**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-K**

 

**ANNUAL REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 
| **For  fiscal year ended December 31, 2003** |   | **Commission File Number 1-14472** |
|----------------------------------------------|--------|------------------------------------|

 

**CORNELL COMPANIES, INC.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                     |   | **76-0433642**                          |
|------------------------------------------------------------------|--------|-----------------------------------------|
| (State  or other jurisdiction  of incorporation or organization) |   | (I.R.S.  Employer   Identification No.) |
|                                                             |   |                                    |
| **1700 West Loop South, Suite 1500, Houston, Texas**             |   | **77027**                               |
| (Address  of Principal Executive Offices)                        |   | (Zip  Code)                             |
|                                                             |   |                                    |
| Registrant’s  telephone number, including area code:        |   | **(713) 623-0790**                      |

 

Securitiesregistered pursuant to Section 12(b) of the Act:

 

| **Title of  Each Class**                                                     |   | **Name of  Stock Exchange**                          |
|------------------------------------------------------------------------------|--------|------------------------------------------------------|
| **Common Stock, $.001 par value per share  Preferred Stock Purchase Rights** |   | **New York Stock Exchange  New York Stock Exchange** |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**NONE**

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý     No  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will be not contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. o.

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Exchange Act Rule12b-2).

 

Yes  ý     No  o

 

At February 27, 2004,Registrant had outstanding 13,198,012 shares of its common stock.  The aggregate market value of theRegistrant’s voting stock held by non-affiliates as of June 30, 2003 wasapproximately $193,517,588 based on the closing price of $15.14 per share asreported on the New York Stock Exchange.

 

DocumentsIncorporated by Reference

 

| Portions of the Proxy  Statement for 2004 Annual Meeting of Stockholders. |   |   | Part III |
|---------------------------------------------------------------------------|--------|--------|----------|

 

 

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**PART I**

 

#### **BUSINESS**

 

**Company Overview**

 

Cornell Companies, Inc.(the “Company”) is a leading provider of corrections, treatment and educationalservices outsourced by federal, state and local government agencies.  The Company provides a diversified portfolioof services for adults and juveniles through three operating divisions, whichare also its reportable segments: (1) adult secure institutional services; (2)residential and community-based juvenile justice, educational and treatmentservices; and (3) adult community-based corrections and treatment services. TheCompany is the successor of several entities that began offering services atvarious times.  The adult secure serviceline began in 1984, while the juvenile operations commenced in 1973. In 1974,the Company began to offer adult community-based corrections and behavioralhealth treatment services.

 

***The Company’s services includeincarceration and detention, transition from incarceration, drug and alcoholtreatment programs, behavioral rehabilitation and treatment, and grades 3-12education.  The Company currently has 66facilities operating in14 states and the District of Columbia. Additionally,the Company has four facilities currently under development orconstruction.  As of December 31, 2003,the Company’s total available facility service capacity was 16,514.  The Company’s facility service capacity iscomprised of the number of beds currently available for service or availableupon completion of construction or renovation of residential facilities and theaverage program capacity of non-residential community-based programs.***

 

***Additional information on the Companycan be found on its web site, www.cornellcompanies.com.  The Company makes available on its websiteand upon request free of charge its annual reports on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K and all amendments to thosereports as soon as reasonably practical after such material is electronicallyfiled with or furnished to the Securities and Exchange Commission (SEC).  Alternatively, reports filed with the SECmay be viewed or obtained at the SEC Public Reference Room in Washington, D.C.,or at the SEC’s web site, www.sec.gov.***

 

#### **The Private Adult and Juvenile Corrections and Treatment ServicesIndustry**

 

***Correctional, detention, treatmentand behavioral health services for both adults and juveniles are essentialgovernment services. In the United States, as the incarcerated and sentencedpopulations of both adults and juveniles continue to rise, and as federal,state and local governments face continuing pressures to control costs andimprove service quality, there is a growing trend toward outsourcing essentialgovernment services and functions.***

 

***Private correctional servicescompanies offer the same range of services that governments have historicallyprovided to house and care for the needs of adult offenders.  They include facility design, constructionmanagement, healthcare and food, security, transportation, education andrehabilitative programming. Governments engaging private companies typicallyreceive these services at a lower cost than the public authority couldprovide.  Although outsourcing hashistorically faced opposition in the U.S., public and government acceptance hasincreased as standards of service improve and cost-savings are documented.During the fiscal budget tightening of 2003, several studies including“Corrections Privatization Generates Savings and Better Service”, which wasconducted by the Rio Grande Foundation, indicated that private prisons not onlysave money for government entities, but also help contain cost increases ofstate departments that provided similar services.***

 

***Several states began evaluatingthe benefit of privatizing services that have been designated to treat thespecial needs and requirements of offender populations.  Some states, as well as the federalgovernment, have***

 

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***also identified other services forprivate management, such as geriatric and behavioral health offenderpopulations.***

*** ***

***Outsourcing has a longer historyin the juvenile justice educational and treatment services, and adultcommunity-based corrections sectors of the industry.  Increasing steadily over the past 50 years, states, counties andlocal governments have used both for-profit and not-for-profit organizations tomeet the needs of troubled youth and adults reintegrating into society after atime in residential treatment or prison.***

 

***Recently, governments have soughtalternatives to the ever-increasing cost of incarceration for offenders who arenon-violent and need treatment, education and rehabilitation.  Adult community-based reentry programs aswell as education, substance abuse and behavioral health programs that cansuccessfully divert an offender from prison are highly valued by thegovernment.***

 

#### **Demand for Adult Secure Institutional Services**

 

***During the past year, states haveseen available adult secure bed space rapidly decrease due in part to surgingincarcerated and sentenced populations, and states have not built new capacityto meet the system demand.  According tothe US Department of Justice, Bureau of Justice Statistics (BJS), the federalgovernment and many states continue to operate at or over capacity, and mostfacilities are outdated. In 2002, the nation’s prison population was up 2.6%,the largest growth rate in three years. As a result of the recent growth, many states are now facing severecorrections budget crises.  For example,Arizona called a special session to address corrections overcrowding issues inlate 2003.  Corrections will also beunder scrutiny in California, where the focus of state funding may shift toallow treatment and adult community-based corrections opportunities for privateproviders.***

 

The federal corrections system continues tooperate over-capacity.  The BJS reportsthe Federal Bureau of Prisons operated at 133.0% over capacity in 2002, thelast full year data is available.  Thefederal system continues to grow at high rates, becoming the largest prisonsystem during 2002. The federal budget states, “The Bureau of Prisons is one ofthe fastest-growing arms of the federal government.  In 1980, the bureau’s budget was $330.0 million, and there were24,000 offenders in 44 prisons. In 2002, the budget was $4.6 billion, and therewere 102 prisons.” Funding for the Federal Bureau of Prisons (BOP) has doubledin the past decade and now accounts for over 28.0% of the Department ofJustice’s total budget.

 

The solution proposed by thecurrent administration includes continuing its initiative to use the privatesector as a means of accommodating the growing federal system population.  Some years ago, the BOP committed tocontracting out bedspace for certain low/minimum-security offenders.  According to the BJS, at year end 2002private facilities house over 12.4% of federal offenders. Just 1.5 % of federaloffenders were housed in non-BOP facilities 20 years ago.  The BOP continues to contract bedspace foroffender populations, and their 2003 budget identifies the need for increasedreliance on those beds for low/minimum/special category offenders.

 

Due to these statistics,Company management continues to believe that targeted strategic developmentefforts offering solutions for overcrowded prison systems will offer long-termgrowth opportunities for the Company.

 

Private correctionsmanagement has grown at a compound annual growth rate of 17.0% since 1995 andadditional growth appears ahead. According to the BJS, the total number of prisoners under thejurisdiction of federal or state adult correctional authorities was 1,440,655at year-end 2002.  Overall, the UnitedStates incarcerated 2,166,260 persons at year-end 2002, including populationsheld in local jails and other facilities. During 2002, states added 30,088prisoners, and the federal prison system added 6,535 prisoners. Of theseoffenders, the BJS reports that privately operated facilities housed 93,771offenders (5.8% of state and 12.4% of federal offenders) and local jails housed71,256 state and federal offenders (4.9% of all prisoners).

 

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The American CorrectionalAssociation continues to report that the adult prison management industry(encompassing federal, state and local jails) spent over $50.0 billion in 2002to house its incarcerated population. Industry wide, jail expenditures areexpected to increase at least 8.0% annually for the next few years, which iscreating a growth opportunity for the Company in publicly run facilities thatcan benefit from the Company’s management.

 

**Demand for Juvenile Justice, Educational andTreatment Services**

 

The juvenile services industry,including detention, education and treatment is estimated to spend over $8billion in 2003 and consists of at least 108,000 secure residential anddetention beds.  The treatment andeducational components of the juvenile corrections industry are estimated to befar larger.  This market segment isfragmented, with several thousand providers across the country, most of whichare small and operate in a specific geographic area.  Many states have programs and services that are regularly put outfor competitive bids.  Generally,contract renewals for juvenile services are competitive, enabling the Companyto continue to vie for business in new markets.

 

The juvenile servicesindustry has expanded rapidly in recent years as the need for at-risk andadjudicated youth services has risen. The at-risk juvenile population is expected to increase to 46 million by2010, a 7.0% increase that will further test industry capacity.  According to the American CorrectionalAssociation’s Directory of Adult and Juvenile Correctional Departments,Institutions, Agencies and Probation and Parole Authorities, spending for theprovision of juvenile services has increased at a compound annual growth rateof almost 20.0% from 1993 to 2002.

 

**Demand for Adult Community-Based Correctionsand Treatment Services**

 

Expenditures in the adult community-basedcorrectional and treatment services industry were estimated at $4.0 billion in2002 and consist of approximately 50,000 residential beds.** **This market segment is extremely fragmented, with severalthousand providers across the country, most of which are small and operate in aspecified geographic area.

 

Similar to the adult secure institutional andthe juvenile services industries, the area of adult community-based correctionsand treatment services has experienced substantial growth.  This is not unexpected, since mostincarcerated individuals eventually pass into the community-based or paroleprograms subsequent to their secure incarceration.  Based on statistics currently available, since 1990 the number ofparolees increased from 531,407 to 753,141 as of December 31, 2002, a compoundannual growth rate of approximately 3.0%. During the same period, the number of individuals on probation increasedfrom approximately 2.7 million to 3.9 million, a compound annual growth rate ofapproximately 3.5%.  The probation andparole populations represent approximately 70.0% of the total number of adultsunder correctional supervision in the United States.

 

**Company Operations**

 

Pursuant to the terms of itsmanagement contracts, the Company is responsible for the overall operation ofits facilities, including staff recruitment, general facility administration,security and supervision of the offenders or clients, and building maintenance.  The Company also provides a variety ofrehabilitative and educational programs as prescribed by the contract.

 

The Company provides this diversifiedportfolio of essential services for adults and juveniles through threeoperating divisions: (1) adult secure institutional services; (2) residentialand community-based juvenile justice, educational and treatment services; and(3) adult community-based corrections and treatment services.

 

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***AdultSecure Institutional Services Division***

 

The Company’s adult secureinstitutional services division provides medium and low-security incarcerationservices.  This division ensures publicsafety through the operation of a secure environment.  Additionally, offenders are provided with a variety of programsand services geared toward a successful return to the community and asubsequent reduction in recidivism.

 

As of December 31, 2003, theCompany operated seven facilities with an aggregate service capacity of 5,917that provide secure services for incarcerated adults.  The services offered within the Company’s adult secureinstitutional services division include:

 

•      low to maximum securityincarceration;

•      integrated facilitydevelopment and operational services;

•      state-of-the-art correctionaltechnology, including electronic controls and surveillance equipment;

•      basic education, such aspreparation and testing for the high school general equivalency diploma (GED),English as a second language (ESL) classes, and Adult Basic Education (ABE);

•      medical, dental, vision,behavioral health and psychiatric services;

•      individual and groupcounseling;

•      substance abuse treatment,including detoxification, testing, counseling, 12-step programs and relapseprevention services;

•      life skills training,including proper hygiene, personal finance and parenting skills;

•      religious opportunities andculturally sensitive programs;

•      food services; and

•      recreational activities,such as exercise programs, hobby and craft, and leisure opportunities.

 

***Juvenile Justice, Educational and TreatmentServices Division***

 

TheCompany’s juvenile division provides residential, community-based, behavioralhealth and alternative education programs to youth, typically between the agesof 10 and 17.  Juvenile justice, educationaland treatment services consist primarily of specially-designed programs thatlead to rehabilitation while providing public safety and holding youthsaccountable for their decisions and behavior. In addition to the meaningful treatment options, the programs alsodevelop continuing care/after-care plans that help juveniles re-integrate backinto their home communities and reduce the likelihood of re-offending.

 

TheCompany operates its juvenile programs within a balanced and restorativejustice model.  The basic philosophy isthat merely serving time in an institution does not relieve juvenile offendersof the obligation to repay their victims and that incarceration alone does notcompensate for the societal impact of crimes. The use of a balanced approach gives equal emphasis to accountability,competency development and community protection.

 

TheCompany offers programs to meet the multiple needs of troubled juveniles.  At December 31, 2003, the Company operated23 residential facilities and 15 non-residential community-based programs withan aggregate service capacity of  4,336.

 

Inaddition, the Company operated the Leadership Academy A Challenge To Succeedprogram under the terms of a unique partnership with the Harrisburg SchoolDistrict in Dauphin County, Pennsylvania. “At-risk” students who have posed behavioral or other problems withinthe normal school environment are assigned to the Academy.  At the school, teachers from the schooldistrict provide curriculum instruction while a trained staff of counselors andadministrators provide truancy management, security and an array of socialservices that deal with the core issues causing the “at risk” status or poorbehavior.  These services, referred toby the Company as wrap services, often involve home visits and familycounseling.

 

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Theservices offered within the Company’s juvenile justice, educational andtreatment services division include:

 

•      diverse treatment settings,including those that are physically-secure, staff-secure and community-based;

•      specialized treatment forunique populations, including females, drug sellers, sex offenders, firesetters and families;

•      wilderness training programsand nationally accredited ropes course challenges;

•      individualized treatmentplanning and case management;

•      individual, group and familycounseling and therapy, cognitive behavior therapy and stress and angermanagement;

•      substance abuse treatmentand relapse prevention and education;

•      life skills training, suchas proper hygiene, personal finance and parenting skills;

•      mental health wrap programs;

•      accredited alternative andspecial education programs;

•      employment training andassistance;

•      medical, dental, behavioralhealth and psychiatric services; and

•      recreational activities,such as exercise programs, hobby and craft, and leisure opportunities.

 

***Adult Community-Based Corrections andTreatment Services Division***

 

TheCompany’s adult community-based corrections and treatment services divisionserves individuals who have been granted parole or sentenced to probation.  Probationers (individuals sentenced for anoffense without incarceration) and parolees (individuals released prior to thecompletion of their sentence) are typically placed in community-basedcorrectional settings.  Theseindividuals usually spend three to nine months in a community-basedcorrectional facility until they are prepared to re-enter society.

 

Theadult community-based corrections facilities provide an alternative to incarcerationand a focus on transitioning offenders from a correctional facility back intosociety.  Through a system of education,employment training, treatment, monitoring and accountability, residents aregiven the necessary tools to make positive life choices that can reduce theincidence of recidivism.  Programsinclude minimum-security residential settings, home confinement and dayreporting.

 

Asof December 31, 2003, the Company operated 14 adult community-based residentialfacilities and seven non-residential community-based programs with an aggregateservice capacity of 3,794.

 

Theservices offered within the Company’s adult community-based corrections andtreatment services division include:

 

•      minimum-security andstaff-secure residential services;

•      home confinement andelectronic monitoring;

•      employment training andassistance, such as preparing for, securing and maintaining employment;

•      education, includingpreparation and testing for the GED, ABE, computer courses, college-levelcourses and use of libraries;

•      vocational training, such asthe culinary arts and construction;

•      individual, group and familycounseling and therapy, cognitive behavior therapy and stress and angermanagement;

•      substance-abuse treatment,including detoxification, testing, counseling, 12-step programs and relapseprevention services; and

•      life skills training,including proper hygiene, securing appropriate housing, personal finance andparenting skills.

 

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**Marketing and Business Development**

 

The Company’s principalcustomers are federal, state and local government agencies responsible foradult and juvenile corrections, treatment and educational services.  During the past year, the Company hasrestructured its development efforts to run on parallel courses, in an effortto address the opportunities available in all of its service lines andpotential markets.  The Companycontinues to respond to Request for Proposals (RFPs), but has also positioneditself to develop sole source opportunities and pursue accretive acquisitions.

 

Government agenciesgenerally procure services from the private sector through a proposalprocess  which consists of severalsteps.  It begins with the issuance ofan RFP. Numerous companies can respond to the request by submitting aproposal.  The process concludes withthe agency awarding the contract, which commences the construction or operationof the facility.  In addition to costs,government agencies consider numerous other factors including bidders’experience and qualifications when awarding contracts.

 

If the Company believes theproject is consistent with its strategic business plan, the Company will submita written response to the RFP.  Whenresponding to RFPs, the Company incurs costs, typically ranging from $10,000 to$100,000 per proposal, to determine the prospective client’s distinct needs inorder to prepare a detailed response. In addition, the Company may incur substantial costs to acquire optionsto lease or purchase land for a proposed facility and engage outside consultingand legal expertise related to a particular RFP.  The preparation of a response usually requires five to 15weeks.  The award process usually takesan additional three to nine months.  Ifthe RFP is for managing or operating an existing facility, the Companygenerally begins operations within 30 days of the award’s receipt.  If new construction is required by thecontract, the Company’s operation of the facility would generally begin between18 and 36 months after the award is made.

 

When a contract requiresconstruction of a new facility, the Company’s success depends, in part, on itsability to acquire real property on desirable terms and in satisfactorylocations.  The Company anticipates thata large majority of new facilities will be constructed in rural areas.  To the extent that these locations are in ornear populous areas, management anticipates legal action and other forms ofopposition from local residents surrounding certain proposed sites.  The Company may incur significant expensesin responding to such opposition and there can be no assurance of success.  In addition, the Company may choose not tosubmit a proposal in response to an RFP or may withdraw a submitted proposal iflegal action or other forms of opposition are anticipated or encountered.

 

The Company pursues solesource opportunities in certain markets. The Company’s management meets withappropriate personnel from potential government agencies to best determine theagency’s distinct needs.  The Companymay also receive inquiries from or on behalf of government agencies that areconsidering privatization of certain facilities or that have already decided tocontract with private providers.  Whensuch an inquiry is received, the Company conducts a due diligence process todetermine if a need for its services truly exists and if the local community’slegal and political climate is conducive to privatization.  The Company then conducts an initial costanalysis to further determine project feasibility.

 

From time to time,management receives unsolicited opportunities for acquisitions.  The Company’s management is selective inthis area and focuses only on those opportunities that it believes will beaccretive to earnings and strategic in nature.

 

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#### **Contracts**

 

The Company’s facilityoperating contracts generally provide that the Company will be compensated atan occupant per diem rate, fees for treatment service, guaranteed take-or-payor cost-plus reimbursement.  Factors theCompany considers in determining billing rates include (1) the specifiedprograms provided for by the contract and the related staffing levels,(2) wage levels customary in the respective geographic area,(3) whether the proposed facility is to be leased or purchased, and(4) the anticipated average occupancy levels that the Company believescould reasonably be maintained. Compensation is invoiced in accordance with the applicable contract andis typically paid to the Company on a monthly basis.  Some of the Company’s juvenile education contracts provide forannual payments.

 

The Company pursues newcontracts that leverage its existing infrastructure and capabilities.  Although the majority of the Company’sopportunities are other than take-or-pay contracts, the Company tries to focuson guaranteed take-or-pay contracts. Take-or-pay contracts provide a fixed minimum revenue stream regardlessof occupancy, thereby adding increased stability to the Company’s revenuestream.  All of the other types ofcontracts produce revenue to the Company that varies with one or more of thenumber of individuals housed or served, the types of services provided and thefrequency of the service.  The Companyhas several projects in development without service contracts, or commitmentsfor service contracts, in effect. In each of these instances, the Company’sdevelopment department and the appropriate divisional management have performedtheir own assessment of the demand for the Company’s services within the marketfor the proposed project.

 

**Quality of Operations**

 

Independent accreditation by variousoversight and regulatory organizations is designed to show that a facilitymeets nationally accepted professional standards for quality operations, facilitydesign, management and maintenance. Accrediting entities include the AmericanCorrectional Association (ACA) for the adult secure institution and adultcommunity-based corrections sectors, and the Joint Commission on Accreditationof Healthcare Organizations (JCAHO), Departments of Public Welfare, Departmentsof Protective and Regulatory Services, and Departments of Human Services andEducation for the juvenile justice, educational and treatment services sector.

 

ACA standards are thenational benchmark for the effective operation of correctional facilitiesthroughout the United States.  Theyaddress services, programs and operations essential to safe and qualitycorrectional management, including administrative and fiscal controls, stafftraining and development, physical plant, safety and emergency procedures,sanitation, food service, and rules and discipline.  ACA accreditation is an important indicator of improvedconditions for adult prisons under court order.  It is the Company’s policy that all of its facilities’ dailyoperations be performed in accordance with ACA accreditation standards.  Accreditation and the standards of servicerequired thereby contribute to the public’s increased acceptance of the Companyand its provision of privatized correctional services.

 

Internal quality control,conducted by the Company’s senior facility staff and executive officers, takesthe form of periodic operational, programming and fiscal audits; facilityinspections; regular review of logs reports and files; and strict maintenanceof personnel standards, including an active training program.  Each of the Company’s facilities developsits own training plan that is reviewed, evaluated and updated annually.  All adult correctional officers undergo aminimum 40-hour orientation upon their hiring and receive academy-leveltraining amounting to 120 hours and on-the-job training of up to80 hours.  Each correctionalofficer also receives up to 40 hours of continuing training and educationannually.  All juvenile justice,educational and treatment employees undergo a minimum 80-hour orientation upontheir hiring and also receive up to 40 hours of continuing training andeducation annually.

 

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**Facilities**

 

As of December 31, 2003, theCompany operated 66 facilities and had four facilities that were underdevelopment, construction or renovation. These four facilities include the Moshannon Valley Correctional Center,the Southern Peaks Treatment Center, the New Mexico Regional CorrectionalCenter and the New Morgan Academy. Additionally, the Company is currently finalizing leases for the 82 bedPlankinton Regional Treatment Center and the 40 bed Plankinton RegionalDetention Center, both in South Dakota. Refer to “Management’s Discussion and Analysis of Financial Conditionand Results of Operations – Liquidity and Capital Resources – ContractualUncertainties Related to Certain Facilities” for a detailed discussionconcerning each of these facilities.  Inaddition to providing management services, the Company has been involved in thedevelopment, design and/or construction of many of its facilities.

 

Either through outrightownership or long-term leases, the Company controls operating facilitiesrepresenting a large majority of its revenues. Management believes that suchcontrol increases the likelihood of contract renewal, allows the Company toexpand existing facilities and thereby realize economies of scale and enchancesthe Company’s ability to win new contracts and control repair costs.  In addition, long-term control of itsoperating facilities allows the Company to better manage cost escalationpressures.

