GEO Group: A Stock With An Options-Like Return Profile

Summary

• My valuation indicates that GEO Group's fair value is about $15.61 per share, given the fact that it plays an important role in social safety.
• Ongoing political and financial pressures have put it in a precarious position; I believe its price is now at an attractive level to buy and carries a huge upside potential.
• I assume that GEO will transition to a combined real estate and IT technology business that will make it less controversial and involve less political risk.
• GEO's current heavily indebted capital structure makes it options-like, and each successful debt payment it makes serves as a catalyst for investors to revalue its true value.

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The story of GEO Group

GEO Group (NYSE:GEO) is a specialty REIT that owns and manages secure facilities (put simply, prisons and jails) and runs community corrections (supervising people on parole and probation) in the United States, England, Australia, and the Republic of South Africa. Primarily serving federal government agencies and states, it has been one of two dominant players in the industry (along with its main competitor, CoreCivic (CXW)) since the 1980s.

In recent years, political and social issues, including mass incarceration and inhumane practices in prisons have caused a great deal of trouble in the prison industry. Moreover, many big financial institutions have announced that they will not provide financial services to private prison companies like GEO. As a result, GEO's stock price has trended downward over the past 5 years. To make matters worse, on Jan. 26, President Biden signed an executive order directing the attorney general not to renew federal contracts with private prison companies. As of April 7, 2021, GEO suspended its quarterly dividend payments, and its stock price collapsed heavily.

I think GEO's decision was reasonable, but reactions from the market were irrational because it did not affect GEO's fundamentals. Rather, the decision will help make more room to service its debt. Now, GEO's stock is trading at less than 4x of the P/FFO ratio, and I think this is deeply underpriced and it is high time to buy.

Data by YCharts

GEO's Correction & Detention business segment is definitely in decline due to decreasing prison populations, but that does not mean it will vanish any time soon because prisons are like infrastructure. Ongoing efforts to reduce mass incarceration have increased demand for alternatives to prisons and given rise to community corrections in which the GEO Care business segment expanded its presence long ago.

GEO Care will serve as a main long-term value driver, enabling the company to generate strong cash flow and avoid refinancing risks. As GEO fulfills and refinances each of its debt obligations, I expect GEO's stock price to soar.

Prison Business

As mentioned above, GEO's main business owns, leases, and manages a broad range of secure facilities in the United States. Its top-3 customers are government agencies: ICE, BOP, and USMS. It is paid a daily rate for each person incarcerated, which means its revenues increase as more people are incarcerated.

According to the World Prison Brief, The United States has the largest prison population of any country in the world. Over 2 million people are incarcerated and the incarceration rate per 100,000 residents is 655, followed by Turkey with an incarceration rate of 287. However, private prison corporations deal with less than 10% of the total prison population.

Source: Prison Policy Initiative

According to the Sentencing Project, to end mass incarceration, many policymakers and organizations insist this number should be cut in half over the next 15 years, but the past average decline rate of 1% indicates that such a reduction would take 65 years. The graph below shows the historical and projected prison population in the United States. Thus, in my valuation, I assumed that GEO's secure service revenue will steadily decline over the long term and that its decreasing revenue bases combined with expected more stringent regulatory requirements will leave it with less operating margin.

Source: The Sentencing Project

Alternatives to prisons

As pointed out above, the United States has the largest prison population of any country in the world. However, it cannot reduce mass incarceration by simply releasing prisoners into society; this practical reality has fueled the growth of the community correction industry.

Community corrections companies provide their customers-government agencies-correction services outside of secure facilities. These services include bail bond agencies, electronic monitoring, residential re-entry centers, day reporting centers, and so on. GEO Care, one of GEO's main business segments, is a dominant player in the provision of electronic monitoring, residential re-entry centers, and day reporting centers. It provides its services to a wider swath of the criminal legal system than the prison segment does. More than two-thirds of adults within the system are under community supervision, making this a rich area for revenue growth.

Source: Prison Policy Initiative

The key difference between prisons and community supervision is that community supervision companies can directly charge people for supervision costs, which include installation fees, drug testing, and mandatory classes.

