GEO - Inexpensive GEO Group May Benefit From Immigration Changes

2023-08-01 10:04:26 ET

Summary

• Private prison operator GEO Group is a cheap stock that could see an earnings benefit from an increase in immigrant processing at the U.S. southern border.
• Despite President Biden's executive order against private prisons, only 20% of GEO's revenue is impacted due to state-level prisons and the exclusion of ICE activities.
• As the Federal government does not renew private prison contracts, there are opportunities to sell the facilities back to the government, or contract at the state level.

Private prison operator GEO Group ( GEO ) is inexpensive and may see an earnings benefit from an uptick in immigrant processing at the southern U.S. border. Also, concerns from the financial impact of contract losses from a Presidential Executive Order are likely overstated.

A Cheap Stock

First off, the GEO is relatively cheap and is a material holding of value investor of Big Short fame Michael Burry . Most simplistically, diluted EPS for the past three years has been $0.94/share in 2020, $0.58/share in 2021, and $1.17/share in 2022. That's a historic PE of 7x-14x. Not expensive, in this market, even at the higher end of the range.

In free cash flow terms, the business has generated $200M to $300M annually over the past 3 years for a valuation of 3x-5x FCF. The business trades for 0.77x book and trades at 5.3x 2022 EV/EBITDA. All of these historic metrics triangulate to suggest the business is somewhere between inexpensive and very inexpensive. I think both the bulls and bears would agree this is a cheap stock on historic multiples, of course, bears would argue it's a value trap with more contract losses coming, and poor asset utilization set to dent profitability against a relatively high debt load. It is worth noting that GEO has approximately $2B of debt compared to a $900M market cap, so leverage is high (including some convertible debt). It is also notable that short interest is running at around 23% of the float today, again. Convertible debt may be part of the reason for that as convertible holders hedge their equity exposure.

2021 Executive Order On Prisons

The bears are worried that President Biden will end private prisons in the U.S. He ordered via Executive Order in January 2021 that the Department of Justice to not renew contracts with private prisons, and GEO is losing contracts as a result, which is part of the reason for the low stock price today.

It is also worth noting that the executive order is obviously anti-private prisons, but also suggests that mass incarceration is something the U.S. should move away from, which has been a theme in cannabis-related political discussion too. If that plays out, it would be a further negative for GEO in underlying demand destruction for prison beds. However, the details here are very important. Firstly, many prisons are run at the state level and so outside of the President's immediate powers. Secondly, not all Federal Prisons are under the Department of Justice, for example, ICE's activities are under the Department of Homeland Security. So though it seems problematic for GEO that the U.S. President wants to stop private prison contracts - actually, given state-level prisons and the fact that the Executive Order excluded the activities of ICE, the revenue that is impacted by the non-renewal order is about 20% of GEO's revenue today. That's obviously a headwind, but at some point, there is a price for everything and bad news is priced in. So, now let's talk about what GEO can do in the event of contract non-renewal.

The challenge is that prisons are in scarce supply. Building new prisons is unlikely to be popular - who wants to live near a prison? Therefore, GEO has another card to play. Here, do remember this business was a former REIT until recently, so a lot of the value is in the properties themselves. If they lose a contract, they can either re-contract the prison at the state level, which they recently did in Georgia, or they could sell the prison. Somewhat ironically, they may sell the prison facility to the Federal Government, who would then run the operations. So GEO can still earn an economic return in various ways when contracts are not renewed, though it does create a drag on earnings during the transition period, though note that operating income rose in Q1 2023, the drag on earnings actually came from higher interest costs. Lastly, private prisons are a contentious political issue, Republicans are generally more supportive of them, so if those in political power change, so may attitudes to private prisons and mass incarceration.

Hence, the current political environment may be about as bad as it gets for GEO, especially if the Presidency shifted to Republicans in the 2024 election ( currently prediction markets have the 2024 election as a toss-up ). If we take the long-term view, things may get better for GEO over the next 5-10 years in terms of the political climate, and they probably don't get much worse from here. Okay, so the business is cheap and the recent Executive Order against private prisons is narrower in scope than it first appeared (20% of the business, not 100%).

Title 42 And The Southern Border

The third part of the thesis (in addition to an attractive valuation and excessive fear around private prisons going away) is a potential catalyst in May's repeal of Title 42 at the southern border of the U.S. and a recent legal challenge to the administration's proposed solution .

This may have increased GEO's workload by +27% year-on-year per June border data, down compared to a few months earlier in 2023, but certainly not down year-on-year. That's because Title 42 simply turns would-be migrants away, without it, some processing under Title 8 is typically needed.

We can see from the data that in June 2023 border encounters rose 27% year-on-year when excluding Title 42 cases. Furthermore, with a legal challenge to the current post-Title 42 framework in recent weeks, the U.S. may have more cases to process.

Interestingly, management is in a tricky position. They never want to be in the political firing line for obvious reasons, so I think any statements by management are guarded, to say the least. They can't talk about Title 42's exit in much of a positive way, and probably seek to say as little as possible, keep their heads down, and do what they are contractually obligated to do.

As such, management isn't really able to 'sell' any positive trends to the market, without exposing themselves to risky political crossfire, given the sensitivity of these issues. Here it may be more insightful to watch management's trading activity , which has so far been relatively muted, but we'll see what they do once what I'm assuming a blackout period ahead of Q2 results ends on August 9 with the Q2 numbers .

So loosely without Title 42, all else equal, immigration encounters that require some degree of processing or monitoring continue at some of the highest levels in recent history and that may rise further on the recent legal decision, unless the Biden administration successfully appeals it.

So to estimate some numbers, if ICAP is 17% of revenue at GEO and that program grows 27% year-on-year (per June border data) with the ending of Title 42, then as a high watermark that could be a 4% revenue boost for GEO in the second half of 2023 into the first half of 2024. Furthermore, their digital monitoring business may have higher margins and is more asset-light than the remainder of the GEO business (that's speculation, but appears to be a reasonable assumption given that segment is more likely to involve a tracking watch or bracelet than a far more capital-intensive prison cell) so the growth in profitability might exceed the growth in revenue.

Conclusion

So to summarize you have an inexpensive business, it's cheap because it is under political attack, but the scope of that attack may be overstated.

For example, on a market multiple, GEO would double and earnings growth could enhance things further. The CEO also founded the company and owns 3% of the stock, so there's some alignment of incentives here.

Catalysts/Validation

We are seeing Title 8 immigration cases increase 27% year-on-year for June (the first full month without Title 42) and may see further validation on the Q2 (August 9) and Q3 calls (late October) from GEO (though bearing in mind that GEO management is very cautious in making any statements that would attract political attention and certainly won't take any public victory laps here in my opinion).

Risks

GEO is still under political attack from a President that ran on ending private prisons and has taken action to do that to some degree. If the scope of Biden's Executive Order against private prisons under the Department of Justice were expanded, perhaps after a 2024 electoral victory, then that could damage the business and investor sentiment further.

As a government contractor, if the company were to have a major headline-generating negative event at one of its prisons or elsewhere, that could impede its ability to sign and renew contracts. Other structural events, such as material changes in U.S. drug policy, could cause a secular decline in the need for U.S. prisons if mass incarceration reduces. The company has relatively high leverage and some debt is floating rate, further rate hikes would reduce earnings, but management has guided for the impact of higher rates this year.

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