Buy Target Hospitality ($TH, 40% Upside)
*I, and individuals or businesses affiliated with me, own shares in TH
**Readers new / unfamiliar with general investing and financial jargon should consult my guide titled “Breaking into Capital Markets Part 1” on this blog.
Recap of Events from 3/31/23 to 8/22/23
*Skip this section first if you are new to the stock and need the background & investment case
On March 31st 2023, Investors were spooked by a release of this document on HHS’s (Health and Human Services) Website. The press release stated that the facility was currently housing no children and the that it was under “warm” status with no pre-defined reactivation date.
Once again the stock suffered from a lack of critical understand, but granted, the company could have done better with communication. The ensuing fallout was comprised of investors dumping the stock, worried that the language stating “no reactivation date” and the fact that there were currently no children under care had very bad implications for the business, which can be summarized through these three dynamics: 1.) If there were no children under care of the facility currently, then there would be no reason for the government to renew the contract without severely cutting the revenue paid to TH 2.) Shorter-term Investors who believed that PCC was on track to earn a large amount of variable service revenue (non-core) had their hopes dashed and 3.) A pervasive idea emerged that the PCC contract would not be renewed at all, potentially rendering the topic of future ICF contracts moot.
March to May: Several misconceptions of the business led to a prolonged malaise in the stock price for several months. Investors would have done well to be reminded of the true nature of these type of ICF contracts. Their sole intent is to be used as surge capacity, in other words, PCC was never intended to be completely full or even occupied at all times. Looking at certain portion of a timeseries in isolation is to flout the intended concept of “surge capacity.” Insurance is not about whether you have been unfortunate enough to need its use at one specific point of time, but rather, is a reflection of the expected long-term need for said safeguard. In other words, the facility being empty now does not portend that it will be empty in the future; immigration trends are inherently fickle and often develop before a proper response can be formed. The government has no interest in closing down a facility only to realize 1 month or 1 year later that they need it. The financial and social alternatives (Tent shelters and emergency intake shelters) are more costly and less humane.
As such, the “reactivation date” is purposefully vague as the government has no exact date of when children will cross the border. There is absolutely no visibility which makes proactive risk management a priority.
The precipitous drop from $16 to $12 then reversed back to $16 in May when management started attending several investor conferences and commenting that there was a road to doubling their profitability by expanding into different government contracts (lithium mining housing, other immigration sheltering, Department of Defense accommodations, etc). Shortly after, the market enthusiasm was dampened by the CFO exercising his 10B5-1 (elective stock-selling plan that triggers at pre-determined certain time intervals or price points) which triggered the sale of a large portion of his shares. Investors read into this far more than they should have, Eric was brought on in 2020 and was unable to monetize his stock compensation for 3 years given the depressed stock price during Covid. Additionally, the volume was relatively low, and he will still own shares and receive even more by the end of the year, meaning his actions could simply be a result of diversification interests. The CEO Brad Archer still owns millions of dollars of shares and has not sold any. However, compounding to the problem was that reported the UC population in HHS care was declining. Investors seemed to have a short-memory of the events that transpired not even several months prior, and sold the stock back down to $12.
