Description

Business: GEO is the 2^nd largest private operator of prisons in the US.  The top 2 players represent 74% of the private market in the US.  They operate through essentially 3 businesses: US Corrections and Detention segment (60% of revs), GEO Care segment (26%) and International (13%). 

8% of the 1.6M state and federal prisoners are in private prisons making GEO the 6^th largest prison operator in the USA.  This segment is the focus of our interest.  The entire state and federal prison population (public and private operators) has increased by 15% since 2000 with the public and private companies taking 30-40% (on average) of this increment.  The reason why municipalities outsource prison to private operators like GEO and CXW is because of the following:

1. Lead time for Prison Build is 5-8 years for state/federal versus 1.5 years for private operators
2. Cost to build/bed is $100k-$150k for state/federal versus ~$70k for private operators
3. Annual OpEx/inmae for state/federal is $24k versus ~$16k for private operators

Prisons are very stable, predictable, businesses and their tenants don’t default.  The business is very sticky with 90% retention rates over the last 5 years.  In addition, the amount of contracts up for competitive rebid is 4% over next 3 years.  The business model is simple.  Beds x price - costs.  Price is contractual and the incremental margins on filling up beds is very high (84%).  Volume or increased utilization of beds is the key driver of EPS as price is contractually derived (based on a fixed monthly rate; less than 1% of revs is based on performance of certain targets) and the cost structure is very fixed. 

We think the prison population grows 1%.  We think that the private players take 30% share of the increment.  As the private players are only 8% of the market, this implies the private players grow 6% (remember there are 2 players with 74% share).  You will see later that our thesis is not dependent on growth but we are trying to show that this was a growth industry historically and with federal and state utilization of designed capacity at well over 100%, we think that growth will continue.

• Last spring, there was fear that the governor of CA would issue a revised budget with major cuts to the out of state inmate program and to the community correctional facilities in-state.  As the budget was worked out by the end of June 2011, the OOS inmates were frozen at current levels and the CCF’s were cut.  This was good for GEO’s competitor CXW because all its facilities housing OOS inmates were fully ramped and therefore it was maintaining the status quo.  It was bad for GEO because its facility that housed OOS inmates (North Lake in MI) had just started to ramp and had only 270 inmates out of a projected 2,500.  Investors had assumed the full ramp of these beds, which was about 15c-20c of annual EPS. 
• Simultaneously, the state of CA cuts its CCF funding by 90%, which affected GEO’s in-state beds.  Three contracts were cancelled in early summer (effective Aug and Nov) and the fourth (and last one) was just cancelled (effective 7/1/12).  Then a contract in AZ was canceled in Dec ’11.  Contract cancellations are very rare.
• Also in Q4’11, a very large privatization contract in FL was delayed by the courts.  This affected GEO more than CXW because investors assumed GEO had an advantage given its more comprehensive offering outside of the core prison business.
• So far 2012 has been relatively quiet except for defeat of the privatization bill again in FL.

This string of disappointments is indicative of the challenging budget environment states face today.  We would not be surprised by small paper cuts continuing over the next year or two but not at anywhere near the rate of the past 9 months.  We think the brunt of disappointment is over.  Over the intermediate term, states need to get creative about solving budgets and private prisons should be at the top of that list.  No new public prisons are being built and the cost states have to pay to provide the service is higher than the private prison operators pay.

The other reason the stock is cheap is because FCF generation has been lacking as the company has been spending a large amount of growth capx and investors are failing to appreciate GEO’s sustainable FCF generation considering their maint capx is a small fraction of their D&A due to facilities that last 50 years (maint capx is $35m vs. D&A of $90m).

The thesis is very simple: The company is finishing up their capex cycle in Q2’12 (page 68 of their 10K says that they are in the midst of 246M capex program and 90M will be spent in fiscal 12 and ’13 with the majority ending in the Q2 according to the company).  The company’s guidance for 2012 adjusted funds from operation (AFFO) is 195-205M.  AFFO is operating cash flow minus maintenance capex (we feel good about the maintenance capex # as the company did a study in April 2010 where they extended the useful life of the buildings from 40 to 50 years).  Let’s call it 200m, or $3.28/share.  That’s an 18% maint FCF yield on 2012 numbers.  Once the capx program is complete, this FCF will be directed towards debt reduction, dividend increases and share buy backs.

Currently GEO operates 79.4K bed but has 7,800 beds which are not being used.  Companywide facility occupancy was 94.6% at year end.  The company also has idle beds that can generate $18m-$24m of AFFO, or 34c of AFFO/share.  We conservatively assume it will take until 2015 to fill up these beds.

How much AFFO/share does $430m of cash (2013+2014 FCF) reinvested generate (AFFO power in 2015)?  Here’s what we think capital allocation looks like the next few years: 

1)      Dividend of $25m in 2013, maybe $40m in 2014 = $65m of cash for dividend. 

2)      Pay down $250m to take out 7.75% debt = 20c of EPS. 

3)      Buy back stock—this is the most accretive option currently.  They spend the rest ($430m - $65m-$250m = $115m) on stock buyback – we’ll assume at $115m / $22 = 5.2m shares.  This adds 39c of accretion (difference between $250m AFFO/61m shares and $250m AFFO and 56m shares). 

So total accretion from AFFO generated in 2013-2014 = 59c (20c + 39c)

We’re looking at a company that has an 18% FCF yield on 2012 numbers ($3.28 of AFFO/$18) with potential to grow this to close to $4 AFFO/share by 2015 ($3.93 is our estimate), a 22% FCF yield. 

The reason the yield is not higher on 2015 estimates (specifically $4.21 if you add up $3.28 + 34c + 59c) is because we take out a few items the company adds back (e.g. we assume a normal GAAP tax rate by 2015 instead of a lower cash tax rate in 2012 and we don’t add back stock option expense).  This is partially offset by the ramp up of beds they are building this year, which adds $10-$15m of AFFO on a run-rate basis in 2013.

Balance Sheet/Valuation:  Some in the market think they have too much debt at 4x net debt/EBITDA.  We don’t and neither does the bond market based on where their debt is trading (above par).  Regardless, the company is committed to get to 3.5x debt EBITDA and their target range is 3-3.5x so part of one years of FCF is going towards paying down. 

Either way, we think this company will trade at 10x-12x AFFO.  We don’t need to compare prisons to REIT’s to make this attractive as 10x FCF to us implies no growth and we think that this is a growing industry over the long term.  That being said, we do think the analogy of prisons to REITS is logical and find the magnitude of the relative valuation differential suggestive of a margin of safety.  REITS trade at 16x-29x AFFO (healthcare at the low end, industrial at the high end) versus GEO at ~6x and CXW at 10x.

10x-12x $4 = $40-$44 in 3.5 years plus about $1 in dividends.  That’s about a 28% IRR.

Arguably, 10x-12x is still too cheap relative to many things (e.g. REITS, bonds, etc).

Catalysts:

1. Conclusion of large capx program reveals true FCF generation.
2. Cash flow is redirected towards debt reduction and returning cash to shareholders.
3. Possible resumption of the Florida contract (largest privatization in the history of the industry).
4. Any other new contract wins.

Catalyst

Catalysts:

1. Conclusion of large capx program reveals true FCF generation.
2. Cash flow is redirected towards debt reduction and returning cash to shareholders.
3. Possible resumption of the Florida contract (largest privatization in the history of the industry).
4. Any other new contract wins.