Having traded off 15% from its highs, GEO is now trading at a 9.5% Free Cash Flow Yield for 2007 which is cheap for company in a non-cyclical oligopoly with a strong growth outlook over the next several years.  GEO has an 11.1% FCF Yield for 2008.  GEO group is the second largest private prison operator in the world.  GEO has traded down about 6 points in the past few days based on the risk that it will not get the 1,261 inmates from California that it was awarded in October.  This sell off creates a great buying opportunity because even if they don’t get the California business they will be able to make up for it quite easily.

 

Summary

GEO is a value name because it is cheap on a free cash flow basis.  Investors who solely focus on PE or EV/EBITDA will miss the intrinsic value of the company. Depreciation and amortization is far higher than maintenance capital expenditures.  GEO can grow top line and earnings without much capital expenditures.  It operates in a non-cyclical industry where three competitors holding 90% of the market.

 

GEO current trades at a 9.5% FCF yield.  (Market Cap/Net Income plus D&A less Maintenance capex).  We estimate that FCF can grow 10+% for the next several years without much volatility.

 

About GEO

GEO is a leading provider of government-outsourced services specializing in the management of correctional, detention, mental health and residential treatment facilities in the United States, Canada, Australia, South Africa and the United Kingdom.  Including projects under development, GEO has total capacity of 53,000 beds at 63 facilities, 6 of which are located outside the United States.

 

GEO has three business segments:

 

 

Competition

Other than government-operated prisons, GEO’s primary competition comes from Corrections Corp (CXW-NYSE), Cornell Companies (CRN-NYSE), and Management and Training Corp (Private).  Corrections Corp holds 50% of the US market, GEO holds 29% of the US market and Cornell holds 10% of the market.  GEO is the only operator with an international presence.  The total number of privatized beds in the US is about 150,000.

Operating Structure of the Corrections Business—To Own or Not to Own

 

Corrections companies that own the facilities that they manage have larger EBITDA margins, have more control in pricing and leveraging contracts to garner higher margins than a company who is just managing the facility.  On the flip side, companies that own the facilities have more capital at risk and are subject to maintenance capital expenditures.  Corrections Corp. largely owns and operates its facilities, which is why its margins are higher than GEO’s but its maintenance capital expenditures are higher as well.  About 65% of Corrections Corp’s beds are owned, while GEO owns (or controls through leases) about 30%.  Facilities that are owned and operated can carry EBITDA Margins in the 25-40% range, facilities that are leased can carry EBITDA margins that range from 15-25%, and managed only facilities carry margins in the 10-15% range. 

 

GEO’s Industry Outlook is Strong and Steady—Industry Analysis--The industry is growing and will continue to grow:

 

1)      Non-Cyclical Industry.  Similar to healthcare, the prison industry is generally not affected by economic downturns.  Inmate populations have grown every year for the past 20 years.

 

2)      Stable Customer Base.  GEO’s customers are the government and their respective agencies.  They are stable credits with long term contracts and high renewal rates.

 

3)      Continued Growth in Inmates.  Supply will have a very difficult time keeping up with this demand over the next several years. There are 2,186,230 inmates behind bars, according to the Department of Justice's Bureau of Justice Statistics (BJS). Two thirds are in state or federal prisons (1,438,701) and the other third (747,529) are in local jails. The U.S. Prison Inmate population has grown every year for the past 10 years by 3.4% or about 60,000 inmates per year.    During that time the U.S. population has grown just 1.1%.  This growth is due to many factors, among them are:  more crime, tougher rules against offenders, growth in “at-risk” youth and young adults resulting from immigration, children from broken families and baby boomers (see below), increased recreational drug use, slower courts appeal process, inmates living longer.  There is no reason to assume that this trend will not change, in fact there are reasons that this growth may accelerate over the next several years due to demographics and homeland security.  Prisons are mostly at full capacity.  It takes a government entity 3-5 years to build a new prison, and a private operator 2 years.

 

4)      Population Growth in high risk age group.  Much of the crime in the U.S. are committed by males within the age of 16-28.  18-25 year olds consist of Children of baby boomers are entering the high risk age group of 18-26.  Between now and 2010 the US Census is forecasting a continued increase in this demographic.

