Five months ago, I published two articles, each about a company renting out different facilities to US government agencies like the FBI, the postal service or the Department of Veteran Affairs. Both were REITs with seemingly safe tenants and high occupancy ratios. I was not convinced of these stocks, though, due to either high debt and / or the financial well-being of some tenants. Today, I am discussing in this third article the two big private prison stocks.

Summary and key takeaways from today’s Weekly
– Prison stocks in the USA gain some attention before presidential elections as democrats seem to be opposed to them while others are of the view that a next president Trump were good for these stocks.
– On the surface, these stocks don’t look expensive and the bull case seems plausible.
– However, there are certain risks and valuations do not seem to be cheap when taking a deeper look.

Should you have missed the first two parts, just go here and here.

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The idea to dig out these two names for today’s episode – which I got to know for the first time in 2018 or so – came to my head after without a doubt political discontent in many countries is rising.

Peaceful protests turn violent due to different reasons like opposing wars, the in many countries still not resolved cost of living crisis, other domestic political issues, etc. or there are rumblings already from the get go.

While I have clearly preferences for peaceful negotiations and outcomes, there’s no denying that arrests and detentions in such an environment are more likely to rise than to fall – justified or not.

This is common sense and objective, not emotional or in any sense wishful thinking.

Without knowing the exact outcome, yet, then there’s the firm belief that a next US president Trump would be good for US prison stocks, offering a potential re-valuation of those.

As always, I want to do a common stock analysis in my style, trying to assess the investment quality of those shares which by the way are not REITs (“anymore” I should say), but corporations, despite being in the properties business.

I am discussing GEO Group (ISIN: US36162J1060, Ticker: GEO) as well as CoreCivic (ISIN: US21871N1019, Ticker: CXW), the two biggest private owners and operators of prisons and related facilities on US soil with the government via different agencies as tenants.

An under-looked chance with a hedge-component or a big and risky trap?

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Under-looked or simply over-valued?

Both companies, GEO Group as well as CoreCivic, are both by far the two biggest private prison owners and managers in the US. As a rule of thumb, half of this “business” is being conducted by the government / public sector straight, while the other is outsourced to the private sector.

CoreCivic claims to have a market share of ~56% in the private sector (i.e. roughly a quarter of all) according to their latest annual report and measured by available beds. It operates 43 facilities of which 39 are owned, offering in total 65,000 beds.

The company has been operating since 1983 and is based in Tennessee. Besides having the largest prison beds capacity, CoreCivic is also the second largest owner and provider of so-called correction facilities / services, with the purpose to rehabilitate and reintegrate prisoners. Its operations are exclusively conducted in the USA.

GEO Group, founded in 1984 and based in Florida, has prisons and bed capacities in the USA, but also the UK, Australia and even South Africa. However, internationally, it has only four facilities, compared to 49 in the US, so it’s practically also a US prison company. In total, GEO has 81,000 beds and besides owning and managing prisons, it also offers monitoring and supervision services.

Besides a rising population and rising criminality, the outdated condition of many state prisons, together with record-low new openings, this was even thought to be a growth sector, ready to absorb plenty of external capital to modernize the infrastructure.

We find such a chart in CoreCivic’s latest investor presentation:

However, at the latest surrounding the presidential election of 2020, this theme has become rather called into question, as at times doubts were raised again, whether private for-profit organizations should conduct such operations at all.

While it seemed only for a brief period that private ownership and operations could be interfered into or even forbidden (which was more noise than substantial), these thoughts somehow still prevailed. Every time such requests are being made from politicians, these stocks tend to react strongly.

Despite offering now also certain (more ESG-friendly) services, these companies mainly are what they were before, landlords and operators of prison facilities.

Both companies had a history of being REITs – real estate investment trusts.

As REITs, both had certain tax advantages, but in return needed to pay dividends to their shareholders.

In the last decade, both have been loading up on debt in the near-zero interest rate environment, but were hit pretty hard during the lockdowns, as so-called social distancing measures were also applied in prisons. This led to dramatically lower occupancy rates which is horrible for such a business with high fixed costs and comparatively lower margins anyhow (compared to other REIT sectors).

Below, you can see that occupancy, though on a multi-year high, by far hasn’t reached pre-2020 levels again (which the company is pitching as a potential growth driver).

Around 2020–2021, both decided to ditch their REIT stati and to convert back to C corps, i.e. normally taxed companies with the free choice whether to pay dividends or not.

Self-explanatory, both companies quickly suspended their dividends which before have seen double-digit yields.

(even though below TIKR still shows positive dividend yields, both companies are not paying dividends)

Further below, we can see that debt levels, measured by net debt to EBITDA, have been rising in the case of GEO to levels above 6x and CoreCivic to above 4x. Both aggressively have delevered since the peaks.

As REITs and measured by sector standards, they had rather normal debt levels, but the problem is their external financing capabilities have been limited compared to “normal” REITs. Also, with low stock prices, higher than usual dilution would have been the result, thus it’s understandable these companies converted back to C corps.

Today, both have leverage ratios of about 2.5x for CoreCivic and 3.5x for GEO which is not low for C Corps, but it would be on the lower end for REITs. As both are technically not REITs, however, still operating mainly in the properties business, I’d say that debt levels are okay and not an immediate threat, despite high interest rates again. A mixed bad, so to speak. Both don’t face any significant near-term maturities.

So, the bullish case is straightforward.

The companies own hard-to-replace assets that not everybody can build from scratch, they have rising occupancy levels again (should lead to growth and higher margins) and they delevered their balance sheets, allowing them to focus again slowly on shareholder distributions.

