GEO - GEO Group: Multiple Ways To Win

2023-04-03 09:38:40 ET

Summary

• GEO has round-tripped since my last article so I feel obligated to provide an update.
• The stock traded down on a couple of concerns: the ISAP population decline and the delay of lifting Title 42.
• GEO is not facing a high bar to create equity value in my view.
• The guidance looks very conservative and should have a decent chance for an earnings beat in 2023.
• GEO will also shift value from debt to equity dramatically over the next 2-3 years.

Situation Overview

I am back with an update on The GEO Group's (GEO) stock price, which has "round tripped" since my last article . Unfortunately, GEO has not had a successful year so far, and its market capitalization has decreased by 25%. The biggest drop came after the Q4-2022 earnings call on Feb 14, 2023 , where shareholders were understandably concerned about a few issues. The most significant concern is the decline in the number of participants in the Intensive Supervision and Appearance Program (ISAP). GEO's Electronic Monitoring and Supervision Services segment had experienced explosive growth in the past two years, thanks to the ISAP program. Before FY2020, GEO did not even report this segment separately because the results were not significant enough. However, the net operating income of this segment doubled from ~$130 million in FY2020 to ~$270 million in FY2022. Hence, when management revised the growth outlook for this program, the stock price naturally took a hit. Additionally, the Supreme Court's decision to maintain Title 42 has caused a significant drop in border crossing statistics between December 2022 and January 2023. I suspect that investors were expecting the pent-up demand to normalize, which would benefit GEO and CXW by leading to a substantial increase in the ICE population .

Guidance Looks Conservative

During the call, management affirmed the effectiveness of GEO's electronic monitoring service in the ISAP program, citing a success rate of over 95% in participants attending their court hearings. Additionally, there was a significant increase in noncompliance among participants once they were taken out of the program. Given the management's explanation that the decline in ISAP participants is due to recent immigration policy changes and budgetary constraints , I believe that the pullback is only temporary. The ISAP program is undoubtedly a more effective, cost-efficient, and overall better alternative to incarcerating people for 3-6 months while they wait for their court hearings. While the high end of the guidance is based on the current level of ISAP program participants, I see the potential for upside, particularly since the equity has already derated.

While I am not an expert in Supreme Court law, there is a chance that Title 42 could be lifted in the near future. This law was put in place when the US administration declared COVID-19 a national and public health emergency. President Joe Biden has stated that he will be ending this emergency declaration on May 11, 2024 . While it is unclear whether Title 42 will be lifted at the same time, in my opinion, removing it would be the most significant obstacle to normalizing border crossing activity in the US. However, there are some Democrats and Republicans in border states who have opposed Biden's efforts to end Title 42.

In my opinion, regardless of the policy outcomes, GEO's stock price does not seem to be factoring in an optimistic scenario. This makes the stock intriguing at its current level. Based on a 1% decline in EBITDA over the next 30 years, a 10% WACC, and a terminal multiple of 3.0x, I can back into the current stock price, which is not a particularly demanding valuation at all. Therefore, even a slight improvement in either of these areas could cause a rerating of GEO's stock to its recent highs.

Debt to Equity Value Transfer

As GEO continues on its deleveraging journey, shareholders should naturally see an increase in value. As I mentioned in my previous article , the deleveraging is not voluntary, as there is an 80% excess free cash flow sweep outlined in the credit agreements, and GEO is required to pay down the first-lien creditors. Nevertheless, I would argue that paying down the first-lien debt as quickly as possible is in the best interest of GEO shareholders. This is because the floating nature of the debt has made the first-lien debt the most expensive part of GEO's debt structure.

According to the management's plans, GEO is targeting a net leverage ratio of less than 3.5x by the end of FY2023 and less than 3.0x by the end of FY2024. Based on my calculations, these targets are reasonably achievable. Paying down expensive debt creates a virtuous cycle, where interest savings can be used to pay down even more debt. Even if we assume an enterprise value that remains stagnant (and keep in mind that this enterprise value assumes a 1% EBITDA decline over the next 30 years, a 10% WACC, and a terminal multiple of 3.0x, which is a very undemanding assumption), value can still transfer from debt to equity. As illustrated below, the net debt and equity split of the enterprise value can shift from 60/40 to 40/60 in FY2026, resulting in a 17% equity value CAGR over three years.

Conclusion

The decline in ISAP participants and the ongoing effects of Title 42 are likely to continue to hinder GEO's equity. However, considering the stock price has dropped below $8.00/share, I believe these headwinds are already priced in. At this level, GEO's equity has multiple opportunities for growth. In my opinion, GEO has a good chance of upgrading its conservative guidance, which could lead to a rerating of the stock within the next 12 months. Patient investors are likely to be rewarded as the deleveraging process transfers value from debt to equity.

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