As a critic of efficient market theory, I believe that the market presents investment opportunities to investors that will outperform the market over the long-term on a somewhat regular basis. The hard part is dedicating the time necessary for finding such investments.
If the efficient market theory was absolutely correct, there would be no legendary investors that have made themselves and others rich while trouncing the broader market, such as Warren Buffett, Peter Lynch, and Seth Klarman.
Today, I'll be discussing why I believe The GEO Group (NYSE:GEO) could deliver significant alpha for investors over the next decade and deserves consideration as a small, more speculative investment in a portfolio because of its skewed risk/reward profile.
I'll be examining the company's dividend safety and growth profile, the company's fundamentals, key risks to consider, and the valuation aspect of an investment in GEO Group.
I'll then close with my estimation of annual total return potential over the next decade.
A Whopping 11%+ Yield That Is Moderately Safe For The Foreseeable Future
When a yield is as massive as GEO Group's, it's especially beneficial for an investor to examine whether the yield is safe for the foreseeable future. After all, the yield is going to be the primary driver of an investor's returns going forward.
To do so, the starting point of our analysis will be conducted by examining GEO Group's AFFO payout ratio. While I would examine the EPS payout ratio, this would be useless because GEO Group is a REIT, and the AFFO payout ratio (the REIT equivalent of FCF) is the ultimate measure of a REIT's dividend safety.
In its previous fiscal year, GEO Group generated AFFO per share of $2.47 against dividends per share of $1.88 during that time, for an AFFO payout ratio of 76.1%.
It's worthwhile to mention that GEO Group was initially guiding for AFFO of $2.50-2.60 per share for FY 2019 when it reported results in Q4 2018 but has upped its guidance in both Q1 2019 and Q2 2019 to the current figure of $2.69-2.73 per share in AFFO.
And before one believes it is just management telling investors what they'd like to hear, we need to consider that through the first 6 months of 2019, GEO Group has generated AFFO of $1.37 compared to last year's first 6 months AFFO of $1.17.
Against the $1.92 in dividends slated to be paid this fiscal year, the most recent $2.71 midpoint AFFO figure represents an improved AFFO payout ratio of 70.8%.
If it wasn't for the company's somewhat elevated debt load and concerns over the political risks facing GEO Group about 18 months from now, I have no doubt Simply Safe Dividends would rate the company's dividend safety in the low 60s.
Source: Simply Safe Dividends
Understandably, Simply Safe Dividends rates GEO Group's dividend on the low end of borderline safe. After all, a double-digit yield virtually never comes without its risks.
With that said, we'll now delve into GEO Group's dividend growth potential going forward.
Source: Simply Safe Dividends
Although GEO Group has delivered strong results in the past few quarters, I believe the company will err on the side of caution and likely freeze its dividend until there is more clarity in its operating environment, following the elections in 2020.
If it is expected that the operating environment will continue to remain the way it currently is, I believe investors could expect low-single digit dividend increases until the next presidential election cycle.
With that said, we'll now delve into why I believe GEO Group will continue to deliver strong operating results in the years ahead.
A Necessary Business Model And An Experienced Management Team
Source: GEO Group Second Quarter & YTD 2019 Supplemental Information Presentation
As per page 3 of GEO Group's most recent 10-K, GEO Group is a fully integrated REIT specializing in the ownership, leasing, and management of correctional, detention, and reentry facilities and the provision of community-based services and youth services in the United States, Australia, South Africa, and the United Kingdom. As of June 30, 2019, GEO Group's worldwide operations included the management or ownership of 97,000 beds at 133 correctional, detention, and community-based facilities, including idle facilities and projects under development.
Source: GEO Group Second Quarter & YTD 2019 Supplemental Information Presentation
GEO Group is composed of the following four reportable business segments:
US Corrections & Detention: The US Corrections & Detention segment encompasses the company's US-based public-private partnership corrections and detention business. According to page 68 of GEO Group's most recent 10-K, the segment accounted for 63.7% of revenues in 2018.
GEO Care: The GEO Care segment involves its community-based services business, the youth services business, and the electronic monitoring and supervision service. The segment accounted for 22.4% of revenues in 2018.
