GEO - A turnaround in the making (2021)
This post was created in 2021, posted on my previous blog that was taken down in early 2023.
Before I begin my thoughts on The GEO Group, I would like to start on the differences between a standard C-Corporation and a Real Estate Investment Trust (REIT) because numerous differences separate them in how they are structured and also in how one should value them. One key structural difference arises from the fact that the Internal Revenue Code (IRC) and the SEC govern which C-Corporations can be REITs. They hold strict requirements because REITS gain an advantage: a large reduction in corporate tax.
In order to qualify as a REIT, a C-Corp must:
1) Invest at least 75% of its total assets in real estate
2) Derive at least 75% of its gross income from rents, interest in mortgages, or sales of real estate
3) Distribute a minimum of 90% of its net income as dividends to shareholders
To put it short, it’s a trust that MUST distribute dividends on almost all of its earnings from real estate. As such, they are categorised similarly to bonds since they are legally forced to distribute quarterly a portion of their earnings as long as they are profitable.
With these requirements in mind, the ideal REIT is a healthy cash flow generating and profitable company that can pay a decent, sustainable dividend while steadily grow its earnings.
Looking over at the GEO Group, a US private jail/prison, and mental health facilities REIT in the midst of an anti-prison privatisation rally from the executive level, it would be very difficult to justify it as a good traditional REIT investment. Conceptualising the business model of the company as a for-profit jail/prison operator leads many to view an investment in GEO as morally impermissible. GEO also carries a total long-term debt of around $2.8B with a big chunk of maturing in 2024. Furthermore, in April 2021, the GEO Group announced its suspension of dividends, threatening its status as a REIT.
Executive order to stop private detention facilities contracts
Source: whitehouse.gov
All these contributing factors have slowly bled the stock price of GEO into its 15-year lows of near $5 at end of May 2021.
GEO (black) vs S&P500 (blue)
Source: Investing.com
Source: TIME
Before we get into the valuation of this company, let us look at where it stands in terms of its business model.
Capitalistic
There’s no question GEO operates prison and jail facilities for profit. But to encapsulate its whole business on that fact is not giving the company a fair evaluation.
Being a privatised prison operator presents a conflict of interest. The management has two responsibilities that clash with each other. On one hand, the company receives revenues from taxpayers for providing services that completely depend on a sensitive social necessity (incarceration). On the other hand, the management has a responsibility to their shareholders to maximise return. To these well, GEO would need to increase earnings either by (1) overpricing government contracts (taxpayer money) and/or (2) cutting costs/increase residents, both of which will heavily affect treatment quality and/or public perception. These conflicts are why I strongly believe GEO should NOT maintain as a REIT.
Extraction of profits
First and foremost, forcibly distributing high dividends, especially 90% of NI, gives a terrible impression to the public on the set of goals that the management strives to achieve. I believe public investors stray away from GEO more so because of this factor than any other factor. Secondly, GEO can easily attain a large amount of intangible value if it instead retains its earnings to focus on expending on and improving its facilities. ESG has never been as large of a factor in financial markets as it is today. Lastly, GEO would be much more flexible in dealing with its large long-term debt.
In regards to political headwinds, the public actually prefers private companies rather than government bodies to run prisons largely because bureaucracy is filled with miles of red tape and wishy-washy decision-making. Don’t forget that in the 1980s, private prisons only emerged because governments could not decide to proceed to fund additional facilities to accommodate overcrowding.
“Compounding the problems created by the growing demand for prison space and funding is the lack of public confidence in the quality of correctional services provided by federal, state, and municipal governments. Penal programs designed to rehabilitate offenders have not demonstrated a significant reduction in crime or recidivism and have thus lost credibility with the public and policymakers. In short, the belief that government is not equipped to meet the challenges of contemporary institutional confinement is spreading.”