 

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The following tablesummarizes certain additional information with respect to the Company’sfacilities as of December 31, 2003.  Asindicated, the majority of the facilities to which the Company providesservices are either owned or leased under long-term leases.  Facilities that are leased are generallyunder terms ranging from one to 45 years.

 
| **Facility Name and Location**                                 |   | **Total  Service  Capacity (1)** |   | **Company  Initial  Contract  Date (2)** |   | **Owned/  Leased or  Managed (3)** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|------------------------------------------|--------|------------------------------------|--------|
|                                                           |   |                             |   |                                     |   |                               |   |
| ***Adult Secure  Institutional Facilities*:**                  |   |                             |   |                                     |   |                               |   |
|                                                           |   |                             |   |                                     |   |                               |   |
| Baker Community Correctional Center                            |   | 262                              |   | 1987                                     |   | Leased                             |   |
| Baker, California                                              |   |                             |   |                                     |   |                               |   |
| Big Spring Correctional Center                                 |   | 2,638                            |   | (4)                                      |   | Leased (5)                         |   |
| Big Spring, Texas                                              |   |                             |   |                                     |   |                               |   |
| D. Ray James Prison                                            |   | 1,555                            |   | 1998                                     |   | Leased (5)                         |   |
| Folkston, Georgia                                              |   |                             |   |                                     |   |                               |   |
| Donald W. Wyatt Detention Center                               |   | 302                              |   | 1992                                     |   | Managed                            |   |
| Central Falls, Rhode Island                                    |   |                             |   |                                     |   |                               |   |
| Great Plains Correctional Facility                             |   | 766                              |   | (6)                                      |   | Leased (5)                         |   |
| Hinton, Oklahoma                                               |   |                             |   |                                     |   |                               |   |
| Leo Chesney Community Correctional                             |   |                             |   |                                     |   |                               |   |
| Center                                                         |   | 200                              |   | 1988                                     |   | Leased                             |   |
| Live Oak, California                                           |   |                             |   |                                     |   |                               |   |
| Valencia County Detention Center                               |   | 194                              |   | 2000                                     |   | Managed                            |   |
| Los Lunas, New Mexico                                          |   |                             |   |                                     |   |                               |   |
|                                                           |   |                             |   |                                     |   |                               |   |
| ***Juvenile Justice,  Educational and Treatment Facilities:*** |   |                             |   |                                     |   |                               |   |
| ***Residential  Facilitie****s*                                |   |                             |   |                                     |   |                               |   |
|                                                           |   |                             |   |                                     |   |                               |   |
| Alexander Youth Services Center                                |   | 143                              |   | 2001                                     |   | Managed                            |   |
| Alexander, Arkansas                                            |   |                             |   |                                     |   |                               |   |
| Campbell Griffin Treatment Center                              |   | 124                              |   | 1996                                     |   | Leased (5)                         |   |
| San Antonio, Texas                                             |   |                             |   |                                     |   |                               |   |
| Contact                                                        |   | 51                               |   | (7)                                      |   | Owned                              |   |
| Wauconda, Illinois                                             |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas I                                              |   | 274                              |   | 1973                                     |   | Leased (5)                         |   |
| Marienville, Pennsylvania                                      |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas II                                             |   | 23                               |   | 1974                                     |   | Owned                              |   |
| Erie, Pennsylvania                                             |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas III                                            |   | 24                               |   | 1975                                     |   | Owned                              |   |
| Pittsburgh, Pennsylvania                                       |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas Center for Adolescent  Females                 |   | 108                              |   | 1989                                     |   | Owned                              |   |
| Pittsburgh, Pennsylvania                                       |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas of Ohio                                        |   | 108                              |   | 1993                                     |   | Leased (5)                         |   |
| Shelby, Ohio                                                   |   |                             |   |                                     |   |                               |   |
| Cornell Abraxas Youth Center                                   |   | 92                               |   | 1999                                     |   | Leased                             |   |
| South Mountain, Pennsylvania                                   |   |                             |   |                                     |   |                               |   |

 

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| **Facility Name and Location**                                 |   | **Total  Service  Capacity (1)** |   | **Initial  Contract  Date (2)** |   | **Company  Owned/  Leased or  Managed (3)** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|---------------------------------|--------|---------------------------------------------|--------|
|                                                           |   |                             |   |                            |   |                                        |   |
| Danville Center for Adolescent Females                         |   | 64                               |   | 1998                            |   | Managed                                     |   |
| Danville, Pennsylvania                                         |   |                             |   |                            |   |                                        |   |
| DuPage Adolescent Center                                       |   | 38                               |   | (7)                             |   | Owned                                       |   |
| Hinsdale, Illinois                                             |   |                             |   |                            |   |                                        |   |
| Erie Residential Behavioral Health Program                     |   | 16                               |   | 1999                            |   | Owned                                       |   |
| Erie, Pennsylvania                                             |   |                             |   |                            |   |                                        |   |
| Jos-Arz Academy                                                |   | 56                               |   | 2003                            |   | Leased                                      |   |
| Washington, D.C.                                               |   |                             |   |                            |   |                                        |   |
| Leadership Development Program                                 |   | 120                              |   | 1994                            |   | Leased                                      |   |
| South Mountain, Pennsylvania                                   |   |                             |   |                            |   |                                        |   |
| Maple Creek Home                                               |   | 8                                |   | (7)                             |   | Owned                                       |   |
| Matteson, Illinois                                             |   |                             |   |                            |   |                                        |   |
| Psychosocial Rehabilitation Unit                               |   | 13                               |   | 1994                            |   | Owned                                       |   |
| Erie, Pennsylvania                                             |   |                             |   |                            |   |                                        |   |
| Residential School                                             |   | 30                               |   | (7)                             |   | Owned                                       |   |
| Matteson, Illinois                                             |   |                             |   |                            |   |                                        |   |
| Salt Lake Valley Detention Center                              |   | 160                              |   | 1996                            |   | Managed                                     |   |
| Salt Lake City, Utah                                           |   |                             |   |                            |   |                                        |   |
| Santa Fe County Youth Development                              |   |                             |   |                            |   |                                        |   |
| Program (8)                                                    |   | 129                              |   | 1997                            |   | Managed                                     |   |
| Santa Fe, New Mexico                                           |   |                             |   |                            |   |                                        |   |
| Schaffner Youth Center                                         |   | 61                               |   | 2001                            |   | Managed                                     |   |
| Steelton, Pennsylvania                                         |   |                             |   |                            |   |                                        |   |
| South Mountain Secure Treatment Unit                           |   | 52                               |   | 1997                            |   | Managed                                     |   |
| South Mountain, Pennsylvania                                   |   |                             |   |                            |   |                                        |   |
| Texas Adolescent Treatment Center                              |   | 121                              |   | 2003                            |   | Leased                                      |   |
| San Antonio, Texas                                             |   |                             |   |                            |   |                                        |   |
| Woodridge                                                      |   | 156                              |   | (7)                             |   | Owned                                       |   |
| Woodridge, Illinois                                            |   |                             |   |                            |   |                                        |   |
|                                                           |   |                             |   |                            |   |                                        |   |
| ***Juvenile Justice,  Educational and Treatment Facilities:*** |   |                             |   |                            |   |                                        |   |
| ***Non-Residential  Facilitie****s*                            |   |                             |   |                            |   |                                        |   |
|                                                           |   |                             |   |                            |   |                                        |   |
| Adams Behavioral Health Services                               |   | 34                               |   | 1998                            |   | Leased                                      |   |
| Oxford, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Cornell Abraxas Parenting Academy                              |   | 36                               |   | 1999                            |   | Leased                                      |   |
| Harrisburg, Pennsylvania                                       |   |                             |   |                            |   |                                        |   |
| Cornell Abraxas Student Academy                                |   | 110                              |   | 1996                            |   | Leased                                      |   |
| Harrisburg, Pennsylvania                                       |   |                             |   |                            |   |                                        |   |

 

11

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| **Facility Name and Location**                                     |   | **Total  Service  Capacity (1)** |   | **Initial  Contract  Date (2)** |   | **Company  Owned/  Leased or  Managed (3)** |   |
|--------------------------------------------------------------------|--------|----------------------------------|--------|---------------------------------|--------|---------------------------------------------|--------|
|                                                               |   |                             |   |                            |   |                                        |   |
| Delaware Community-Based Programs                                  |   | 49                               |   | 1994                            |   | Leased                                      |   |
| Milford, Delaware                                                  |   |                             |   |                            |   |                                        |   |
| Erie Behavioral Health Services                                    |   | 36                               |   | 1997                            |   | Owned                                       |   |
| Erie, Pennsylvania                                                 |   |                             |   |                            |   |                                        |   |
| Harrisburg Community-Based Programs                                |   | 334                              |   | 1996                            |   | Leased                                      |   |
| Harrisburg, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Harrisburg Day Treatment                                           |   | 58                               |   | 1996                            |   | Leased                                      |   |
| Harrisburg, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Leadership Academy/ACTS Program                                    |   | 600                              |   | 2001                            |   | Managed                                     |   |
| Harrisburg, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Lehigh Valley Community-Based Programs                             |   | 53                               |   | 1992                            |   | Leased                                      |   |
| Lehigh Valley, Pennsylvania                                        |   |                             |   |                            |   |                                        |   |
| Lycoming/Clinton Behavioral Health Services                        |   | 30                               |   | 1998                            |   | Leased                                      |   |
| Williamsport, Pennsylvania                                         |   |                             |   |                            |   |                                        |   |
| Non-Residential Care - West                                        |   | 107                              |   | 1991                            |   | Leased                                      |   |
| Pittsburgh, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Non-Residential Detention/Non-Residential                          |   |                             |   |                            |   |                                        |   |
| Treatment                                                          |   | 91                               |   | 1999                            |   | Leased                                      |   |
| Harrisburg, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
| Philadelphia Community-Based Programs                              |   | 72                               |   | 1992                            |   | Owned                                       |   |
| Philadelphia, Pennsylvania                                         |   |                             |   |                            |   |                                        |   |
| Washington D.C. Community-Based Programs                           |   | 155                              |   | 1993                            |   | Leased                                      |   |
| District of Columbia                                               |   |                             |   |                            |   |                                        |   |
| WorkBridge                                                         |   | 600                              |   | 1994                            |   | Leased                                      |   |
| Pittsburgh, Pennsylvania                                           |   |                             |   |                            |   |                                        |   |
|                                                               |   |                             |   |                            |   |                                        |   |
| ***Adult  Community-Based Corrections and Treatment Facilities*:** |   |                             |   |                            |   |                                        |   |
| ***Residential  Facilities***                                      |   |                             |   |                            |   |                                        |   |
|                                                               |   |                             |   |                            |   |                                        |   |
| Cordova Center                                                     |   | 192                              |   | 1985                            |   | Leased (5)                                  |   |
| Anchorage, Alaska                                                  |   |                             |   |                            |   |                                        |   |
| Dallas County Judicial Treatment Center                            |   | 300                              |   | 1991                            |   | Managed                                     |   |
| Wilmer, Texas                                                      |   |                             |   |                            |   |                                        |   |
| El Monte Center                                                    |   | 55                               |   | 1993                            |   | Leased                                      |   |
| El Monte, California                                               |   |                             |   |                            |   |                                        |   |
| Leidel Comprehensive Sanction Center                               |   | 150                              |   | 1996                            |   | Leased (5)                                  |   |
| Houston, Texas                                                     |   |                             |   |                            |   |                                        |   |
| Marvin Gardens Center                                              |   | 52                               |   | 1981                            |   | Leased                                      |   |
| Los Angeles, California                                            |   |                             |   |                            |   |                                        |   |
| Midtown Center                                                     |   | 32                               |   | 1998                            |   | Owned                                       |   |
| Anchorage, Alaska                                                  |   |                             |   |                            |   |                                        |   |

 

12

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| **Facility Name and Location**                                     |   | **Total  Service  Capacity (1)** |     | **Initial  Contract  Date 2)** |     | **Company  Owned/  Leased or  Managed (3)** |     |
|--------------------------------------------------------------------|--------|----------------------------------|----------|--------------------------------|----------|---------------------------------------------|----------|
|                                                               |   |                             |     |                           |     |                                        |     |
| Northstar Center                                                   |   | 135                              |     | 1990                           |     | Leased                                      |     |
| Fairbanks, Alaska                                                  |   |                             |     |                           |     |                                        |     |
| Oakland Center                                                     |   | 61                               |     | 1981                           |     | Owned                                       |     |
| Oakland, California                                                |   |                             |     |                           |     |                                        |     |
| Parkview Center                                                    |   | 112                              |     | 1993                           |     | Leased (5)                                  |     |
| Anchorage, Alaska                                                  |   |                             |     |                           |     |                                        |     |
| Reid Community Residential Facility                                |   | 500                              |     | 1996                           |     | Leased (5)                                  |     |
| Houston, Texas                                                     |   |                             |     |                           |     |                                        |     |
| Salt Lake City Center                                              |   | 78                               |     | 1995                           |     | Leased                                      |     |
| Salt Lake City, Utah                                               |   |                             |     |                           |     |                                        |     |
| Seaside Center                                                     |   | 48                               |     | 1999                           |     | Leased                                      |     |
| Nome, Alaska                                                       |   |                             |     |                           |     |                                        |     |
| Taylor Street Center                                               |   | 177                              |     | 1984                           |     | Leased (9)                                  |     |
| San Francisco, California                                          |   |                             |     |                           |     |                                        |     |
| Tundra Center                                                      |   | 85                               |     | 1986                           |     | Leased (5)                                  |     |
| Bethel, Alaska                                                     |   |                             |     |                           |     |                                        |     |
|                                                               |   |                             |     |                           |     |                                        |     |
| ***Adult  Community-Based Corrections and Treatment Facilities*:** |   |                             |     |                           |     |                                        |     |
| ***Non-Residential Facilitie****s*                                 |   |                             |     |                           |     |                                        |     |
|                                                               |   |                             |     |                           |     |                                        |     |
| Dixon Correctional Center (10)                                     |   | 68                               |     | 2003                           |     | Managed                                     |     |
| Dixon, Illinois                                                    |   |                             |     |                           |     |                                        |     |
| East St. Louis                                                     |   | 80                               |     | (7)                            |     | Leased                                      |     |
| East St. Louis, Illinois                                           |   |                             |     |                           |     |                                        |     |
| LifeWorks                                                          |   | 156                              |     | (7)                            |     | Leased                                      |     |
| Joliet, Illinois                                                   |   |                             |     |                           |     |                                        |     |
| Northside Clinic                                                   |   | 254                              |     | (7)                            |     | Owned                                       |     |
| Chicago, Illinois                                                  |   |                             |     |                           |     |                                        |     |
| Santa Fe Electronic Monitoring Program (11)                        |   | 50                               |     | 1999                           |     | Leased                                      |     |
| Santa Fe, New Mexico                                               |   |                             |     |                           |     |                                        |     |
| Southwestern Illinois Correctional Center  (12)                    |   | 671                              |     | (7)                            |     | Managed                                     |     |
| East St. Louis, Illinois                                           |   |                             |     |                           |     |                                        |     |
| Southwood                                                          |   | 538                              |     | (7)                            |     | Owned                                       |     |
| Chicago, Illinois                                                  |   |                             |     |                           |     |                                        |     |
|                                                               |   |                             | * * |                           | * * |                                        | * * |
| ***Facilities Under  Development, Construction or Renovation***    |   |                             |     |                           |     |                                        |     |
|                                                               |   |                             | * * |                           | * * |                                        | * * |
| Moshannon Valley Correctional Center                               |   | 1,095                            |     | (13)                           |     | Leased (9)                                  |     |
| Philipsburg, Pennsylvania                                          |   |                             |     |                           |     |                                        |     |
| New Mexico Regional Correctional Center                            |   | 1,000                            |     | (14)                           |     | Leased                                      |     |
| Albuquerque, New Mexico                                            |   |                             |     |                           |     |                                        |     |
| New Morgan Academy                                                 |   | 214                              |     | (15)                           |     | Leased (9)                                  |     |
| New Morgan, Pennsylvania                                           |   |                             |     |                           |     |                                        |     |
| Southern Peaks Treatment Center                                    |   | 160                              |     | (16)                           |     | (16)                                        |     |
| Canon City, Colorado                                               |   |                             |     |                           |     |                                        |     |

 

13

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(1)       Total service capacity is comprised of the number of beds currentlyavailable for service or available upon the completion of construction orrenovation of residential facilities and the average program capacity of  non-residential community-based programs.  At certain facilities, the Company’scontracted capacity is lower than the facility’s service capacity.  The Company could increase a facility’scontracted capacity to service capacity by obtaining additional contracts or byrenegotiating existing its contracts. However, there is no guarantee that the Company will be able to obtaincontracts that provide occupancy levels at a facility’s service capacity orthat the Company’s current contracted capacities can be maintained in futureperiods.

(2)       Date from which the Company, or its predecessor, has had a contract forservices on an uninterrupted basis.

(3)       The Company does not incur any facility use costs, such as debtservice, rent or depreciation, for facilities that the Company has a managementcontract only.  The Company isresponsible for all other facility operating costs at these facilities.

(4)       The City of Big Spring entered into the Intergovernmental Agreementwith the BOP for an indefinite term (until modified or terminated) with respectto the Big Spring Correctional Center, which began operations during 1989.  The Big Spring Operating Agreement, asamended, has a term through 2047 including renewal options at the Company’sdiscretion, pursuant to which the Company manages the Big Spring CorrectionalCenter for the City of Big Spring.  Theportion of the Big Spring Operating Agreement relating to the Cedar Hill Unithas a term of 30 years with four five-year renewal options at the Company’sdiscretion.

(5)       Facility was sold on August 14, 2001 to Municipal Corrections Finance,L.P. (MCF) as part of the Company’s 2001 Sale and Leaseback Transaction asdiscussed in “Financial Statements and Supplementary Data - Note 11.”

(6)       The prison is operated pursuant to a one-year contract with nineone-year renewal options between the Oklahoma Department of Corrections and theHinton Economic Development Authority, or HEDA. HEDA in turn has subcontractedthe operations to the Company under a 30-year operating contract with fourfive-year renewals.

(7)       The Cornell Interventions programs/facilities contract with numerousagencies throughout Illinois.  Initialcontract dates vary by agency and range from 1974 to 1997.

(8)       The Company elected to terminate its operating contract for the SantaFe County Youth Development Program effective January 28, 2004.

(9)       Facility was financed with the Company’s synthetic lease financingarrangement under its amended 2000 Credit Facility. Refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources.”

(10)     The Company manages a 68 bed dual diagnosis program located within theSpecial Treatment Center within the state operated Dixon Correctional Center.

(11)     The Company elected to terminate its operating contract for the SantaFe Electronic Monitoring Program effective January 28, 2004.

(12)     The Company manages a therapeutic community drug and alcohol programwithin the state operated Southwestern Illinois Correctional Center.

(13)     The Company is in the process of negotiating with the BOP relative to MoshannonValley Correctional Center and is also engaged in efforts to secureconstruction financing.  Refer to“Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Liquidity and Capital Resources – Contractual UncertaintiesRelated to Certain Facilities” for a detailed discussion concerning thisfacility.

(14)     The Company leased the NewMexico Regional Correctional Center in January 2003 and is currently renovatingthe 1,000 bed facility which will be used to provide adult secure confinementservices.   As of December 31, 2003, theCompany did not have an operating contract for the facility but was indiscussions with various agencies that have demonstrated a need for the bedspace.  The Company estimates that itwill begin operating the first 500 beds of the facility in July 2004 and theremaining 500 beds in December 2004. Refer to “Management’s Discussion and Analysis of Financial Conditionand Results of Operations – Liquidity and Capital Resources – ContractualUncertainties Related to Certain Facilities” for a detailed discussionconcerning this facility.

(15)     The Company closed the New Morgan Academy in the fourth quarter of 2002and is currently considering several options ranging from the sale orlease of the facility to the utilization of the facility for another type ofprogram.  Refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Liquidity and Capital Resources – Contractual Uncertainties Related to CertainFacilities” for further discussion concerning this facility.

(16)     In June 2003, the Companyentered into an agreement with a developer to purchase a 160 bed juvenileresidential treatment center, named the Southern Peaks Treatment Center, uponcompletion of construction of the facility by the developer.  In August 2003, the Company fundedapproximately $12.9 million into an escrow account for the purchase price ofthe project.  Subsequently, the Companydiscovered that a portion of the funds in the escrow account had beenmisappropriated.  See “Item 3. LegalProceedings” and “Management’s Discussion and Analysis of Financial Conditionand Results of Operations — Recent Developments – Southern Peaks TreatmentCenter” for additional information.

 

14

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**Competition**

 

Since the Company’s servicesencompass several diverse markets, competition is viewed within marketsegments. Currently, a few large national operators characterize the adultsecure institutional services market.  Management believes its principal competitors in this market areCorrections Corporation of America, Inc., The Geo Group (formerly WackenhutCorrections Corporation) and Management and Training Corporation.  Although the adult community-basedcorrections and treatment and juvenile justice, educational and treatmentservices markets generally have a large number of smaller operators, some ofthe Company’s main competitors in the juvenile justice, educational andtreatment services market include Correctional Services Corporation, Inc.,Securicor New Century, Ramsay Youth Services and other smaller regionaloperators. The Company’s larger competitors in the adult community-basedcorrections and treatment services market include Bannum, Gateway, Salvation Army,Volunteers of America and other smaller regional operators.

 

**Employees**

 

At December 31, 2003, theCompany had 3,783 full-time employees and 258 part-time employees.  The Company employs management,administrative and clerical, security, educational and counseling services,health services and general maintenance personnel.  Approximately 1,003 employees at five of the Company’s facilitiesare represented by unions.

 

**Regulations**

 

The industry in which theCompany operates is subject to federal, state and local regulationsadministered by a variety of regulatory authorities.  Generally, prospective providers of correctional, detention,treatment and community-based services must comply with a variety of applicablefederal, state and local regulations, including education, healthcare andsafety regulations.  The Company’scontracts frequently include extensive reporting requirements and requiresupervision with on-site monitoring by representatives of contracting governmentalagencies.

 

In addition to regulationsrequiring certain contracting governmental agencies to enter into a competitivebidding procedure before awarding contracts, the laws of certain jurisdictionsmay also require the Company to award subcontracts on a competitive basis or tosubcontract with businesses owned by women or members of minority groups.

 

**BusinessConcentration**

 

For the years ended December31, 2003, 2002 and 2001, 21.7%, 20.9% and 20.2%, respectively, of the Company’sconsolidated revenues were derived from multiple contracts with the BOP.

 

**Insurance**

 

The Company maintains a $10million per occurrence per facility general liability insurance policy for allits operations.  The Company alsomaintains insurance in amounts management deems adequate to cover property andcasualty risks, workers’ compensation and directors’ and officers’ liability.

 

The Company’s contracts andthe statutes of certain states in which the Company operates typically requirethe maintenance of insurance by the Company. The Company’s contracts provide that, in the event the Company does notmaintain such insurance, the contracting agency may terminate its agreementwith the Company.  The Company believesthat it is in compliance in all material respects with these requirements.

 

15

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**ITEM 2.**** ****PROPERTIES**

 

The Company leases officespace for its corporate headquarters in Houston, Texas and regionaladministrative offices in Ventura, California, Pittsburgh, Pennsylvania andChicago, Illinois.  The Company alsoleases various facilities it is currently operating or developing.  For a listing of owned and leasedfacilities, see “Business - Facilities.”