In the case of CoreCivic, they already conducted some share repurchases. Even though limited (share count is down by 4–5% since 2021), still worth mentioning. They also recently upped their existing authorization to 350 mn. USD compared to a market cap of only 1.4 bn. USD or 25% – that’s substantial!

However, one should be aware that this isn’t meant to be done in a single year.

The final bullish point is the valuation which is showing high discounts, at least on the surface. Below is a screenshot from the current investor presentation of GEO which shows a per share net asset value (NAV) of 26.71 USD – double the current share price.

However, at this point the issues for me from a defensive perspective start to emerge.

GEO’s calculation is based on estimated (by them) replacement costs, not what they have on their balance sheet. I know that properties become more expensive in practice over time due to inflation and higher rent income, while their value gets written down in the books.

That seems to be a bit contradictory, however, buildings are used and with time need investments to be kept in shape to keep a certain value.

On the other side, I do not expect a massive investment offensive into entirely new prison facilities due to being a politicized topic and also due to occupancy being below 80%, at least for GEO and CoreCivic. Thus replacement values seem not to be the parameter to look at.

Hence, that’s a bit aggressive, though, as the discrepancy compared to shareholder’s equity of only 1.3 bn. USD is high with 50%. GEO has a market cap of 1.7 bn. USD, so it’s trading factually even above book value.

CoreCivic has not shown such a NAV calculation. It is more or less trading at 1x book value and it has less leverage which is a plus.

While I do not want to question the validity of these replacement cost numbers and there’s something to it that investments in this sector have been neglected (under the assumption of wanting to have at least a certain modern standard), the implication can only be that more investments will lead to less cash flows and less distributions.

Without investments, their properties won’t be able to hold their values.

You see, either asset values are too high or huge investments will negatively influence cash flows.

Looking at historical book values, we can see that both companies have been valued lower and lower over time, once coming from 3x book value.

Interestingly, there have also been three occasions where they traded below book value, namely 2020 with its high uncertainty and also during 2022 and 2023. All three would have been good entry points valuation-wise, however, only for short-term engagements which I am not looking for here.

And honestly, I do not see these stocks to come back to the former highs again.

Despite the seemingly plausible upside aspects above, there are some points one should be aware of – besides the valuation differences.

For example, even though occupancy has been rising again, margins are under pressure still. This is seldom a good sign and definitively not what I’d like to see.

Keep in mind that occupancy has been rising again – margins are falling, though?

Below, we see net income margins which are relevant again since they converted back to C Corps. We see that margins are very weak, despite an oligopolistic position.

The same applies to cash flow margins by the way.

(look right to the frame, not inside the frame)

Of course, one measure to improve margins again could be to close one or the other facility and redistribute prisoners in order to increase occupancy levels. However, both companies have also some idled facilities already which are causing maintenance costs while not earning anything. What they rarely do is to sell or close such properties for good, hence the effect should be rather limited.

Another point which was the final nail in the coffin for me is that there are contracts where despite certain leasing durations a government agency can terminate the agreement “for convenience” (as they say in their annual report) and without any penalty for pre-termination.

If you think this is just a theoretical risk because the government needs prisons, please take a look at what happened in June of this year.

This was two months prior notice.

Little surprising, these news resulted in a collapse of the stock price of CoreCivic by 20%, because this contract generated 156 mn. USD in sales in 2023 or 8% of the whole.

On the other side, sure, they also have won one or the other new (smaller) contract, but this shows that the contracting structure differs from what one is used to when thinking about renting out properties. One needs long-term commitment / leasing durations, especially when operating with fixed leverage.

And that’s also why despite a higher buyback authorization, management now won’t repurchase much – their leverage ratio has worsened as a bigger chunk of higher-margin earnings disappears.

And here’s my valuation approach regarding earnings:

With the publication of the latest results, management adjusted their guidance. They are now expecting earnings per share to be 0.37–0.45 USD, respectively 0.58–0.66 USD on an adjusted basis. With a share price of currently 12.87 USD, this results in a price to earnings ratio of at least 20x – far from being a bargain or once in a lifetime buying opportunity (just the equity portion without debt).

GEO looks a bit cheaper with expected adjusted earnings per share of 0.82–0.93 USD and a share price of 13.22 USD (PE = 14–15x), however, they have a good chunk of more debt – about 14 USD per share to be more precise.

Neither seems to be dramatically undervalued, especially considering all the risks.

Maybe should we see these stocks trade for 0.5x their book value – with preferably slightly better balance sheets – could we start talking about a better risk and reward profile. This is a downside of at least 50%, though…

There’s also another factor which affects everyone being depended on government funds, namely the tough fiscal situation. A new government shutdown or reshuffling of budgets can cause uncertainty and even destroy management’s planning. One should be well aware of that.

To close this overview, I wanted to ask the question: How did the prison stocks develop during president Trump’s tenure?

The answer might be disappointing (yes, even before the lockdowns).

As we:

• didn’t have any “Trump-boom”
• democrats tend to be opposed to private prisons
• valuations do not look cheap, yet even slightly high
• margins are already comparatively low and compressed (and even falling)
• we have seen a special set of risks with sudden termination possibilities
• have a high dependence on friendly politics which cannot be planned
• an aged infrastructure which will likely need lots of investments, pressuring free cash flows

I seriously must say, that I am passing on these.

Conclusion

Prison stocks in the USA gain some attention before presidential elections as democrats seem to be opposed to them while others are of the view that a next president Trump were good for these stocks.

On the surface, these stocks don’t look expensive and the bull case seems plausible.

However, there are certain risks and valuations do not seem to be cheap when taking a deeper look.

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