GEO Group＇s Attractive 15% Yield: Unfair Incarcera...

亮gjuraqcsmfsy 2020-03-24

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Mr. Market already was unfairly punishing this big-dividend REIT, but the recent market wide turmoil has made the price absurdly low and attractive. In this report, we analyze the company’s income profile, growth, dividend prospects as well as political risks and finally conclude whether the REIT offers an attractive balance between risks and rewards.

Overview: The GEO Group (GEO)

The GEO Group (GEO) is a specialty REIT that owns, operates and manages correctional, detention and reentry facilities in the US, UK, South Africa, and Australia. The portfolio consists of a total of 129 facilities including of 95,000 beds. Out of these 129 facilities, 80 are owned and operated by the company, 14 are leased and operated whereas 35 are managed only. Almost 92% of the beds are located in the US. GEO’s operating income can be divided into three segments:

Revenue is derived primarily from local, state and federal agencies. In 2019, 29% of the total revenue came from US Immigration and Customs Enforcement, 27% came from State agencies, 12% from Bureau of Prisons, while the rest came from US Marshall services, local agencies, and others.

Company is a prisoner to swings between the political left and right

The private prison industry is heavily impacted by political and regulatory changes in the country. These risks are magnified in election years as Democrats have been negatively predisposed to the concept of private prisons, while on the other hand, the GOP usually takes the opposite stance. A case in point is the 2016 memo by the Obama Administration which moved away from the use of private prisons by federal agencies. The stock plummeted almost 45% from panic selling pressure. Later in the same year, the Trump Administration rescinded the memo, fueling a violent move up in the stock.

The other challenge on similar lines comes from the broader public backlash. Private prisons face continuous monitoring and checks from activists who believe that inmates are kept in inhumane conditions in private prisons and that private companies are, for all practical purposes, profiteering from human misery. As a result of the growing public pressure, seven banks, namely JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), SunTrust, PNC Bank (NYSE:PNC), BNP Paribas (OTCQX:BNPQF), and Fifth Third Bancorp (NASDAQ:FITB), have pledged not to extend lines of credit to companies which are involved in operating private prisons. Additionally, a large number of institutions and funds are now becoming ESG compliant. In fact, in the US, Sustainable, Responsible and Impact (SRI) investing assets have gone up 38% since 2016 to $12 trillion in 2018. Large amounts of capital staying away from prison stocks could structurally depress valuation multiples in the segment.

Business fundamentals on the other hand are robust

The company’s revenue is driven by three metrics: Occupancy, compensated man-days, and revenue per man-day which is a proxy for pricing. There has been a surge in occupancy levels of private detention and correctional facilities since Donald Trump’s administration took charge in 2017. The average daily population of detained immigrants has reached record highs. As per U.S. government data, in 2018, 42,188 immigrants were held by ICE daily. As a result, there has been a surge in the occupancy levels at private detention facilities. In Q3 2019, GEO group’s occupancy level reached 95.7%, which is the highest number in more than five years.

Compensated man-days (number of days of occupancy for which the company is compensated) grew by a CAGR of 4.5% between 2014 and 2018. For year-to-date 2019, the compensated man-days were 17.7 million, which represents growth of 3.5% on a year-to-date basis. The growth was fueled by an increase in population of inmates due to new contracts signed with the federal government.

Finally, revenue per compensated man-day has increased at a CAGR of 2.4% during the last five years. For Q3 YTD 2019, revenue per compensated man-day was $67.86, translating into growth of almost 5% on a YoY basis.

The combined effect of both volumes as well as pricing growth has helped the company deliver strong earnings. Revenue in the U.S. Secure Services segment (66% of the OI) has grown at a CAGR of 8% during the last five fiscal years.

Earnings momentum has returned

An increase in occupancy levels and revenues also has led to an expansion in operating income per man-day which was on a declining trend for the past four years. YTD 2019, the company has reported an operating profit per man-day of $14, which is an increase of almost 8% on a YoY basis. Margins remained stable at around 20%. The GEO Group also reported a strong improvement of 11% in AFFO in the year ending 2019.

Source: The GEO Group, Blue Harbinger Research

Company’s liquidity and solvency metrics look sound for now

GEO Group’s debt to FFO is 8.2 times and interest coverage is at 2.2 times. The next major debt repayment of $212 million is due in 2022. Management seems comfortable with the maturity schedule:

“We currently have approximately $340 million in available capacity under our revolving credit facility in addition to an accordion feature of $450 million under our credit facility. We have ample capacity under our revolver to take out the remaining amount outstanding of our 2022 senior notes, which is our debt obligations with the nearest maturity. And we continue to enjoy access to capital with several dozens of lenders and financial institutions currently committed under our credit facility.” - Brian R. Evans (NASDAQ:CFO) on February 12, 2020

As mentioned earlier in this report, major financial institutions have denied future credit facilities to private prison organizations due to public pressure. As a result, these organizations will have to look for other sources to raise funds, which may lead to higher interest rates. In the case of GEO Group, the company’s senior credit facility is maturing in 2024 and until then the company’s internal cash flows can service debt.