 

**ITEM 3.**** ****LEGAL PROCEEDINGS**

 

**Southern Peaks Treatment Center**

 

In June 2003 the Company entered into an agreement to purchasea correctional facility to be built in Colorado – the Southern Peaks TreatmentCenter (the “Center”) – upon completion of its construction.  In lateAugust 2003, in connection with the transaction, the Company depositedapproximately $12.9 million of the purchase price (the “Funds”) into what itbelieved to be an escrow account to assure the developer’s construction lenderof the Company’s ability and willingness to purchase the Center uponcompletion.  After funding the account, and after repeated unsuccessfulattempts by the Company and its counsel to obtain confirmation of the wiretransfer and the interest accrued since the date of the wire transfer, theCompany was informed in early December 2003 that (1) the bank purportedlyserving as escrow agent claimed that its signature to the escrow agreement hadbeen forged and that the escrow agreement was not an obligation of the bank;(2) the Funds that were not held in an escrow account at the bank, but wereheld instead in one of the construction lender’s bank accounts; and (3) certainof the Funds had been released from such bank account prior to completion ofthe Center, in contravention of the terms of the escrow agreement.

 

The Company began an investigation to locate the Funds andto determine the circumstances that resulted in their misappropriation. In the process of trying to locate the Funds and establish a valid escrowarrangement, the construction lender and the developer of the Centerrepresented to the Company that the Funds were then being held in a bank inFlorida which had agreed to be the escrow agent under a new escrowagreement.  Subsequently, the bank in Florida confirmed to the Companythat an account had been established with deposits totaling $12.9 million andthat it was willing to serve as the escrow agent under a new escrowagreement.  After executing a new escrow agreement with the Florida bank,the Company learned that the available funds in the new escrow account totaledonly $5.0 million.  The Florida bank later advised the Company that theremaining $7.9 million of deposits in the new escrow account had been depositedin the form of a check drawn on a foreign bank account.  The foreigncheck, although deposited for collection, was never paid.

 

Accordingly, on January 5, 2004, the Company initiatedlegal proceedings in the lawsuit styled*Cornell Corrections of California, Inc. v. Longboat Global Advisors, LLC, etal.,*No.2004 CV79761**inthe Superior Court of Fulton County, Georgia under theories of fraud,conversion, breach of contract and other theories to determine the location ofand to recover the Funds.  The Company has obtained temporary restrainingorders freezing any and all financial accounts of the construction lender, oneof its principals and certain other defendants identified duringdiscovery.  The frozen accounts include one of the construction lender’sbank accounts which contains approximately $250,000.

 

Approximately $2.3 million ofthe funds have been expended on the project, which have been classified as constructionin progress at December 31, 2003.  Therecan be no assurances that any of the missing funds will be recovered.  Accordingly, based on current information,the Company currently believes its potential maximum exposure is approximately$5.4 million (which has been recognized as a loss and is included in generaland administrative expenses for the year ended December 31, 2003) plus anyattorneys’ fees and costs associated with its investigation and the legalproceedings discussed above.  The Company is unable at this time todetermine the ultimate outcome of this matter.

 

16

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**Shareholder Lawsuits**

 

In March and April 2002, theCompany, Steven W. Logan (the Company’s former President and Chief Executive Officer),and John L. Hendrix (the Company’s Chief Financial Officer), were named asdefendants in four federal putative class action lawsuits styled as follows:(1) *Graydon Williams, On Behalf of Himselfand All Others Similarly Situated v. Cornell Companies, Inc, et al.*,No. H-02-0866, in the United States District Court for the Southern District ofTexas, Houston Division; (2) *Richard Picard,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.*, No. H-02-1075, in the United States District Court forthe Southern District of Texas, Houston Division; (3) *Louis A. Daly, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1522, in the United States District Court for the Southern District ofTexas, Houston Division, and (4) *Anthony J.Scolaro, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1567, in the United StatesDistrict Court for the Southern District of Texas, Houston Division.  The aforementioned lawsuits were putativeclass action lawsuits brought on behalf of all purchasers of the Company’scommon stock between March 6, 2001 and March 5, 2002 and relate to theCompany’s restatement in 2002 of certain financial statements.  The lawsuits involved disclosures madeconcerning two prior transactions executed by the Company: the August 2001 saleleaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits were consolidated intothe *Graydon Williams* action andFlyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint was filed by FlylinePartners, LP.  Richard Picard andAnthony Scolaro were also named as plaintiffs. Since then, the court has allowed plaintiffs to file an amendedconsolidated complaint. The amended consolidated complaint alleges that thedefendants violated Section 10(b) of the Securities Exchange Act of 1934 (the“Exchange Act”), Rule 10b-5 promulgated under Section 10(b) of the ExchangeAct, Section 20(a) of the Exchange Act, Section 11 of the Securities Act of1933 (the “Securities Act”) and/or Section 15 of the Securities Act.  The amended consolidated complaint seeks,among other things, restitution damages, compensatory damages, rescission or arescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.  A motion to dismiss is currentlypending.

 

In March 2002, the Company,its directors, and its former independent auditor Arthur Andersen LLP, weresued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127thJudicial District Court of Harris County, Texas.  The lawsuit related to the Company’s restatement in 2002 ofcertain financial statements.  Thelawsuit alleged breaches of fiduciary duty by all of the individual defendantsand asserted breach of contract and professional negligence claims only againstArthur Andersen LLP.  This lawsuit hasbeen dismissed without prejudice by agreement.

 

In May and June 2002, theCompany and its directors were sued in three other derivative lawsuits styledas follows: (1) *Juan Guitierrez,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the Southern District ofTexas, Houston Division; (2) *Thomas Pagano,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.*,No. H-02-1896, in the United Stated District Court for the Southern District ofTexas, Houston Division; and (3) *JesseMenning, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits relate to the Company’s restatement in 2002 of certain financialstatements.  These lawsuits all allegebreaches of fiduciary duty and waste of corporate assets by all of thedefendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

17

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***The plaintiffsin these cases have not quantified their claim of damages and the outcome ofthe matters discussed above cannot be predicted with certainty.  However, the Company believes it has gooddefenses and intends to vigorously defend against the claims asserted in theseactions.  The Company has not recordedany loss accruals related to these claims as of December 31, 2003.***

 

On January 27, 2004,the  Company received a letter fromWilliam Williams, the plaintiff in the *WilliamWilliams* action discussed above, demanding that the Company pursuebreach of fiduciary duty claims against various officers and directors based onthe August 2001 sale leaseback transaction and the subsequent restatement.  The Company has issued a preliminaryresponse to the letter indicating that the Board will consider the request andinform Mr. Williams of its decision.

 

***Certaininsurance policies held by the Company to cover potential director and officerliability may limit the Company’s cash outflows in the event of a decisionadverse to the Company in the matters discussed above.  However, if an adverse decision in thesematters exceeds the insurance coverage or if the insurance coverage is deemednot to apply to these matters, an adverse decision to the Company in thesematters could have a material adverse effect on the Company, its financialcondition, its results of operations and its future prospects.***

 

**Securities and Exchange Commission Investigation**

 

***Following therestatement of the Company’s 2001 financial statements in 2002, the SECinitiated an investigation into the circumstances leading to thisrestatement.  Following the SEC’sinitial inquiry in 2002 the SEC made no further inquiry with respect to theinvestigation until July 2003.  SinceJuly 2003, the Company has received additional information requests from theSEC.  The Company has cooperated, andintends to continue to fully cooperate, with the SEC’s investigation.***

 

***Depending onthe scope, timing and result of the SEC investigation, management’s attentionand the Company’s resources could be diverted from operations, which couldadversely affect the Company’s operating results and contribute to future stockprice volatility.  The SEC investigationcould also require that the Company take other actions not currentlycontemplated.  In addition, the SECinvestigation or its outcome may increase the costs of defending or resolvingcurrent litigation.***

 

***The SEC has notgiven the Company any indication as to the outcome of its investigation.  If the SEC makes a determination adverse tothe Company, the Company and its officers and directors may face penalties,including, but not limited to, monetary fines and injunctive relief.  The Company has not recorded a loss accrualas of December 31, 2003 related to this matter.  In addition, in the event of an adverse determination by the SECagainst the Company or its officers or directors, federal and/or state agenciesmay be reluctant to enter into or prohibited from entering into contracts forthe Company’s services.  Any suchreaction from the Company’s customer base could have a material adverse effecton its business.***

*** ***

***Other***

*** ***

***Additionally,the Company currently and from time to time is subject to claims and suitsarising in the ordinary course of business, including claims for damages forpersonal injuries or for wrongful restriction of or interference with offenderprivileges and employment matters.  Theoutcome of such matters cannot be predicated with certainty, based on theinformation known to date, management believes that the ultimate resolution ofthese matters will not have a material adverse effect on the Company’sfinancial position, operating results or cash flow.***

 

18

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**ITEM 4.****          SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS**

 

No matters were submitted tothe Company’s stockholders’ during the fourth quarter of 2003.

 

**PART II**

 

**ITEM 5.****                            ****MARKET FOR CORNELLCOMPANIES, INC. COMMON STOCK AND RELATED STOCKHOLDER MATTERS**

 

The common stock of theCompany is currently listed on the New York Stock Exchange (“NYSE”) under thesymbol “CRN.”  As of February 27, 2004,there were 39 record holders and approximately 2,032 beneficial holders ofcommon stock.  The quarterly high andlow closing sales prices for the common stock from January 1, 2002 throughFebruary 27, 2004 are shown below.

 
|                                      |   | **High** |   | **Low** |   |
|-------------------------------------------|--------|----------|--------|---------|--------|
|                                      |   |     |   |    |   |
| 2002:                                     |   |     |   |    |   |
| First Quarter                             |   | $        | 18.21  |    | $      | 9.96 |   |
| Second Quarter                            |   | 13.00    |   | 9.63    |   |
| Third Quarter                             |   | 12.99    |   | 7.53    |   |
| Fourth Quarter                            |   | 9.45     |   | 5.50    |   |
| 2003:                                     |   |     |   |    |   |
| First Quarter                             |   | $        | 9.46   |    | $      | 6.55 |   |
| Second Quarter                            |   | 15.14    |   | 8.12    |   |
| Third Quarter                             |   | 16.98    |   | 14.80   |   |
| Fourth Quarter                            |   | 16.70    |   | 11.13   |   |
| 2004:                                     |   |     |   |    |   |
| First Quarter (through February 27, 2004) |   | 13.75    |   | 11.86   |   |

 

The Company has neverdeclared or paid cash dividends on its capital stock.  The Company currently intends to retain excess cash flow, if any,for use in the operation and expansion of its business and does not anticipatepaying cash dividends on the common stock in the foreseeable future.  The payment of dividends is within thediscretion of the Board of Directors and is dependent upon, among other factors,the Company’s results of operations, financial condition, capital requirements,restrictions, if any, imposed by financing commitments and legalrequirements.  The Company’s Amended andRestated Credit Agreement, dated as of July 21, 2000 (“2000 Credit Facility”),currently prohibits the payment of dividends. See “Management’s Discussion and Analysis of Financial Condition andResults of Operations — Liquidity and Capital Resources.”

 

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The following tablesummarizes as of December 31, 2003, certain information regarding equitycompensation to our employees, officers, directors, and other persons under theCompany’s plans:

 
| **Plan Category**                                           |   | **Number of  Securities to be  Issued upon  Exercise of Out-  standing Stock  Options and Warrants** |   | **Weighted-average  Exercise Price of  Outstanding  Stock Options  and Warrants** |   | **Number of  Securities Remaining  Available for  Future Issuance  Under Equity  Compensation  Plans (Excluding  Securities Reflected  in Column A)** |    |
|-------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   |                                                                                                 |   |                                                                              |   |                                                                                                                                                  |    |
| Equity compensation plans approved by security  holders     |   | 766,294                                                                                              |   | $                                                                                 | 10.33  |                                                                                                                                                  | 522,827 | (1) |
| Equity compensation plans not approved by  security holders |   | 438,262                                                                                              |   | $                                                                                 | 7.93   |                                                                                                                                                  | 213,472 | (2) |
| Total                                                       |   | 1,204,556                                                                                            |   | $                                                                                 | 9.45   |                                                                                                                                                  | 736,299 |   |

 

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(1)   Includes 61,161 shares issuable pursuant to theCompany’s Employee Stock Purchase Plan and 44,569 shares issuable pursuant tothe Company’s 2000 Director Stock Plan. Also includes 417,097 shares issuable pursuant to the Company’s Amendedand Restated 1996 Stock Option Plan. The total number of shares issuable pursuant to the Company’s Amendedand Restated 1996 Stock Option Plan is equal to the greater of 1,500,000 sharesor 15.0% of the number of shares issued and outstanding immediately after thegrant of any option under the Plan.

 

(2)   Includes 100,000 shares issuable pursuant to theCompany’s Deferred Compensation Plan and 113,472 shares issuable pursuant tothe Company’s 2000 Broad-Based Employee Plan. The number of shares issuable pursuant to the Company’s 2000 Broad-BasedPlan is equal to the greater of 400,000 shares or 4.0% of the shares issued andoutstanding immediately after the grant of any option under the Plan.

 

**EquityCompensation Plans Not Approved by Security Holders**

 

*Deferred Compensation Plan*

 

The Company maintains theCornell Companies, Inc. Deferred Compensation Plan for the purpose of providingdeferred compensation for eligible employees. The Deferred Compensation Plan is a nonqualified plan.

 

A participant in theDeferred Compensation Plan may defer into an account a percentage ofcompensation each year up to 75.0% of the participant’s compensation receivedfrom the Company.  In addition, theCompany may make contributions to the Deferred Compensation Plan on behalf ofeach participant.  Compensation deferredby a participant, or contributions made by the Company on behalf of aparticipant, will be invested in mutual funds and the common stock of theCompany.  Participants are 100.0%  vested in their accounts and may elect toreceive the amounts credited to their accounts either in a lump sum or in five orten-year annual installment payments. In the event of a change of control (as defined in the Plan), theamounts in each participant’s account will be paid to the participant in a lumpsum.

 

20

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*Warrants*

 

In conjunction with theissuance of the Subordinated Notes in July 2000, the Company issued warrants topurchase 290,370 shares of its common stock at an exercise price of $6.70.  The warrants may only be exercised bypayment of the exercise price in cash to the Company, by cancellation of anamount of warrants equal to the fair market value of the exercise price, or bythe cancellation of Company indebtedness owed to the warrant holder.  During 2001, 168,292 shares of common stockwere issued in conjunction with the exercise and cancellation of 217,778warrants; therefore 72,592, warrants remain outstanding at December 31, 2003.

 

*2000 Broad-Based Employee Plan*

 

In December 2000, theCompany adopted the 2000 Broad-Based Employee Plan (the “2000 Plan”).  Pursuant to the 2000 Plan, the Company maygrant non-qualified stock options to its employees, directors and eligibleconsultants for up to the greater of 400,000 shares or 4.0% of the aggregatenumber of shares of common stock issued and outstanding immediately after thegrant of any option under the 2000 Plan. The 2000 Plan options vest over a period of up to five years and expireten years from the grant date.  Thevesting schedule and term are set by the Compensation Committee of the Board ofDirectors.  The exercise price ofoptions issued pursuant to the 2000 Plan can be no less than the market priceof the Company’s common stock on the date of grant.

 

Upon notice of anExtraordinary Transaction (as defined in the 2000 Plan), options granted underthe 2000 Plan shall become fully vested. Upon consummation of the Extraordinary Transaction, such options, to theextent not previously exercised, shall terminate.

 

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**ITEM 6.****     ****SELECTED CONSOLIDATEDFINANCIAL DATA**

 

The following data has beenderived from audited financial statements, including those included in thisForm 10-K for the year ended December 31, 2003 and should be read inconjunction with the Company’s consolidated financial statements and Notesthereto and “Management’s Discussion and Analysis of Financial Condition andResults of Operations” included elsewhere in this report.

 

The consolidated financialstatements for the years ended December 31, 1999 through 2001 were  audited by Arthur Andersen LLP (“Andersen”)who has ceased operations.  A copy ofthe report previously issued by Andersen on the Company’s financial statementsas of December 31, 2001 and 2000 and for each of the three years in the periodended December 31, 2001 is included elsewhere in this Form 10-K.  Such report has not been reissued byAndersen.

 
|                                                                                                      |                                                                 | **Year Ended December 31,**               |    |
|-----------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------|-------------------------------------------|---------|
|                                                                                                      |                                                                 | **2003 (1)**                              |    | **2002** |   | **2001 (2)** |   | **2000** |   | **1999 (3)** |   |
|                                                                                                      |                                                                 | **(in thousands, except per share data)** |    |
| **Statements of Operations Data:**                                                                        |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
| Revenues                                                                                                  |                                                                 | $                                         | 271,632 |   | $ | 275,145 |   | $ | 265,250 |   | $ | 226,050 |   | $ | 176,967 |   |
| Income from operations                                                                                    |                                                                 | 24,384                                    |    | 31,577 |   | 31,018 |   | 29,653 |   | 22,249 |   |
| Income before provision for income taxes and cumulative effect of  changes in accounting principles       |                                                                 | 6,730                                     |    | 12,279 |   | 6,847 |   | 13,507 |   | 13,844 |   |
| Income before cumulative effect of changes in accounting principles                                       |                                                                 | 3,970                                     |    | 7,327 |   | 3,889 |   | 7,969 |   | 8,306 |   |
| Cumulative effect of changes in accounting principles, net of related  income tax provision (benefit) (4) |                                                                 | —                                    |    | (965 | ) | 770 |   | — |   | (2,954 | ) |
|                                                                                                      |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
| Net income                                                                                                |                                                                 | $                                         | 3,970   |   | $ | 6,362 |   | $ | 4,659 |   | $ | 7,969 |   | $ | 5,352 |   |
|                                                                                                      |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
| Earnings per share:                                                                                       |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
| -                                                                                                         | Basic                                                                |                                      |    |   |   |   |   |   |   |   |   |   |
|                                                                                                      | Income before cumulative effect of changes in accounting principles  |                                      | $       | .31 |   | $ | .57 |   | $ | .40 |   | $ | .85 |   | $ | .88 |   |
|                                                                                                      | Cumulative effect of changes in accounting principles (4)            |                                      | $       | — |   | $ | (.08 | ) | $ | .08 |   | $ | — |   | $ | (.31 | ) |
|                                                                                                      | Net income                                                           |                                      | $       | .31 |   | $ | .49 |   | $ | .48 |   | $ | .85 |   | $ | .57 |   |
|                                                                                                      |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
| -                                                                                                         | Diluted                                                              |                                      |    |   |   |   |   |   |   |   |   |   |
|                                                                                                      | Income before cumulative effect of changes  in accounting principles |                                      | $       | .30 |   | $ | .55 |   | $ | .39 |   | $ | .84 |   | $ | .86 |   |
|                                                                                                      | Cumulative  effect of changes in accounting principles (4)           |                                      | $       | — |   | $ | (.07 | ) | $ | .07 |   | $ | — |   | $ | (.31 | ) |
|                                                                                                      | Net income                                                           |                                      | $       | .30 |   | $ | .48 |   | $ | .46 |   | $ | .84 |   | $ | .55 |   |
|                                                                                                      |                                                                 |                                      |    |   |   |   |   |   |   |   |   |   |
| Number of shares used to compute EPS:                                                                     |                                                                 |                                      |    |   |   |   |   |   |   |   |   |
|                                                                                                      | -  Basic                                                        |                                      | 12,941  |   | 12,911 |   | 9,616 |   | 9,383 |   | 9,432 |   |
|                                                                                                      | -  Diluted                                                      |                                      | 13,263  |   | 13,232 |   | 10,069 |   | 9,495 |   | 9,660 |   |
|                                                                                                           |                                                                      |                                           |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

22

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|                                                                      |   | **Year Ended December 31,**                       |   |
|---------------------------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                                      |   | **2003**                                          |   | **2002** |   | **2001** |   | **2000** |   | **1999(3)** |   |
|                                                                      |   | **(dollars in thousands, except per share data)** |   |
| **Operating Data:**                                                       |   |                                              |   |   |   |   |   |   |   |   |   |
| Total service capacity (5):                                               |   |                                              |   |   |   |   |   |   |   |   |   |
| Residential                                                               |   | 12,378                                            |   | 11,267 |   | 11,267 |   | 11,318 | (6) | 11,796 |   |
| Non-residential community-based                                           |   | 4,136                                             |   | 4,177 |   | 4,177 |   | 3,046 |   | 3,049 |   |
| Total                                                                     |   | 16,514                                            |   | 15,444 |   | 15,444 |   | 14,364 | (6) | 14,845 |   |
| Service capacity in operation (end of period)                             |   | 14,045                                            |   | 14,135 |   | 14,349 |   | 13,269 |   | 12,240 |   |
| Contracted beds in operation (end of period) (7)                          |   | 9,566                                             |   | 9,289 |   | 9,503 |   | 10,061 |   | 9,029 |   |
| Average contract occupancy based on contracted beds in operation (7)  (8) |   | 100.1                                             | %      | 98.7 | % | 95.9 | % | 94.3 | % | 95.8 | % |
| Average contract occupancy excluding start-up operations (7)              |   | 100.5                                             | %      | 98.7 | % | 96.3 | % | 96.0 | % | 97.0 | % |
|                                                                      |   |                                              |   |   |   |   |   |   |   |   |   |
| **Balance Sheet Data:**                                                   |   |                                              |   |   |   |   |   |   |   |   |   |
| Working capital (deficit)                                                 |   | $                                                 | 86,214 |   | $ | 95,988 |   | $ | 97,814 |   | $ | 29,703 |   | $ | (12,636 | ) |
| Total assets                                                              |   | 448,157                                           |   | 441,291 |   | 444,807 |   | 336,850 |   | 273,991 |   |
| Long-term debt, net of current portion                                    |   | 227,292                                           |   | 232,258 |   | 238,768 |   | 191,722 |   | 101,500 |   |
| Stockholders’ equity                                                 |   | 166,235                                           |   | 159,952 |   | 153,104 |   | 104,320 |   | 97,208 |   |
|                                                                           |        |                                                   |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Notes toSelected Consolidated Financial Data**

 

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(1)   Income from operations for theyear ended December 31, 2003 includes a charge of approximately $5.4 million toprovide an allowance for an unrecovered escrow deposit.  Refer to Item 3. “Legal Proceedings –Southern Peaks Treatment Center” and Item 7. “Managements Discussion andAnalysis of Financial Condition and Results of Operations – Significant 2003Events” for a detailed discussion concerning this charge.

(2)   The Company adopted theprovisions of Statement of Financial Accounting Standard (SFAS) No. 145 asrequired on January 1, 2003.  Inaccordance with the provisions of SFAS No. 145, the Company recorded anextraordinary charge of approximately $2.9 million, net of income taxes ofapproximately $2.0 million, in 2001 for the early retirement of debt.  As a result of the adoption of theprovisions of SFAS No. 145, the Company reclassified total costs of approximately$4.9 million to loss on extinguishment of debt and the related income taxbenefit of approximately $2.0 million to provision for income taxes.  This reclassification is reflected in the2001 amounts presented in this table.

(3)   Includesthe operations of Interventions-Illinois acquired in November 1999.

(4)   For the year ended December 31, 2002, the Company recognized acumulative effect of a change in accounting principle charge of approximately$1.0 million, net of income taxes of approximately $0.7 million, related to theimpairment of goodwill in connection with the adoption of SFAS No. 142 inJanuary 2002.  For the year endedDecember 31, 2001, the Company recognized a cumulative effect of a change inaccounting principle benefit of approximately $770,000, net of an income taxprovision of approximately $535,000, related to a change in the Company’smethod of accounting for durable supplies. For the year ended December 31, 1999, the Company recognized acumulative effect of a change in accounting principle charge of approximately $3.0million, net of income taxes of approximately $2.0 million, in connection withthe adoption of the American Institute of Certified Public AccountantsStatement of Position 98-5 (SOP 98-5) which required entities to expensestart-up costs as incurred and to expense previously capitalized start-up costsas cumulative effect of a change in accounting principle.

