Prison Demographics Bode Well for Geo Group's Stock

Like license plates, shivs and pruno, there's money to be made in prison. Just ask investors in Geo Group (GEO), who've seen their stakes in the private jailer more than triple in value in the past year. A breakout as brazen as that might have some investors thinking about locking in profits, but the prison business, sad to say, is booming, and Geo Group looks to have secured its place in the yard.

Geo Group, of Boca Raton, Fla., operates in the shadow of Corrections Corp. of America (CXW), the nation's largest publicly traded prison company, but its share performance for the trailing 12 months has been second to none, jumping to $48.35 as of Friday's close from $15, including a 3-for-2 split on Oct. 2. That outshines Correction Corp.'s 85% gain for the same period and clobbers the small-cap benchmark Russell 2000 index's 13% rise.

The proximate cause for Geo Group's pumped up stock price is that the company keeps raising guidance, pummeling Wall Street's estimates and moving past analysts' price targets. Geo Group has beaten the Street for six consecutive quarters. Last week, it said fourth-quarter earnings, to be reported Tuesday, will also come in better than expected. Geo Group now sees its most recent quarter producing pro-forma earnings of 51 to 53 cents a share, 10 cents higher than its previous forecast. Analysts, on average, were looking for 43 cents, but have since lifted their own view to 51 cents, according to Thomson Financial. Geo Group said revenue should come in at $242 million to $247 million, up from its prior view of $237 million to $242 million.

There are a couple of factors behind those results, and observers say neither should abate anytime soon. Sure, Geo Group benefited handsomely from the November 2005 acquisition of Correctional Services Corp., but the company is also enjoying sky-high average occupancy rates (standing at 98% by third-quarter's end), new contract wins and better contract terms. Perhaps more important, there's a severe shortage of prison space in the country, leaving states and the federal government with no choice but to outsource incarceration to nimbler, and cheaper, private concerns.

As for Geo Group specifically, the company has a number of advantages, including experience and management talent. "To some extent building prisons is like real estate development," says Robert Wasserman, an analyst with New York investment bank Jesup & Lamont. "You have to know how to get all the permits and you have to know how to build everything and do it correctly. Sometimes you have NIMBY [not in my backyard] situations that have to be dealt with. Geo Group has been doing this a long time and they have the relationships."

Robert Sullivan, manager of Satuit Capital Micro Cap fund (SATMX), was forced to sell the fund's position when Geo Group's market cap exceeded the fund's $500 million threshold, but says he still thinks it's a great company, partly because of how well it's run. Geo Group's current market cap is $934 million.

"After you talk to management a couple of times you find out that these guys are really solid operators," Sullivan says. "To be able to bid successfully on a contract and then to be able to manage the facility, and then to be able to drive the margins to make it more profitable to actually generate cash flow, that's a pretty big undertaking for this kind of an industry."

But it's the severe shortage of prison space and the climbing prison population that make the best case for Geo Group going forward. There are currently 2.2 million people behind bars in the U.S. More than 7% of them are held in the type of privately run facilities built and operated by Geo Group, which has about 30% of the market, according to Patrick Swindle, an analyst with Avondale Partners, the Nashville, Tenn., investment bank. "It's difficult for me to see an environment where we don't grow the aggregate inmate population between 1.5% and 2% each year," Swindle says.

That jibes with a new report from the Pew Charitable Trusts that the prison population will grow 13% by 2011, and that construction of new prison beds will cost as much as $12.5 billion. That kind of burden will likely force states and the federal government to outsource even more. It's simple mathematics, Swindle says: "With construction costs having doubled over the last four-and-a-half years, the private sector today can build for typically $60,000 per bed. States would build at some price north of $75,000 to $80,000 per bed. The federal government builds at north of $100,000 per bed."

Consistent public policy with tougher, mandatory sentences was already straining the country's jail cells. Now the Department of Homeland Security's Border Initiative and its detention of undocumented immigrants has further burdened the system. "The story is very simple: There are too few prison beds," says Swindle, who has a Market Outperform rating and $55 price target on Geo Group's stock.

One caveat: The prison industry has gone through a period of boom and bust before. In the 1990s the private sector was building beds very quickly, inmate population growth slowed, and by the end of the decade there was too much supply. By 2001 the beds that were started in the late '90s were finished and filled. So, as in any industry, there are certainly cycles of which to be mindful.

But Jamie Cuellar, co-manager of the Brazos Micro Cap fund (BJMIX), which first took a position in Geo Group in September, said the prospects look good in the near- and medium-term, at least. "These are typically long cycles," Cuellar says. "And the amount of debt the prison companies are carrying on their balance sheets right now is sort of regulating a little bit how much capacity they can add." At the end of the third quarter Geo Group was carrying about $267 million in debt, down from about $350 million at the beginning of 2006.

While Geo Group's stock has enjoyed a steep run-up over the past year, and it looks expensive by some measures, the tremendous industry fundamentals are tough to ignore. So too is Geo Group's auxiliary business of running residential treatment facilities. A five-year deal signed last week with the state of Florida to operate a 175-bed mental-health center is expected to add $14.5 million to the top line this year and $21 million in 2008. For the third quarter, Geo Care's total revenue more than doubled to $19.8 million from $8.3 million.

That revenue stream could prop up Geo Group when the prison-building cycle turns south. Avondale's Swindle thinks the company's Geo Care business, where states outsource their mental health, substance abuse and health-care services to the firm, could reasonably double over the next three years. "These are predominantly very old state facilities, many of which need to be replaced," says Swindle. "Geo Care is a first mover in a space that was not previously privatized. That business is really beginning to get its legs."

There's another bright side to the somewhat dark prospect of owning shares in a company that's bread and water, er, butter, is prisons: They have a defensive aspect. As Cuellar points out, they're almost counter-cyclical to the broader economy. "When times are bad, more people tend to go to jail," says Cuellar. "It's awful, but it's true."