GEO Group: Sentenced to Limited Gains, Federal Regulation

| About: The GEO (GEO)

Amidst a string of schizophrenic positive-negative-positive news, I closed my position in prison operator The GEO Group (NYSE:GEO) early last week.

Barron’s identified the prison operator sector’s recent weakness as a buying opportunity. I agree that the prison population is more likely growing at the 13% forecast by the Pew Charitable Trusts than the incomplete Census report of a 4% growth. We all know how reliable government data are…just look at other statistics like the Jobs Data.

However, with the stock up 70% year-over-year, I wanted to take profits. With such an amazing run and with some increased near-term risk, I’d like to see some consolidation or pullback as these issues work themselves out. I want to observe the following situations from the sidelines and am more than willing to jump back into GEO:

  1. Acquisitions and debt. Part of GEO Group’s powerful growth has been accomplished through acquisitions. The GEO Group acquired Correctional Services Corporation (Florida-based provider of privatized corrections/detentions) for $62.1 Million in 2005, Recruitment Solutions International (U.K. transportaiotn services for The Home Office Nationality and Immigration Directorate) for $2.3 Million in 2006, and completed the acquisition of CentraCore Properties Trust (13 U.S. Correctional Facilities) for $427.6 Million. The company itself emphasizes the significant amount of debt used to expand its operations as its biggest risk. In particular, roughly 30% of its debt is based on the LIBOR (London Interbank Offered Rate) rate plus various margins from 2.25% to 3.45%. The 3-month LIBOR rates hitting 5.7% in September before slowly easing to 5.24% currently after the Fed’s rate cut. Thus, GEO had to pay much higher rates this quarter, probably between 8%-9%. Furthermore, it is my opinion that the Fed may not cut again in October, which might leave LIBOR at these lofty levels. I believe the Fed rate cut has greased the financial system with liquidity, but not necessarily solved the credit crunch. As such, with less cash left over from paying the higher rates and in a tighter credit environment, GEO might have to slow down its acquisition pace and thus its growth.
  2. Monopoly and Federal regulation. True, the privatized prison operator industry is pretty much a monopoly held by Corrections Corp of America (NYSE:CXW), The GEO Group (GEO), and Cornell Companies (NYSE:CNL). Still, all monopolies must eventually deal with some federal regulation. Until now, prison operators have mostly been operating under their own discretion because 1. federal and state prisons were so overcrowded the government was just glad the prison operators could help and 2. prison operators did a much better job than the government. As more and more prison operations are contracted out to private operators like GEO, the government seems to be taking a increased interest in how these private operators apply their government funding. The recent withdrawal of a contract by the Texas Youth Commission due to poor conditions at the Coke County Juvenile Justice Center might just be a one time event or could lead to more stringent regulations. First Analysis Securities Analyst Todd Van Fleet might be correct that GEO will not lose a group of contracts due to GEO’s good relationship with the government in Texas. However, the contract withdrawal is a slap on the wrist and saying “We’re watching you, so you better do your job right.” Moreover, situations like the riot in April in Indiana at a GEO operated facility has brought more public attention to the conditions and operations at privately run prisons. Thus, the profit margin per inmate might drop a little if prison operators have to spend extra resources on each inmate.

I’m not saying the prison operators are a bad place to put your money. I still think they offer one of the best opportunities in this market. My point is simply that we might have to temper our expectations a little from stocks that double to stocks that “just” gain 50% going forward.

In a possible economic slowdown and rising unemployment, I can’t think of a better defensive play than the prison operators. All the positives I mentioned before when analyzing Corrections Corp of America early in the year still holds true. I do believe The GEO group could offer more upside than Corrections Corp once the prison operators look safe to jump back in. Thus, it seems the price action lately where CXW has dropped more than GEO is justified.

The GEO Group is more diversified with some international correctional services exposure and diversification in mental/psychiatric hospitals with GEO Care. International Services (U.K., Australia, South Africa) account for 12% of revenues in 2006 and GEO Care was 8.2% of revenues. The GEO Group has a good opportunity to expand further into the niche psychiatric hospital market.

The company has facilities concentrated in Florida but I would love to see them make acquisitions or win contracts in other states where they already have a presence as a prison operator and have a good relationship with the local government. I believe diversifying into this market would strengthen GEO with a great portfolio of businesses.

So, bottom line…for now, The GEO Group is a don’t buy (but not a sell!). Watch and wait for an opportunity to jump in if you don’t already have a good defensive position in your portfolio.

Disclosure: no positions in the stocks mentioned.

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