(5)   The Company’s service capacity is comprised of the number of bedscurrently available for service or available upon the completion of constructionor renovation of residential facilities and the average program capacity ofnon-residential community-based programs. At certain facilities, the Company’s contracted capacity is lowerthan the facility’s service capacity. The Company could increase a facility’s contracted capacity to servicecapacity by obtaining additional contracts or by renegotiating its existingcontracts.  However, there is noguarantee that the Company will be able to obtain contracts that provideoccupancy levels at a facility’s service capacity or that the Company’s currentcontracted capacities can be maintained in future periods.

(6)   The Utah Department of Corrections (Utah DOC) selected the Company’sbid in June 1999 for the 490 bed Timpie 

 

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Valley Correctional Facilitysubject to final contract negotiations. In 2000, the Utah DOC declined to pursue this project; therefore theCompany’s service capacity was reduced accordingly.

(7)   Occupancy percentages are calculated based on actual occupancyfor the period as a percentage of the contracted capacity for residentialfacilities in operation.  Thesepercentages do not reflect the operations of non-residential community-basedprograms.  At certain facilities, theCompany’s contracted capacity is lower than the facility’s service capacity.Additionally, certain facilities have and are currently operating above theCompany’s contracted capacity.  As aresult, average contract occupancy percentages can exceed 100% if the average actualoccupancy exceeded contracted capacity. The average contract occupancy percentages reflected in the table wouldbe lower if the percentages were calculated based on average actual occupancyfor the period as a percentage of service capacity rather than contractedcapacity.

(8)   Occupancy percentages reflect less than normalized occupancy during thestart-up phase of any applicable facility, resulting in a lower averageoccupancy in periods when the Company has substantial start-up activities.

 

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**ITEM 7.**          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION

**AND RESULTS OF OPERATIONS**

 

**General**

 

The Company is a leadingprovider of correctional, treatment and educational services outsourced byfederal, state and local government agencies. The Company provides a diversified portfolio of services for adults andjuveniles through its three operating divisions: (1) adult secure institutionalservices; (2) juvenile justice, educational and treatment services and (3)adult community-based corrections and treatment services.  At December 31, 2003, the Company operated66 facilities with a total service capacity of 14,045 and had fourfacilities under development, construction or renovation with an aggregate servicecapacity of 2,469 upon completion.  The Company’s facilities are located in 14states and the District of Columbia.

 

Thefollowing table sets forth for the periods indicated total service capacity,the service capacity and contracted beds in operation at the end of the periodsshown and average occupancy percentages.

 
|                                                                    |   | **Year Ended December 31,** |   |
|-------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                    |   | **2003**                    |   | **2002** |   | **2001** |   |
| Total service capacity (1):                                             |   |                        |   |   |   |   |   |
| Residential                                                             |   | 12,378                      |   | 11,267 |   | 11,267 |   |
| Non-residential community-based                                         |   | 4,136                       |   | 4,177 |   | 4,177 |   |
| Total                                                                   |   | 16,514                      |   | 15,444 |   | 15,444 |   |
| Service capacity in operation (end of period)                           |   | 14,045                      |   | 14,135 |   | 14,349 |   |
| Contracted beds in operation (end of period) (2)                        |   | 9,566                       |   | 9,289 |   | 9,503 |   |
| Average contract occupancy based on contracted beds in operation (2)(3) |   | 100.1                       | %      | 98.7 | % | 95.9 | % |
| Average contract occupancy excluding start-up operations (2)            |   | 100.5                       | %      | 98.7 | % | 96.3 | % |

 

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(1)   The Company’s service capacity is comprised of the number of bedscurrently available for service or available upon the completion of constructionor renovation of residential facilities and the average program capacity ofnon-residential community-based programs. At certain facilities, the Company’s contracted capacity is lowerthan the facility’s service capacity. The Company could increase a facility’s contracted capacity to servicecapacity by obtaining additional contracts or by renegotiating existingcontracts.  However, there is noguarantee that the Company will be able to obtain contracts that provideoccupancy levels at a facility’s service capacity or that the Company’s currentcontracted capacities can be maintained in future periods.

(2)   Occupancy percentages are calculated based on actual occupancyfor the period as a percentage of the contracted capacity for residential facilitiesin operation.  These percentages do notreflect the operations of non-residential community-based programs.  At certain facilities, the Company’scontracted capacity is lower than the facility’s service capacity.  Additionally, certain facilities have andare currently operating above the Company’s contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.  The average contractoccupancy percentages reflected in the table would be lower if the percentageswere calculated based on average actual occupancy for the period as apercentage of service capacity rather than contracted capacity.

(3)   Occupancy percentages reflect less than normalized occupancy during thestart-up phase of any applicable facility, resulting in a lower averageoccupancy in periods when the Company has substantial start-up activities.

 

The Company derivessubstantially all its revenues from providing adult corrections and treatmentand juvenile justice, educational and treatment services outsourced by federal,state and local government agencies in the United States.  Revenues for the Company’s services aregenerally recognized on a per diem rate based upon the number of occupant daysor hours served for the period, on a guaranteed take-or-pay basis or on acost-plus reimbursement basis.  For the year ended December 31, 2003 the Company’s revenue baseconsisted of 72.0% for services provided under per-diem contracts, 9.5% forservices provided under take-or-pay and management contracts, 9.8% for servicesprovided under cost-plus reimbursement contracts, 6.7% for services providedunder fee-for-service contracts and 1.9% from other miscellaneous sources.  These percentages are 

 

25

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generally consistent with comparable statistics for the years endedDecember 31, 2002 and 2001.  Revenues can fluctuate from year to year dueto changes in government funding policies, changes in the number of clients referredto the Company’s facilities by governmental agencies, the opening of newfacilities or the expansion of existing facilities and the termination ofcontracts for a facility or the closure of a facility.

 

Revenues forthe Company’s adult secure institutional services division are primarilygenerated from per-diem, take-or-pay and management contracts.  For the years ended December 31, 2001, 2002and 2003, the Company realized average per diem rates on its adult secureinstitutional facilities of approximately $46.36, $48.21 and $47.79,respectively.  The decrease in theaverage per diem rate in 2003 as compared to 2002 is attributable to areduction in the per diem rate at a large facility in the second half of 2003as requested by the contracting agency (the Company mitigated a portion of thisrate reduction by negotiating reductions in the level of serviceprovided).  In the past year, theCompany has experienced increasing pressure from contracting governmentalagencies to limit or even reduce per diem rates.  Many of these governmental entities are under severe budgetpressures and the Company anticipates that more governmental agencies mayapproach the Company about per diem rate concessions.  The Company has implemented measures in hopes of protecting theCompany from rate decreases and assuring itself of attaining rate increasesnecessary to offset cost increases.

 

Factors the Companyconsiders in determining billing rates to charge include (1) the programsspecified by the contract and the related staffing levels, (2) wage levelscustomary in the respective geographic areas, (3) whether the proposed facilityis to be leased or purchased and (4) the anticipated average occupancy levelsthat the Company believes could reasonably be maintained.

 

Revenues forthe Company’s juvenile justice, educational and treatment services division areprimarily generated from per diem, fee-for-service and cost-plus reimbursementcontracts.  For the years ended December31, 2001, 2002 and 2003, the Company realized average per diem rates on itsresidential juvenile justice, educational and treatment facilities ofapproximately $173.49, $170.98 and $164.89, respectively.  The decrease in the average per diem ratefor 2003 as compared to 2002 is primarily attributable to the closure of theNew Morgan Academy in the fourth quarter of 2002.  For the years ended December 31, 2001, 2002 and 2003, the Companyrealized average rates for its non-residential community-based juvenile facilities/programs,including rates that are limited by Medicaid and other private insuranceproviders, of approximately $26.19, $28.82 and $28.19, respectively.  The decrease in the average rate for 2003 ascompared to 2002 is due to changes in the mix of the services provided by theCompany’s various juvenile justice, educational and treatment programs andfacilities.  Additionally, the Companydid not receive per diem rate increases for its juvenile programs inPennsylvania in 2003. The Company expects to receive per diem rate increasesfor these programs in 2004.  Themajority of the Company’s juvenile services contracts renew annually.

 

Revenues forthe Company’s adult community-based corrections and treatment services divisionare primarily generated from per diem contracts and fee-for-service contracts.  For the years ended December 31, 2001, 2002and 2003, the Company realized average per diem rates on its residential adultcorrections and treatment facilities of approximately $62.68, $58.72 and$58.69, respectively.  The decrease inthe average per diem rate for 2003 as compared to 2002 is due to thetermination of the Santa Barbara Center contract in May 2003 and the InglewoodMen’s Center contract in June 2003. Additionally the Company experienced slight rate reductions at certainof its Alaskan facilities resulting from contract renewals in 2003.  For the years ended December 31, 2001, 2002and 2003, the Company realized average fee-for service rates on itsnon-residential adult community-based corrections and treatment facilities andprograms of approximately $7.95, $8.97 and $9.67, respectively.  The increase in the average rate for 2003 ascompared to 2002 is due to changes in the mix of the services provided by theCompany’s various adult community-based programs and facilities.

 

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The Company has historicallyexperienced higher operating margins in its adult secure institutional servicesand adult community-based corrections and treatment services as compared to thejuvenile justice, educational and treatment services division.  Additionally, the Company’s operatingmargins within a division can vary from facility to facility based on whether afacility is owned or leased, the level of competition for the contract award,the proposed length of the contract, the occupancy levels for a facility, thelevel of capital commitment required with respect to a facility, theanticipated changes in operating costs over the term of the contract, and theCompany’s ability to increase a facility’s contract revenue.  A decline in occupancy of certain juvenilejustice, educational and treatment facilities can have a more significantimpact on operating results than the adult secure institutional servicesdivision due to higher per diem revenues at certain juvenile facilities.  The Company has experienced and expects tocontinue to experience interim period operating margin fluctuations due to thenumber of calendar days in the period, higher payroll taxes in the first halfof the year, and salary and wage increases and insurance cost increases thatare incurred prior to certain contract rate increases.  Additionally, a decrease in per diemrates could adversely affect the Company’s operating margin.

 

The Company is responsiblefor all facility operating costs, except for certain debt service and interestor lease payments for facilities where the Company has a management contractonly.  For facilities that theCompany has a management contract only, the facility owner is responsible forall debt service and interest or lease payments related to the facility.  The Company is responsible for all otheroperating expenses at these facilities. The Company operated 13 facilitiesunder management contracts at December 31, 2001 and December 31, 2002 and 10facilities at December 31, 2003.

 

A majority of the Company’sfacility operating costs consists of fixed costs.  These fixed costs include lease and rental expense, insurance,utilities and depreciation.  As a result,when the Company commences operation of new or expanded facilities, fixedoperating costs increase.  The amount ofthe Company’s variable operating costs, including food, medical services,supplies and clothing, depend on occupancy levels at the facilities operated bythe Company.  The Company’s largest singleoperating cost, facility payroll expense and related employment taxes andcosts, has both a fixed and a variable component.  The Company can adjust a facility’s staffing levels and therelated payroll expense to a certain extent based on occupancy at a facility,however a minimum fixed number of employees is required to operate and maintainany facility regardless of occupancy levels. Personnel costs are subject to increases in tightening labor marketsbased on local economic and other conditions.

 

TheCompany incurs pre-opening and start-up expenses including payroll, benefits,training and other operating costs prior to opening a new or expanded facilityand during the period of operation while occupancy is ramping up.  These costs vary by contract.  Since pre-opening and start-up costs aregenerally factored into the revenue per diem rate that is charged to thecontracting agency, the Company typically expects to recover these upfrontcosts over the life of the contract. Because occupancy rates during a facility’s start-up phase typicallyresult in capacity under-utilization for at least 90 to 180 days, the Companymay incur additional post-opening start-up costs.  The Company does not anticipate post-opening start-up costs atfacilities operated under any future contracts with the BOP because thesecontracts are currently and expected to continue to be take-or-pay contracts,meaning that the BOP will pay the Company at least 95.0% of the contractualmonthly revenue once the facility opens regardless of actual occupancy.

 

Newly opened facilities arestaffed according to applicable regulatory or contractual requirements when theCompany begins receiving offenders or clients. Offenders or clients are typically assigned to a newly opened facilityon a phased-in basis over a one- to six-month period.  The Company’s start-up period for new juvenile operationsis 12 months from the date the Company begins recognizing revenue unlessbreak-even occupancy levels are achieved before then.  The Company’s start-up period for new adult operations is ninemonths from the date the Company begins recognizing revenue unless break-evenoccupancy levels are achieved before then. Although the Companytypically recovers these upfront costs over the life of the contract, quarterlyresults can 

 

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besubstantially affected by the timing of the commencement of operations as wellas the development and construction of new facilities.

 

Working capital requirementsgenerally increase immediately prior to the Company’s commencing

management of a new or expanded facility asthe Company incurs start-up costs and purchases necessary equipment andsupplies before facility management revenue is realized.

 

General and administrativeexpenses consist primarily of costs for the Company’s corporate andadministrative personnel who provide senior management, legal, finance,accounting, human resources, payroll and information systems, costs of businessdevelopment and outside professional and consulting fees.

 

# **Management Overview**

 

***Demand*.**  The Company’s business is driven generallyby demand for incarceration or treatment services, and specifically by demandfor private incarceration or treatment services, within its three primarybusiness segments: adult secure institutional services; juvenile justice,educational and treatment services; and adult community-based corrections andtreatment services.  The demand foradult and juvenile corrections and treatment services has generally increasedat a steady rate over the past ten years, largely as a result of increasinglylong sentences and/or mandatory sentences for criminals, increasing demand forincarceration of illegal aliens and a public recognition of the need to provideservices to juveniles that will improve the possibility that they will leadproductive lives.  Recent suggestions bysocial commentators and various political or governmental representativessuggest that community-based corrections of adults may be emphasized in thefuture as alternatives to traditional incarceration.  Among other things, the Company’s management monitors federal,state and industry statistics relative to trends in prison populations,juvenile justice statistics and initiatives, and developments in alternativesto traditional incarceration or detention of adults.

 

Demandfor private provision of the services within the Company’s three businesssegments has not, on a capacity basis, precisely mirrored the increase ingeneral demand because the federal, state and local governmental provideservices which satisfy a portion of the demand.  The federal government increasingly is turning to privateproviders for the incarceration of adults whether they are serving prisonsentences, detained as illegal aliens, detained in anticipation of pendingjudicial administration or transitioning from prison to society.  Chief among the federal agencies which useprivate providers are the BOP, The Bureau of Immigration, Customs and Enforcement,and the U.S. Marshals Service.  Most ofthe federal involvement in juvenile administration in the federal system ishandled via Medicare and Medicaid assistance to state governments. Althoughthere are circumstances in which the Company may contract with a federal agencyon a sole source basis, the primary means by which the Company secures acontract with a federal agency is via the RFP bidding process.  From time to time, the Company contracts toprovide management services to a local governmental unit who then bids on afederal contract.

 

Statesand smaller governmental units are divided on the issue of private prisons andprivate provision of juvenile and community-based programs.  A majority of states permit privateprovision of the Company’s services. The Company anticipates that increasing budget pressure on states andsmaller governmental units will lead to more states and smaller governmentalunits looking for services from private providers such as the Company.  Although it varies from governmental unit togovernmental unit, the primary political forces who oppose privatization ofprisons is organized labor and religious groups.

 

Privatejuvenile and community-based programs are much more widely accepted andutilized by states and local governmental units than adult prisons.  Many private providers are organized on anot-for-profit basis, but there a number of large, for-profit providers, suchas the Company, of juvenile and community-based 

 

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programs.  The Company’s management monitorsopportunities in these segments via its corporate and regional developmentofficials.  Many of these opportunitiesare not published in any manner and, accordingly, the Company views a localinitiative as being key.

 

***Performance*.**  Management tracks a number of factors as itmonitors the Company’s financial performance. Chief among them are:

 

•      capacity (the number of bedswithin each business segment’s facilities);

•      occupancy (utilization);

•      per diem reimbursementrates; and

•      operating expenses.

 

TheCompany’s capacity, commonly expressed in terms of a number of beds, isprimarily impacted by the number and size of the facilities owned or leased bythe Company and the facilities which are not owned or leased by the Company butwhich are managed by the Company on behalf of a third party owner orlessee.  Management views capacityprimarily as a measure of its development efforts, which may increase capacityby adding new projects or adding to existing projects.  The Company has a number of projects in developmentwhich it expects to be placed into service in 2004 and 2005.  As part of measuring its developmentefforts, management will assess (a) whether a given development project wasbrought into service in accordance with management’s expectation as to time andexpense; and (b) the number of projects in development at the relevant point intime.  In addition to the focus on newprojects, capacity will reflect management’s success in renewing andmaintaining existing contracts and facilities. Recently, the Company has been confronted with the possibility thatstate or local budgetary limitations may cause the contractual commitment to agiven facility to be reduced or even eliminated, which would cause the Companyto secure alternate customers or close the operation and ultimately bereflected as a decrease in capacity.

 

Occupancyis typically expressed by the Company in terms of percentage of capacityutilized.  Management looks at occupancyto assess the efficacy of both its efforts to market its facilities and itsefforts to retain existing customers or contracts.  Because revenue varies directly with occupancy, occupancy is adriver of the Company’s revenues.  Someof the Company’s contracts are “take-or-pay,” meaning that the agency makinguse of the facility is obligated to pay for beds even though they are notused.  Historically, the Company’soccupancy has been very high and management is mindful of the need to maintainhigh occupancy levels.  As newdevelopment projects are brought into service, occupancy percentages maydecline until the projects reach full utilization.  Where the Company has commitments for utilization before thecommencement of operations, occupancy reflects the speed at which the Companyachieves full service/implementation. However, the Company has undertaken fivedevelopment projects without written commitments to make full use of afacility. In these instances, the Company has performed its own assessment,based on conversations with local government representatives and other factors,of the demand for services at the facility. The Company will monitor occupancy as a measure of the accuracy ofmanagement’s estimation of the demand for the services of a developmentfacility.

 

Per diem reimbursement rates are the other key elementof the Company’s gross revenue and operating margin.  Per diem rates are a function of negotiation between the Companyand a governmental unit at the inception of a contract or through the RFPprocess.  Actual per diem rates varydramatically across the Company’s business segments, and then within eachbusiness segment depending upon the particular service or program provided. Theinitial per diem rates often change during the term of a contract in accordancewith a schedule.  The amount of thechange can be a fixed amount set forth within the contract, an amountdetermined by formulas set forth within the contract or an amount determined bynegotiations between the Company and the governmental unit (often thesenegotiations are along the same lines as the original per diem negotiation – areview of the Company’s expenses and approval of an amount to recompense theCompany for expenses and assure the Company the potential of an operatingprofit).  In recent years, as budgetarypressures on 

 

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governmental units haveincreased, some of the governmental units who are parties to agreements withthe Company have negotiated relief from formulaic increase provisions withintheir agreements or have declined to include in their appropriation legislationamounts that would increase the per diem rates payable to the Company (neededby the Company in some cases to offset operating expense increases).  Although the Company has mitigated a portionof the impact of these developments, it has taken steps primarily in the areaof legislative and governmental monitoring and lobbying, to avoid these sortsof adverse developments in the future. The Company will continue to monitor per diem rates as a measure ofnegotiation skill, customer service, management and maintenance, political andbusiness astuteness.

 

#### **Management tracks severaldifferent areas of its operating expenses. Foremost among these expenses are employee compensation and benefits andexpenses, risk related areas such as general liability, medical and worker’scompensation, client/inmate costs such as food, clothing and programming costs,costs of financing and administrative overhead expenses such as travel.Increases or decreases in one or more of these items, such as the Company’srecent experience with rising insurance costs, can have a material effect onthe Company’s performance.  Managementis particularly monitoring the costs of complying with the Sarbanes-Oxley Actof 2002, both in terms of fees paid to third parties, such as independentauditors and consultants, and internal administrative costs.**

#### ** **

Managementof the Company recognizes that its operating margins are subject to pressurefrom a variety of factors, but most notably rising costs and governmental andagency budgetary constraints. Management also believes that successful development is key tomitigating such pressure.  The Companyhas several development projects committed and in various stages of completion.Until those projects are completed and brought into service, management willmonitor operations and existing customer relationships in an attempt to protectoperating margins.

 

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#### **Significant 2003 Events**

 

The Company has not beenable to develop a use for the operation of the New Morgan Academy since thetermination of its last program in the fourth quarter of 2002.  The Company has recognized pre-tax costs ofapproximately $3.9 million in its Consolidated Statements of Operations andComprehensive Income (Loss) in 2003 for related holding costs (depreciation,interest, property taxes and other maintenance costs).  See “Managements Discussion and Analysis ofResults of Operation — Contractual Uncertainties Related to Certain Facilities”for additional information.

 

In January 2003, the Companyexecuted a five year lease for the New Mexico Regional Correctional Center inAlbuquerque, New Mexico.  Thefacility consists of two units – the South Tower and the North Tower, whichhave a service capacity of 500 beds each. The Company is currently renovating the South Tower and anticipatesopening the 500 bed unit in July 2004. The Company will then renovate the North Tower.  Management estimates that the facility willreach full capacity of 1,000 beds by December 2004.  As of December 31, 2003, the Company had spent approximately $1.0million on renovations of the 500 bed South Tower unit and expects to spend anadditional $2.8 million to complete the renovation of both units.  For the year ended December 31, 2003, theCompany recognized pre-opening and start-up costs of approximately$321,000.  At December 31, 2003, theCompany did not have a contract for the facility but was in discussions withvarious governmental agencies for use of the facility.  Based on the Company’s discussions withpotential contracting governmental agencies and the demand for services to beprovided, management of the Company anticipates obtaining contracts for theinitial 500 bed South Tower unit in the near future. However, there can be noassurance that the Company will develop enough volume at the facility to assureits profitability.  The lease for thefacility requires monthly rental payments of approximately $113,000 for thefirst two years and $130,000 for the last three years of the lease.  Management currently expects to incurpre-opening and start-up costs between $1.5 and $2.0 million for the yearending December 31, 2004.  Changes inmanagement’s current estimates as a result of delays in obtaining an operatingcontract for the facility and the related ramp-up of occupancy could effect theamount of pre-opening and start-up costs currently anticipated by the Company.

 

In May 2003,the Company purchased a building in San Antonio, Texas for approximately $2.2million.  The Company renovated this 121bed residential juvenile facility, named the Texas Adolescent Center, forapproximately $1.3 million in cash.  Thefacility became operational in October 2003 and is currently operating at acapacity of approximately 109.  For theyear ended December 31, 2003, the Company incurred pre-opening and start-upcosts of approximately $759,000 and recognized revenue of approximately$348,000 for this facility.  Annualrevenues are estimated to be approximately $6.1 million in the year endingDecember 31, 2004.

 

In June 2003,the Company entered into an agreement with a developer to purchase a 160 bedjuvenile residential treatment center, named the Southern Peaks TreatmentCenter, upon completion of construction of the facility by the developer.  In August 2003, the Company fundedapproximately $12.9 million into an escrow account for the purchase price ofthe project.  The Company recognized acharge of approximately $5.4 million to general and administrative expenses inthe fourth quarter of 2003 related to the portion of these funds which werediverted and have not been recovered. See Item 3. "Legal Proceedings" for a further discussion.

