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GEO Says It's Committed to Dividend For Now But Safety Profile is Fragile

GEO Group (GEO) and CoreCivic (CXW) operate over 80% of America's privately managed prison facilities.

GEO derives about 64% of its revenue from managing correctional and detention facilities for federal and state government agencies.

Another 25% of the business is from operating community reentry centers and youth treatment facilities, with the remaining 11% from providing correctional services in international markets.

Though somewhat controversial, managing prisons has historically been a predictable business.

GEO provides an essential service and enjoys contractual cash flow paid by the government, resulting in minimal credit risk and high contract renewal rates.

However, as we discussed in our recent note on CoreCivic, the COVID-19 pandemic is pressuring the U.S. private prison industry in several ways.

The largest impact has come from lower activity at the Immigration and Customs Enforcement (ICE) agency, which accounted for 28% of GEO's revenue last quarter.

In March, the federal government closed the southern border in an effort to contain the spread of COVID-19.

As a result, ICE's detention population has fallen from 43,000 detainees at the end of 2019 to about 30,000 nationwide, reducing the number of immigrants sent to CoreCivic's facilities.

The federal government also issued a recommendation to reduce capacity at ICE processing centers to 75% in order to promote social distancing practices.

Meanwhile, the U.S. Marshals Service, a federal law enforcement agency, accounted for 12% of GEO's revenue in the first quarter.

Shelter-in-place orders have disrupted the criminal justice system, causing a decline in the number of courts in session. This has resulted in fewer prosecutions and reduced the number of new prisoners arriving at GEO's facilities.

Additionally, many state and local government agencies have decided to release certain offenders to reduce the risk of COVID-19 transmission.

These issues have also caused revenue challenges at GEO's reentry centers and youth treatment facilities due to lower occupancy.

At the same time, expenses are climbing. Labor costs have increased, and GEO said it is spending millions of dollars more on personal protective equipment, diagnostic testing, and medical expenses.

Overall, management now expects 2020 revenue to decline at a high single-digit pace with profits falling at a somewhat faster rate due to the REIT's relatively high fixed costs.

Based on GEO's updated guidance, the company's adjusted funds from operations (AFFO) payout ratio will increase from 70% in 2019 to nearly 85% this year. 

For now, that level of coverage is enough for management to feel comfortable continuing the current dividend.

Despite the significant challenges associated with this global pandemic, we believe our business earnings and cash flows remain resilient and continue to support our dividend payments. 

We have taken what we believe is a prudent approach to our guidance for the full year, and we believe we have adequate liquidity and access to capital.

– Chairman and CEO George Zoley

GEO remains confident in its cash flow forecast in part because the majority of its facilities contracts contain fixed-price or minimum guarantee payment provisions.

This clause is intended to ensure that GEO maintains adequate staffing levels and can deliver consistent service despite fluctuations in prison population levels.

Management said on the earnings call that GEO's ICE processing centers and U.S. Marshals facilities are now operating at around the capacity level tied to these payment provisions.

As a result, incremental occupancy declines should have less of an impact on the company's cash flow.

However, just because the dividend is covered by cash flow doesn't mean that it's a safe bet in the long term.

GEO entered this crisis with an elevated leverage ratio near 5.5x and a BB- junk credit rating from Standard & Poor's.

With minimal growth spending planned, management had expected to redirect excess cash flow towards debt reduction to reduce leverage to about 4.5x by the end of 2020. (Management previously said they are comfortable operating with leverage between 4x and 5x.)

Standard & Poor's recently revised its outlook on GEO's rating to negative, anticipating that leverage could climb above 6.5x this year before falling back below its mid-5x area in 2021 once the virus outbreak is contained. 

GEO's debt covenants limit leverage to 6.25x, though the calculation of leverage under its credit facility is likely somewhat different than Standard & Poor's.

Regardless, if GEO's leverage exceeds this threshold and the covenants are unable to be amended, the consequences are heavy.

For example, the company's debt payments could be accelerated, and GEO would potentially not be allowed to pay dividends.

Management doesn't appear to be concerned about this possibility since most of the headwinds hurting profitability are expected to be of a transitory nature.

The REIT's liquidity isn't a concern either. Cash flow is expected to cover the dividend, capital expenditures are modest, and no major debt maturities occur until 2022.

However, REITs are capital-intensive businesses and require access to debt and equity markets to grow over time. This is problematic for GEO since more lenders are refusing to work with the private prison industry.

In 2019, most of the lead lenders in GEO's credit facility said they will stop servicing the private prison industry, including J.P. Morgan, Bank of America, Barclays, Wells Fargo, and SunTrust.

We estimate that GEO's credit facility can cover its debt maturities through 2023. But the facility expires in 2024 when $1.4 billion of debt comes due.

With more banks dropping out of servicing the private prison industry, GEO could have a difficult time finding new lenders to refinance its debt on reasonable borrowing terms. And issuing equity at today's valuation would be highly dilutive.

Coupled with the company's weak BB- credit rating and uncertainty over long-term government policy toward incarceration, this could make management desire to be more conservative with preserving liquidity.

Reducing the dividend would be the easiest lever to pull to retain more cash flow and improve the balance sheet, but earlier this month management said they expect the dividend to remain safe based on their 2020 guidance.

An imminent dividend cut seems unlikely. However, GEO's falling cash flow, rising leverage, and tightening access to capital markets are enough for us to downgrade GEO's Dividend Safety Score from our lowest Borderline Safe score (41) to Unsafe
In the short term, GEO's performance will depend on how long border traffic restrictions and social distancing measures are kept in place. The stock could do very well if the virus is contained quickly and occupancy improves.

But the company also faces elevated political risk with the U.S. 2020 election. Private prison stocks tanked more than 30% in a single day in 2016 when the Justice Department said it would phase out using private prisons.

The Trump administration put a stop to those plans, but government policies could change once more if Democrats sweep this year's elections.

GEO notes that its business continued to grow and operate profitably under the Obama administration, but it's admittedly hard to size up future political risks.

Well, there might be less occupancy in our ICE facilities, but I don't think it would be less than it is today. We operated very profitably under the 8 years of the Obama administration. In fact, we expanded considerably under the Obama administration. 

And the reason why is because under that administration, there was a raising of the standards of quality for those that were civilly detained. And there were physical plant upgrades that were necessary, staffing upgrades, health care upgrades and a lot of the previous governmental service providers for ICE, in particular, said, "No, we're not able to meet those requirements." 

And the ICE turned to the private sector, which did meet those standards. So we built new facilities and that met those standards. And we grew under a Democratic administration. And that, I would think if there is a Democratic president, such as the former Vice President, that he would have a continuation of those policies.

– Chairman and CEO George Zoley

A lot of bad news is already reflected in GEO's stock price, but current shareholders should review if they are comfortable with the growing risks faced by the private prison industry. 

GEO has the liquidity to weather this storm for a few years and plans to maintain its payout for now. However, the REIT's dividend may eventually need to be reduced, and its longer-term outlook remains somewhat hazy. 

We will continue monitoring the situation, though a Dividend Safety Score upgrade is unlikely until GEO's leverage profile improves.

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