 

5)      High Barriers to Entry.  Limited Competition. Oligopolistic.  In the U.S. there are 3 major players, Corrections Corp. (CXW) with 50% market share, GEO with 30%, and Cornell with 10%.  Newcomers into the industry face significant challenges namely experience, track record and cost.  In addition, larger prison operators have an advantage as they can shuffle inmates around their system to offer flexibility to state agencies and to optimize capacity.

 

6)      Current Prisons are hugely overcrowded.  State prisons are operating at 99% of capacity, with 24 states operating at 100% or more of their capacity.  The Federal prison system is operating at 134% of capacity.

 

7)      Under-penetrated Market.  Private prison operators only manage 6.7% of the prison population in the U.S.  The government operates the rest.  There is a trend towards outsourcing management of prisons.  In fact over the past 15 years, the number of inmates held under private correction facilities has grown an average growth rate of 17%.  The outsourcing trend will continue as the public sector is overwhelmed, it is cheaper to outsource and studies show that performance of privately managed facilities perform better than public ones.

 

8)      Constraints on Building New State Prisons.  Generally speaking, state budgets are fiscally constrained and state spending usually puts prisons down on the list behind education and healthcare.  There are usually difficulties with finding new locations which require public approval.  This delay prevents additional capacity from popping up all of a sudden.  States are looking towards the private sector to meet their growing population needs.

 

9)      Federal Prisons expanding rapidly.  The Federal Bureau of Prisons (“BOP”) will be a significant driver of private prison beds over the next five years.  In the last 5 years, the BOP has contracted with the private sector to house up to 8,500 inmates.  Currently the BOP is operating at 134% capacity and has indicated that up to 30,000 beds will be needed by 2011.

 

10)  Private Prisons are High Quality and Lower Cost.  The quality and service of private prison operators are stronger than their government counterparts.  The private operators have lower escape rates than public prisons.  Because private prisons are needing to renew contracts every few years they have more motivation to do a good job.  This quality of service is reflected in higher accreditation of private prisons from the American Corrections Association.  In addition private operators operate at lower costs than the government can do for themselves.

 

11)  Illegal Immigration and Secure Border Initiative.  The United States Marshals Service (“USMS”) and U.S. Immigration and Customs Enforcement (“ICE”) are leading the charge for dealing with the illegal immigration issue.  ICE (formerly the Immigration and Naturalization Service) holds non-citizen detainees waiting for a hearing in the civil immigration courts, or facing immediate deportation. The Marshals Service is responsible for housing both citizens and non-citizens waiting trial or sentencing in federal criminal court.  USMC and ICE do not operate their own facilities and require private operators like GEO.  Just in the last two years, Congress has authorized 40,000 new ICE beds over the next five years and given the Marshals Service funding for another 4,000 to 5,000.  Last year the Department of Homeland Security has initiated the Secure Border Initiative which is a comprehensive plan to secure the U.S. borders and reduce illegal immigration.  One of the action items is eliminating a “catch and release” program, and instead retain and deport illegal aliens.  There are millions of illegal aliens in the U.S. and dealing with this issue will continue for years.  Prison operators such as GEO benefit as they operate detention centers for the illegal aliens.

 

12)  Pricing is going up.  Due to the industry conditions.  Prison operators have strong pricing power and will be increasing pricing as their contracts roll off with their customers.

 

 

 

 

 

 

GEO can grow the following ways with minimal risk:

 

 

 

 

 

 

 

 

What’s Up with California?

 

California has current operational capacity of 90,000 inmates.  They currently hold 172,000.  It is the largest system in the country.  They are overcrowded and mismanaged.  There has been a decade-long lawsuit on behalf of inmates on this overcrowding.  Recently a federal judge warned California that he will consider a cap on inmates if nothing is done to improve the situation by June of 2007.  Well aware of this issue, Gov. Schwarzenegger has tried to make steps to deal with the situation over the past year.  He has proposed new bond issues to invest in new prisons (which has failed in the 2006 legislature) and declared a state of emergency and is trying to send prisoners out of state. 