“While a handful of banks have announced plans to not extend future financing arrangements to our industry all of those banks are contractually obligated under our senior credit facility through May 2024 and those banks only represent approximately 25% of GEO's total borrowing capacity. Further, the handful of bank announcements have not impacted our operations or financial flexibility and the credit agencies have not changed our ratings for over 30 months.” – Brian R. Evans (CFO) on Nov. 5, 2019

Growing dividends and an attractive yield

The GEO Group has increased its dividend per share at a CAGR of 4% over the last five years. In FY 2019, the company declared a dividend of $1.92 per share, which is a year-over-year increase of 2%. The payout ratio for FY 2019 was 70% (dividend % of AFFO) implying reasonable dividend cushion.

Despite growing dividends, the stock has been under pressure due to the earlier discussed political factors. As a result, the stock’s dividend yield has swelled to more than 15% vs. the 6% dividend yield in the specialty REIT space as per NAREIT.

The worst-case scenario isn’t as awful as some think

We realize that many in the market believe that the worst-case scenario is the company losing government contracts as well as the associated cash flows with them post elections in case a Democrat, especially a far left leaning one, becomes president. That argument is usually put forth to highlight a scenario that could see the company file for bankruptcy. While that sort of election outcome will definitely create volatility in the stock, we believe it's important to have a better understanding of the strategic value of the company’s assets at the same time.

As per data from World Prison Brief, capacity utilization of US prisons is likely more than 100%. As such, while the government might move away from private corporations running prisons, the underlying correctional facilities cannot be taken out of the system overnight due to an already overcrowded prison system. Given these limitations, there may be immense strategic value of the physical infrastructure owned by GEO Group in the eyes of the government and its agencies.

The following quote from Damon Hininger, CEO of Corecivic (NYSE:CVX), GEO’s competitor on the company’s Q3 2019 earnings call, is worth paying attention to:

“So as you know, we've got about 73,000 beds of capacity in our safety segment; of that about 65,000 is beds that we own outright. So if you take that 65,000 and consider some recent building that the federal or states have done here in the last, let's say probably four years or five years, at the federal level, we've seen cost per beds in a range of $200,000 to $400,000 per bed and at the state level, we've seen some building projects in the range of $100,000 to $200,000 a bed. So look at it this way, if you think about half our business with federal, half our business with the states, $200,000 per bed probably a good average per bed, if you look at recent building projects within our industry. So you take that $200,000 per bed. It gives the 65,000 beds that we own that gives you an evaluation about $13 billion for our real estate.”

We valued GEO’s correctional/care facility assets based on EV/bed of 100K, 200K and 300K. Additionally, we also applied average specialty REIT multiple to the company’s international business operating income. As evident in the chart below, even at the low end of the valuation range (EV/bed 100K), we get to $24.8 per share equity value as compared to around $13 per share now, implying significant disconnect between fundamentals and market perception of the company’s value.

Risks

Liquidity constraints: Recent announcements by financial institutions discontinuing credit to companies that own or operate detention facilities can make refinancing of the existing debt more expensive after 2024 for GEO, which is when the existing credit facilities are set to expire.

Political risks: Election of a far-left leaning Democrat in this year’s election will most likely lead to significant volatility in the stock even though as we mentioned earlier in the report, there's likely to be continued strategic value in the company’s assets.

Coronavirus: The virus is atop of many investors minds currently as it roils the financial markets almost indiscriminately. There's a risk that Geo could face unexpected challenges and backlash if a virus outbreak were to occur at one of more of its facilities. However, this fear already has contributed to the massive sell off as GEO has been lumped in with other 'healthcare facility' REITs, whereby an outbreak at a nursing home healthcare facility REIT has put indiscriminate selling pressure on these REITs, including GEO, over the last week.

Conclusion

The GEO Group’s financial performance has been consistent and the dividend has grown as a result. Despite the dividend growth, political risks surrounding this industry, combined with coronavirus fears, have severely compressed multiples and expanded the stock’s dividend yield to 15%. While we admit the stock is going to be volatile, we disagree with the notion that there's no value to the company’s assets in case private parties are banned from operating prisons. As such, we have ranked GEO No. 7 on our recent list of top 10 big-dividend REITs (market turmoil edition) because we think the current valuation is overly pessimistic and investors should take a more balanced view of risks and rewards. Plainly, GEO’s big 15% dividend yield is absolutely worth considering for a spot in your prudently-diversified, long-term, income-focused investment portfolio.

And if you are looking for more attractive big-dividend REIT opportunities (especially in light of the recent market turmoil), be sure to check out our recent report, Top 10 Big-Dividend REITs (Market Turmoil Edition).