GEO Group Stock: Tactically Hedging Short (NYSE:GEO)

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GEO Group has sufficient cash flow for a deal

Given the forecast for fiscal year 2022, a successful out-of-court restructuring is almost a certainty at this point. In what was previously disclosed cleaning equipment term lenders requested L+775 basis points with a floor of 100 basis points (i.e. 8.75%) and a cash redemption of $191 million. I assume the lender of the revolving credit facility will ask for the same treatment. The bond ad hoc group requested a coupon of 9.5%, a PIK interest of 1-1.5% and different levels of cash redemption for the three senior unsecured bonds (50% for the 2023 and 5% for the 2024). A quick modeling exercise would suggest that these terms are affordable for GEO (NYSE: GEO)but this will limit the amount of leverage GEO can provide in the future.

Guidance low and high range

Orientation FY2022 and march FCF (Investor Presentation)

Accepting the ad hoc group’s proposal would mean nearly doubling annual interest expense and leaving $85-100 million in free cash flow to lighten the balance sheet in fiscal year 2022 (~$130 million in subsequent years , as all FCF is used to repay the term loan and RCF, saving interest charges). In this scenario, the total net leverage will decrease by 0.6x from the current 5.0x over the next 4 years.

While I don’t think this deleveraging trajectory is going to make equity work long term, it does mean that GEO can afford to take the most punishing deal while still leaving some free cash to slowly deleverage. Anticipating a relief rally from the removal of this debt restructuring overhang, I hedge my short GEO position. This doesn’t necessarily mean that I would recommend rewinding this pair (+14% YTD) as I still see CXW outperforming GEO in the medium to long term. In effect, I’m moving from a neutral market position to a net long position.

GEO

Pro forma capital structure (Author’s estimates)

GEO

Cash flow and leverage forecasts (Author’s estimates)

Source: Investor presentation and author’s estimates

Performance GEO vs. CXW YTD

Performance GEO vs. CXW YTD (Google Finance)

Source: Google Finance

Where I see the conditions will be settled

While anything is still possible, we generally know the starting points of both parties and I think the final terms will be somewhere in the middle, but favor the creditors as GEO doesn’t really have much bargaining power. I don’t believe term lenders will accept a coupon lower than 7%, but they may accept a lower cash repayment (I assumed $130 million) to give GEO more liquidity. Bondholders asked for +1.75% to be in a second lien position behind term loan and RCF, which translates to a coupon of 8.75%.

I think the 7% and 8.75% coupons are fair given the short-term COVID-related occupancy risk and the lingering political risk. It also gives GEO ample liquidity (~$200m) and an opportunity to pay off its debt. Granted, deleveraging will continue at a slow pace, but at least GEO has a line of sight to 1.5x first-tier leverage and 4.0x total net leverage, both being ratios of indebtedness, in 4 years. Note that I’m also assuming a 3% year-on-year decline in EBITDA. If I assume that EBITDA remains stable at $430, the leverage ratio of 1.5x and 4.0x can be achieved in 3 years.

Pro forma capital structure

Pro forma capital structure (Author’s estimates)

Cash flow and leverage forecasts

Cash flow and leverage forecasts (Author’s estimates)

Source: Investor presentation and author’s estimates

Conclusion

GEO can afford the most punitive terms, but that just means it won’t be able to get out of debt very quickly. I think secured lenders will accept a fair coupon for the fundamental risk while still allowing GEO some leeway to repay the secured debt in a reasonable time frame – a 7% coupon will allow GEO to reduce leverage first privilege from 2.7x currently to 1.5x in 4 years. I expect bondholders to add only 1.75-2% more to be below term loan and RCF. In any case, I don’t see how GEO will be able to return capital to shareholders in the next few years, but I am (partially) hedging my short GEO position in anticipation of a successful out-of-court restructuring in the near term.

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