In October, California awarded GEO 1,261 inmates that were to be held at GEO’s Indiana facility.  Subsequently, guard labor unions and prisoner advocacy groups have filed lawsuits requiring a stoppage of the prisoner move.  Guard labor unions are afraid that they jobs will be lost, and prisoner advocacy groups do not want the prisoners sent out unless prisoners agree to it.  While no formal stoppage has occurred, this has added some uncertainty to the prisoners moving out of California.

When GEO announced the deal with California, they upped guidance by .15 in 2007.  Within the last week, it appears that the transfer is on hold either due to advocacy groups or GEO saying that they do not want the inmates any longer.  This has sent GEO’s stock down 15%.

 

Overreaction in GEO’s stock price

 

Even if California does not send the 1,261 prisoners to GEO’s location in Indiana which is not definite, there are other overcrowded states which are sending inmates out of state and need GEO’s capacity.  GEO can and will most likely fill this capacity quite easily.  Just last week, Colorado shipped 240 prisoners out of state and Arizona is currently trying to ship 5,700 prisoners out of state.

California will not be out of the woods anytime soon and will need companies like Corrections Corp. and GEO.  Transferring prisoners out of California is inevitable.  The overcrowding is that bad.  Recently Schwarzenegger proposed raising $4 billion through lease financing to build prison space for 16,000 inmates.  Nice idea but there are four problems with this:  1) $4 Billion is a lot of money, 2) it will take 5 years to complete (what do you do in the meantime) 3) the California prison population is growing at 4,000 year so by the time you finish the prisons you will still be 4,000 beds short, 4) 16,000 beds is a drop in the bucket when they are overcrowded by 70,000.  Even if California does get around to building a few facilities, they will require private contractors like GEO to operate it.  California cannot address this problem without the help of the private sector, namely Corrections Corp. and GEO Group.

 

 

The CPT Acquisition—Expensive but strategic

 

CPT is a publicly held REIT from which owns 13 facilities of which GEO leases 11 of them. GEO announced the acquisition of CPT in September and it will close in February.  They paid $356 plus 40mm in debt for a total purchase price of $396.  This is a cash flow positive but GAAP negative acquisition.  29mm of additional interest expense, offset by 26mm in saved rental expense and an increase of rental revenue of 5mm.  There is 10mm of additional depreciation.  While expensive from an EV/EBITDA basis at about 12-13X, this acquisition was very strategic as it eliminated the growth impediments of GEO relating to having to renegotiate lease rates.  It gives GEO greater visibility and gives GEO a key foothold and control of 11 facilities including 3 in the very important State of California.  It further allows GEO to invest in these now owned facilities.  About a year ago, GEO started buying a significant amount of property adjacent to these CPT facilities and will most likely expand capacity at these locations significantly, particularly in California.  These announcements could most likely occur after they close the transaction in January.  We believe that while the acquisition looks expensive, it was very strategic. 

 

While GEO’s Total Debt/EBITDA ratio stands at about 5.1X as a result of this acquisition, this is the right time to lever up to take some risk through higher leverage and take advantage of the strength of the industry.  A normal optimal leverage ratio in this industry would be about 3.5 to 4X.  CXW is at about 3.2X but plans to increase leverage this year.  GEO could immediately reduce leverage by selling the 2 facilities it acquired in the CPT transaction that it does not manage.  I estimate that these properties are worth about $40-50mm.

 

GEO is also no stranger to making acquisitions work.  In 2005, GEO acquired CSC (a prison operator) for $62mm plus $124mm in debt.  Post acquisition, GEO spun off the juvenile division of CSC and was able to improve profitability of the acquired business immediately.

 

 

 

 

The Balance Sheet Pro-forma after acquisition

 

50mm Cash

647mm Debt  (365 in Term Loan, 150mm in Sr. Unsecured Notes, 132mm in non-Recourse debt)

597mm in Net Debt

 

 

Valuation

 

While GEO trades at a slight discount to CXW on a PE and EV/EBITDA basis, the big discrepancy comes when analyzing Price to FCF.  GEO trades at 10.5X P/FCF while CXW trades at 19.6X P/FCF.

 

Market cap- 684

Net Debt – 597

Enterprise Value =  1.28Bln

 

My estimates for 2007 are for:

2.00/share after tax EPS (exclusive .10 of start-up expenses)

142mm in EBITDA

67mm in FCF (As defined as Fully Taxed Net-Income plus Depreciation less Maintenance Capital Expenditures) or 40 +35 – 10 = 65mm or $3.25/share or a 9.5% P/FCF yield.  