International Services: The International Services segment focuses on public-private partnership corrections and detention operations in Australia, South Africa, and the UK. International segment accounted for 13.6% of revenues in 2018.
Facility Construction & Design: The Facility Construction & Design segment primarily contracts with various state, local, and federal agencies, as well as international agencies, for the design and construction of facilities, for which the company generally has been awarded management contracts. The segment accounted for the remaining 0.2% of revenues in 2018.
Source: GEO Group Second Quarter & YTD 2019 Supplemental Information Presentation
In terms of GEO Group's top 10 customers, the above illustration shows that YTD, U.S. Immigration & Customers Enforcement or ICE accounts for 21.9% of owned and leased revenue, the Federal Bureau of Prisons accounts for 11.6% of revenue, and the United States Marshals Service accounts for 10.2%, with no other customer accounting for more than 2.5% of owned and leased revenue.
On the managed only side of the business, Australia is the company's top customer accounting for 9.2% of revenue and no other customer accounts for 5% or more of GEO Group's managed only revenue.
Now that we have a better understanding of the business, we'll delve into the growth prospects for GEO Group.
Source: GEO Group Second Quarter & YTD 2019 Supplemental Information Presentation
As shown by the above slide, GEO Group has a few projects that are coming online later this year (i.e. 1,800 bed owned North Lake Michigan Correctional Facility in Q4 of this year and 489 bed managed Junee Correctional Center in Australia). The North Lake Correctional facility contract is expected to add $37 million in annualized revenues. The Junee Correctional Center contract is expected to add $12 million in annualized revenues.
As indicated below by CEO George Zoley in GEO Group's Q2 2019 Earnings Call, GEO Group will experience significant cash flow growth in the second half of 2019:
Our second half results will reflect a significant level of start-up activity, which is expected to drive future earnings and cash flow growth. In total, we are scheduled to activate new and expansion projects with more than 5,700 beds during the third and fourth quarters of this year. These projects involve the reactivation of 4,600 beds that were previously idle as well as contract capacity expansions in the U.S. and Australia totaling within more than 1,000 beds. On a combined basis, this start-up activity is expected to add more than $100 million in annualized revenues, with higher than average margins and only minimal CapEx requirements. We believe our strong quarterly results and new project activations are indicative of the stability of our cash flows and the sustainability of our annual dividend payments.
Given that 4,600 previously idle beds were reactivated and contract capacity expansions in the US and Australia total more than 1,000 beds, GEO Group expects that the 5,700 beds will provide over $100 million in additional annualized revenues.
This will allow GEO Group to continue to focus on deleveraging its balance sheet to prepare for whatever the outcome of the 2020 election cycle is and also enable the company to plan for the possibility in 2024 that its revolving credit isn't renewed by its banks.
The other reason for my optimism toward GEO Group lies in its capable management team.
Starting with the Founder, Chairman of the Board, and CEO himself, George Zoley founded GEO Group in 1984. Mr. Zoley has served as GEO Group's CEO since the company went public in 1994. During his time with GEO Group, the company has transformed itself from a startup company to the leader of its industry, alongside CoreCivic (CXW). Mr. Zoley has played a large role in the company's transformation, and I'm confident that he will continue to lead it into the future.
CFO Brian Evans joined GEO Group in 2000 and possesses over 20 years of business management experience. Since he joined the company, Mr. Evans has served in increasingly senior business management positions, including VP of Finance, Chief Accounting Officer, and Controller. Mr. Evans was appointed to his current role in 2009.
When we consider the necessity of GEO Group's services to society, the company's growth projects, and its experienced management team, I'm confident that GEO Group will deliver strong future results.
Risks To Consider:
While GEO Group is the leader of the private prison REIT industry along with its peer CoreCivic, it's worthwhile to note that a company operating in a somewhat controversial industry comes with its fair share of risks.
I believe there are two key risks associated with an investment in GEO Group.
The first risk is GEO Group's relatively high level of indebtedness. According to Simply Safe Dividends, GEO Group's net debt to EBITDA ratio in the last 12 months is 6.1 compared to what is considered to be a desired debt to EBITDA ratio of sub 5.5.
The common theme with GEO Group and the headlines associated with the company is that it's mostly politically-driven rhetoric that will likely never play out or have any significant repercussions for the company.
