It’s that time of the month folks…yes that right, Nick’s Picks is back in business! I was back home in Halifax this past weekend, and whilst at the Lower Deck (a truly fine Nova Scotian institution for those who haven’t been) I had a conversation with a friend of mine who informed me that they’re a loyal Ticker Talking reader (you know who you are…). Hearing that brought a smile to my face; however, it quickly vanished as they followed it up by saying, “the blog is satire though, right?”
I can’t really blame them though…considering how the last Nick’s Pick has performed (I still have faith in the Babaton though…), I’d be asking myself if this was a joke, too! Anyway, I think this article will get us back in the win column…and hopefully transform Ticker Talking’s public perception from laughingstock to legitimacy!
Without any further ado, this post is about The GEO Group (Ticker: GEO), a company that operates and manages correctional and detention facilities primarily in the US but also in South Africa, Australia, and the UK. Now, similar to gambling, alcohol, and tobacco industries, I would be remiss if I didn’t note the ethical concerns involved with investing in a private prison company. I won’t get into that debate in this article (ultimately you must make that choice yourself), but I will discuss the company’s performance and whether or not I believe the stock could make you money.
I first caught wind of this stock when famed investor Michael Burry’s hedge fund disclosed a few quarters ago that GEO was the only long position they held at the time. This certainly raised some eyebrows as GEO has really struggled over the last 4-5 years; the company’s revenues have remained stagnant and they decided to transition from a REIT to a C-Corp in 2021, which allowed GEO management to cut its dividend and focus on debt repayment. As a result, the stock has sold-off pretty hard over the last few years, and it currently trades at less than a fourth of its all-time high achieved in 2017.
So, what’s gone wrong for the private prison operator? A few things.
1. Pandemic Policy. The Trump administration invoked Title 42 in 2020,
which gave US border authorities the right to immediately send back migrants
crossing in from Mexico (including those seeking asylum), which reduced the
number of occupied beds in GEO detention facilities.
2. Biden’s Executive Order. This 2021 ruling demanded that the Department of
Justice (which covers entities such as the Bureau of Prisons and U.S. Marshals
Services) cease the renewal of agreements with privately-run, profit-oriented
penitentiaries (GEO’s business with these organizations accounted for
approximately 20-25% of sales).
3. Interest Rates. As is the case with many asset-intensive businesses, GEO has
a high debt load, and as such higher interest rates have weighed on their bottom
line. GEO reported second quarter earnings last week and they highlighted a year-
over-year increase of $26.1 million in net interest expense.
However, legislative changes could change things for The Geo Group. Firstly, Title 42 expired in May of this year, which should theoretically be a tailwind for the company as it will likely translate into more migrants crossing the border (and thereby being placed in detention centers). **Yes, I am aware of how that sounds—to be clear by no means am I advocating for profiting off of detaining immigrants…just giving you the facts.** In their Q1 earnings call, GEO CEO George Zoley said that “the scheduled expiration of Title 42 restrictions at the southwest border could provide upside to our current forecast.” The true impact of the Title 42 repealment remains to be seen, but early indications are that it is driving more traffic at the border, evidenced by data from the US government that June border encounters were up about 28% YoY.
Regarding Biden’s executive order, I believe this is definitely a headwind, but I don’t see it spelling the end of private prisons in the US. Specifically, Biden’s powers only apply to certain federal prisons (representing about a quarter of GEO’s revenue), meaning that upon ending, these contracts wouldn’t be renewed. I realize that these prisons still bring in a lot of coin for GEO, but their hands aren’t completely tied in the event of a non-renewal. Prisons are in scarce supply and difficult to build…I can’t imagine anyone would be too keen on having a new jail plopped down in the neighbourhood. As such, GEO could re-contract the prison at the state level (where the executive order doesn’t apply) as they just did in Georgia, or alternatively they could sell the prison to the government or another party. Additionally, we must consider the current political backdrop—Republicans tend to be somewhat more open to private prisons and incarceration, and with a federal election coming up in 2024, GEO’s business is likely to be impacted one way or the other depending on the result.
Finally, the debt burden. The good news is that management has established paying down long-term debt as arguably their biggest priority, and they’ve been steadily deleveraging since ditching their REIT status (where they were required to payout 90% of earnings as dividends) See Exhibit A.
GEO management is aiming to bring debt down to 3.5x EBITDA by FYE 23 and 3x by FYE 24, a move that reduces a ballooning interest expense and could also potentially open the door for the company to start returning capital to investors once again. See Exhibit B
Now for the numbers. As I’ve outlined, various problems over the year have dragged down GEO’s share price to the point now where it appears quite cheap. In fact, as seen in Exhibits C and D, GEO’s trading multiples are close to the lowest they’ve ever been.
I’ve thrown together a DCF to value GEO intrinsically (See Exhibit E), which also makes the case that GEO could be undervalued.
I’d say that many of the model’s assumptions were conservative—I had EBITDA declining at 2% a year into perpetuity to reflect the stagnating revenues of what you could argue is a structurally shrinking business. Additionally, I used a 7x EV/EBITDA (an average of comps pulled from the security and protection services industry) and a discount rate of 10%. These inputs led me to value GEO at $8.22/share, 16% above where it currently trades.
I read an article that likened GEO to a cigar butt, which as described by Warren Buffett is an investing style where you pick a struggling company but it sells so cheap that you think it has one good puff left in it. I certainly don’t recommend making a habit out of buying cigar butt businesses (and I don’t think a value investor like Buffett would either considering he’s made his fortune by picking quality companies…as opposed to companies like this), but it could be appropriate the odd time for certain investors who are willing to take on the risk that comes with a more speculative investment. Overall, I’d give the company a cautious buy rating.
**I don’t own any shares myself at this time.