since GEO and CXW own or have long-term leases on their facilities, the threat of new competitors are very low. In many areas of the company GEO is ingrained in the legal system. To give you an example of this, GEO's San Diego Detention Facility for the US Marshall Service is located in the building next to the courthouse with a walkway between the two. A competitor cannot uproot that relationship.

Risks

Delays of Inmate transfers.

Riots and bad press from inmate alleged mistreatment

Losing renegotiated contracts. Retention of existing contracts have been north of 90% however.

Catalysts

The company has numerous RFPs in house and outstanding which they will hear results from during the next 6 months. These opportunities could be a couple hundred million dollars and add .20-.30 cents or more in EPS when/if fully realized. Since GEO competes with a limited number of competitors (2-3), we have high conviction that GEO will win its share or more. Below is a list of a few opportunities:

Expansion of California facilities to support California’s 50,000 inmate overcrowding.

Geo Care contract wins. Geo Care is in discussion with numerous entities to manage public mental health/forensic facilities worth over $120mm in annual revenue. The biggest near-term opportunity is with the State of Pennsylvania which is about $40mm in annual revenue. The company has good relations with Pennsylvania as demonstrated by another recent renewal of a detention facility which they have already managed successfully for 12 years. We should hear results in early 2008.

South Africa prison build-out of 16,000 new beds.

US Marshall Service 1,000 bed facility in Las Vegas.

Filling the currently unoccupied prison in Michigan.

33,000 new beds for the Immigrations and Customs Enforcement.

2,000 new beds with the State of Arizona

Catalyst

1)New contract wins from Geo Care
2)Expansion of California Prisons
3)Contract wins from Immigration and Customs Enforcement and US Marshalls Service
4)Filling Unoccupied Prison Beds in Michigan