 

While management’s most recent 2007 guidance given in November is for 1.75 –1.90 in EPS, management has always been very conservative and they have not financially detailed the benefits of the CPT acquisition.  My estimate of 2.00 in 2007 is conservative in my view.

 

Thus, for my 2007 estimates, GEO is trading at a 17.5 PE, 9X EBITDA, and 10.5 P/FCF.

 

Corrections Corp (price 45.5, Market Cap 2.8Bln, EV 3.6Bln) is the closest comp.  The 2007 estimates for CXW are: 

 

1.95 in EPS

330 in EBITDA

144mm in FCF (as defined above)

 

and thus CXW is currently trading at a 23X 2007 PE, a 11X EV/ 2007 EBITDA ratio, and a P/FCF of 19X or 5.2% P/FCF yield.

 

Analyzing GEO versus CXW on return on Assets and Equity shows that GEO has higher returns on Assets and Equity.  If you annualize last quarter’s results for both companies, GEO’s ROA is 4.9% and ROE of 14.2%.  CXW was 4.7% on assets and 10.1% on Equity.  The primary difference is that CXW’s business is more capital intensive than GEO’s.  Of CXW’s total capacity, 65% of total beds are owned or leased.  Of GEO’s total capacity, 30% are owned or leased, and the rest are managed.  While owned or leased facilities have higher margins, they require higher capital expenditures and maintenance.  All of GEO’s international facilities are managed-only, and all of GEO Care’s facilities are managed-only. 

 

The primary difference in FCF between GEO and CXW is that, GEO’s maintenance capex will run at about $10mm/year while they are accruing $35mm in D&A.  CXW’s maintenance is running at about $46mm while they are accruing about $77mm in D&A.  The big discrepancy is because CXW owns the facilities on 46,000 beds.  GEO owns (or controls through leases) 14,000 beds.  Through the growth projects listed above, we believe that GEO can continue to grow recurring FCF to common shareholders with minimal capex. 

 

Cornell Companies will be acquired for 8.2X 2007 EBITDA by private equity firm.  While this multiple is less than Corrections Corp, and GEO Group.  Cornell has had numerous contract and facility issues in the past.  Furthermore, Cornell’s business consists of 35% youth services and adult community based services which have much lower barriers to entry than Secure Adult Facilities.  Both CXW and GEO operate adult facilities which have higher barriers to entry.

 

 

GEO’s growth will really start to pick up in 2008 and beyond. 

 

First of all, GEO has three announced projects for a total of 2,800 beds that doesn’t hit until late in 2007.  Furthermore, they will probably fill their existing capacity at their idle facilities next year.  GEO Care will be gaining more traction and GEO may be adding capacity to the recently acquired CPT properties.

 

My Estimates for 2007 and 2008 are as follows:

 

                         2007                2008

Revenues            945                  1050

EBIT                  107                    123

Interest                42                      40

EBT                    65                       83

Tax                     25                       32

Net Income          40                       51                   

EPS                 $2.00                   2.55

 

DA                      35                    37

EBITDA             142                  160

Maintenance         10                    12

FCF                     65                    76

FCF/Share          3.25                 3.80

In Summary
At FCF yields of 9.5% for 2007 and 11.1% for 2008, GEO is cheap given its stable growth, competitive position, and versus its comparables.  Because it has 1/4 the market cap of CXW, growth projects have a bigger impact to earnings and FCF than it would to CXW, therefore earnings will grow faster at GEO.  Our near term target for the stock is 45.5/share which represents a 14X 2007 FCF, still a discount to CXW.  Our longer-term target is 50/share which represents 13X 2008 FCF.

 

 

Catalysts

 

-GEO announces fills the 1,261 beds that are currently in question which were supposed to be filled by California

-GEO closes CPT acquisition in January and delineates new guidance for 2007, and plans to expand its newly acquired properties

-GEO fills its 1,100 other vacant beds with inmates from either California, Colorado or Arizona.

-GEO announces a contract win for any other of their outstanding RFPs.