From Emerging Issues on Privatised Prisons, Bureau of Justice Assistance
GEO has been expanding its services to meet its objective – rehabilitation and correction. The company does not have the power to determine whether or not a criminal is guilty but it can provide ways to better society by treating those who have committed a crime.
2021 and onwards
GEO is currently already on the path to diversify and address social governance while incorporating new technology to enhance its services. Within the company, GEO Care has been a growing revenue sector in the past decade. The business model focuses on the reintegration of convicts into society both during their custody and after they are released into the community, using community-based services facilities all over the U.S to perform this job and to reduce recidivism.
GEO Care is an area that the company can expand and market upon. While prison and jail facilities have been scrutinised by the public, rehabilitation and probation services are positive factors that people can vouch for. These services also closely integrate with GEO’s main revenue stream while having very high barriers to entry. The company has the reputation, the management, and the experience to dominate and continue dominating it.
GEO also owns and uses BI, an electronic monitoring company with many products that enable individuals to be released back into society to continue fulfilling their roles as responsible members of society. BI has software and hardware to measure where you have been, what you’ve been doing, whether or not you have drunk alcohol, etc to facilitate officers to manage those individuals.
If GEO decides to push further in this direction, the company will change its presence in terms of its type of investment, from a traditional, socially sensitive dividend play, to a high-MOAT, ESG-compliant investment.
A REIT in quandary
In terms of valuation, REITS use different key metrics than standard C-Corporations since GAAP accounting standards distort the clarity of standard valuation metrics such as book value and other ratios. Firstly, an important principle to know in GAAP accounting standards (which US REITS must comply with) is that GAAP does not enforce real estate reevaluations. This is a big reason why book values give the wrong impression. GAAP requires a hefty depreciation expense to be included in the income statement while not addressing the changes in real estate value under market rates. And as we know, real estate historically has always either retain its value or appreciate.
Part 1: Income metrics
While it is common to use Net Income to gauge profitability, REITs have their own tool for measurement primarily because depreciation and amortisation expenses reflected in net income do not have a similar impact in REITs (due to the nature of real estate, compared to an item such as machinery). Instead, REITs use Funds from Operations(FFO) and Adjusted Funds from Operations (AFFO) to more fairly assess their ability to do their task: distribute dividends.
GEO’s most recent quarter FFO and AFFO sits at $53m and $72m, or 0.44 and 0.6 per diluted share. This translates to a TTM P/AFFO (akin to P/FCF ratio for REITS) of 2.79x, compared to a sector median of 21.5x. The issue here is not in its profitability and value, but in GEO paying out dividends higher than its FFO, leading the company into a precarious situation with long-term debt obligations today.
2024 Debt Service
One of the biggest risks in GEO lies within its ability to repay its huge 2024 debt while at the same time servicing its borrowings and dividends up to then. With its history of overpaying dividends, GEO would have had to sacrifice an arm and a leg to be able to continue doing so. But I believe GEO made the correct choice on April 2021 to bite the bullet and suspend its dividends to focus on deleveraging.
GEO’s long term obligations
Source: GEO Supplemental Q1 2021
GEO’s next 5 years borrowings in detail
Source: GEO Supplemental Q1 2021
Senior Notes tend to be more sensitive to restructure as they have fixed arrangements and are sold to the secondary market, and in GEO’s case, these Notes are held by many financial institutions and traded publicly. The likely scenario is to roll into later maturity dates or pay down in full if possible.
On the other hand, Revolver Borrowings are more flexible can be discussed to extend with their administrative agent and its respective syndication.
The ideal scenario here is GEO extends its revolver borrowings by another 3 years (GEO has successfully extended it before without other implications, most recently in 2019). In any case, companies usually maintain revolver facilities for lengthy periods of time as they require short-term borrowings to fund shortfalls and prepare for fluctuations in working capital. In GEO’s case, it has ~$180m available credit left in the revolver facility in Q1. This leaves $980m (2024) + $360m (2021,2022 and 2023 term loans and senior notes) to be serviced by 2024.
