A Prison Stock That Won't Hold Your Portfolio Down

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Up until recently, the prison business was a no-brainer, what with the U.S.'s ballooning inmate population and jail-friendly policing, coupled with a lack of space, personnel, funding, and logistics. Private prison enterprises had the hard work taken care of for them: They could earn government subsidies and, once they were running, had access to the cheapest labor in the country. Now, inmate populations are on the decline in some areas, and even some prisons are shutting down in places such as Florida and Texas. One would think this would send such stocks as The GEO Group (NYSE: GEO  ) cascading down like newspaper clippings on cell search day, but it hasn't. GEO is riding 52-week highs and just recently transformed its corporate structure to a real estate investmnet trust (REIT). Here's what you need to know.

Prison-real estate complex
It makes sense for a company like GEO to change its operating structure into a REIT, but it's not the typical REIT you may be familiar with. This is the first fully integrated equity REIT that participates not only in owning the land but design, operations, development, and financing of correctional facilities. It's attractive as investors can still profit with capital appreciation from the operating side of the business while also benefiting from the REIT rule of 90% of profits paid out as dividends. For GEO itself, a REIT structure made sense as 60% of the company's revenue comes from company-owned or leased real estate. While there is a very substantial day-to-day operations business in place, GEO is really a real estate play, and becoming a REIT will help identify it with investors as such.

Despite contracting prison populations in certain areas, GEO managed to expand quite nicely throughout 2012. The company opened a new correctional facility in Georgia with expected annual revenues of $28 million. It added 512 beds to a facility in Indiana with incremental revenues of $8 million. There were two more new facilities opened in Texas and California that should account for $36 million in new annual revenue going forward.

All of the newly activated and reactivated beds played a part in bringing the company to $1.5 billion in total revenue for 2012, up from $1.4 billion the year before. Gross profit came in at $390 million from $371 million in 2011. Adjusted EBITDA grew in line, hitting $319 million from $301 million in the prior year.

Looking forward, growth appears to soften a bit as the company lost a contract with the state of Alaska, worth $23 million. GEO also divested its GEO Care health-care facilities, with previous revenues of $165 million. These two factors were not enough to dissuade investors, though, as the stock continues to push through into new highs. The company currently has 6,000 idle beds in various facilities around the country. In the recent conference call, management seemed optimistic yet not quite willing to commit to the possibility that those thousands of beds would be reactivated throughout this and coming years. However, with budgets tightening across the board and the aforementioned leveling off of inmate population growth in the U.S., it would make sense for state and federal corrections departments to utilize existing facilities and beds vs. the much more expensive option of commissioning new ones.

Valuation and the call
As I've mentioned a couple of times now, GEO is riding at its 52-week highs and continues to push further as investors seem very confident in the new REIT structure and the continued strength of the company as a correctional facility contractor.

For a comparison, take a look at Corrections Corporation of America (NYSE: CXW  ) . CXW is a larger company that followed suit with the REIT-conversion strategy, effective Feb.  1. The company has witnessed similar success to GEO and operates in largely the same fashion.

GEO trades at a forward P/E of just under 20 times. Free cash flow has more than doubled over the past three years. The company trades at 2.4 times book value, indicating a relatively rich valuation for an asset-heavy business. CXW, on the other hand, trades at a forward P/E of 18.3, with cash flows essentially flat over three years and at 2.48 times book value. Really, though, investors should not use the typical price-to-earnings calculation. Instead, they should use price-to-adjusted funds from operations because it is a more accurate valuation measurement for a REIT. According to GEO's guidance, 2013 AFFO  will be in the range of $2.78 to $2.92, implying a forward ratio of 12.82 times to 12.2 times. For CXW, guidance suggests $2.82-$2.87 in 2013 AFFO. That's a ratio range of 13.4 times to 13.2 times.

According to our metrics above, GEO appears to be a slightly undervalued compared to its closest peer. With decent growth prospects and a very attractive dividend payout on the horizon ($2 for 2013 and likely more over time), GEO is an attractive income investment with capital appreciation potential.

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9/30/2016 4:04 PM
CXW $13.87 Up +0.05 +0.36%
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