The Geo Group , a private prison REIT, has positioned itself as a buy. Sell-side analysts’ have been significantly adjusting their EPS estimates to the upside, propelling GEO into a Zacks Rank #1 (Strong Buy).
The Geo Group’s revenue is driven primarily by correction & detention facilities, making up 64% of its top-line. Geo Care, the group’s rehabilitation business, drives 25% of revenue, and their international segment makes up the remaining 11%. They operate 134 facilities around the world, representing a 46% increase since the end of 2014.
GEO has beaten EPS estimates every quarter since 2014, with strong double-digit beats the last 8 quarters. This firm is expected to grow its top and bottom-line by high single-digits this year and continue the growth thru next year.
The Geo Group has some political risk involved being a for-profit private prison in the United States. They rely on government contracts for their continued expansion. This upcoming election in 2020 could have a material impact on GEO.
REITs are usually quite sensitive to interest rates because of the nature of the business. REITs are required to pay out a minimum of 90% of their taxable income to its investors through dividends, making these stocks “high-yield”. As interest rates decrease fixed-income options start looking bleak, and the risk to return (Sharpe ratio) of high-yield REITs begins looking more and more attractive.
GEO is boasting an 8.8% dividend yield, while the rest of REITs are only returning investors 3-4% dividend yields. The Geo Group has been growing its dividend per share consistently since 2012, making it a reliable fixed-income alternative.
REITs are typically highly leveraged, meaning that they have a substantial amount of debt financing compared to other industries. This makes REITs even more sensitive to interest rates with their cost of capital highly correlated with the Federal Reserve’s Fed Funds benchmark.
GEO currently has over $1.3 billion financed by a Credit Facility (revolving debt), which makes them quite exposed to the credit markets. According to the Geo Groups most recent 10-Q, every 1% change in their interest rate benchmark would impact interest expense on the income statement by $13 million.
Jerome Powell and the Federal Reserve has been using dovish verbiage as of the last 7 months or so, pushing the US 10 Year Treasury yield down roughly 35%, to its lowest levels in almost 2 years. As of now, the market is pricing in a 98% chance of a rate cut this year, with an over 50% chance of 75 basis points or more being shaved off of the Fed’s universal interest rate benchmark (Fed Funds Rate).
This dovish monetary policy is good news for The Geo Group if the equity market is able to stay afloat during this period of economic uncertainty.
GEO is trading at a forward P/E of 8x, on the lowest end of its 10-year valuation trend, and less than half of the industry average of 17x. The enterprise value (EV) to EBITDA is another reliable valuation tool for a highly leveraged firm because it takes debt into account. The Geo Group’s forward EV/EBITDA is 10.8x, far below the industry average of 18.7x and on the lower end of GEO’s 10-year trend.
These multiples bring me to believe that this firm is substantially undervalued compared to its peers. This could be partially due to political risks involved, but either way, I feel the substantial discount compensates sufficiently for the added risk.
The large degree of leverage in this firm has caused the stock to be somewhat volatile, with two 20% trough-to-peaks already this year. This type of volatility would typically lead me to say, wait for another trough to buy, but the level of EPS upward adjustments has put GEO in the top 1% based on our Zacks algorithm. With its astonishingly favorable multiples, GEO looks like a hard buy to pass up at its current price.
There is no question that GEO is a high-risk stock due to its leverage, credit market exposure, and added political risk. I believe that the heavy dividend payout along with its extremely favorable multiples more than make up for the added risk. Also you have to remember that higher-risk means higher potential returns. Look out for any policy changes having to do with private prisons as well as the polls for the 2020 election considering the next president could make this firm obsolete. Also, keep an eye on the Fed’s next meeting and interest rate outlooks.
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