Rosy financial outlook for Geo Group, or will scandals, debt be its undoing?

In the wake of the Geo Group scandal at the private youth prison in Coke County, and protests at a Geo-run unit in Del Rio over the weekend (organized after the facility won the Texas Jail Project's "Worst Local Jail" contest), Barron's looks at the private prison industry and declares it a growth industry and solid investment, despite such setbacks. According to Barron's:

IF THE GAME OF MONOPOLY WERE a reality show, Jail would be worth more than Boardwalk. Crime, you see, does pay if you're a sharp-eyed investor. Specifically, there's money to be made in shares of prison companies like GEO Group, Corrections Corp. of America and Cornell Co. -- despite a recent U.S. Census report intimating that the prison population is growing at 4% annually, not the widely publicized 13% forecast by the Pew Charitable Trusts in February. The census report took the wind out of the billowing sails of the jailer's stocks, and herein lies an opportunity. The Pew data, by our reckoning, are almost certainly more accurate.

Government statisticians sampled just 37 states, while Pew looked at hard data from 42 states and estimates from the other eight. By the time Census had published its report last month, the actual prison population figures reported by the states to the Justice Department for 2006 were higher than its estimates. So Pew's forecast that the number of prisoners will rise by 192,000, to close to two million by 2011, appears to hold up. The Pew report estimates that the growth in the prison population will produce a five-year cost to taxpayers of $27.5 billion.

ALTHOUGH ALL THREE PRISON COMPANIES trade at lofty price-to-earnings ratios, they look reasonable in light of the prison population's likely growth. ...

Granted, the jailers are in a risky business. A riot or high-profile escape or a case of abuse can cost them dearly -- in the form of congressional hearings, lost federal contracts and more. But the rewards to investors can be considerable -- not only in stocks but also in bonds.

Similarly, the Wall Street Journal earlier in May predicted rapid growth in the private prison industry over the next few years. Securities analysts are telling investors the Coke County incident was an isolated case and that Texas officials are not on a "witch hunt" aimed at other Geo facilities:

If Geo did lose its other contracts with the TDCJ, he said, it would cost the company 7 to 8 cents per share each year. But he believes the greater risk to the company is that the Coke County news will hinder its efforts to sign new contracts.

Van Fleet kept an "Overweight" rating on the stock.

If the Coke County facility were the only private unit in Texas with serious problems, I might agree that Geo wasn't risking future growth. But with protesters decrying conditions in their Del Rio facility, a recent escape on their watch in Beaumont, the state of Idaho pulling inmates out of two different Geo facilities this year, I wonder if they're really so immune from these scandal's fallout?

The company's base economics don't look so stable to me. As Grits reported earlier this year, citing the company's 10-K filing with Securities and Exchange Commission:

the company has a "significant level of indebtedness that could adversely affect our financial position," mostly spent to buy competing private prison companies. And how might this debt "adversely" affect Geo? First and foremost, the company says, it could "require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness." Translated, that means they've got so much debt they're going to have to divert funds from their facilities they're operating to help pay it off!

I wonder if siphoning off funds for debt payment contributed to worsening conditions at the Dickens County unit?

The 10-K declares that Geo relies on "distributions" (i.e., "profits") from its subsidiaries to pay its increasingly large debt. Profits from subsidiaries made up more than 28% of Geo revenue last year, but the 10-K cautions that "Our subsidiaries are separate and distinct legal entities and are not obligated to make funds available for payment of our other indebtedness in the form of loans, distributions or otherwise."

In other words, we're not solvent without payments we can't ensure will keep coming, and our subsidiaries are "separate and distinct legal entities" who we don't control.

Did Geo use operating funds from Coke and Dickens Counties to make its debt payments? Did the Geo Group allow its Texas facilities to deteriorate because of a corporate decision to shift "a substantial portion of our cash flow from operations to payments on our indebtedness"? That looks to me from their SEC reports like what's happening.

The Texas Senate Criminal Justice Committee, which will review Geo and other private prison contractors in a hearing on Friday, should question the company over whether they've shifted money from their Texas operations to pay for debt, as their 10-K declared.

It's quite possible that neglect at Coke County, Dickens County, and other Geo units stems directly from using money needed for "operations" to pay for debt. - if so, that raises serious questions about the propriety of continuing Geo's state contracts. The state prisons have their problems, but when they're appropriated money to spend at this or that unit, at least they spend it and don't siphon off money to pay for corporate acquisitions.