One such instance of this was the decision from major banks such as Bank of America to stop funding operators of private prisons and detention centers.
The interesting caveat to this decision from major banks was cited in GEO Group's most recent earnings conference call by CFO Brian Evans.
Moving to our capital structure. In early June, we extended the maturity of our $900 million revolving credit facility to May 2024, which contractually obligates all banks in the facility for approximately five years. We were able to complete this extension without any changes to the revolver size or the pricing grid. The extended revolver provides ample liquidity with approximately $390 million in available capacity, in addition to an accordion feature of $450 million under the senior credit facility.
With this extension, we do not have any upcoming debt maturities for approximately three years when $250 million in senior unsecured notes mature in 2022. We will have the opportunity if we choose to take out the 2022 notes with our available liquidity under the revolver. We recognize that since the execution of the revolvers extension, recent headlines from our banking partners have created significant volatility in our debt and equity. This volatility is directly tied to a high political rhetoric that, as George mentioned, is based on a mischaracterization of our role as a service provider in our overall company record.
While the major banks have publicly stated that they will not be funding private prisons any longer, they appear to have executed a savvy political move.
In spite of the political rhetoric from immigration activists and protesters, GEO Group was able to extend its revolving credit facilities for another 5 years.
Although it's unclear whether or not GEO Group will be able to extend its revolving credit facilities past 2024, the good news for the company is that they have 5 years to address a potential lack of funding from their current credit facilities and for political sentiment toward private prisons to possibly decrease in intensity. If they need to the company could seek to raise more of its funds through retained capital, future bond offerings at more attractive rates as the company commits to improving its junk credit ratings with the major rating agencies, and if/when its stock price eventually improves to a level that isn't dilutive, GEO Group could also issue additional shares to raise funds.
The other major risk is from a political/regulatory standpoint.
Although few candidates running for the 2020 Democratic presidential nomination have publicly criticized and shown opposition to private prisons (most notably Elizabeth Warren, who some describe as the front runner for the Democratic Party), it's likely that most are opposed to private prisons.
Unless policymakers either agree to buy out GEO Group's facilities or build and operate their own, the issue of prison overcrowding won't be addressed.
If they decide to do the former, it is likely that GEO Group will receive a fair buyout price of its facilities, which ensures that there is a margin of safety for investors buying in at current prices.
If policymakers decide upon the latter approach, this buys GEO time to diversify away from owning and operating private prisons while the federal government fills the necessary capacity to replace private prisons. GEO Group will then be able to focus more on the rehabilitation aspect of the services they offer, which is what most, if not all of the 2020 candidates are likely to endorse over incarceration itself.
Although I have outlined what I believe to be the key risks associated with an investment in GEO Group, for the sake of brevity, I didn't include a comprehensive listing of risks facing GEO Group. I would refer interested readers to pages 28-49 of GEO Group's most recent 10-K for a more complete listing of the risks facing GEO Group.
An Industry Leader Trading At A Highly Attractive Valuation
Based upon the premise of this article and the section heading, readers know that I believe GEO Group is undervalued. But the question we will answer in this section is the extent to which I believe GEO Group is undervalued at its current stock price.
The first valuation metric we'll use to assess the fair value of shares of GEO Group is the 13-year median TTM dividend yield.
According to Gurufocus, GEO Group's TTM yield of 11.41% is well above its 13 year median of 6.83%, and very close to the highest yield it has reached in the past 13 years, which was 12.47%.
Even in a very conservative scenario in which we assume that GEO Group's fair value yield reverts to 9.0% and its fair value is $21.33 a share, this implies that shares of GEO Group are trading at a 21.5% discount to fair value and offer 27.4% upside from the current price of $16.74 a share (as of August 25, 2019).
The second valuation method I'll use is the price to AFFO ratio.
Using GEO Group's most recent midpoint AFFO figure of $2.71 for FY 2019, GEO Group is trading at a 6.18 price to AFFO ratio. This yet again suggests the uncertainty around the outcome of the 2020 elections and funding beyond 2024 has left the company's stock price in a very depressed state.
In a conservative scenario, it seems reasonable to assume a reversion to a price to AFFO ratio of 8.0 and a fair value of $21.68 once the outcome of the 2020 elections is decided and the company's future is clarified following the elections.