 

In June 2003, the Companyexecuted a five-year management agreement, with an additional five year option,to operate the Jos-Arz Residential Treatment center, a 56-bed juvenileresidential facility in the District of Columbia. The facility was previouslyoperated by Corrections Research Institute, Inc. , a 501(c)(3) not-for-profitcorporation.  At December 31, 2003, thefacility was operating at a capacity of 10. Management is unable to determine when the facility will reach abreak-even expected capacity.  TheCompany incurred start-up costs of approximately $2.2 million for the yearended December 31, 2003.

 

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In September2003, the Company entered into negotiations with the state of South Dakota tolease the former State Training School in Plankinton, South Dakota for theoperation of a 40 bed juvenile justice center, the Plankinton RegionalDetention Center, and a 82 bed residential juvenile treatment center, thePlankinton Regional Treatment Center. The Company will make minor renovations to the facilities at anestimated cost of approximately $400,000. As of December 31, 2003, the Company had not finalized the leaseagreements or obtained contracts for services at the facilities.  However, management believes there is demandfor the Company services to be provided at these facilities and anticipatescommencing operation of the detention center in April 2004 and the treatmentcenter in August 2004.  Managementanticipates that approximately $1.0 to $1.5 million of pre-opening and start-upcosts will be incurred by the Company in the year ending December 31, 2004related to this facility.

 

In November 2003, theCompany executed a five-year management agreement to operate the Jos-ArzTherapeutic Public Charter School in Washington, DC.  This 70 student school provides for the needs of children who havea diagnosed, level four or five, special educational requirement.  The school will be located within theJos-Arz Residential Treatment Center already leased by the Company under afive-year lease agreement.  The Companywill not incur any significant capital expenditures or rent increases fromoperating the school.  At current rates,the program is expected to produce approximately $5.0 million in annualizedrevenues when at full capacity, currently anticipated to be reached in thesecond quarter of 2004.

 

#### **RecentDevelopments**

 

**Southern Peaks Treatment Center**

 

Construction of the Southern Peaks Treatment Center is ongoing and progress to date iswithin the agreed time schedule, but the developer is unable to continueconstruction in the absence of a valid construction loan.  The Company remains committed to theCenter and has reached an oral understanding with the general contractor andthe developer for the Company to purchase the property in the near future(prior to its completion), serve as the construction supervisor in lieu of thedeveloper and assume the developer’s rights and obligations under theconstruction contract.  The Company andits legal counsel are in the process of documenting these understandings.  However, there can be no assurance that thegeneral contractor, the developer and the Company will enter into the writtenagreements.  Based on these oralunderstandings, and in accordance with written agreements between the Companyand the general contractor, the Company has advanced approximately $1.3 millionto the general contractor subsequent to December 31, 2003.  See Item 3. “Legal Proceedings” for furtherdiscussion of the Southern Peaks Treatment Center.

 

**Las Vegas Center**

 

InJune 2003, the BOP issued a RFP for the operation of a 65 bed adultcommunity-based correctional center in Las Vegas, Nevada.  The Company submitted a proposal inSeptember 2003 and received a request for clarifications to its proposal inJanuary and February 2004.  The Companypurchased a building in January 2004 for approximately $1.3 million inanticipation of winning the contract award. The Company anticipates renovating the building at a cost ofapproximately $786,000 and anticipates that these renovations can be completedwithin 120 days after receiving the notice to proceed by the BOP.  If the Company is awarded the contract, thefacility, which will have a service capacity of 100 beds after renovations,should be operational in June 2004.

 

**CentralCalifornia Treatment Center**

 

InJanuary 2004, the Company purchased a building in Los Angeles, California forapproximately $2.5 million.  The Companyanticipates renovation costs of approximately $2.0 million.  The state of California is in the midst of asevere budget crisis and the California Department of Corrections (CDC) hasbeen charged with reducing their budget by $400.0 million. In addition,California courts have mandated “halfway back” 

 

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treatmentfor parole violators. This new facility could provide service to 220 inmates ina work furlough type program.  Due tothe growth of the inmate population, severe budget crisis and recent legalsettlement requiring additional community services, management anticipates thatthis facility will fill a small part of the overall demand.  The potential uses for the facility rangefrom a “halfway back” program to a comprehensive drug and alcohol treatmentprogram.  The Company does not currentlyhave a contract for this facility.

 

**Baker Community Correctional Center Purchase**

 

The Company has a purchase option on theBaker Community Correctional Center, which it is currently leasing.  The Company anticipates finalizing thepurchase in the first quarter of 2004 at a purchase price of approximately$2.0 million.  The Company'scurrent operating contract for this facility expires in June 2004.  There is a possibility that the CDC, theCompany’s current contracting agency, may cut the funding for the currentprogram at the facility. However, the Company estimates there is enough demandfor minimum-security services for another inmate population from the CDC orthrough a contract with another agency. Although the Company is actively pursuing a contract renewal with theCDC and believes that it will be forthcoming, there can be no assurance that arenewal will be executed.

 

#### **Recently Issued Accounting Standards**

 

In January 2003, theFinancial Accounting Standards Board (FASB) issued Interpretation No. 46,“Consolidation of Variable Interest Entities” (FIN 46), which addresses the consolidationof variable interest entities as defined in the Interpretation.  The Company’s adoption of FIN 46 does notchange the Company’s accounting for the 2000 synthetic lease transaction andthe 2001 Sale and Leaseback Transaction which are consolidated for reportingpurposes.  The Company has no otherarrangements subject to the provisions of FIN 46. It is reasonably possiblethat the Company may enter into future arrangements for the development of newfacilities or to operate facilities which may become subject to the provisionsof FIN 46 and, in some cases, may be required to consolidate the relatedactivities, facilities and financings.

 

In April 2003, the FinancialAccounting Standards Board (FASB) issued SFAS No. 149 “Amendment of StatementNo. 133 on Derivative Instruments and Hedging Activities.” This statementamends and clarifies accounting for derivative instruments, including certainderivative instruments embedded in other contracts, and for hedging activitiesunder SFAS No. 133. Other provisions of this statement that related to SFAS No.133 Implementation Issues should continue to be applied in accordance withtheir respective effective dates. The Company adopted SFAS No. 149 on July 1,2003 with no significant impact on its results of operations or financialposition.

 

In May 2003, the FASB issued SFAS No. 150 “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity.”  This statement establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity. The Companyadopted SFAS No. 150 on June 30, 2003 with no significant impact on its resultsof operations or financial position.

 

In May 2003, the EmergingIssues Task Force (EITF) reached a consensus on EITF 01-8 “Determining Whetheran Arrangement Contains a Lease.” EITF 01-8 provides guidance for determiningwhether an arrangement contains a lease that is within the scope of SFAS 13.The Company adopted EITF 01-8 on June 30, 2003 with no significant impact onits results of operations or financial position.

 

**CriticalAccounting Policies and Estimates**

 

The discussion and analysisof financial condition and results of operations are based upon the Company’sconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States (GAAP).  The preparation of these financialstatements requires that the 

 

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Company’smanagement make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses and the related disclosure ofcontingent assets and liabilities.  TheCompany evaluates its estimates on an on-going basis, based on historicalexperience and on various other assumptions that management believes to bereasonable under the circumstances. Actual results may differ from these estimates under differentassumptions or conditions.

 

The Company believes thefollowing critical accounting policies affect its more significant accountingpolicies and estimates used in the preparation of the accompanying consolidatedfinancial statements.

 

*Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of the Company, itswholly-owned subsidiaries, and the Company’s activities relative to twofinancings of operating facilities. All significant intercompany balances andtransactions have been eliminated. Minority interest in consolidated special purpose entities representsequity that other investors have contributed to the special purposeentities.  Minority interest is adjustedfor income and losses allocable to the owners of the special purpose entities.  As the cumulative losses of the specialpurpose entity exceed the equity which is recorded as minority interest by theCompany, the excess losses are recorded in the Company’s ConsolidatedStatements of Operations and Comprehensive Income.

 

*Revenue Recognition*

 

The Company recognizesrevenue in accordance with SEC Staff Accounting Bulletin No. 104, “RevenueRecognition in Financial Statements,” as amended.  Substantially all of the Company’s revenues are derived fromcontracts with federal, state and local government agencies which pay eitherper diem rates based upon the number of occupant days or hours served for theperiod, on a take-or-pay basis, cost-plus reimbursement or fee for service basis.  Revenues are recognized as services areprovided under the Company’s established contractual agreements to the extentcollection is considered probable.

 

*Accounts Receivable and Related Allowance for DoubtfulAccounts*

 

The Company extends creditto the government agencies contracted with and other parties in the normalcourse of business.  The Companyregularly reviews its outstanding receivables and historical collectionexperience, and provides for estimated losses through an allowance for doubtfulaccounts.  In evaluating the adequacy ofestablished allowances for doubtful accounts, the Company makes judgmentsregarding its customers’ ability to make required payments, economic events andother factors.  As the financialcondition of these parties change, circumstances develop or additionalinformation becomes available, necessary adjustments to the allowance fordoubtful accounts may occur.

 

*Insurance Reserves*

 

The Company maintainsinsurance coverage for various aspects of its business and operations.  The Company retains a portion of losses thatoccur through the use of deductibles and retention under self-insuranceprograms.  The Company regularly reviewsthe estimates of reported and unreported claims and provides for these lossesthrough insurance reserves.  Thesereserves are influenced by rising costs of health care and other costs,increases in claims, time lags in claims information and levels of insurancecoverage carried. As claims develop and additional information becomesavailable to management, adjustments  tothe related loss reserves may occur. The Company’s reserves for medical and worker’s compensation claims issubject to change based on management’s estimate of the number and themagnitude of claims to be incurred.

 

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*Impairment or Disposal of Long-Lived Assets*

 

The Company reviews itslong-lived assets for impairment annually or when changes in circumstancesindicate that the carrying amount of the asset may not be recoverable inaccordance with SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.”  SFAS No. 144 requiresthat long-lived assets to be held and used be reported at the lower of theircarrying amount or fair value.  Assetsto be disposed of and assets not expected to provide any future servicepotential to the Company are recorded at the lower of their carrying amount orfair value less estimated cost to sell. The Company’s estimates of fair valueare determined based upon discounted expected future cash flows to be producedby the assets. Factors that significantly influence estimated future cash flowsinclude the periods and levels of occupancy for the facility, expected per diemor reimbursement rates, assumptions regarding the levels of staffing, servicesand future operating and capital expenditures necessary to generate forecastedrevenues, related costs for these activities and future rates of increases ordecreases associated with these factors. The Company also considers the resultsof any appraisals on the properties when assessing fair value. These estimatesare highly subjective, particularly in circumstance where no current operatingcontract is in place and changes in the assumptions and estimates could resultin the recognition of impairment charges. The most subjective estimates made inthis analysis for 2003 and 2002 relate to the New Morgan Academy and theMoshannon Valley Correctional Center properties.  The Company may be required to record an impairment charge in thefuture should it not be able to successfully negotiate a contract on any of thefacilities that it does not currently have an operating contract.

 

*Accounting for Stock-Based Compensation*

 

The Company accounts for itsstock-based compensation plans in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (APB No.25).  In accordance with the provisionsof APB No. 25, stock-based employee compensation cost is not reflected in netincome, as all options granted under those plans had an exercise price equal toor in excess of the market value of the underlying common stock on the date ofgrant. The FASB has recently proposed to mandate expense recognition forstock options and other types of equity-based compensation based on the fairvalue of the options at the grant date. Additionally, the FASB is evaluating alternatives regarding how todevelop a measure of the fair value of an option.  Based on the final outcome of the FASB proposal, the Company maybe required to recognize expense related to stock options and other types ofequity-based compensation in future periods. Additionally, the Company may be required to change its current methodfor determining the fair value of stock options.  Members of congress have recently introduced legislation whichwould limit the proposed standard.

 

*Goodwill*

 

The Company accounts for itsgoodwill in accordance with SFAS No. 142, “Goodwill and Other IntangibleAssets” which states that there will be no amortization of goodwill orintangible assets with indefinite lives. Impairment of these assets is assessed at least annually to determine ifthe estimated fair value of the reporting unit exceeds the net carrying valueof the reporting unit, including the applicable goodwill.  The estimates of fair market value are basedupon management’s estimates of the present value of future cash flows.  Management makes assumptions regarding theestimated cash flows and if these estimates or their related assumptionschange, an impairment charge may be incurred.

 

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**Results ofOperations**

 

Materialfluctuations in the Company’s results of operations are principally the resultof the level of new contract development activity conducted by the Company, thetiming and effect of facility expansions, occupancy rates at Company-operatedfacilities, contract terminations and facility closures and extraordinary andnon-recurring charges.

 

The following table setsforth for the periods indicated the percentages of revenue represented bycertain items in the Company’s Consolidated Statements of Operations andComprehensive Income (Loss). The percentages for the year ended December31, 2001 reflect the reclassification of a loss for the early extinguishment ofdebt of approximately $4.9 million and the related income tax benefit ofapproximately $2.0 million to the provision for income taxes from extraordinaryitems as a result of the Company’s adoption of SFAS No.145 on January 1, 2003.

 
|                                                                                                |   | **Year Ended December 31,** |   |
|-----------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                |   | **2003**                    |   | **2002** |   | **2001** |   |
|                                                                                                |   |                        |   |   |   |   |   |
| Revenues                                                                                            |   | 100.0                       | %      | 100.0 | % | 100.0 | % |
|                                                                                                |   |                        |   |   |   |   |   |
| Operating expenses                                                                                  |   | 77.2                        |   | 77.2 |   | 77.6 |   |
| Pre-opening and start-up expenses                                                                   |   | 1.3                         |   | — |   | 1.4 |   |
| Depreciation and amortization                                                                       |   | 3.9                         |   | 3.6 |   | 3.5 |   |
| General and administrative expenses                                                                 |   | 8.6                         |   | 7.8 |   | 5.8 |   |
| Income from operations                                                                              |   | 9.0                         |   | 11.4 |   | 11.7 |   |
| Interest expense, net                                                                               |   | 6.5                         |   | 6.8 |   | 7.9 |   |
| Loss on extinguishment of debt                                                                      |   | —                      |   | — |   | 1.9 |   |
| Minority interest in consolidated special purpose entities                                          |   | —                      |   | 0.2 |   | (0.6 | ) |
| Income before provision for income taxes and cumulative effect of  changes in accounting principles |   | 2.5                         |   | 4.4 |   | 2.5 |   |
| Provision for income taxes                                                                          |   | 1.0                         |   | 1.8 |   | 1.0 |   |
| Income before cumulative effect of changes in accounting principles                                 |   | 1.5                         | %      | 2.6 | % | 1.5 | % |

 

***Year Ended December 31, 2003 Compared to Year Ended December 31, 2002***

 

***Revenues.***** Revenues decreased 1.3% to $ 271.6 million for the year endedDecember 31, 2003 from $275.1 million for the year ended December 31, 2002.

 

Adult secureinstitutional services division revenues increased 2.6%, or approximately $2.6million, to $102.1 million for the year ended December 31, 2003 from $99.5million for the year ended December 31, 2002. Revenues increased approximately $1.3 million due to improved occupancyat the Baker Community Correctional Center. Due to the expected closure of the facility as of June 30, 2002,occupancy decreased significantly in the second quarter of 2002.  Subsequently, the state of Californiaapproved the continued use of the facility and a new contract was obtained forthe facility.  The contract is for aterm of one year.  Occupancy beganramping up in the third quarter of 2002 but had not reached contract capacitylevel until late in the fourth quarter of 2002. Additionally, revenuesincreased approximately $1.9 million due to a 32 bed expansion at the BigSpring Correctional Center completed in April 2003 and a per diem rate increasein June 2003.

 

The Company’sadult secure institutional services division revenues are primarily generatedfrom contracts with federal and state government agencies.  At December 31, 2003, the Company operatedseven adult secure facilities with an aggregate service capacity of 5,917 and acontracted capacity of 5,912.  Theremaining contract term for these facilities range from one to seven years.

 

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***Averagecontract occupancy was 99.3% for the year ended December 31, 2003 compared to97.6% for the year ended December 31, 2002 and the average per diem rate was$47.79 for the year ended December 31, 2003 compared to $48.21 for the yearended December 31, 2002.  The decreasein the average per diem rate was due to a per diem rate reduction at a largefacility in the second half of 2003. The rate reduction was requested by the Company’s contracting agency(the Company mitigated a portion of this rate reduction by negotiatingreductions in the level of service provided). The Company anticipates obtaining a contractual consumer price index(CPI) rate increase for the operating contract at this facility in July2004.  There were no revenuesattributable to start-up operations for the years ended December 31, 2003 and2002.  Management anticipates thatrevenue for the adult secure institutional services division will increaseapproximately $5.7 million in the year ending December 31, 2004 due to theexpected opening of the initial 500 beds at the New Mexico RegionalCorrectional Center in July 2004.  TheCompany has noted increasing pressure from state and local governments to limitincreases or even reduce per diem rates. Many of these governmental entities are under severe budget pressuresand it is possible that more of the Company’s contracting government agenciesmay approach the Company about per diem rate concessions.  Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely effect the Company’s currentestimate of adult secure institutional services division revenues for the yearending December 31, 2004.  Currently,the Company anticipates obtaining contractual rate increases at its adultsecure institutional facilities in 2004.***

 

Juvenile justice,educational and treatment services division revenues decreased 4.9%, orapproximately $6.2 million, to $118.8 million for the year ended December 31,2003 from $125.0 million for the year ended December 31, 2002.  Revenues decreased approximately $13.3 million due to the closure ofthe New Morgan Academy in the fourth quarter of 2002.  This decrease was offset by a net increase in revenue ofapproximately $7.1 million which included (1) the acquisition of the Jos-ArzResidential Treatment Center management contract in June 2003 which contributedapproximately $1.1 million to 2003 revenues and (2) a combined increase inrevenues of approximately $6.0 million due to increased occupancy at variousfacilities including the Alexander Youth Center, the Leadership DevelopmentProgram (LDP), the Cornell Abraxas I facility, the Abraxas Center forAdolescent Females (ACAF), the Danville Mental Health programs and the CampbellGriffin Treatment Center.  Additionally,the Texas Adolescent Center, which began operations in October 2003, contributedapproximately $348,000 to 2003 revenues. The Company did not receive per diem rate increases at its juvenilefacilities and programs in Pennsylvania in 2003. The Company expects to receiveper diem rate increases at these facilities in 2004.

 

***At December 31,2003 the Company operated 23 residential juvenile facilities with a totalservice capacity of 1,971 and 15 non-residential juvenile community-basedprograms with a total program capacity of 2,365.  The Company’s contracts for these facilities and programs aregenerally with state and local government agencies and generally renewannually.  The Company expects that allcurrent annual contracts will be renewed in 2004.***

*** ***

***Averagecontract capacity for the year ended December 31, 2003 was 90.8% compared to89.8% for the year ended December 31, 2002. Excluding the occupancy and contract capacity for the New Morgan Academyin 2002 and the start-up activities of the Jos-Arz Residential Treatment Centerand the Texas Adolescent Center in 2003, average contract occupancy was 93.1%for the year ended December 31, 2003 compared to 92.4% for the year endedDecember 31, 2002.  Although theexclusion of start-up operations and the operations of the New Morgan Academyis a non-GAAP measure, the Company believes it is important to provide averagecontract capacity rates excluding start-up facilities so as to provide morecomparable information with other periods. The average per diem rate for the Company’s residential juvenilefacilities was approximately $164.89 for the year ended December 31, 2003compared to approximately $170.98 for the year ended December 31, 2002. Thedecrease in the average per diem rate was primarily due to the closure of theNew Morgan Academy in the fourth quarter of 2002. The Company’s average ratefor its juvenile non-residential community-based programs was approximately$28.19 for the year ended December 31, 2003 compared to approximately $28.82for the year ended December 31, 2002.***

*** ***

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*** ***

***Revenuesattributable to start-up operations were approximately $1.4 million for theyear ended December 31, 2003 and were attributable to the Jos-Arz ResidentialTreatment Center and the Texas Adolescent Center.  There were no revenues attributable to start-up operations forthe year ended December 31, 2002.***

*** ***

***The Companyanticipates that its juvenile services division revenues will increaseapproximately $24.2 million in the year ending December 31, 2004 due to theoperations of the Jos-Arz Residential Treatment Center and the Texas AdolescentCenter and the opening of the Jos-Arz Therapeutic Public Charter School whichis currently estimated to begin operating in the second quarter of 2004.  Additionally, the Company anticipates anincrease in revenue of approximately $8.2 million in 2004 due to the PlankintonRegional Detention Center, the Plankinton Regional Treatment Center and theSouthern Peaks Treatment Center, which are currently estimated to beginoperating in April 2004, August 2004 and June 2004, respectively. Operatingcontracts for these facilities have not yet been secured. A delay inconstruction or renovation of these facilities or a delay in the execution ofoperating contracts, or occupancy levels below management’s current estimatescould effect the realization of the projected revenue increase. Additionally,the Company terminated its contract for the Santa Fe County JuvenileDevelopment Program effective January 28, 2004. Revenues for the Santa FeCounty Juvenile Development Program were approximately $4.0 million for theyear ended December 31, 2003.***

*** ***

***Adultcommunity-based corrections and treatment services division revenues increased0.2%, or approximately $86,000, to $50.7 million for the year ended December31, 2003 from $50.6 million for the year ended December 31, 2002 due to overallincreased occupancy throughout the division offset, in part, by a decrease inrevenue as a result of the Company’s termination of the Santa Barbara Centercontract in March 2003 and the Inglewood Men’s Center contract in June2003.  These contract terminationsdecreased revenues for the year ended December 31, 2003 by approximately$879,000.***

 

At December 31, 2003, the Company operated 14residential adult community-based corrections and treatment facilities with atotal service capacity of 1,977 and seven non-residential community-basedcorrections and treatment programs with a total service capacity of 1,817.  The Company’s contracts for these servicesare primarily with federal, state and local government agencies.  The remaining term on these contracts rangefrom one to five years, with additional renewal options.  Average contract occupancywas 110.7% for the year ended December 31, 2003 compared to 110.2% for the yearended December 31, 2002.  The Companyexperienced occupancy percentages in excess of 100.0% due to actual occupancyat certain residential adult community-based corrections and treatmentfacilities exceeding contracted capacity. The Company currently cannot predict whether this level of occupancywill continue in future periods. There were no revenues attributable tostart-up operations for the years ended December 31, 2003 and 2002.

 

The Company anticipatesa decrease in revenues from its adult community-based corrections and treatmentservices division of approximately $363,000 in the year ending December 31,2004 due to the termination of the Inglewood Men’s Center contract in June 2003and the termination of the Santa Fe Electronic Monitoring program in early2004, offset in part, by increases in revenues at various other of theCompany’s adult community-based facilities and programs.

 

***Operating Expenses.*** Operating expenses decreased 1.2%, or $2.6 million, to $209.7 millionfor the year ended December 31, 2003 from $212.3 million for the year endedDecember 31, 2002.

 

Adult secure institutionalservices division operating expenses increased 4.5%, or approximately $3.1million, to $72.5 million for the year ended December 31, 2003 from $69.4million for the year ended December 31, 2002 due primarily to the increasedoccupancy at the Baker Community Correctional Center as a result of thecontract renewal in June 2002 and increased occupancy at the Big SpringCorrectional Center as a result of an expansion completed in April 2003.

