The purpose of this exercise is not to do an absolute valuation for The GEO Group (NYSE:GEO) or CoreCivic (NYSE:CXW) using the DCF method. Rather, I want to do a relative valuation and see if there is any obvious mispricing between GEO and CXW. There seems to be a deep value-driven narrative around GEO (i.e. GEO is super cheap and undervalued vs. CXW) that I’d like to try to push back a little. As always, I’m happy to hear your thoughts in the comment section.
As you are aware, DCF is notoriously sensitive to input assumptions, especially for the assumptions for growth rate and discount rate. However, since this is a comparative analysis, the sensitivity isn’t an issue as long as we keep the assumptions consistent around the two DCF models. Here are my assumptions for both companies:
- EBITDA: starting with the FY2022 guidance and decrease by 3% YoY
- Depreciation Expense: Q1-2022 annualized
- Tax Rate: 30%
- Capex: ~15% of EBITDA for FY2022 and flatline going forward
- Terminal Growth Rate: -3%
- Net Debt: Q1-2022
- Share Count: Q1-2022
- Stock Price: as of May 6, 2022
You might think it’s not appropriate to use the exact same set of assumptions for two different companies. Here is how to think about this. For growth rates, the companies face essentially the same demand curve (albeit a small difference in business mix), so it’s okay to make the growth rates the same. For tax rates, I don’t see any reason why it would be different for either GEO or CXW. The 15% capex intensity (capex/EBITDA) was in GEO’s last cleansing material. This should be the barebone maintenance capex. I apply the same percentage for CXW to make the comparison appropriate. Keep in mind, this is a comparative analysis and not an absolute valuation exercise.
Instead of using the DCF to value the companies, I used the stock price and the assumptions above to back out the implied discount rate to make the comparison more apples-to-apples.
Perhaps not surprising at all but it seems like the market is valuing the assets of CXW and GEO the same as the implied discount rates for both companies is around 10%, under the same set of assumptions. Similarly, EV/EBITDA and Unlevered FCF Yield are very similar between CXW and GEO. The major difference is when you get to the equity value, the market is demanding a whopping 20% levered FCF yield from GEO vs. only 8.8% for CXW.
The fact that the implied discount rates are very similar is not surprising because CXW and GEO are in the same industry facing the same industry forces. The business mix is also very similar but GEO has a bit more exposure to the Federal Bureau of Prisons and state governments, which is comparatively worse. However, I believe GEO’s Electronic Monitoring business is a hidden gem that arguably (more than?) offsets the business mix (but keep in mind it’s only ~15% of the revenue as of today). My takeaway is that there doesn’t seem to be any obvious mispricing between GEO and CXW at the asset level.
The equity valuation sends a mixed signal. GEO trades at 20% levered FCF yield or 5.0x P/FCF, and CXW trades at 8.8% levered FCF or 11.4x P/FCF – that’s definitively intriguing. The first place to check is the balance sheet because the leverage profile influences equity valuation significantly. GEO has a 4.0x net leverage vs. CXW’s 2.7x, so directionally it makes sense for GEO’s equity to trade lower than CXW, but does the magnitude make sense as well?
There are also idiosyncratic factors at play for both companies to cause the equity valuation discrepancy. For CXW, the shareholder return initiative has been well telegraphed by the management team. On the most recent earnings call, the CEO clearly stated that as soon as they get a new revolving credit facility in place, they will initiate share buyback, which could happen in weeks. I believe this is being priced in CXW’s stock elevating the equity valuation multiple.
GEO, on the other hand, will not be able to spend more than $5 million a year on dividend/buyback as long as the proposed new credit facilities are in place. Additionally, while the likelihood of a successful amend/extend transaction has increased significantly with parties reaching consensus on major terms, there is still a small chance that the negotiation falls apart. It’s likely that the combination of these two factors are depressing GEO’s equity valuation.
Does this Make GEO a Buy?
For the first time ever, I’m tempted to own some GEO stocks. The relative valuation gap is too large to ignore. While I can tie the depressed valuation back to the two fundamental reasons explained above, I at least feel comfortable betting against the latter (i.e. I believe a successful amend/extend transaction is almost a certainty vs. the market seems to have way less confidence in this regard).
My biggest concern (among many) with buying GEO stock is that I don’t know where the marginal buyers will come from. CXW will act as its own buyer of last resort. On my math, CXW should be able to return 75% of FCF back to shareholder and still maintain its 2.25-2.75x leverage target. Who will bid up GEO? ESG concern aside, the tiny market cap and zero yield means even the passive money won’t flow into GEO. On the other hand, I acknowledge given the depressed equity valuation and the financial leverage, it doesn’t take too much capital to rerate the stock (maybe I just talked myself into buying GEO here…).
Short Squeeze is Unlikely
I believe if Title 42 is lifted, the stock could rerate initially (whether it stays there is debatable), but I don’t believe a short squeeze is likely. I get that everybody is looking for the next GameStop (GME), but the fact is the ~21-22 million GEO short is largely from the delta hedging by the Exchangeable Notes. $230 million of the Exchangeable Notes can be converted into stock at $9.225 per share, which if fully delta-hedged, equals to ~25 million shares shorted. I’m far from being an expert in convertible bond arbitrage but I bet a major portion of the existing short interest won’t be squeezed as these are not naked shorts.
Below are the likely scenarios. This is a torquey stock with every 1.0x EBITDA multiple change translating to very outsized equity movements, so size the position accordingly. I intend to take some profits in CXW and apply the proceeds to build a tracking position in GEO. Finally, I want to wrap up by a comparison between GEO and CXW.
Here is a quick summary of my thoughts on GEO and CXW. Besides the same industry dynamics:
- Merits: CXW has a lower financial leverage and shareholder return is on the horizon which should support the stock to rerate further.
- Risks: some of the benefit of share buyback has been priced in already (although CXW is still cheap in an absolute sense at ~7.5x EV/EBITDA)
- Merits: GEO’s relative valuation very attractive vs. CXW. A successful amend/extend transaction scenario has not been fully priced in.
- Risks: GEO has higher financial leverage and doesn’t have the capacity to return capital to shareholder in the next few years.