May to the Present: Since the unfortunate timing of Eric’s share sales, the stock was frustratingly rangebound at $12-13. At those prices, the valuation implied that there the opportunity to double their EBITDA through projects outside of UC sheltering were almost certainly farcical, a disconnect that would have been well capitalized on. On their 2Q23 earnings call, the company reported some news that assuaged investors. Not only were discussions around the renewal of PCC proceeding as plan with the same economic terms, there was an open bid for 7,000 more ICF beds, or ~2 more PCC sized shelters. Of this open bid, TH (and an unnamed partner) along with a few other competitors were selected into phase 2 of the bidding. Although this number was floated around before, the market clearly didn’t believe it was going to actually happen. If investors doubted that PCC would be renewed, why would they assume that the government would want to pay for 7,000 more beds? Clearly they were misinformed. I estimate that if TH were to win 50% of these incremental beds, their Government EBITDA would double, which is excluding their original call o double EBITDA through programs outside of UC sheltering. The stock has recently rallied to $15, but remains under their $16-18 peaks back in January of 2023, which is perplexing to me. HHS reported that on August 18th, there were about 9,700 kids in care, compared to 5,900 at the start of July and 9,000 at the start of January. As a reminder, once 70-80% of 13,500 licensed beds in the government’s network are occupied, they will move to using overflow (ICFs). Within one month (Jul - Aug) the UC population spiked over 50%, demonstrating how rapid these changes are, and how little visibility the government has. The unequivocal fact is that UC trends have only increased since 2009, and a surge could happen at any time. While we can only speculate why this surge occurred, I suspect it has to do with multiple factors regarding the post-migration landscape after Title 42 was removed. In hopes of staunching the pending tide of migrants after Title 42, the Biden adminsitration enacted several new reforms. 1.) Transit Ban - if a migrant was caught crossing the border illegally and they were found to have travelled through Mexico without seeking Asylum there first, they would be immediately sent back and unable to return to apply for Asylum for years and 2.) Any migrants who cross the border illegally without making an appointment through the CBPone App (which only allowed a certain number of appointments per day) would be sent back. The more draconian measures clearly worked through May and June, with the help of messaging from Mexican officials. Many immigrants were afraid or confused abotu the changes, and decided to wait near the Border and its cities while they trying to secure an official appointment. Unaccompanied minors were excluded from these laws, but many travelled as a family unit. As things become increasingly unsafe (these migrants are often extorted and even killed by gangs while waiting on the border) there is an increasing exigence to risk an illegal crossing or to send children alone. The Transit Ban was recently tossed out by a federal judge in California, which would pave the way for more asylum seekers, adding to the pressure for the Government to have better solutions. All that being said, the situation around unaccompanied minors is clearly more pressing than it was in January 2023, and the fact that there is now material evidence TH could even receive more contracts just related to ICFs in the near future should make the stock more attractive than it was 8 months ago. The stock could easily reach infrastructure asset multiples which implies a $20-25 valuation compared to its $15 stock price currently.
The Timeline:
3Q23-4Q23: PCC details will be announced
4Q23-1Q24: Additional ICF facility contracts will be announced
1Q24-4Q24: Additional government contract wins may be revealed.
Financial Snapshot:
*2023 - 2026 are personal estimates
**2023 includes 117MM (2022: 77MM) of one-time revenue related to the reimbursement of the facility enhancements. 2024 is considered “normalized” recurring earnings.
Company Summary:
Business: TH primarily operates under two segments: Hospitality & Facility Services (HFS) and Government. While the HFS segment had primarily been the focus of the business, most of the company’s earnings are now derived from the government segment.
HFS: Under HFS, the company effectively operates as a managed service hotel provider primarily in the South (Permian Basin, etc) – essentially owning all their property and equipment, and a smaller, but sizeable percentage of the land they are situated on. Their primary customers are large energy and exploration customers (Chevron, Halliburton, etc) while competitors include Permian Lodging and Civeo Corporation. TH has developed communities in remote areas where drilling, oil, and other related energy exploration occur, describing their service as a relatively “luxury” service offering – with amenities like meeting and leisure rooms, laundry, and dining halls. From there, the company enforces drug & safety compliance, strict no co-habitation rules, and any other legal requirements set by the businesses to reduce costs and headaches for their customers.
Generally, contracts are entered with TH based on minimum revenue commitment, meaning that the customer pays for a defined number of employees even if the actual number of people who end up staying in the lodges is fewer than contracted upon, a clause that is colloquially referred to as “take-or-pay”. In addition, their customers are mandated to send their employees to a TH lodge if their work site is within a few hours drive of the facility. In general, employees from a singular company or a small number of companies will occupy a single community. While certainly correlated to energy prices (WTI, Brent), this segment is less exposed to short-term fluctuations given the longer-term duration of projects that these massive energy exploration companies take on.
Although there are few barriers to entry other than a large capital commitment, the true differentiator around the business is the service and diversity of offerings. Competitors are generally small “man-camps” populated with a few trailers and no amenities on-site. Workers must travel into the nearest town for food/groceries and go through the more onerous aspects of creating suitable accommodations for themselves. TH, on the other hand, is one of the largest operators (beds in the region) is considered all-inclusive (provides food, laundry, beds, entertainment, etc). Given the scale of the business (TH is one of the top 5 largest food purchasers in North America) they can offer daily room rates that are more favorable to alternatives when factoring in the benefit of the the entire offering. This segment is considered mature and is not expected to rapidly grow, rather maintaining a rate slightly over GDP growth and operates at a ~40% gross margin.
