Previously in Jan 2021, U.S President Joe Biden issued an executive order, which many refer to as a “ban” on private prisons, affecting Geo Group stock that we are discussing today.
Well, for completeness sake, we will start off with just a little bit of background to the matters on hand.
Private Prisons In The United States
Apparently, in the United States, there are two key listed private prison companies. They operate and manage private prisons on behalf of the US government, namely CoreCivic and The Geo Group.
And the controversy of private companies profiting from mass incarceration has been going on for some time.
Source: Prison Policy / Mass Incarceration: The Whole Pie 2020
Just to put it into context, government policy and spending are the ones causing mass incarceration. The private companies only contract for less than 9% of all cells. Yet they get a disproportionate share of attention.
Anyway, long story short, President Joe Biden finally signed an executive order to direct the Justice Department to not renew its contract with private prison operators.
Well, let me stress, the order is for non-renewal, and not immediate termination. So, it doesn’t mean that the executive order has killed off the private prison industry entirely, at least for now.
So, the next question is, to what extent will these 2 companies be affected?
The Geo Group Stock Business Overview
Since today we are talking about The Geo Group, we will just focus on this company. Or more correctly this real estate investment trust, after the group transitioned to become a fully integrated equity REIT back in 2012.
Source: GEO 4Q20 Earnings Presentation / REIT Structure
First, understand that The Geo Group works with various federal government agencies and state governments.
The executive order issued currently only applies to the Department of Justice (DOJ). In simple terms, it will affect the revenue that the group derives from Bureau of Prisons (BOP) and U.S. Marshals Service (USMS).
Just for your understanding, the BOP houses inmates who have been convicted of federal crimes. They USMS is generally responsible for detainees who are awaiting trial or sentencing in U.S. federal courts.
Source: GEO 4Q20 Earnings Presentation / Revenue By Customer Type FY2020
Take a look at Geo’s revenue breakdown. Observe that the Bureau of Prisons makes up 14% of its revenue, while U.S. Marshals Service contributed 13% to its revenue.
The biggest revenue contributor of 28% comes from the Immigration and Customs Enforcements (ICE). At this point in time, the executive order is not affecting this segment of the business.
The question of whether all the facilities under these 2 segments will be renewed eventually shouldn’t be the focus.
To be conservative, as investors we should take it that this 27% of Geo Group’s revenue will be gone eventually.
The question is if the market has already priced it in?
Geo Group Stock Price Trend
Source: Yahoo Finance / The Geo Group, Inc Share Price 2-Year Chart
Let’s take a look at Geo’s share price for the past 2 years. It has since been on a downward trend.
See that prior to the Covid-19 market correction, the share price was hovering around the $15 range.
Well, the pandemic has definitely impacted the group’s business with lower mandays chargeable, hence a lower revenue.
But instead of recovering like the rest of the market, it has been trending lower and lower.
In fact, the market had already been selling off in anticipation of Joe Biden winning the U.S presidential election. Hence, you saw the further downward pressure in Nov 2020 when the result was announced.
Well, that’s because historically, the Democrats have been the one campaigning to ban the use of private prisons. Thus, Joe Biden’s winning of the election resulted in the market reacting negatively to the news, in anticipation of the eventual curbs coming on the use of private prison operators.
And finally, Geo’s share price trended even lower upon the actual signing of the executive order.
So the question you will ask is, so has the market overreacted and oversold the REITs, resulting in an opportunity? Or could it go lower?
Geo Group Stock Potential Upside
Let’s talk about the upside first.
Source: The Geo Group Inc / 2021 Guidance
Well, the management is well aware of all these issues and adjusted their guidance for 2021. They have accounted for some of the facilities that will not have their contracts renewed by the federal government.
In addition, management is also aware of the private-public partnership risks and also the associated financing risks if banks start refusing to loan to the group.
Source: SEC 10-K / The Geo Group Annual Report 2020
Hence, the group will reduce its annualized dividends payout to $1.00 per share. This is a drastic reduction from the $1.92 per share dividend declared previously in 2020. This will help the REIT to start paying off part of its debt to reduce its exposure to financing risks.
At $1 dividend per share, and the current share price of around $7.60, it will translate to a 13% dividend yield. That’s a really attractive dividend yield.
Price-to-Funds From Operations Metric
That’s one part. To understand how the REIT is being valued, we need to compare its Fund From Operation, or what we call FFO. This is a common metric used in analyzing REITs.
Source: Corporate Finance Institute / FFO – Funds From Operations
FFO is basically the net income adding back non-cash expenses and deductions like real estate related depreciation. This will derive a figure closer to the actual cash collected from its properties.
And a lot of times, different REITs will make some adjustments to derive a more accurate measurement.
Source: The Geo Group Inc / 2020 Financial Highlights
For instance, Geo reports Normalized FFO and Adjusted FFO at $1.91 per share and $2.51 per share respectively for the full year of 2020.
I will not go into the details of each individual definition. Basically, they are just trying to add back non-cash expenses and removing any exceptional gains for better comparison.
Source: REIT Notes / REIT Rating Score vs AFFO per REIT
Based on the current share price of $7.60, Price-to-FFO will work out to be about 4.75. Price-to-Normalized FFO will work out to be about 3.9.
Undervalued Price-to-FFO Ratio
Aassume that contribution from BOP and USMS are completely terminated, say we remove 27% from its FFO and normalized FFO. We will still get a Price-to-FFO value of 6.5 and Price-to-Normalized FFO value of 5.45 respectively. These figures are still way below that of the average Price-to-FFO values of US REITS at around 15.