 

As a percentage of adultsecure division revenues, adult secure institutional services divisionoperating expenses were 71.0% for the year ended December 31, 2003 compared to69.7% for the year ended December 31, 2002. The decline in the 2003 operating margin as compared to 2002 is due to aper diem rate decrease at a large facility in the 

 

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secondhalf of 2003.  Additionally, theper diem rate increase at a certain other large facility was not enough tocompensate for the increase in operating costs, specifically Department ofLabor (DOL) wage increases mandated in the operating contract. The Company alsoexperienced higher medical and worker’s compensation insurance costs in 2003 ascompared to 2002.

 

Juvenile justice,educational and treatment services division operating expenses decreased 5.3%,or approximately $5.5 million, to $99.4 million for the year ended December 31,2003 from approximately $105.0 million for the year ended December 31, 2002 dueprimarily to the closure of the New Morgan Academy in the fourth quarter of2002. Operating expenses for the New Morgan Academy were approximately $1.6million for the year ended December 31, 2003 compared to approximately $12.0million in the year ended December 31, 2002. This decrease was offset, in part, by a net increase in operatingexpenses of approximately $4.8 million due primarily to increased occupancy atvarious facilities including the Alexander Youth Center, LDP, the CornellAbraxas I facility, ACAF, Danville Mental Health programs and the CampbellGriffin Treatment Center.

 

As a percentage of juveniledivision revenues, excluding start-up operations, juvenile justice, educationaland treatment services division operating expenses were 84.7% for the yearended December 31, 2003 compared to 84.0% for the year ended December 31,2002.  The decline in the 2003 operatingmargin is due to the lack of per diem rate increases at the Company’s juvenilefacilities and programs in Pennsylvania coupled with an increase inmedical and worker’s compensation insurance expense in 2003 as compared to2002.

 

Adult community-basedcorrections and treatment services division operating expenses increased 2.0%,or approximately $0.8 million, to $38.4 million for the year ended December 31,2003 from $37.6 million for the year ended December 31, 2002 due to overallincreased occupancy throughout the division offset, in part, by a decrease inoperating expenses as a result of the termination of the Santa Barbara Centercontract in March 2003 and the Inglewood Men’s Center contract in June 2003.

 

As a percentage of adult community-basedrevenue, adult community-based corrections and treatment services divisionoperating expenses were 75.7% for the year ended December 31, 2003 compared to74.3% for the year ended December 31, 2002. The decline in the 2003 operating margin was due primarily to increasedmedical and worker’s compensation insurance in 2003 as compared to 2002.

 

***Pre-Opening and Start-up Expenses.*** Pre-opening and start-up expenses for the year ended December 31, 2003were approximately $3.4 million and were attributable to the pre-opening andstart-up costs of the Jos-Arz Residential Treatment Center, the Southern PeaksTreatment Center, the New Mexico Regional Correctional Center and the TexasAdolescent Center. These expenses consisted primarily of personnel and relatedexpenses, building rent, professional and recruiting expenses. There were nopre-opening and start-up expenses for the year ended December 31, 2002.

 

***The Companyanticipates incurring pre-opening and start-up costs of approximately $4.6million in the year ending December 31, 2004 for the pre-opening and start-upactivities of the Jos-Arz Residential Treatment Center, the Southern PeaksTreatment Center, the New Mexico Regional Correctional Center, the PlankintonRegional Treatment Center and the Plankinton Regional Detention Center.  Unforeseen construction or renovationdelays, occupancy levels below management’s current estimates, or additionaldevelopment projects not included within current estimates, could affect theCompany’s projected pre-opening and start-up costs.***

 

***Depreciation andAmortization*. * *** Depreciation and amortization expense increased 9.4%, or $920,000,to approximately $10.7 million for the year ended December 31, 2003 fromapproximately $9.8 million for the year ended December 31, 2002. The increasein depreciation and amortization expense was due primarily to depreciation ofcurrent year property and equipment additions of approximately$22.3 million which included, among other things, the repurchase offurniture and equipment leased under a sale and leaseback transaction in 1999for approximately $4.8 million, the purchase and renovation of the TexasAdolescent Center for approximately $4.3 million, land and construction costsfor the Southern Peaks Treatment Center of approximately $2.3 million,capitalized interest and development costs for the Moshannon ValleyCorrectional Center of 

 

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approximately $2.6 million, renovations to the New Mexico RegionalCorrectional Center of approximately $1.0 million, an expansion at the CornellAbraxas I facility for approximately $921,000, an expansion at the Salt LakeCity Center for approximately $491,000, the purchase of a software licenseagreement for approximately $424,000 and a 32 bed expansion at the Big SpringCorrectional Center for approximately $302,000.  Amortization of intangibles was approximately $895,000 and$878,000 for the years ended December 31, 2003 and 2002, respectively.  The Company expects amortization ofintangibles to increase by approximately $200,000 in the year ending December31, 2004 due to the amortization of two non-compete agreements resulting fromthe acquisition of the Jos-Arz Residential Treatment Center management contractin June 2003.

 

***General and AdministrativeExpenses.***  General and administrative expensesincreased 9.0%, or approximately $1.9 million, to $23.4 million for the yearended December 31, 2003 from $21.5 million for the year ended December 31,2002. Included in general and administrative expenses for the year endedDecember 31, 2003 is a charge of approximately $5.4 million to provide anallowance on an unrecovered escrow deposit related to the Southern PeaksTreatment Center.  Additionally, generaland administrative expenses include costs of approximately $580,000 for siteacquisition costs and legal expenses primarily associated with the Company’sincreased development activity, expenses related to various financing effortsand other compensation costs.

*** ***

***General andadministrative expenses for the year ended December 31, 2002 included chargestotaling approximately $4.4 million for (1) legal and professional fees ofapproximately  $1.9 million related tothe Special Committee review and the subsequent restatement of the Company’s2001 financial statements and for the defense of the Company’s relatedstockholder litigation, (2) a write-off of approximately $1.0 million ofdeferred project financing costs associated with the BOP Southeast Project and(3) the settlement of a management contract with the Company’s former presidentwho resigned his position in September 2002 for approximately $1.5 million.***

*** ***

***Excluding thecharges discussed above from the 2003 and 2002 periods, general andadministrative expenses were approximately $17.4 million and $17.1 million forthe years ended December 31, 2003 and 2002, respectively.***

 

***Interest.*** Interest expense, net of interest income, decreased toapproximately $17.7 million for the year ended December 31, 2003 fromapproximately $18.7 million for the year ended December 31, 2002. For the yearended December 31, 2002, interest expense includes approximately $825,000 forlenders’ fees and related professional fees incurred to obtain certain waiversand amendments to the Company’s credit agreement in conjunction with therestatement of the Company’s 2001 financial statements.  The remaining decrease in net interestexpense of approximately $245,000 is attributable to a reduction in overallborrowings during 2003 as compared to 2002 due principally to annual repaymentsMCF’s the 8.47% Bonds.

*** ***

The Company capitalizedinterest of approximately $760,000 and $823,000 for the year ended December 31,2003 and 2002, respectively, related solely to the design and development ofthe Moshannon Valley Correctional Center. The decrease in capitalized interestin 2003 as compared to 2002 was due to decreased interest rates on theCompany’s Synthetic Lease Investor Notes discussed in more detail under“Management’s Discussion and Analysis of Financial Condition and Results ofOperations - Liquidity and Capital Resources - Long-Term Credit Facilities.”

 

***Minority Interest in Consolidated SpecialPurpose Entities*****.**  The cumulative losses of MCF exceeded therecorded minority interest of MCF during the first quarter of 2002.  The cumulative losses of the Synthetic LeaseInvestor (discussed in more detail under “Management’s Discussion and Analysisof Financial Condition and Results of Operations - Liquidity and CapitalResources - Long-Term Credit Facilities”) exceeded the recorded minorityinterest of the Synthetic Lease Investor during the third quarter of 2001.  Since the cumulative losses of MCF and theSynthetic Lease Investor exceed the equity that was recorded as minorityinterest by the Company, the excess losses can no longer be allocated to theminority interest in the Company’s Consolidated Statements of Operations andComprehensive Income (Loss).  For theyear ended December 31, 2002, the Company recorded a charge of approximately$0.6 million as a result of a distribution made by MCF to its equity investors.

 

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***Income Taxes.***  Forthe year ended December 31, 2003, the Company recognized a provision for incometaxes at an estimated effective rate of 41.0%.   For the year ended December 31, 2002, the Company recognized aprovision for income taxes at an estimated effective rate of 40.3%.  The increase in the effective tax rate isdue primarily to higher estimated effective state tax rates and highernon-deductible lobbying expenses in 2003 as compared to 2002.

 

***Cumulative Effect of Changes in AccountingPrinciples.***  The Company recorded a cumulative effect ofa change in accounting principle charge of approximately $965,000, net of tax,for the year ended December 31, 2002 related to the impairment of goodwill inaccordance with the provisions of SFAS No. 142 related to an acquisition madein November 1999.

 

***Year Ended December 31, 2002Compared to Year Ended December 31, 2001***

 

***Revenues*****.** Revenues increased 3.7% to $275.1 million for the year ended December31, 2002 from $265.3 million for the year ended December 31, 2001.

 

Adult secure institutionaldivision revenues decreased 0.2% to $99.5 million for the year ended December31, 2002 from $99.8 million for the year ended December 31, 2001.  Revenues decreased approximately $5.1million as a result of the Company’s termination of the Santa Fe County AdultDetention Center contract in September 2001 due to the under performance andoperating losses experienced at the facility. Additionally, revenues decreased approximately $1.3 million due toreduced occupancy at the Baker Community Correctional Facility and the LeoChesney Community Correctional Facility during the second and third quarters of2002 as the Company’s contracts with the California Department of Corrections(“CDC”) for the operation of these facilities were set to expire June 30, 2002and were not expected to be renewed by the CDC due to the lack of governmentalbudget appropriations.  The finalCalifornia state budget was approved in late September 2002 and included theappropriations for both of these facilities. As of December 31, 2002, the Company had executed contracts for bothfacilities and occupancy was at contracted levels.  The decrease in revenue due to the facilities mentioned above wasoffset, in part, by per diem rate increases realized in June 2001 and March2002 at the Big Spring Complex and improved occupancy at certain other adultsecure institution facilities.  Therewere no revenues attributable to start-up operations for the years endedDecember 31, 2002 and 2001.  Averageoccupancy was 97.6% for the year ended December 31, 2002 compared to 97.0% forthe year ended December 31, 2001.

 

Juvenile division revenuesincreased 7.5% to $125.0 million for the year ended December 31, 2002 from$116.3 million for the year ended December 31, 2001.  Revenues increased by approximately $6.5 million  due to the commencement of a managementcontract at the Alexander Youth Center and the opening of the William PennHarrisburg Alternative School in the third quarter of 2001.  Additionally, revenues increased at certainresidential facilities and non-residential programs due to improved occupancyand increased service hours.  Suchfacilities and programs included the Cornell Abraxas Center for AdolescentFemales (“ACAF”), the Erie Residential Behavioral Health Program and theGriffin Juvenile Facility.  Revenuesdecreased by approximately $5.1 million due to the closure of the New MorganAcademy early in the fourth quarter of 2002. On September 27, 2002, the Companyannounced that it would be closing this facility.  The Company is currently evaluating several alternatives for thereutilization of the facility for a different type of program as well as thepossibility of selling the facility. Revenues attributable to the New Morgan Academy were approximately $13.3million and $18.3 million for the years ended December 31, 2002 and 2001,respectively. There were no revenues attributable to start-up operations forthe year ended December 31, 2002. Revenues attributable to start-up operations for the year ended December31, 2001 were approximately $2.8 million and were attributable to the start-upoperations of the New Morgan Academy. This start-up revenue is included in the revenue of approximately $18.3million for the year ended December 31, 2001 as discussed above. 

 

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Averageoccupancy, excluding start-up operations in 2001, was 89.8% for the year endedDecember 31, 2002 compared to 91.2% for the year ended December 31, 2001.

 

Pre-release divisionrevenues increased 2.9% to $50.6 million for the year ended December 31, 2002from $49.2 million for the year ended December 31, 2001 due primarily toincreased average occupancy at various facilities offset, in part, by adecrease in revenues as a result the Company’s termination of the DurhamTreatment Center contract effective June 30, 2001.  Revenues for the Durham Treatment Center were approximately$700,000 for the year ended December 31, 2001. There were no revenues attributable to start-up operations for the yearsended December 31, 2002 and 2001. Average occupancy was 110.2% for the year ended December 31, 2002compared to 98.6% for the year ended December 31, 2001.  The Company experienced occupancy in excessof 100.0% due to occupancy at certain pre-release facilities exceeding contractedcapacity.  The Company currently cannotpredict whether this level of occupancy will continue in future periods.

 

***Operating Expenses.*** Operating expenses increased 3.2% to $212.3 million for the year endedDecember 31, 2002 from $205.8 million for the year ended December 31, 2001.

 

Adult secure institutionaldivision operating expenses decreased 7.0% to $69.4 million for the year endedDecember 31, 2002 from $74.6 million for the year ended December 31, 2001 dueprimarily to the Company’s termination of the Santa Fe County Adult DetentionCenter contract effective September 30, 2001. Additionally, operating expenses decreased at the Baker CommunityCorrectional Facility and the Leo Chesney Community Correctional Facility dueto reduced occupancy during 2002 as previously discussed.  The decrease in operating expenses due tothe above facilities was offset, in part, by an increase in operating expensesat the Big Spring Complex due to a facility expansion completed in the firstquarter of 2001.  As a percentage ofrevenues, adult secure institutional division operating expenses were 69.7% forthe year ended December 31, 2002 compared to 74.8% for the year ended December31, 2001.  The 2002 operating margin wasimpacted favorably due to the termination of the lower margin Santa Fe CountyAdult Detention Center contract, the expansion of the Big Spring Complex, perdiem increases at various facilities, unusually high utility costs during thefirst quarter of 2001 as a result of increased natural gas prices and anincrease in offender medical expenses at certain facilities.

 

Juvenile division operatingexpenses increased 11.8% to $105.0 million for the year ended December 31, 2002from $93.8 million for the year ended December 31, 2001 due primarily to (1)the commencement of a management contract at the Alexander Youth Center and theopening of the William Penn Harrisburg Alternative School in the third quarterof 2001, (2) increased occupancy at ACAF due to a facility expansion completedearly in 2001 and (3) increased average occupancy at various facilities.  Additionally, operating expenses increasedat the New Morgan Academy in 2002 as a portion of 2001 operating expenses wereclassified as pre-opening and start-up expenses.  Including 2001 pre-opening and start-up expenses, operatingexpenses for the New Morgan Academy decreased in 2002 as compared to the prioryear due to reduced occupancy.  Aspreviously discussed, the Company closed the New Morgan Academy early in thefourth quarter of 2002.  As a percentageof revenues, excluding start-up operations in 2001, juvenile division operatingexpenses were 84.0% for the year ended December 31, 2002 compared to 82.7% forthe year ended December 31, 2001.  Thedecline in the 2002 operating margin was primarily a result of the decline inoccupancy and the closing of the New Morgan Academy.  This decline was offset, in part, by improved margins at theAlexander Youth Center in 2002 as occupancy reached contracted capacity.

 

Pre-releasedivision operating expenses increased 0.5% to $37.6 million for the year endedDecember 31, 2002 from $37.4 million for the year ended December 31, 2001 dueprimarily to fluctuations in average occupancy at various facilities offset, inpart, by a decrease in operating expenses as a result of the termination of theDurham Treatment Center contract effective June 30, 2001.  As a percentage of revenue, pre-releasedivision operating expenses were 74.3% for the year ended December 31, 2002compared to 76.1% for the 

 

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year ended December31, 2001.  The 2002 operating margin wasimpacted favorably due to the expiration of the San Diego Center contract earlyin 2001 and the Durham Treatment Center contract in June 2001 and increasedoccupancy at various facilities.  Theimprovement in the 2002 operating margin was offset, in part, by an increase ofapproximately 13.0% in employee insurance costs in the year ended December 31,2002 as compared to the prior year.

 

***Pre-Opening and Start-up Expenses.***** **There were nopre-opening and start-up expenses for the year ended December 31, 2002. Pre-opening and start-up expenses were $3.9 million for the year endedDecember 31, 2001 and were attributable to the start-up activities of the NewMorgan Academy and an expansion of ACAF.

 

***Depreciation and Amortization*****.** Depreciation and amortization was approximately $9.8 million for theyear ended December 31, 2002 compared to $9.3 million for the year endedDecember 31, 2001.  Amortization expensefor intangibles decreased approximately $646,000 in the year ended December 31,2002 from prior year due to the Company’s adoption of SFAS No. 142, “Goodwilland Other Intangible Assets,” which eliminated the amortization of goodwilleffective January 1, 2002.  Depreciationand amortization of property and equipment increased approximately $1.2 millionin the year ended December 31, 2002 from prior year due primarily to propertyand equipment purchases made in 2002.

 

***General and Administrative Expenses.*** General and administrative expenses increased 40.5% to $21.5 million forthe year ended December 31, 2002 from $15.3 million for the year ended December31, 2001.  General and administrativeexpenses for the year ended December 31, 2002 included (1) a charge ofapproximately $1.9 million for legal and professional fees related to theSpecial Committee review and the subsequent restatement of the Company’sfinancial statements and for defense of the Company’s related stockholderlitigation, (2) a charge of approximately $1.0 million for the write-off ofdeferred project financing costs associated with the BOP Southeast Project and(3) a charge of approximately $1.5 million for the settlement of a managementcontract with the Company’s former president who resigned his position inSeptember 2002.  General and administrativeexpenses for the year ended December 31, 2001 included (1) a charge ofapproximately $668,000 for the write-off of deferred acquisition costsassociated with the Fort Greeley, Alaska project and (2) a charge ofapproximately $200,000 for legal costs associated with the class actionlawsuits filed as a result of the Company’s restatement of its prior yearfinancial statements.  Excluding thesecharges, general and administrative expenses increased 18.7% from prior yeardue principally to increased personnel and compensation, business developmentand certain public affairs costs.

 

***Interest.*** Interest expense, net of interest income, decreased to $18.7 million forthe year ended December 31, 2002 from $20.9 million for the year ended December31, 2001.  The Company capitalizedinterest of approximately $823,000 for the year ended December 31, 2002 relatedto the construction of the Moshannon Valley Correctional Center.  For the year ended December 31, 2001, theCompany capitalized interest of approximately $1.3 million related primarily tothe construction of the Moshannon Valley Correctional Center. The decrease incapitalized interest in 2002 was due to decreased interest rates on theCompany’s Synthetic Lease Investor Notes discussed in more detail under“Management’s Discussion and Analysis of Financial Condition and Results ofOperations - Liquidity and Capital Resources - Long-Term CreditFacilities.”  For the year endedDecember 31, 2002, interest expense includes approximately $825,000 for lenders’fees and related professional fees incurred to obtain certain waivers andamendments to the Company’s credit agreement obtained in conjunction with therestatement of its financial statements. For the year ended December 31, 2001, interest expense included a chargeof approximately $818,000 for the write-off of a portion of unamortizeddeferred debt issuance costs related to the Company’s amended 2000 CreditFacility (defined under “Management’s Discussion and Analysis of FinancialCondition and Results of Operations - Liquidity and Capital Resources -Long-Term Credit Facilities”) as a result of the repayment of all outstandingborrowings and the associated reduction in the credit commitment.  The Company also recognized less interestexpense in the year ended December 31, 2002 due to repayment of the Company’sdebt under its revolving line 

 

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ofcredit and its subordinated notes from the proceeds from a Common Stockoffering in 2001 and the 2001 Sale and Leaseback Transaction.  Additionally, the Company recognized lessinterest expense in 2002 due to decreased interest rates on the Company’sSynthetic Lease Investor Notes.

 

***Loss on  Extinguishment of Debt*.**  For the year ended December 31, 2001, theCompany recognized a loss on the extinguishment of debt of approximately $4.9million for the early retirement of the Company’s Senior Secured Notes and theCompany’s Subordinated Notes in 2001.

 

***Minority Interest in Consolidated SpecialPurpose Entities*****.**  The cumulative losses of MCF exceeded therecorded minority interest of MCF during the first quarter of 2002.  The cumulative losses of the Synthetic LeaseInvestor (discussed in more detail under “Management’s Discussion and Analysisof Financial Condition and Results of Operations - Liquidity and CapitalResources - Long-Term Credit Facilities”) exceeded the recorded minorityinterest of the Synthetic Lease Investor during the third quarter of 2001.  Since the cumulative losses of MCF and theSynthetic Lease Investor exceed the equity that was recorded as minorityinterest by the Company, the excess losses can no longer be allocated to theminority interest in the Company’s Consolidated Statements of Operations andComprehensive Income in 2002.  For theyear ended December 31, 2002, the Company recorded a charge of approximately$0.6 million as a result of a distribution made by MCF to its equity investors.

 

***Income Taxes.***** **For the yearended December 31, 2002, the Company recognized a provision for income taxes atan estimated effective rate of 40.3%.  For the year ended December 31, 2001, the Company recognized a provisionfor income taxes at an estimated effective rate of 41.0%.  The decrease in the effective tax rate isdue primarily to a lower estimated effective state tax rate.

 

***Cumulative Effect of Changes in AccountingPrinciples.***  The Company recorded a cumulative effect ofa change in accounting principle charge of approximately $965,000, net of tax,for the year ended December 31, 2002 related to the impairment of goodwill inaccordance with the provisions of SFAS No. 142 related to an acquisition madein November 1999.

 

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**Liquidity and Capital Resources**

 

***General*.**  The Company’s primary capital requirementsare for (1) purchases, construction or renovation of new facilities,(2) expansions of existing facilities, (3) working capital, (4)pre-opening and start-up costs related to new operating contracts, (5)acquisitions, (6) information systems hardware and software and(7) furniture, fixtures and equipment purchases.  Working capital requirements generally increase immediately priorto the Company commencing management of a new facility as the Company incursstart-up costs and purchases necessary equipment and supplies before facilitymanagement revenue is realized.

 

***Cash Flows From Operations.***  Cashflows provided by operating activities were approximately $26.2 million for theyear ended December 31, 2003 compared to approximately $19.8 million forthe year ended December 31, 2002. The increase was primarily attributableto the $5.4 million loss recorded on the Southern Peaks Treatment Center escrowdeposit reported as a provision for bad debt, plus increases in deferred taxliabilities and accounts payable and accrued liabilities.  These cash flow increases were partiallyoffset by other working capital changes.

 

***Cash Flows From Investing Activities*****. **Cash used ininvesting activities was approximately $36.0 million for the year endedDecember 31, 2003 due primarily to capital expenditures of approximately$22.3 million related primarily to (1) the purchase and renovation ofthe Texas Adolescent Center for approximately $4.3 million, (2) the repurchaseof furniture and equipment previously leased under a sale and leasebacktransaction in 1999 for approximately $4.8 million, (3) renovations to the NewMexico Regional Correctional Center of approximately $1.0 million, (4) land anddevelopment costs for the Southern Peaks Treatment Center of approximately $2.3million, (5) capitalized interest and development costs for the MoshannonValley Correctional Center of approximately $2.6 million, (6) a 32 bedexpansion at the Big Spring Correctional Center Cedar Hill unit forapproximately $302,000, (7) an expansion at the Salt Lake City Center forapproximately $491,000, and (8) information technology and software developmentcosts of approximately $1.0 million. Additionally, the Company made netpayments of approximately $10.4 million related to the Southern Peaks TreatmentCenter’s restricted escrow arrangement. Cash used in investingactivities was approximately $12.3 million for the year ended December 31,2002 due primarily to capital expenditures of approximately $11.1 millionrelated to various facility improvements and/or expansions, informationtechnology and software development costs.