Pictured below: Target Hospitality Community (left) versus Typical “Man-Camp” (right)
Government: The Government segment is currently the mainstay of their business, generating most of their revenue and EBITDA. Through two owned immigration facilities, they provide food and maintenance services while their respective operating partners oversee the daily management of the properties.
Their entrance into the government business arose from a conversion of their traditional man camp facility into what is now called the South Texas Family Residential Center (STRFC) – a 2,400 bed facility which accommodates mostly women and children, many of whom are considered detained at the property and are awaiting further status on either deportation or an alternative court proceeding. TH owns the facility, but the operations are run by CoreCivic, a for-profit prison company. This contract is done through the government with minimum revenue guarantees (meaning the level of occupancy within the facility does not effect the total payment). To date, the contract was progressed from a short-term to a long-term multi-year duration by the government that generates about 50-60MM a year in revenue.
I should mention that there have been reports about the inappropriate/poor treatment of detainees within the center over its lifetime. The company’s stance is generally that they are not necessarily part of the operation, as they only own the building and provide the food services, but are constantly striving to produce the best and most humane level of service possible. I will generally not comment on the potential morality/ethical issues of the business further on only to note that the current only alternative solutions to this issue are objectively worse.
Their largest facility, (Pecos Children's Facility), operates a shelter housing 6,400 total individuals including unaccompanied minors (UAC) and non-profit employees. This property generates a majority of the company’s earnings and revenue and had its most recent expansion completed in the last several months
Pictured below: Pecos Children’s Facility (left) versus Fort Homestead Shelter (right) versus Licensed Shelters (Link)
The Business Model and the Opportunity:
The UAC Situation: Over the last several decades, there has been a consistent increase in the number of children (unaccompanied/alone) trying to enter the United States along the Southwest Border. Generally, the native countries of these children (El Salvador, Guatemala, Honduras, Mexico, etc) face persistent economic issues as well as prevalent gang violence. The number of these unaccompanied children has grown from ~19,000 in 2009 to ~150,000 in 2022.
Regrettably, the government’s historical solution for dealing with this population has been very unstructured. Many of these kids are processed through temporary “influx shelters,” solutions that are comprised of the tent cities, repurposed Forts, and other locations not optimal for the care of children. These temporary solutions are not only much more expensive than permanent shelters, but also have been reported to be vastly lacking in many humanitarian aspects.
During COVID, the number of UAC exploded from ~76,000 in 2019 to 145,000 in 2021, inundating the government, whom, in turn, frantically funded the construction of dozens of temporary shelters around the region. The ensuing media and press revealed that the government was spending hundreds of millions of dollars on poorly run and crammed facilities that often mistreated the children. Compared to a permanent solution, these temporary shelters can cost up to $1,000 per day (4-5X more) to care for a child. Today, most to all of these temporary solutions have been wound down, leaving more opportunity for children to be properly cared for at permanent facilities.
I will note, that different sources cite different numbers of UAC. Recently, the definition was expanded to total “encounters.” This new definition overstates the number as some of them are deemed ineligible. I have included a picture below this graph which from a congressional report that reported total referrals to ORR Care from Department of Homeland Security. This number should be a fraction of the total children encountered (80% - 95%) historically and reflects the minors who will be placed into differing shelters and other humanitarian solutions while awaiting their processing. There are special rules regarding immigration from contiguous countries (Mexico/Canada) which are specifically designed to be more deterrent, however, since 2010, the level of non-Mexican UAC migration has exploded which would continue to drive the rate of referrals versus encounters/apprehensions upwards.