Furthermore, from the standpoint of government agencies, community supervision is more cost-effective than prison and helps reduce mass incarceration. Considering those facts, I assumed GEO Care's revenue will enjoy a robust long-term growth rate and that its operating margin will remain above that of the prison business and improve slightly over time.

Valuation

I used a DCF Model to value GEO, inputting my estimates of key fundamentals such as growth rates, operating margins, and reinvestment (Working Capital + Capital Expenditure). My value per share projections is $15.61 in the base case scenario, about 150% higher than the current price, and $6.24 in the downside case scenario, even in the downside case, about 1% higher than the current price. I believe the base case is most likely and this belief is strong enough to make me comfortable acting on it.

Revenue Growth Rates

First, President Biden's recent executive order and the declining trend in the United States prison population will dampen growth rates for the U.S. Corrections & Detentions, one of GEO's main business segments.

I estimated that the 10-year CAGR will be -1.0%, and the year 1 growth rate will be -5.0%, reflecting the short-term effect of the executive order and the ongoing COVID-19 pandemic. The table below shows the facilities and revenues affected by the executive order.

Agencies	Facility Name	Type	Capacity(beds)	Annualized Revenue($ M)	Expiration Date
BOP	Great Plains Correctional Facility	GEO Owned	1,940	35	2021-05-31
BOP	Big Spring Correctional Facility	GEO Owned	1,732	33	2021-11-30
BOP	Flightline Correctional Facility	GEO Owned	1,800	35	2021-11-30
BOP	North Lake Correctional Facility	GEO Owned	1,800	35	2022-09-30
BOP	Reeves County Detention Center I & II	GEO Managed	1,800	4	2022-09-30
BOP	Reeves County Detention Center III	GEO Managed	1,376	3	2022-06-30

Click to enlarge

Source: Created by author using data from company filings

Meanwhile, GEO Care will experience a robust growth rate because the community corrections industry functions as an alternative to prisons and has a larger customer base. Moreover, according to a report by McKinsey & Company, before the end of Q2, vaccines will be available for 100% of adults in the United States. So, I expect social distancing is going to end in the short term.

I estimated that the 10-year CAGR will be +12.0%, and the year 1 growth rate will be 21.1%, reflecting the base effect; this rate will steadily decrease after year 1 to a terminal growth rate of about +1.70%. GEO Care's CAGR was 8.3% from 2012 to 2020, (11.2% from 2012 to 2019 excluding COVID-19 effects). I believe GEO Care's dominant position and the high barriers to entry in the industry (reputation risk, industry-specific knowledge, and high regulatory requirements) justify my long-term growth rate projection.

Net Operating Margin

U.S. Corrections & Detentions segment's operating margin will decline from the current level of 24% to 20% because operating costs are expected to increase due to decreasing revenues and a tougher operating environment. On the other hand, GEO Care's operating margin will increase from the current level of 31% to 35%. I assumed that GEO Care's business model combines real estate and IT technology (electronic monitoring). In addition, a GEO subsidiary is a dominant player in the electronic monitoring industry, and it is easier to pass along incurred costs to the customers (users) than the prison industry, supporting a higher operating margin.

Sales-to-Capital Ratio

Sales-to-capital ratio measures how efficiently a company generates revenues from the capital it sources from investors. Capital-intensive industries like REITs feature low sales-to-capital ratios. I estimated reinvestment (working capital + capital expenditure) by using sales-to-capital ratio. GEO's historical sales-to-capital ratio is 0.7x and I assumed that it will increase to 1.0x as it transitions to a combined real estate IT technology business. Meanwhile, I estimated terminal reinvestment using the industry-average ratio of 0.2x.

Cost of Capital

I estimated that the weighted average cost of capital will initially be 10.03% and decrease to 8.0% by the terminal year, indicating that GEO's now distressed status will improve in the long term. The table shows the inputs used in calculating the cost of capital.

Valuation Summary

Source: Created by using company filings and author's estimates

This is my base case scenario valuation summary. Considering that GEO is struggling to refinance its debts, I estimated that its probability of failure is 8% (default rate), higher than the average high-yield default rate; its proceeds will be zero if it fails. GEO's employee options are deep out of the money (the average strike price of options outstanding is $22.07) and expected to result in no dilution.

