GEO: When what seemed like bad news, actually isn't that bad
Today, GEO released a financial update before the market opened:
The market opened with the stock down as much as 9%.
When you glanced at the update, it was easy to think it was bad.
They detailed how revenues were down because of the COVID19 environment, and then they mentioned how in Sep 2020, they will lose a 60M prison contract because one client was not going to renew.
Then they mentioned that they are cutting their dividend.
I knew this would cause a knee jerk reaction to many investors, and contemplated if one should sell. But when you look at the details, it's actually not terrible but more or less in line with expectations. Also, I forgot to mention... the dividend cut is not because profitability dropped that much. They decided to use more of the dividend to pay off debt. Their cash flow generated from earnings ex maintenance CAPEX is actually 0.66 this quarter!
In fact, once we frame the lower baseline of profitability of this year... it's actually quite reasonable. Here's what I wrote in a comment in an investment forum:
"It's not bad actually, this is fair guidance to me. Not impressive, not very bad either. Their AFFO is high, it's just that they are using more of it to pay off debt than giving it as dividends. Even with the "cut", the dividend rate is still high at 10%.
How I see it is that this quarter is close to the bottom in terms of visible profitability. This Q2 sets the baseline of 0.66 per share of AFFO. This is the effect of COVID19. In September, they drop another 60M vs 1200M revenues in revenue due to contract expiration, only 5%. This is the bottom before "Additionally, our updated guidance continues to assume no contribution from our 700-bed Central Valley, 750-bed Desert View, and 700-bed Golden State facilities in California, even though we remain hopeful to be able to activate these facilities as ICE Processing Center annexes, beginning as early as late third quarter or early fourth quarter of 2020."
So, a way to look at it is there is a lower limit of about 0.62 per share of AFFO per quarter until the COVID situation improves, or, the California facility starts contributing.
0.62 per share a quarter = annualized 2.48 per share = roughly 5x P/AFFO.
This is great when you compare it to some other companies that are loss-making at this time.
For them paying off debt is a very wise move. This is to safeguard in case there are some banks that do not want to refinance them because of political reasons.
Is 5x P/AFFO to pay off debt and pay a 10% dividend worth it? I think it's reasonable."
The point being is that a dividend being cut is not the end of the world so long as the underlying segments are profitable. Perhaps on the negative one could say that choosing to pay off debt could indicate a lack of growth opportunities, but that's reasonable considering the climate we are in.
Further, in another way of looking at the value and risk of the company, a value fund, https://millervalue.com/income-strategy-2q20-letter/ writes that the replacement cost of GEO beds is estimated at $20/share by a value fund.
"While quotation risk implies changes in price, real risk implies changes in fundamental value. Criminal justice reform is the biggest likely source of real risk, especially when you consider that criminal justice reform gave birth to the industry. Harsher sentencing guidelines in the ‘80s created a need for correctional facility growth, and the private sector stepped in to fill the void, growing its share of the total correctional population to just under 10%. Today, the incarceration rate in the US is significantly higher than in other developed countries, which likely means that the aggregate population will fall over time, presenting a bit of a secular headwind, though the private sector could still grow if it takes market share at a greater rate. Still, we estimate that it would cost the government ~$5.6B to replace GEO’s beds, equating to a replacement cost value north of $20/share.
It is important to realize we are not making any ethical value judgements about the relative efficacy of private prisons. The bet is that the assets and contracts associated with GEO are worth substantially more than where the stock currently trades. However, very few people or entities with means would elect a government service offering over a private sector offering. Taxpayers who dislike the behavior of private prison operators should alter the objective function and contract structures in relation to measurable public operator outcomes, rather than try and eliminate the existence of the private sector. One other important idea — since much of the risk in the portfolio is tied to economic growth, the idiosyncratic nature of the fundamental risk here justifies a much larger position in the portfolio than one might expect; unlike most real-estate investments, there is little cyclical risk tied to COVID-19 other than elevated sanitation costs as 100% of GEO’s tenants are investment-grade."
However, I grant that the uncertainty is in Criminal Justice return (politically driven), and perhaps a gradual reduction in imprisonment rates in the US. At the same time, when one realizes that many of GEO's contracts have a minimum long term value; the assets and contracts have a value that is likely worth more than the share price now.
Hence, when someone asked me what to do about the stock my reply would be, "if you have a diversified portfolio and don't have a position in it, now is a good time to start one. But, you must have the expectation that the share price might bounce in a range because of the "optics" of the company. This is a value play that you will likely take a long time to play out. At today's prices, you will likely enjoy a dividend rate between 10-17% until such time that the market realizes the private prison isn't going anywhere, and is actually a good shelter from the economic damage of COVID19."
At the same time, this is a value position with no sexy catalyst, and so no guarantee the price won't drift lower. The earnings likely won't be growing in the foreseeable future. But, with each quarter that passes, and the cash flow shows profitability (remember that unlike other companies, GEO is actually profitable, it's far from loss-making), I think the price will eventually reflect decent performance.
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