Number of unaccompanied children encountered on the South West Border annually. “D” or “R” represents the President’s affiliated political party during that year. Certain values may be restated or estimated when specifics were inexact
Process for asylum seeking children - average length of stay at a shelter is <30 days
Wanting to eliminate the multitude of issues surround the use of temporary facilities involving bad press, poor childcare, and costliness, the Government decided to try and expand their permanent shelter network. They issued a competitive bid for a contract to rapidly develop a massive shelter as to unwind their more temporary solutions. Together with their new nonprofit partner Endeavors, TH was the awarded this new contract in 2021. The terms were initially for a ~4,000 bed facility and minimum revenue commitments of ~160MM annually over an 18 month contract. Last year upon renewal, the group announced that the government extended their contract until 2023 with expanded terms; Target would be paid 194MM to expand their facility, growing the total number of beds to 6,400 (3,000 for kids, and the rest for non-profit/government employees). The updated economic terms were 196MM in annualized contract minimum revenue, as well as the addition of a variable service revenue component ranging from $0 to $185MM depending on how many children are being taken care of in the facility over the contract duration. To be clear, TH does not deal with the direct care of the children (education, etc), but rather serves as the provider of food, furnishing, and other maintenance related needs and services.
Most recently, the company announced that the government and their nonprofit partner entered into an agreement that generally precedes the creation of a longer-term 5 (with 5-year extension extension) year contract. Although specifics on the economics have not been released, the company has strongly implied they will be the same or better. The clear opportunity arises from 1.) The continuance of the high level of migrating Children and 2.) the objective economic and humanitarian superiority of using Target’s Pecos Children’s Facility over alternatives. The Pecos facility is by far the largest and most comprehensive shelter in the nation, currently. The second and third largest facilities are 1.) a repurposed Walmart that was mired in scandals and 2.) Fort Bliss, which is not a facility meant to care for children.
Although there was a clear spike of UAC encountered during COVID, I believe this trend is likely to continue and will not revert back to 2019 levels. The primary motivation of these immigration patterns is predicated off of their respective home countries’ poverty and crime levels. Of the four nations that make up the overwhelming majority of unaccompanied minors, 3 of the 4 are projected to have a consistent or elevated poverty rate. In 2023, there have been, on average, 10,000 - 11,000 kids encountered per month. If we assume a similar historical rate of 80-95% are referred to ORR, TH only needs to be allocated care of ~30-35% of those children to have maximum occupancy (reflecting 100% of the 185MM of variable service revenue). If the level reverts back to 2019, the difference between the maximum occupancy of the facility (3,000) and the number of children (80,000/12 = 6.7K per month) and the superiority of the facility itself still makes it the obvious choice for priority allocation.
Valuation and the Investment Thesis :
TH is undervalued given it’s mix of ~90% recurring and non-cyclical EBITDA from their Government segment. This portion of their earnings base should not be impacted by an economic recession, as migration patterns are dependent on unrelated factors. Because of the uniqueness of the business, I break down the valuation into two parts and use comparable sectors as a relative valuation.
For the HFS segment, I use a multiple of ~7.0X on 2024 EBITDA, a 1-2X premium to what equipment rental companies trade at (URI, HRI, AHT, HEES). These companies have similar margin profiles (40-50%) but are much more cyclical as they rent equipment for construction heavy projects (cranes, bulldozers, etc). In addition, the market is split between these four big players which offer very little differentiation between each other in the type of product and service they offer. By comparison, TH’s HFS segment is less cyclical as they are tied to longer-term oil price outlooks versus shorter-term fluctuations, and the market is more fragmented, meaning an operator of scale is able to more effectively compete. Other hospitality management and facility service providers (Black Diamond, Civeo, Dexterra) trade between 5-7X multiples are should be considered lower quality businesses due to their lack of scale and much lower margins (peer set total gross margins of ~10-30% versus TH 35-45%). This business is not a priority of growth so I assign a closer to base-level multiple.
For the Government, I value the base business excl. new contracts through their expected cash flow and assume reduced unit economics after 10 years in addition to valuing their growth opportunities separately, labeled “Growth Investments, Discounted.” Government maintenance and other facility service operators (VSE, V2X) trade at around 7.0-8.0X multiples with ~10% EBITDA margins. Consumer staples businesses like Dollar Tree (DLTR), Dollar General (DG) trade at 12-18X EBITDA multiples at much lower margins for their perceived stability. These companies grow LSD-MSD in revenue every year and EBITDA by a similar amount due to GDP growth and new stores. These businesses are generally unimpacted by recessions and have more visibility than something like TH’s business. Hotel Franchisors like MAR, HLT, and CHH trade at 12-15X multiples. In comparison to TH’s government business, their business models are more cyclical but generally have a better annual growth profile.