Sensitivity Analysis

I conducted sensitivity analyses after my valuation to test its validity and determine how the market evaluates GEO based on my key fundamental assumptions (Growth, Margin, and Probability of Failure). The table below shows my key assumptions case by case.

Business Segments	Care	Care	Secure	Probability	Terminal
Cases	Growth	Margin	Growth	of Failure	Growth
Upside	15.0%	40.0%	1.0%	5.5%	1.7%
Base	12.0%	35.0%	(1.0%)	8.0%	1.7%
Downside	7.0%	30.0%	(1.0%)	15.0%	1.0%

Click to enlarge

Source: Author's estimates

First of all, the main value driver of my valuation is the GEO Care business, and I analyzed two of the fundamentals, growth and margin. The yellow cells indicate where the value is below the current share price of $6.2. The results in this table indicate that the stock would be fairly valued to overvalued at a growth level between 8.0% and 5.0% and operating margins between 30.0% and 33.0%.

Source: Author's estimates

Second, GEO's prison business may decline at a faster rate. In my base case scenario, no matter how fast it declines, GEO's value will remain higher than the current share price. In the downside case, meanwhile, although GEO's value will be lower, the value ranging from the difference among assumed growth rates will not differ substantially. Thus, I believe the market already reflects the future of the prison business.

Source: Author's estimates

Lastly, my valuation assumes an 8.0% probability of failure. As shown below, GEO's current stock is overpriced, above an 16.0% of probability of failure.

Source: Author's estimates

To conclude, GEO's current stock price seems to already reflect the decline in the security business and indicate that GEO's survival depends on its community corrections business. Given that GEO's businesses have infrastructure like features and that the decreasing prison population will give the GEO Group increasing opportunities, I believe GEO is likely undervalued by the market.

Risk

As it turns out, the executive order may have more impact on other government agencies such as U.S. Immigration & Customs Enforcement, therefore making GEO's credit profile more vulnerable and increasing the refinancing risk. However, I carefully expect that the Biden administration's less unfair treatment of immigrants may decrease the additional impact on it.

Source: GEO 4Q20 Supplemental Disclosure

However, as we know, the refinancing risk is the biggest risk GEO faces. Since many financial institutions are unwilling to provide loans to private prison companies, GEO's heavy debt burdens have been troublesome for a long time.

The figure below shows GEO's debt maturities. While the 2021 scheduled debt payment is relatively small, the 2024 payment will be substantial. In my view, each year's debt refinancing will be a catalyst to reassess its distress.

Source: GEO 4Q20 Supplemental Disclosure

Equities distressed with heavy debts are similar to call options. Consider a call option payoff. Call option buyers make money when the underlying stock price is above the strike price, and they lose money when the price is below the strike price, though losses are limited to the amount of the option premium they paid. Similarly, if a firm's value (underlying stock) is above the debt amount (strike price) it carries, the remainder belongs to an equity investor, and if it fails, the loss is limited to the initial investment amount.

In this sense, GEO stock is like a call option. GEO may fail to survive (out of the money), but what makes the option valuable is the time value of the option. Even if an option is now out of the money, it may have value because of the time value. GEO's weighted average debt maturity is about 4.5 years, which gives GEO a significant time value.

Likewise, volatility makes the option valuable. the more volatile the underlying is, the more valuable. As GEO approaches its scheduled debt payments, it will become more volatile because each investor has a different view of GEO's ability to pay its debts, as the short interest of about 25% indicates. It seems high enough to worry about. However, as mentioned above, long positions have much longer time horizons (4.5 years) than short positions. I believe the time is on the long's side.

Conclusion

Many people invest in REITs to acquire a stable income stream over long periods of time. GEO is not such an investment at this time. I expected additional dividend cuts so that it can carry enough cash to pay its debt. But it took things further by suspending dividend payments. That's not a bad sign for me. Nevertheless, if you are interested in investing in GEO stock, you need a high-risk tolerance. High-risk tolerance comes from such traits as long-term investment horizons, large portfolio sizes, and non-financial asset income sources.

Notwithstanding the risks and constraints mentioned above, I believe GEO's current stock price is undervalued and that it has an attractive return/risk profile, given that GEO's businesses play essential roles in the states and that it has sufficient time to deal with its debt obligations.

Analyst’s Disclosure: I am/we are long GEO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.