Term loans are negotiated directly between a financial institution and borrower and thus also give more leeway in terms of extensions and other emergency changes. GEO likely will attempt to pay down some portion and roll the rest into longer-term maturities.
Repayment ability
GEO’s capacity to repay its debt and to receive financial services relies on its profitability. The best metric to gauge this for REITs is AFFO, a measurement free of non-cash expenses but the inclusion of Capex and maintenance costs. GEO’s TTM AFFO hovers at $306m, 13.2% of revenue. I estimate, with a yearly drop in AFFO by 2% due to contract cancellations (closely in line with TTM), GEO will collect $880m in AFFO up to 2024 as gunpowder to fight its battle with $1.34b of debt. With some rolling and repayments, I am sure they will find a way out.
On their guidance for 2021, the management has forecasted to pay up $125m to $150m in long-term debts, though I view it as a conservative estimate. In Q1, the company has already contributed $57m while distributing $30m in dividends before they decided to suspend dividends. From Q2 to Q3, I believe the team will sit down, discuss and make an informed decision to either remain as a REIT or change its corporate structure to a C-Corp just as Core Civic (its main competitor) has.
The risks for GEO lie not within the company but within the policies in financial institutions on lending to private prison operators. ESG and political sensitivity have been deterring big banks to lend to private prison operations, but I believe with such expansive fiscal and monetary policy, GEO’s robust income statement will find it a suitable lender.
Another option for GEO to reduce its burden is through asset sales, which it has already begun. The company may choose to sell away their idle facilities that will not have prospective contracts to the US government in case it lacks sufficient cash flow. With the current overcrowding and long construction periods to start up a new incarceration facility, the government’s best and most feasible choice is to acquire existing facilities.
This is where I come back to the point I made earlier on the distortion caused by GAAP accounting standards. In the case of government acquisitions, GEO’s properties under the balance sheet do not reflect fair market value as they are calculated by depreciable base (salvage value calculated conservatively) less GAAP accumulated depreciation.
Part 2: Real estate portfolio valuation
In order to accurately value GEO’s real estate portfolio traditionally, it would be a long and arduous journey. Because the financials do not reflect a mark to market value, to assess the company’s portfolio, you would have to estimate a capitalisation rate of a highly illiquid real estate category and apply it to the net operating income generated for each facility to get the fair market value. Instead, let us take a small sample and look at some of GEO’s recent divestitures and also past market acquisitions of these types of facilities to give us a rough estimate of GEO’s real estate value.
Q1 2021 Dispositions
Source: GEO Q1 Supplementary Disclosure
Talbot Hall Summary
Source: Schedule III, GEO 2020 Annual Report
McCabe Center did not have as thick of a difference in book to market value as Talbot Hall did, but a difference of $1.9m translates to 3.1x book value. Both of these give an indicator that the book value gives an unjust value to GEO’s main asset base – property.
GEO’s facilities vary in size, shape, and form, so to extrapolate this data and fairly value the rest of its facilities, we need to use the price per bed. These recent 2 dispositions give us a general idea of price per bed, a multiple we can use to estimate the rest of the company’s similar facilities. For Talbot and McCabe, their net proceeds per bed stand at $24.6k and $22.6k respectively.
Talbot and McCabe fall under community-based services facilities, and GEO has a total of 9,871 beds in this category. With an estimate of $23,500 per bed, this brings the estimated market value of these facilities to $231m.
Youth Services
Youth services constitute a rather small portion of GEO’s real estate portfolio, 1199 beds. There is a dearth of information concerning youth services centers and as a result, I roughly estimate it will be cheaper than community-based services by 20% to build/acquire. This leads to a total value of $22m.
GEO Secure Services
For Secure Services (SS) type of facilities, GEO did not have any recent sales to compare to, but we can utilize a historical benchmark in the Bureau of Prison’s acquisition during the Obama administration in 2012 of Thomson Correctional facility for our valuation purposes.