TH’s contracts generally don’t have inflationary escalators but they have the variable service component to compensate (0-185MM). In addition, these contracts are always subject to repricing after every renewal. These earnings face practically no cyclicality, but investors are likely unsure of the business given it’s relative uniqueness and newness. I believe a discount of 10.0X EBITDA properly reflects this uncertainty while conservatively leaves upside for future contracts, remembering that TH is not just limited to immigration projects in the future.
In aggregate, this Sum of the Parts (SOTP) estimates a $20-30 value of the shares (40-70% upside) with 20%+ multi-year IRR.
Related Risks and Mitigations: It’s very clear the economics of this contract are incredibly compelling, presenting the question of whether they are sustainable. Typically, classic economics dictates that “excess” profits are competed away as supply outpaces demand for lucrative business models, i.e) why wouldn’t other people rush in to build these facilities if they make so much money?
This question is definitely a salient one, the company was paid 194MM to enhance their center from 4000 to 6,400 beds, a project that cost them around 130-150MM. On top of this, TH earns, at a minimum, 196MM a year in revenue on ~70% margins, given they do not need to staff the location. Because they own the building, their only costs are occupancy related (cost of replacing the furniture, fixing any minor damages, and providing food, laundry, and other hospitality services). The business is infinitely scalable for this reason with a stable corporate cost base. The return on their investment is quite literally, infinite because they were paid to create something that generates incremental profitability.
However, this is not a typical “supply” and “demand” market. The government’s dealing with shelters (both temporary and permanent) have been very unstructured and inconsistent. The current network of permanent shelters is mostly comprised of small 50-100 bed locations within small municipalities, facilities that can house hundreds to thousands (3,000 for TH) are very rare, with the Pecos facility being the largest of its kind increasingly, the government is finding that the incredibly sparse network of 50-100 bed shelters is too time-consuming and hard to manage and that they prefer the large consolidated nature of the Pecos facility. Because this business is also funded and contracted solely by the government, it makes no sense for any group to prematurely develop and construct supply which would oversaturate the market. Putting the two together, the government is unlikely the ask for an expansion of existing facilities at this point, and in the future, will likely only issue bids for projects like TH’s facility. In that regard the majority of their permanent shelter “competitors” are non-profit organizations that ultimately deal with several humanitarian issues concurrently and lack any sort of expertise in construction, development, or food service. The TH and Endeavors partnership is unique in that TH is able to leverage it’s national scale of food purchasing, construction, hospitality service, and geographic expertise to create the lowest financial cost to the government while Endeavors is able to solely focus on the care of the children. If there are future bids to create more facilities, TH seems best poised to operate, as the government is also cautious to do business with people whom have no experience doing so.
With regards to the current contract, and the worries that it will be renewed under terms less favorable for TH, it seems far less likely. Not only has TH just announced they are likely going to extend the contract to a long-term 5+ year length, they heavily implied the economics of the contract will be the same or better. Because TH owns the building and the land, the government would have to displace every single person in the facility and contract to build a new one if they decided to not award the contract back to TH. Remember that this is a facility that the government paid TH to build but still does not own. This move would cost multiple times more than the 194MM they paid for TH for the initially construction. Any prospective competitor would then 1.) have to offer to pay for the construction and 2.) offer to take much less than the 196MM annual revenue currently offered to TH. Since there are no other competitors that have the same scale or capital as TH that have experience in the immigration and hospitality sector, this would not a financially attractive choice to make. Furthermore, with the current contract, the facility operates with a 1 for 1 ratio of non-profit employees and children, for up to a maximum of 6,400 individuals. This is obviously not easily replaceable or replicated.
Pictured below: My estimates of the cost of care per child per day at TH’s Pecos Facility versus other competitor’s based on public contract records. At 75% - 100% occupancy, I estimate TH’s cost of care is <30% cheaper on average - making it more economically sensible to initially allocate to from the government’s perspective.
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