 

***Cash Flows From Financing Activities*****.**  Cashused in financing activities was approximately $2.7 million for the year endedDecember 31, 2003 due primarily to the payments on long-term debt ofapproximately $28.6 million, offset by borrowings on long-term debt ofapproximately $24.3 million, and the repurchase of approximately $1.2 million oftreasury shares. The Company had cash provided by financing activities ofapproximately $2.4 million from the proceeds from stock option exercises andapproximately $440,000 from the repayment of shareholder notes.  Net cash used in financing activitiesin 2002 was approximately $8.1 million. Net cash used in financing activities was lower in 2003 as compared to2002 due to net borrowings of $2.0 million on the Company’s revolving line ofcredit and $1.3 million on the Company’s Synthetic Lease Notes A and B to fundan increase in capital expenditures and interest costs on the Moshannon ValleyCorrectional Center in 2003. Additionally, proceeds from the exercise of stock options wereapproximately $1.8 million higher in 2003 and cash spent for treasury share repurchaseswas approximately $1.2 million lower in 2003 as compared to 2002.

 

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***Long-Term Credit Facilities.*** The Company’s amended 2000 Credit Facilityoriginally provided for borrowings of up to $45.0 million under a revolvingline of credit.  The commitment amountis reduced by $1.6 million quarterly beginning July 2002 and byoutstanding letters of credit. The Company had outstanding letters of credit ofapproximately $5.1 million at December 31, 2003. Accordingly, theavailable undrawn commitment amount under the amended 2000 Credit Facility was$28.2 million as of December 31, 2003. The amended 2000 Credit Facility matures in July 2005 and bears interest,at the election of the Company, at either the prime rate plus a margin of 2.0%,or a rate which is 3.0% above the applicable LIBOR rate.  The amended 2000 Credit Facility iscollateralized by substantially all of the Company’s assets, including thestock of all of the Company’s subsidiaries; does not permit the payment of cashdividends; and requires the Company to comply with certain leverage, net worthand debt service coverage covenants. Additionally, the Company is limited to $2.5 million annually for therepurchase of its common stock with an aggregate limit of $7.5 million. TheCompany has obtained an amendment from the lenders under the amended 2000Credit Facility extending the scheduled construction termination date for theMoshannon Valley Correctional Center. The amendment is effective through June 30, 2005.  The Company and its lenders agreedsubsequent to December 31, 2003 to amend covenants to facilitatecompliance with the terms of the facility despite the loss of the SouthernPeaks Treatment Center escrowed funds. Included in the Company’s cash and cash equivalents at December 31,2003 is approximately $39.8 million that is invested in a separate account thatis available to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  This separate account is maintained, inpart, to assure future credit availability.

 

Additionally,the amended 2000 Credit Facility provides the Company with the ability to enterinto synthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the leases of upto $100.0 million, of which approximately $52.4 million had been utilized as ofDecember 31, 2003.  The Companypays commitment fees at a rate of 0.5% annually for the unused portion of thelease financing capacity.

 

TheCompany’s lease financing arrangement under the amended 2000 Credit Facility isa “synthetic lease.”  A synthetic leaseis a form of lease financing that qualifies for operating lease accountingtreatment and, when all criteria pursuant to GAAP are met, is accounted for“off-balance sheet”.  Under such astructure, the Synthetic Lease Investor may be considered a virtual SPE when itobtains debt and equity capital to finance the project(s) and leases theprojects to a company.  This financialstructure was used to finance the construction of the New Morgan Academycompleted in the first quarter of 2001, the acquisition of the Taylor StreetCenter building in early 1999, and the construction-to-date of the incompleteMoshannon Valley Correctional Center. The synthetic lease used to finance the above projects was originallyentered into in December 1998 and was amended in July 2000 wherebythe available financing was increased from $40.0 million to $100.0 million andthe lease term extended to July 2005.

 

TheSynthetic Lease Investor for the above projects received payments to assist asco-arranger in the structure of the initial $40.0 million synthetic lease facilityin 1998 and in July 2000 when the synthetic lease facility was increasedto $100.0 million.  Although the Companydoes not believe the lessor is a special purpose entity, the lessor could beconsidered as a virtual special purpose entity under certain accountinginterpretations.  Therefore, thesepayments could be interpreted to reduce the Synthetic Lease Investor’s equityownership in the leased projects below the required 3.0% level as of the secondquarter of 2000.  Pursuant to thisinterpretation, these synthetic leases no longer qualify for off-balance sheettreatment beginning in the second quarter of 2000.  Accordingly, the assets and liabilities and results of operationsof the synthetic lease owned by the Synthetic Lease Investor are consolidatedin the Company’s financial statements beginning in the second quarter of 2000.

 

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Asa result of consolidating the synthetic lease assets and liabilities, theCompany’s accompanying consolidated financial statements reflect thedepreciation expense on the associated properties and interest expense relatedto the Synthetic Lease Investor’s debt, instead of rent expense.

 

TheCompany’s adoption of FIN 46 in 2003 did not change the Company’s accountingfor the 2000 synthetic lease transaction and the 2001 Sale and LeasebackTransaction, which are consolidated for reporting purposes.  It is reasonably possible that the Companymay enter into future arrangements for the development of new facilities or tooperate facilities that may become subject to the provisions of FIN 46 and, insome cases, may be required to consolidate the related activities, facilitiesand financings.

 

TheSynthetic Lease Investor’s Note A and Note B have total credit commitments of$81.4 million and $15.1 million, respectively. The Synthetic Lease Investor’s Notes A and B are cross collateralizedwith the Company’s revolving line of credit and contain cross defaultprovisions.

 

Managementis in the process of negotiating terms for a new senior credit facility torefinance the amended 2000 Credit Facility. If the Company is successful in refinancing the amended 2000 CreditFacility, the Company will incur charges related to the extinguishment of thesynthetic lease obligations and write-off of previously deferred financingcosts.  At December 31, 2003, thesecosts totaled approximately $2.3 million.

 

***Contractual Uncertainties Related toCertain Facilities.******* In January 2003, the Company executed afive year lease for the New Mexico Regional Correctional Center in Albuquerque,New Mexico.  The facilityconsists of two units – the South Tower and the North Tower, which have aservice capacity of 500 beds each.  TheCompany is currently renovating the South Tower and anticipates opening the 500bed unit in July 2004.  The Companywill then renovate the North Tower. Management estimates that the facility will reach full capacity of 1,000beds by December 2004. As of December 31, 2003, the Company had spentapproximately $1.0 million on renovations of the 500 bed South Tower unit andexpects to spend an additional $2.8 million to complete the renovation of bothunits.  For the year endedDecember 31, 2003, the Company recognized pre-opening and start-up costsof approximately $321,000.  At December 31,2003, the Company did not have a contract for the facility but was indiscussions with various governmental agencies for use of the facility.  Based on the Company’s discussions withpotential contracting governmental agencies and the demand for services to beprovided, management of the Company anticipates obtaining contracts for theinitial 500 bed South Tower unit in the near future. However, there can be noassurance that the Company will develop enough volume at the facility to assureits profitability.  The lease for thefacility requires monthly rental payments of approximately $113,000 for thefirst two years and $130,000 for the last three years of the lease.  Depending on the ultimate services toprovided and the timing of occupancy ramp-up, management expects this facilitywill incur additional pre-opening and start-up costs of approximately $1.5 to$2.0 million.

 

In June 2003, the Company entered into an agreement with adeveloper to purchase a 160 bed residential treatment center for juveniles,named the Southern Peaks Treatment Center, upon completion of construction ofthe facility by the developer.  InAugust 2003, the Company funded approximately $12.9 million into an escrowaccount for the purchase of the real property. The escrow account is the subject of litigation and has resulted in theCompany recognizing a loss of $5.4 million. See Item 3. “Legal Proceedings” andItem 7. “Management’s Discussion and Analysis of Financial Condition andResults of Operations – Recent Developments – Southern Peaks Treatment Center”for additional information.

 

In September 2003, the Company entered into negotiations with thestate of South Dakota to the lease the former State Training School inPlankinton, South Dakota to operate a 40 bed juvenile justice center, thePlankinton Regional Detention Center, and a 82 bed residential juveniletreatment center, the Plankinton Regional Treatment Center.  The Company will make some minor renovationsto the facilities at an estimated cost of approximately $400,000.  As of December 31, 2003, the Companyhad not finalized the lease agreements or obtained contracts for services atthe facilities.  However, managementbelieves there is demand for the Company’s services to be provided at thesefacilities and anticipates operating the detention center in April 2004and the treatment center in August 2004.

 

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The Company closed the New Morgan Academy in the fourth quarter of 2002and is currently considering several options ranging from the sale or lease ofthe facility to the utilization of the facility for another type of program. Asof December 31, 2003, management of the Company was focusing its effortson reactivating the facility.  Theprimary use currently under consideration is using the facility to houseillegal non-criminal adult detainees or to house non-criminal juvenile aliens.Management is discussing these opportunities with the Bureau of Immigration andCustoms Enforcement (BICE), who has indicated a level of interest but necessarybudget appropriations have not been made and the parties have not progressed tocontract phase. There can be no assurance that the Company will be successfulin securing a contract with BICE. Further, before the Company could house adult detainees, the Companywill likely need to obtain a change in the zoning of the Academy, which iscurrently zoned only for the housing of juveniles. There can be no assurancesthat the Company will be able to secure the contemplated zoning change or to doso on terms favorable to the Company. Management of the Company believes that there is a market for theservices the Company could provide at per diem rates that will support therecovery of the cost structure of the facility.  However, the Company will continue to evaluate any offers to buyor lease the facility.  The Company is maintaining a small staff tosecure and maintain the facility while the Company considers its options forthe use or sale of the facility.  TheCompany expects to incur operating expenses of approximately $150,000 per monthfor payroll, property taxes and other operating costs until the facility isutilized for an alternative program or until the facility is sold.  Additionally, the Company is incurringinterest expense of approximately $140,000 per month related to the borrowingsfor the facility and depreciation expense of approximately $46,000 per monthfor the building.

 

The carrying value of theproperty and equipment at the New Morgan Academy was approximately $30.4million at December 31, 2003. Management performed a probability-weighted recoverability analysis andbelieves that, based on its analysis, the long-lived assets at the New MorganAcademy are recoverable from the range of alternative courses of action currentlyavailable to the Company.  Accordingly,pursuant to the provisions of SFAS No. 144, an impairment allowance is notdeemed necessary as of December 31, 2003. However, management estimates that, were the Company to sell thefacility, it is reasonably possible that the Company would not be able to fullyrecover the carrying value of its long-lived assets for this facility.

 

InMarch 2003, the Company reached an agreement with the Commonwealth ofPennsylvania that resolved all outstanding administrative issues relative tothe contract awarded to the Company by the BOP to operate the Moshannon ValleyCorrectional Center. In October 2003, the Company received final approvalfrom the BOP of a revised building design for Moshannon Valley CorrectionalCenter. Construction plans are being developed for the new design and work isexpected to begin in the second quarter of 2004. In the interim, the Company isnegotiating a contract amendment with the BOP to accommodate the revisedfacility design and update the contract for changes since it was originallysigned. If and when an amendment to the contract with the BOP is successfullynegotiated, this agreement would allow the Company to move forward with theconstruction and operation of the facility.

 

Asof December 31, 2003, the Company had incurred approximately $18.2 millionfor design, construction and land development costs and capitalized interestrelated to the Moshannon Valley Correctional Center contract. The Company is inthe process of submitting a claim to the BOP for reimbursement of costs relatedto the original construction efforts incurred beginning in 1999. The Companyestimates an additional capital investment of approximately $74.0 million tocomplete construction of the facility. Financing of the facility is subject to re-approval of the project bythe lenders under the Company’s amended 2000 Credit Facility and agreement bysuch lenders to amend certain financial covenants and provisions of the amended2000 Credit Facility. In the event the Company’s lenders are unwilling tore-approve the project or to adopt the necessary amendments, or if theCompany’s cash and current financing arrangements do not provide sufficientfinancing to fund construction costs related to the project, the Company anticipatesneeding to obtain additional sources of financing.

 

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According to the BOPcontract, as amended, the Company was required to complete the construction ofthe project by January 15, 2004. The Company did not complete constructionby that date and anticipates obtaining another long-term contract amendmentfrom the BOP extending the construction deadline. In the event the Company isnot able to negotiate a contract amendment with the BOP, then the BOP may havethe right to assert that the Company has not completed construction of thefacility within the time frame provided in the BOP contract, as amended.Management expects that the contract will be amended to address cost andconstruction timing matters resulting from the extended delay.  In the event that the BOP decides not tocontinue with the construction of the Moshannon Valley Correctional Center andterminates the contract, management believes that the Company has the right toand will recover its invested costs. In the event any portion of these costsare determined not to be recoverable upon contract termination by the BOP, theCompany will expense that portion of costs that cannot be capitalized withrespect to the Company's remaining real property interest.

 

Separate from a possiblerecovery in the event that the BOP terminates the Moshannon Valley contract,the Company is pursuing a claim for reimbursement of a portion of its expensesincurred in connection with the issuance of the Stop-Work Order and the delayof the project (included among these expenses is approximately $1.4 million inaccounts receivable for expenses incurred by the Company after theJune 1999 issuance of the Stop –Work Order).  This reimbursement claim is independent of the amendment to thecontract – i.e., if the BOP agrees to an amendment of the contract, the Companywill still pursue its claim – and the Company is currently negotiating thisclaim with the BOP.  The BOP has assertedthat it is only responsible for reimbursing a portion of these costs – thatportion of the investment lost due to the issuance of the Stop-Work Order.  Although the Company believes that the BOPwill reimburse substantially more than the $1.4 million account receivable, itis uncertain how much the BOP will agree to pay in connection with theCompany’s claim for reimbursement.  Anyamounts not reimbursed by the BOP will be included in the construction costsfor the Moshannon Valley project.

 

***Treasury Stock/Repurchases.***  TheCompany repurchased in the open market 106,500 shares of its common stock forapproximately $1.2 million in the year ended December 31, 2003.  The Company repurchased in the open market277,100 shares of its common stock for approximately $2.4 million in the yearended December 31, 2002.

 

In2002, the board of directors authorized the repurchase of an aggregate $10.0million of the Company’s outstanding shares. The annual repurchase of shares is limited to $2.5 million, and anaggregate limit of $7.5 million, under the amended 2000 Credit Facility.  Under the current aggregate limitation underthe amended 2000 Credit Facility, as of December 31, 2003 the Company canpurchase additional shares of treasury stock valued at approximately $0.8million.

 

***Future Liquidity.*** Management believes that the Company’s existing cash and cashequivalents and the cash flows generated from operations, together with therevolving credit available under the amended 2000 Credit Facility, and thesynthetic lease financing capacity thereunder, will provide sufficientliquidity to meet the Company’s committed capital and working capitalrequirements for currently awarded and certain potential future contracts.  To the extent the Company’s cash and currentfinancing arrangements do not provide sufficient financing to fund constructioncosts related to future adult secure institutional contract awards orsignificant facility expansions, the Company anticipates obtaining additionalsources of financing to fund such activities. Management is in the process of negotiating terms for a new seniorcredit facility to refinance the amended 2000 Credit Facility which matures inJuly 2005. Additionally, management is pursuing other sources of debtfinancing to fund a portion of the construction costs for the Moshannon ValleyCorrectional Center. However, there can be no assurance that such financingwill be available, or will be available on terms favorable to the Company.

 

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***Contractual Obligations andCommercial Commitments*****.**  The Company has assumed various financialobligations and commitments in the ordinary course of conducting itsbusiness.  The Company has contractualobligations requiring future cash payments under its existing contractualarrangements, such as management, consulting and non-competition agreements.

 

TheCompany maintains operating leases in the ordinary course of its businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, and theterms of the agreements vary from 2004 until 2075.  As of December 31, 2003, the Company’s total commitmentunder these operating leases was approximately $41.9 million.

 

Thefollowing table details the Company’s known future cash payments (on an undiscountedbasis) related to various contractual obligations as of December 31, 2003(in thousands):

 
|                                        |   | **Payments Due by Period** |    |
|---------------------------------------------|--------|----------------------------|---------|
|                                        |   | **Total**                  |    | **2004** |   | **2005 -  2006** |   | **2007 -  2008** |   | **Thereafter** |   |
| Contractual Obligations:                    |   |                       |    |   |   |   |   |   |   |   |   |
| Long-term debt                              |   |                       |    |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.                   |   | 2,000                      |    | — |   | 2,000 |   | — |   | — |   |
| - Special Purpose Entities                  |   | $                          | 233,590 |   | $ | 8,300 |   | $ | 69,290 |   | $ | 21,900 |   | $ | 134,100 |   |
| Capital lease obligations                   |   |                       |    |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.                   |   | 8                          |    | 6 |   | 2 |   | — |   | — |   |
| Operating leases                            |   | 41,933                     |    | 5,783 |   | 8,219 |   | 6,275 |   | 21,656 |   |
| Consultative and non-competition agreements |   | 980                        |    | 360 |   | 620 |   | — |   | — |   |
| Total contractual cash obligations          |   | $                          | 278,511 |   | $ | 14,449 |   | $ | 80,131 |   | $ | 28,175 |   | $ | 155,756 |   |

 

TheCompany enters into letters of credit in the ordinary course of operating andfinancing activities.  As ofDecember 31, 2003, the Company had outstanding letters of credit ofapproximately $5.1 million primarily for certain workers’ compensationinsurance and other operating obligations. The following table details the Company’s letter of credit commitmentsas of December 31, 2003 (in thousands):

 
|                      |   | **Total**              |   | **Amount of Commitment Expiration Per Period** |   |
|---------------------------|--------|------------------------|--------|------------------------------------------------|--------|
|                      |   | **Amounts  Committed** |   | **Less than  1 Year**                          |   | **1-3 Years** |   | **4-5 Years** |   | **Over  5 Years** |   |
|                      |   |                   |   |                                           |   |   |   |   |   |   |   |
| Commercial Commitments:   |   |                   |   |                                           |   |   |   |   |   |   |   |
| Standby letters of credit |   | $                      | 5,108  |                                           | $      | 5,108 |   | $ | — |   | $ | — |   | $ | — |   |
|                           |        |                        |        |                                                |        |  |  |  |  |  |  |  |  |  |  |  |

 

**Related Party Transactions**

 

Oneof the directors of the Company is a partner in a law firm that provides legalservices to the Company. The Company pays legal fees for such services.  Legal fees paid to this law firm wereapproximately $1.1 million, $1.5 million and $2.7 million for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

InJuly 1996, the Company entered into promissory notes with the Company’sformer president and the Company’s founder, a director of the Company untilOctober 2003.  The promissory notesbear interest at an annual rate of 6.63%, mature in June 2004 with nointerim interest or principal payments, are full recourse and collateralized byshares of the Company’s common stock. These notes were repaid in total prior to December 31, 2003.

 

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In connection with the Company president’s resignation inSeptember 2002, the outstanding principal and interest balance ofapproximately $76,000 and $35,000, respectively, was repaid. InOctober 2003, the principal and related accrued interest receivablerelated to the Company founder’s note of $270,000 and $129,000, respectively,was repaid.  The Company recognizedapproximately $17,000, $29,000 and $29,000 of interest income related to thesenotes for the years ended December 31, 2003, 2002 and 2001.

 

EffectiveSeptember 1, 1999, the Company entered into a consulting agreement withthe Company’s founder, who was a director of the Company throughOctober 2003.  As compensation forconsulting services, the Company agreed to an annual payment of at least$255,000 for each of the first four years of the seven-year initial term of theconsulting agreement with an annual payment of at least $180,000 for each ofthe last three years of the seven-year initial term of the consultingagreement.  The Company has an option torenew the consulting agreement for an additional three-year term at an annual salaryof at least $300,000 for each of the three years of the renewal term.  As additional compensation, the Companyagreed to an annual bonus, subject to certain limitations, equal to $75,000during the first four years of the seven-year initial term and an annual bonusof $60,000 during the last three years of the seven-year initial term andduring any renewal term.  The Companyalso agreed to grant options to purchase an aggregate 120,000 shares of theCompany’s common stock in four equal annual installments beginningSeptember 1, 2000.  The optionshave an exercise price equal to the fair market value of the Company’s commonstock on the date of grant and vest at the time such options are granted,subject to certain limitations on exercise. For the year ended December 31, 2003, the Company’s founderaccepted a $100,000 cash payment in lieu of unexercised options.  This payment was expensed by the Company in2003.

 

Aspart of the consulting agreement discussed above, the Company entered into anon-compete agreement with the Company’s founder.  The non-compete agreement has a term of 10 years and requires theCompany to pay a monthly fee of $10,000 for the seven-year initial term of theconsulting agreement.  The Companycapitalizes the monthly payments and amortizes the amounts over the 10-yearterm of the consulting agreement. The Company recognized amortization expenserelated to this agreement of approximately $84,000 for each of the years endedDecember 31, 2003, 2002 and 2001.

 

TheCompany maintains a life insurance policy for the Company’s founder and madepayments related to this policy of approximately $223,000, $214,000 and$215,000 for the years ended December 31, 2003, 2002 and 2001,respectively.

 

TheCompany also compensated the Company’s founder for board of director fees inamounts of $12,000, $30,000 and $22,000 for the years ended December 31,2003, 2002 and 2001, respectively.

 

Totalpayments made for the above consulting and non-compete agreements, board ofdirector fees and expense reimbursements for the Company’s founder wereapproximately $531,000, $477,000 and $428,000 for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

TheCompany also has a non-compete agreement with a director of the Company inconnection with the acquisition of The Abraxas Group, Inc. inSeptember 1997.  Under thisagreement, the Company is required to pay annual installments of $60,000beginning January 2, 1998.  Thesepayments can and have been accelerated upon the mutual agreement of thedirector and the Company.  As ofDecember 31, 2003, the balance on this non-compete agreement had been paidin full. The balance due on this non-compete agreement as of December 31,2002 was approximately $200,000.  TheCompany made payments under this agreement of $200,000, $80,000, and $200,000for the years ended December 31, 2003, 2002 and 2001, respectively.

 

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**Inflation**

 

Otherthan personnel, offender medical costs at certain facilities and employeemedical and worker’s compensation insurance costs, management believes thatinflation has not had a material effect on the Company’s results of operationsduring the past three years.  Most ofthe Company’s facility management contracts provide for payments to the Companyof either fixed per diem fees or per diem fees that increase by only smallamounts during the term of the contracts. Inflation could substantially increase the Company’s personnel costs(the largest component of operating expenses), medical and insurance costs orother operating expenses at rates faster than any increases in contractrevenues.

 

**Risk Factors and Cautionary Statement for Purposes of the“Safe Harbor” Provisions of the Private Securities Litigation Reform Act of1995**

 

Thisreport contains or incorporates by reference forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995.  These statements are based on current plansand expectations of management and involve risks and uncertainties that couldcause actual future activities and results of operations to be materiallydifferent from those set forth in the forward-looking statements.  Important factors that could cause actualresults to differ include, among others, (1) the outcomes of pending putativeclass action shareholder and derivative lawsuits, and related insurancecoverage (2) the outcome of the pending SEC investigation (3) risks associatedwith acquisitions and the integration thereof (including the ability to achieveadministrative and operating cost savings and anticipated synergies), (4) thetiming and costs of the opening of new facilities or the expansions of existingfacilities, (5) changes in governmental policy and/or funding to discontinue ornot renew existing arrangements or to eliminate or discourage the privatizationof correctional, detention and adult community - based services in the UnitedStates, or to eliminate rate increases (6) the availability of debt and equityfinancing on terms that are favorable to the Company, (7) fluctuations inoperating results because of occupancy, competition (including competition fromtwo competitors that are substantially larger than the Company), increases incost of operations, fluctuations in interest rates and risks of operations, (8)significant charges to expense of deferred costs associated with financing andother projects in development if management determines that one or more of suchprojects is unlikely to be successfully concluded, (9) results from alternativedeployment or sale of facilities such as the New Morgan Academy or theinability to do so and (10) the Company's ability to negotiate a contractamendment with the BOP related to the Moshannon Valley Correctional Center.