So, clearly there’s some value we are looking at here.
Of course, the market is pricing Geo’s shares that way due to the inherent political risks in the United States. And this is not just with the recent executive order affecting its revenue segment from the BOP and USMS. But also the potential termination for future contracts with other government agencies like ICE.
Geo Group Stock Potential Downside
The question is what is the extent that a greater portion of Geo’s portfolio may be affected? And what is the likelihood of that happening?
To do that we go back to look at the company’s business again.
Source: GEO 4Q20 Earnings Presentation / Revenue By Customer Type FY2020
Risk of Banning States and Local Prisons
Other than the 27% revenue make-up by BOP and USMS which will have a more immediate impact from president Joe Biden’s executive orders, activists are still advocating to remove the use of private prisons completely.
Indeed, the risk of further negative impact to Geo Group’s business moving forward is still there. Similar executive orders may reverberate through other government agencies which are relying on the private prisons. For instance, the individual states which are relying on private prisons.
But, this will not be something that can take form immediately. The government will have to work out plans to redeploy the detainees to other facilities. A lot of times, these public facilities may already be experiencing overcrowding effects.
Then again this is a real possibility in the long term. So, the risk of Geo Group losing its customers in the State and Local segment is low to medium.
Risk of Banning Prisons Engaged By U.S. Immigration and Customs Enforcement
Other than Geo Group’s revenue source classified under International and Other segments that shouldn’t have such risks, I want to highlight the segment pertaining to the facilities used by the U.S. Immigration and Customs Enforcement (ICE).
As for this segment, understand that most of the detention facilities employed by ICE currently are private ones. This is unlike the states where they still have public detention facilities to move detainees to.
Thus, this good 28% revenue source will be even harder for the US government to effect any change on the reliance of private prisons. Because the alternatives are just not there. So, the risk of the government banning this segment is lower. And if in any case they do implement any ban, the change will be slow.
So together, i think we can pretty much safely assume these 3 segments – International, Other and ICE, making up 42% of Geo Group’s revenue, have very low risk of being impacted even in the medium to long term.
Valuation – Conservative Estimate
But let’s say we want to be super conservative. We can dive a bit deeper to the Geo Group stock reporting on its operating segments.
Source: SEC 10-K / The Geo Group Annual Report 2020
Different Impacts To Geo Group Operating Segments
Instead of classifying its revenue under different customers, Geo categorize them into 4 key segments – U.S. Secure Services, GEO Care, International Services and Facility Construction and Design.
Well U.S Secure Services are namely all the detention facilities we are talking about in the U.S. They are customers from BOP, USMS or ICE or the Local and States’ facilities.
Source: The Geo Group / GEO Care
GEO Care mainly includes services the company provides in the U.S. for non-residential treatment, educational and community based programs, pre-release and half-way house programs, monitoring services and compliance technologies, just to name some.
So these services are going to continue even if the government decides to ban the management of private prisons. Because, these services assist to monitor and help inmates to reenter society, which are programs that complement the Secure Services.
Source: GEO 4Q20 Earnings Presentation / International Services Map
As for its International Services segment, they are secure services like in the U.S. But its partners are mainly in South Africa, Australia and the United Kingdom. So, political risk in the U.S will not affect them per se.
Source: The Geo Group / Design, Build and Finance
As for the Facility Construction & Design segment, the company is diversifying to building facilities and solutions for the various state, local and federal agencies. This means that further bans on private prisons by the administration will not affect this segment. Because it complements and services the public prisons.
Let’s say we want to go all the way to the extreme for valuation purpose. Assume that the company loses this U.S Secure Services segment enirely.
We will be left with its other 3 operating segments. Together, they contributed a cumulative total of about $779 million out of the total $2.35 billion for the full year of 2020. Meaning, Geo Group will have this one-third of its revenue remaining.
Just for quick estimation purposes. If we proportion one-third of the 2020 per share Normalized FFO of $1.91, we will be left with $0.64 per share of FFO.
Again, this is the extreme case of losing the entire U.S Secure Services. At that point in time, there will be no more such private-public relationship risk. Therefore, Geo Group stock should equilibrate to a reasonable Price-to-FFO value.
Let’s say we take a Price-to-FFO value of 12, and assuming the base case of Geo’s $0.64 FFO per share, a fair value of Geo’s share will be about $7.68.
Now you can see why the market has overreacted and oversold Geo’s shares currently.
Valuation – Reasonable Estimate
I think more reasonably, the executive order will only wipe out the 27% revenue from BOP and USMS at most. And again, this will take time.
So, let’s say instead we proportion the remaining 73% revenue to Geo’s 2020 Normalized FFO per share of $1.91. This will give rise to an eventual reasonable Normalized FFO of $1.39 per share.
Now, assume two scenarios. First, the market remained depressed to Geo’s prospect in the future, pricing it at a Price-to-FFO value of 8. Second scenario is where the market is more positive about Geo’s prospect giving it a Price-to-FFO value of 12.
Together with a Normalized FFO of $1.39 per share, this will translate to potential recovery of Geo’s share price to $11.12 and $16.68 respectively. Base on the current’s share price of around $7.60, this represents an upside of around 45% to 120%.
That’s why we think The Geo Group stock is currently undervalued and something you can consider as well, albeit the controversy on private prisons and the potential political headwinds and financing risks ahead.
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