An acquisition value of $165m of the Thomson Correctional facility with a capacity of 2,100 beds translates to a value per bed of $78,471. A conservative reduction of 20% to benchmark means $62.9k per bed for GEO’s Secure Services facilities. Multiplying this number by the amount of total owned SS beds under the GEO Group gets us $3.02b.
Another benchmark we can compare lies in the discussions between the state of Alabama and the GEO Group to acquire one of its SS facilities at the beginning of 2020. Since SS facilities are highly illiquid, any information we can use will be helpful in our valuation.
During these discussions, the state had authorised a bond issuance of up to $60m for funds to acquire Perry County, but the deal did not finally close. With its preparation to issue up to $60m, I estimate the final net proceeds given to the GEO group would have been $54m, 10% lower. Perry County Correctional Facilities can house 690 prisoners, and so the per bed value translates to $78.3k, extremely close to that of United States Penitentiary, Thomson’s.
Valuation combination
With all three together, GEO’s owned facilities add up to $3.27b, a difference to book value of $1.16b. This estimated PP&E value does not include other revenue streams such as GEO’s managed contracts and its other non-residential services business that account for up to the remaining 40% of revenue and 34% of net operating income.
Liquidation Value
The table above assumes that the properties will be sold at market value. The Net Asset Value comes out to $8.08 per share, giving GEO a P/NAV of 0.83. This represents the level at which I believe GEO’s owned assets are fairly valued and comes from a conservative approach.
Using the PP&E valuation above, the liquidation table above gives a general idea of the intrinsic value of GEO’s assets and liabilities. One thing to note is this assumes the company operates only on its balance sheet. GEO has numerous intangible aspects, one of them notably being its position as a dominant operator in an almost impossible to enter business. Its knowledge, experience, and capability also give it the reputation to receive contracts on managing and constructing these types of facilities all over the world. In numerical terms, it receives approximately $900m in revenue and $48m in net operating income in the last twelve months as a result of these extra services.
Part 3: Discounting other revenue streams
In addition to estimating the value of GEO’s owned properties, we have to include its other operations into account. GEO collects a stable revenue and profit from its managed-only facilities, non-residential services, electronic-monitoring services, and international services. I foresee these businesses will not be affected as poorly as their main revenue stream from political headwinds and instead will show a stable performance moving forward.
From year 0-5 I assume a 1% yearly increase in revenues from its management contracts and other services and a 0% terminal growth. EBIT here derives from a fixed percentage of revenue (in line with historical). Summing up NPV for uFCF, we arrive at $1.025b at enterprise value, or $8.51 per share. This number translates 1 to 1 to equity value as we have already included cash and debt in the NAV of GEO’s owned assets above.
Putting 2 and 2
Combining the NAV and DCF estimation above, we arrive at a combined equity value of $1.997b, and a per-share equity value of $16.59. If GEO handles its debt well, I believe GEO’s floor value lies at this price. Moreover, I made numerous reductions during both valuations to keep the approach as conservative as possible. Even so, the price target represents a 247% upside from its current price.
Though a 247% upside already sounds amazing, we should not lose sight of the fact that this derives from using a NAV liquidation approach to GEO’s owned property, and I used this method to address the short (or bear) thesis that relies on the debt and contract cancellations. Using a DCF model will give a much juicier, but less suitable valuation.
Rocky road forward
The path for GEO moving forward will be filled with lots of unknowns and surprises. Its business model links strongly with bureaucracy, giving it’s future an even thicker uncertainty. But I believe GEO stands alone as a leader in a specialty business. Though debt burdens hinder its cash flow, it will overcome this bump in the road and continue providing and improving the services necessary to society. Its much-needed transformation from a REIT to a C-Corp will not give shareholders value in terms of dividend payment but will provide value in terms of capital appreciation, such as Core Civic (CXW has) in the past 8 months.