This would indicate that shares of GEO Group are trading at a 22.8% discount to fair value and offers 29.5% upside from the current price.
While I typically like to use the dividend discount model or DDM to determine a company's fair value, I don't believe it would be particularly useful in this case. Because the company's yield is well above my required rate of 10%, it wouldn't take any growth in the dividend to warrant a buy, provided one believes the dividend will be maintained in the years ahead.
A yield above 10% when I require a rate of return of at least 10% would obviously lead to a misleading fair value of infinity, factoring in zero dividend growth, which is why I'll opt to use the DCF valuation method.
Source: MoneyChimp
If we use the past 4 quarters of AFFO in lieu of EPS (due to AFFO being the more appropriate figure to use for a REIT) and plug them into the DCF calculator, we arrive at a fair value per share of $22.25 a share, assuming no AFFO growth and a 12% required rate of return.
This calculation illustrates simply how bearishly GEO Group is currently being valued by the market. A roughly 2% annual decline in AFFO is currently baked into GEO Group's share price, which would be a significant deviation from past AFFO growth.
The $22.25 fair value of GEO Group means that assuming literally no growth in the company's AFFO, GEO Group is trading at a 24.8% discount to fair value and offers 32.9% upside from its current price.
When we average the three fair values, we arrive at a fair value of $21.75 a share. This suggests that shares of GEO Group are trading at a 23.0% discount to fair value and offer 29.9% upside from the current price.
Summary: GEO Group's Skewed Risk/Reward Profile Makes It A Solid Speculative Buy
GEO Group's absolutely eye-popping yield of 11.5% would lead one to believe that there is a very high likelihood of a dividend cut. From my perspective, this appears to be a rare case in which a cut to such a massive dividend isn't a foregone conclusion.
While the risk of Democrats taking control following the 2020 elections and implementing policies that are existential threats to private prison REITs such as GEO Group is possible, I don't view it as the likely outcome.
On the operating front, GEO Group is continuing to take the steps necessary to prepare itself for the worst-case scenario in which Democrats attempt to eradicate the private prison system.
The uncertainty and the fear surrounding the private prison industry and whether it will exist 5-10 years now somewhat resembles that of the tobacco industry in the late 1990s and early 2000s, following the Tobacco Master Settlement Agreement.
As we're aware, the investments in the major tobacco companies at absurd valuations following the Tobacco MSA proved to be incredibly lucrative for contrarian investors, and the fear of public scrutiny and hatred toward the private prison industry bears a resemblance to our tobacco industry example.
At its core, an investment in GEO Group at these levels is a bet that the company will exist and continue to pay its dividend 5-10 years from now or that the government will buy out GEO Group's assets (which it would be obligated to do if it intended to run GEO Group's facilities on its own). The already compressed AFFO multiple of only 6 can't go much lower. GEO Group offers a very favorable risk/reward ratio for investors that care to allocate a small portion of their portfolio to a more speculative investment such as GEO Group.
Between the 11.5% yield, a somewhat conservative estimate of ZERO AFFO growth, and yet another conservative assumption of a static valuation multiple, GEO Group's dividend alone will power 11.5% annual total returns over the next decade, thereby delivering alpha for investors.
In more of a base case scenario, I believe GEO is going to provide an 11.5% yield, 1-2% AFFO growth, and 2.6% annual valuation multiple expansion, for outsized annual total returns of 15.1-16.1% over the next decade.
Kody's Dividends
Hi, my name is Kody. Aside from my articles here on Seeking Alpha, I am also a contributor to Dividend Kings and iREIT on Alpha. I have been investing since September 2017 and interested in dividend investing since about 2009.Since July 2018, I have ran Kody's Dividends. This is a blog that is documenting my journey towards financial independence using dividend growth investing as the means to transform the dream of financial independence into a reality. It's also the inspiration of my pseudonym here on Seeking Alpha.By God's grace, I owe everything to my blog for introducing me to the Seeking Alpha community as an analyst. That's my story and I hope you enjoy my work examining dividend growth stocks and the occasional growth stock!
Analyst’s Disclosure: I am/we are long GEO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