 

Whereany forward-looking statement includes a statement of the assumptions or basesunderlying the forward-looking statement, the Company cautions that, while itbelieves these assumptions or bases to be reasonable and in good faith, assumedfacts or bases almost always vary from the actual results, and differencesbetween assumed facts or bases and actual results can be material, dependingupon the circumstances. Where, in any forward-looking statement, the Company orits management express an expectation or belief as to future results, thatexpectation or belief is expressed in good faith and is believed to have areasonable basis. The Company cannot assure you, however, that the statement ofexpectation or belief will result or be achieved or accomplished.  The words “believe,” “expect,” “estimate,”“anticipate” and similar expressions will generally identify forward-lookingstatements.  All of the Company’sforward-looking statements, whether written or oral, are expressly qualified bythese cautionary statements and any other cautionary statements that mayaccompany such forward-looking statements. In addition, the Company disclaims any obligation to update anyforward-looking statements to reflect events or circumstances after the date ofthis report.

 

Withthis in mind, you should consider the risks discussed elsewhere in this reportand other documents the Company files with the Commission from time to time andthe following important factors that could cause actual results to differmaterially from those expressed in any forward-looking statement made by theCompany or on its behalf.

 

***Public resistance to privatization ofcorrectional and detention facilities could result in the Company’s inabilityto obtain new contracts or the loss of existing contracts.***

 

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Managementof correctional and detention facilities by private entities has not achievedcomplete acceptance by either the government or the public.  The movement toward privatization ofcorrectional and detention facilities has also encountered resistance fromcertain groups, such as labor unions, local sheriff’s departments, and groupsbelieving that correctional and detention facility operations should only beconducted by government agencies. Changes in the dominant political party in any market in whichcorrectional facilities are located could have an adverse impact onprivatization.  Further, some governmentagencies are not legally permitted to delegate their traditional managementresponsibilities for correctional and detention facilities to privatecompanies.

 

Anyof these resistances may make it more difficult for the Company to renew ormaintain existing contracts, to obtain new contracts or sites on which tooperate new facilities or to develop or purchase facilities and lease them to governmentor private entities, any or all of which could have a material adverse effecton the Company’s business.

 

***The Company is subject to the short-termnature of government contracts.***

 

Manygovernmental agencies are legally limited in their ability to enter intolong-term contracts that would bind elected officials responsible for futurebudgets.  Therefore, many contracts withgovernment agencies typically either have a very short term or are subject totermination on short notice without cause. In addition, the Company’s contractswith government agencies may contain one or more renewal options that may beexercised only by the contracting government agency.  No assurance can be given that any agency will exercise a renewaloption in the future.  The non-renewalor termination of any of the Company’s significant contracts with governmentagencies could materially adversely affect the Company’s financial condition,results of operation and liquidity, including its ability to secure newfacility management contracts from others.

 

***The Company is dependent on governmentappropriations. If government appropriation levels are reduced, the Company’sbusiness may be harmed.***

 

TheCompany’s cash flow is subject to the receipt of sufficient funding of andtimely payment by contracting government entities. If the appropriategovernment agency does not receive sufficient appropriations to cover itscontractual obligations, a contract may be terminated or the amounts payable tothe Company may be deferred or reduced. Any delays in payment, or the termination of a significant contract,could have an adverse effect on the Company’s cash flow and financialcondition.  Moreover, as a result of theslowing economy, federal, state and local governments may encounter unusualbudgetary constraints and there is a risk that spending on outsourced servicesprovided by the Company may be curtailed. The Company has experienced both rate reductions and rescission ofscheduled rate increases at the hands of several state and local governments.  The Company has implemented measures toprotect itself from such occurrences in the future, but there is no assurancethat such steps will be completely successful.

 

***The Company may notbe successful in meeting the requirements of the Sarbanes-Oxley Act of 2002.***

 

The Sarbanes-Oxley Act of 2002 has introduced many new requirementsapplicable to the Company regarding corporate governance and financialreporting.  Among many otherrequirements is the requirement under Section 404 of the Act, beginning withthe 2004 Annual Report for management to report on the Company’s internalcontrols over financial reporting and for the Company’s registered publicaccountant to attestto this report.  During 2003, theCompany commenced actions to ensure its ability to comply with theserequirements, including but not limited to, the engaging of outside experts toassist in the evaluation of our controls, additional staffing requirements ofour internal audit department and documentation of existing controls.  In addition, the Company expects to continueto devote substantial time and incur substantial costs during 2004 to ensurecompliance.  There can be no assurancethat the Company will be successful in complying with Section 404.  Failure to do so could result in the loss ofcustomers, penalties and additional expenditures to meet the requirements.

 

***The Company’s ability to win new contractsto develop and manage correctional, detention and treatment facilities dependson many factors outside its control.***

 

TheCompany’s growth is generally dependent upon its ability to win new contractsto develop and manage new correctional, detention and treatmentfacilities.  This depends on a number offactors the Company cannot control, including crime rates and sentencingpatterns in various jurisdictions. Accordingly, the demand for the Company’s facilities could be adverselyaffected by the relaxation of enforcement efforts, leniency in conviction andsentencing practices or through the legal decriminalization of certainactivities that are currently proscribed by criminal laws.  For instance, any changes with respect todrugs and controlled substances or illegal immigration could affect the numberof persons arrested, convicted and sentenced, thereby potentially reducingdemand for correctional facilities to house them. Similarly, reductions incrime rates could lead to reductions in arrests, convictions and sentencesrequiring correctional facilities.  TheBureau of Justice

 

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Statisticsreports that the level of violent crime in the United States has declinedsteadily since 1994 and the level of property crime is at the lowest levelsince 1974.  However, the number ofdetained offenders has grown steadily during that period.

 

Whilethe Company believes that governments will continue to privatize correctional,detention and treatment facilities, the Company believes the rate of growthexperienced in the state private corrections industry during the late 1980’sand early 1990’s is moderating.  Certainjurisdictions recently have required successful bidders to make a significantcapital investment in connection with the financing of a particular project, atrend that could require the Company to have sufficient capital resources tocompete effectively.  The Company maynot be able to obtain these capital resources when needed.  Additionally, the Company’s success inobtaining new awards and contracts may depend, in part, upon its ability tolocate land that can be leased or acquired under favorable terms.  Otherwise desirable locations may be in ornear populated areas and, therefore, may generate legal action or other formsof opposition from residents in areas surrounding a proposed site.

 

TheCompany is currently negotiating a contract amendment with the BOP related tothe Moshannon Valley Correctional Center. If the Company is unable to successfully negotiate the amendment withthe BOP or if the Company is unable to obtain the re-approval of the project bythe lenders under the Company’s amended 2000 Credit Facility, the Company willbe unable to move forward with the construction and operation of the facility.

 

***The Company’s profitability may suffer ifthe number of offenders occupying its correctional, detention and treatmentfacilities decreases.***

 

TheCompany’s correctional, detention and treatment facilities are dependent upongovernment agencies supplying offenders. A substantial portion of the Company’s revenues is generated undercontracts that specify a net rate per day per resident, or a per diem rate,sometimes with no minimum guaranteed occupancy levels, even though mostcorrectional facility cost structures are relatively fixed.  Under such a per diem rate structure, a decreasein occupancy levels at a particular facility could have a material adverseeffect on the financial condition and results of operations at such facility.

 

***A failure to comply with existingregulations could result in material penalties or non-renewal or termination ofthe Company’s contracts to manage correctional, detention and treatmentfacilities.***

 

TheCompany’s industry is subject to a variety of federal, state and localregulations, including education, health care and safety regulations, which areadministered by various regulatory authorities.  The Company may not always successfully comply with theseregulations, and failure to comply could result in material penalties ornon-renewal or termination of facility management contracts.  The contracts typically include extensivereporting requirements and supervision and on-site monitoring byrepresentatives of contracting government agencies.  Corrections officers are customarily required to meet certaintraining standards, and in some instances facility personnel are required to belicensed and subject to background investigation. Certain jurisdictions alsorequire the subcontracts to be awarded on a competitive basis or to subcontractwith businesses owned by members of minority groups.  The Company’s facilities are also subject to operational andfinancial audits by the governmental agencies with which the Company hascontracts.  The failure to comply withany applicable laws, rules or regulations and the loss of any required licensecould adversely affect the financial condition and results of operations at theCompany’s affected facilities.

 

***Government agencies may investigate andaudit the Company’s contracts and, if any improprieties are found, the Companymay be required to refund revenues it has received, to forego anticipatedrevenues and may be subject to penalties and sanctions, including prohibitionson the Company’s bidding in response to requests for proposals, or RFPs.***

 

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Certainof the government agencies the Company contracts with have the authority toaudit and investigate the Company’s contracts with them.  As part of that process, the governmentagency reviews the Company’s performance on the contract, its pricingpractices, its cost structure and its compliance with applicable laws,regulations and standards.  If theagency determines that the Company has improperly allocated costs to a specificcontract, the Company may not be reimbursed for those costs and the Companycould be required to refund the amount of any such costs that have beenreimbursed.  If a government audituncovers improper or illegal activities by the Company or the Company otherwisedetermines that these activities have occurred, the Company may be subject tocivil and criminal penalties and administrative sanctions, includingtermination of contracts, forfeitures of profits, suspension of payments, finesand suspension or disqualification from doing business with thegovernment.  Any adverse determinationcould adversely impact the Company’s ability to bid in response to RFPs in oneor more jurisdictions.

 

***If the Company fails to satisfy itscontractual obligations, the Company’s ability to compete for future contractsand its financial condition may be adversely affected.***

 

TheCompany’s failure to comply with contract requirements or to meet its client’sperformance expectations when performing a contract could materially andadversely affect the Company’s financial performance and its reputation, which,in turn, would impact the Company’s ability to compete for new contracts.  The Company’s failure to meet contractualobligations could also result in substantial actual and consequentialdamages.  In addition, the Company’scontracts often require it to indemnify clients for the Company’s failure tomeet performance standards. Some of the Company’s contracts contain liquidateddamages provisions and financial penalties related to performancefailures.  Although the Company hasliability insurance, the policy limits may not be adequate to provideprotection against all potential liabilities.

 

***New competitors in the Company’s industrymay adversely affect the profitability of the Company’s business.***

 

TheCompany must compete on the basis of cost, quality and range of servicesoffered, experience in managing facilities, reputation of personnel and abilityto design, finance and construct new facilities on a cost effective competitivebasis.  While there are barriers forcompanies seeking to enter into the management and operation of correctional,detention and treatment facilities, there can be no assurance that thesebarriers will be sufficient to limit additional competition.

 

***A disturbance in one of the Company’sfacilities could result in closure of a facility or harm to the Company’sbusiness.***

 

Anescape, riot or other disturbance at one of the Company’s facilities couldadversely effect the financial condition, results of operations and liquidityof the Company’s operations. Among other things, the adverse publicitygenerated as a result of an event could adversely affect the Company’s abilityto retain an existing contract or obtain future ones. In addition, if such anevent were to occur, there is a possibility that the facility where the eventoccurred may be shut down by the relevant governmental agency.  A closure of certain of the Company’sfacilities could adversely affect the financial condition, results ofoperations and liquidity of the Company’s operations.

 

***Inaccurate, misleading or negative mediacoverage could adversely affect the Company’s reputation and its ability to bidfor government contracts.***

 

Themedia frequently focuses its attention on private operators’ contracts withgovernment agencies.  If the mediacoverage is negative, it could influence government officials to slow the paceof outsourcing government services, which could reduce the number of RFPs.  The media may also focus its attention onthe activities of

 

55

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politicalconsultants engaged by the Company, even when their activities are unrelated tothe Company’s business, and the Company may be tainted by adverse mediacoverage about their activities. Moreover, inaccurate, misleading or negative media coverage about theCompany could harm its reputation and, accordingly, its ability to bid for andwin government contracts.

 

***The Company may incur significant costsbefore receiving related revenues, which could result in cash shortfalls.***

 

Whenthe Company is awarded a contract to manage a government program, it may incursignificant expenses before the Company receives contract payments. Theseexpenses include leasing office space, purchasing office equipment and hiringand training personnel. As a result, in certain large contracts where thegovernment does not fund program pre-opening and start-up costs, the Companymay be required to invest significant sums of money before receiving relatedcontract payments.  In addition,payments due to the Company from government agencies may be delayed due tobilling cycles or as a result of failures to approve governmental budgets andfinalize contracts in a timely manner. Several of the Company’s contracts provide for annual collection severalmonths after a school year is completed.

 

***The Company may be unable to attract andretain sufficient qualified personnel necessary to sustain its business.***

 

TheCompany’s delivery of services is labor-intensive.  When the Company is awarded a government contract, the Companymust hire operating management, security, case management and other personnel.  The success of the Company’s businessrequires that the Company attract, develop, motivate and retain thesepersonnel. The Company’s inability to hire sufficient personnel on a timelybasis or the loss of significant numbers of personnel could adversely affectits business.

 

***Unsuccessful financing or acquisitionprojects may result in charges to expense for deferred costs.***

 

Ifthe Company determines that one or more financing or acquisition projects isunlikely to be successfully concluded, the Company could incur significantcharges to expense for deferred costs associated with such projects.

 

***Failure to obtain additional capital in thefuture could reduce the Company’s ability to grow.***

 

TheCompany believes that existing cash and cash equivalents and the cash flowsgenerated from operations, together with the Company’s revolving creditavailable under the amended 2000 Credit Facility, and the lease capacitythereunder, will be adequate to fund the Company’s operating plans for theforeseeable future.  However, theCompany may need additional debt or equity financing in order to carry out itsgrowth strategy.  To the extent that theCompany requires additional financing in the future and is unable to obtainsuch additional financing on satisfactory terms, if at all, it may not be ableto fully implement its growth strategy.

 

***If the Company does not successfullyintegrate the businesses that it acquires, the Company’s results of operationscould be adversely affected.***

 

TheCompany may be unable to manage businesses that it may acquire profitably orintegrate them successfully without incurring substantial expenses, delays orother problems that could negatively impact the Company’s results ofoperations.

 

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Moreover,business combinations involve additional risks, including:

 

•        diversion of management’s attention;

•        loss of key personnel;

•        assumption of unanticipated legal orfinancial liabilities;

•        the Company’s becoming significantlyleveraged as a result of the incurrence of debt to finance an acquisition;

•        unanticipated operating, accounting ormanagement difficulties in connection with the acquired entities;

•        amortization or charges of acquiredintangible assets, including goodwill; and

•        dilution to the Company’s earnings per share.

 

Also,client dissatisfaction or performance problems with an acquired business couldmaterially and adversely affect the Company’s reputation as a whole.  Further, the acquired businesses may notachieve the revenues and earnings the Company anticipated.

 

***Because federal environmental laws imposestrict as well as joint and several liability for clean up costs, unforeseenenvironmental risks could prove to be costly.***

 

TheCompany’s facilities may be subject to unforeseen environmental risks.  The federal Comprehensive EnvironmentalResponse, Compensation, and Liability Act, as amended, or CERCLA, imposesstrict, as well as joint and several, liability for certain environmentalcleanup costs on several classes of potentially responsible parties, includingcurrent owners and operators of the property and, in some cases, lenders whodid not cause or contribute to the contamination.  Furthermore, liability under CERCLA is not limited to the originalor unamortized principal balance of a loan or to the value of the propertysecuring a loan. Other federal and state laws in certain circumstances mayimpose liability for environmental remediation, which costs may besubstantial.  Moreover, certain federalstatutes and certain states by statute impose a lien for any cleanup costsincurred by such state on the property that is the subject of such cleanupcosts.  All subsequent liens on suchproperty generally are subordinated to such an environmental lien and, in somestates, even prior recorded liens are subordinated to environmental liens.

 

***The Company is the subject of class actionlawsuits that, if decided against it, could have a negative effect on itsfinancial condition, results of operations, cash flows and future prospects.***

 

***In March andApril 2002, the Company, the Company’s former President and ChiefExecutive Officer and the Company’s Chief Financial Officer were named asdefendants in four federal putative class action lawsuits. These lawsuits werebrought on behalf of all purchasers of the Company’s common stock betweenMarch 6, 2001 and March 5, 2002 and relate to the Company’srestatement in 2002 of certain financial statements.  The lawsuits involved disclosures made concerning two priortransactions executed by the Company: the August***

 

57

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***2001 sale leaseback transactionand the 2000 synthetic lease transaction. These four lawsuits were consolidated into one action and an amendedconsolidated complaint was filed.  Theamended consolidated complaint seeks, among other things, restitution damages,compensatory damages, rescission or a rescissory measure of damages, costs,expenses, attorneys’ fees and expert fees.***

 

In May and June 2002, the Company and its directors were sued incertain other derivative lawsuits. These lawsuits relate to the Company’s restatement in 2002 of certainfinancial statements.  These lawsuitsall allege breaches of fiduciary duty and waste of corporate assets by all ofthe defendants.

 

The plaintiffs in thesecases have not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  Certain insurance policies held by the Company to cover potentialdirector and officer liability may limit the Company’s cash outflows in theevent of a decision adverse to the Company in the matters discussedabove.  However, if an adverse decision in these matters exceeds theinsurance coverage or if the insurance coverage is deemed not to apply to thesematters, an adverse decision to the Company in these matters could have amaterial adverse effect on the Company, its financial condition, its results ofoperations and its future prospects.

 

***The Company is thesubject of a Securities and Exchange Commission investigation that could have anegative effect on the Company if adversely determined.***

 

***Following therestatement of the Company’s 2001 financial statements in 2002, the SECinitiated an investigation into the circumstances leading to thisrestatement.  Following the SEC’sinitial inquiry in 2002 the SEC made no further inquiry with respect to theinvestigation until July 2003. Since July 2003, the Company has received additional informationrequests from the SEC.  The Company hascooperated, and intends to continue to fully cooperate, with the SEC’sinvestigation.***

 

***Depending onthe scope, timing and result of the SEC investigation, management’s attentionand the Company’s resources could be diverted from operations, which couldadversely affect the Company’s operating results and contribute to future stockprice volatility.  The SEC investigationcould also require that the Company take other actions not currentlycontemplated.  In addition, the SECinvestigation or its outcome may increase the costs of defending or resolvingcurrent litigation.***

 

***The SEC has notgiven the Company any indication as to the outcome of its investigation.  If the SEC makes a determination adverse tothe Company, the Company and its officers and directors may face penalties,including, but not limited to, monetary fines and injunctive relief.  In addition, in the event of an adversedetermination by the SEC against the Company or its officers or directors,federal and/or state agencies may be reluctant to enter into or prohibited fromentering into contracts for the Company’s services.  Any such reaction from the Company’s customer base could have amaterial adverse effect on its business.***

 

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**ITEM 7A.**         **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**Quantitative and Qualitative Disclosures about Market Risk**

 

Inthe normal course of business, the Company is exposed to market risk, primarilyfrom changes in interest rates.  TheCompany continually monitors exposure to market risk and develops appropriatestrategies to manage this risk.  TheCompany is not exposed to any other significant market risks, includingcommodity price risk, foreign currency exchange risk or interest rate risksfrom the use of derivative financial instruments. Management does not usederivative financial instruments for trading or to speculate on changes ininterest rates or commodity prices.

 

**Interest Rate Exposure**

 

The Company’s exposure tochanges in interest rates primarily results from its long-term debt with bothfixed and floating interest rates.  Thedebt on the Company’s consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction.  At December 31, 2003, approximately22.3% (approximately $50.6 million of debt outstanding to the Synthetic LeaseInvestor Notes A and B and $2.0 million outstanding on the Company’s amended2000 Credit Facility) of the Company’s consolidated long-term debt was subjectto variable interest rates.  Thedetrimental effect of a hypothetical 100 basis point increase in interest rateswould be to reduce income before provision for income taxes by approximately$526,000 for the year ended December 31, 2003.  At December 31, 2003, the fair value of the Company’sconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

 

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**REPORT OF****INDEPENDENT AUDITORS**

 

Tothe Board of Directors and Stockholders of

CornellCompanies, Inc.:

 

Inour opinion, the accompanying consolidated balance sheets as ofDecember 31, 2003 and 2002 and the related consolidated statements ofoperations and comprehensive income, stockholders’ equity and cash flows foreach of the years then ended present fairly, in all material respects, thefinancial position of Cornell Companies, Inc. and its subsidiaries(collectively the Company) at December 31, 2003 and 2002, and the resultsof their operations and their cash flows for each of the years then ended inconformity with accounting principles generally accepted in the United Statesof America.  These financial statementsare the responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.  The consolidated financial statements of theCompany for the year ended December 31, 2001, prior to the revisionsdescribed in Note 3 of the consolidated financial statements, were audited byother independent accountants who have ceased operations.  Those independent accountants expressed anunqualified opinion on those financial statements in their report datedApril 16, 2002.

 

As discussed above, theconsolidated financial statements of the Company as of December 31, 2001,and for the year then ended, were audited by other independent accountants whohave ceased operations.  As described inNote 3, those financial statements have been revised to include thetransitional disclosures required by Statement of Financial Accounting StandardNo. 142, “Goodwill and Other Intangible Assets,” which was adopted by theCompany as of January 1, 2002.  Weaudited the transitional disclosures for 2001 included in Note 3.  In our opinion, the transitional disclosuresfor 2001 in Note 3 are appropriate.  Additionally, as described in Note 3, thesefinancial statements have been revised to conform to the requirements set forthin Statement of Financial Accounting Standard No. 145, “Rescission of FASB Statements No. 4, 44, and64, Amendment of FASB Statement No. 13, and Technical Corrections,” which wasadopted by the Company as of January 1, 2003.  Weaudited the adjustments described in Note 3 that were applied to revise the2001 financial statements.  In ouropinion, such adjustments are appropriate and have been properly applied.  However, we were not engaged toaudit, review, or apply any procedures to the 2001 financial statements of theCompany other than with respect to such disclosures and, accordingly, we do notexpress an opinion or any other form of assurance on the 2001 financialstatements taken as a whole.

 

 
| /s/  PRICEWATERHOUSECOOPERS LLP |   |
|---------------------------------|--------|
|                            |
| Houston,  Texas                 |
| March 11,  2004            |

 

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Thefollowing report is a copy of a report previously issued by Arthur Andersen LLP(“Andersen”).  This report has not beenreissued by Andersen and Andersen did not consent to the incorporation byreference of this report (as included in this Form 10-K) into any of theCompany’s registration statements.

 

Asdiscussed in Note 3, the Company has revised its financial statements for theyear ended December 31, 2001 to include the transitional disclosuresrequired by statement of financial accounting standards No. 142, “Goodwill andIntangible Assets.”  The Andersen reportdoes not extend to these changes.  Therevisions to the 2001 financial statements related to these transitionaldisclosures were reported on by PricewaterhouseCoopers LLP, as stated in theirreport appearing herein.

 

Additionally, as discussed in Note 3, theCompany has revised its financial statements for the year endedDecember 31, 2001 to conform to the requirements set forth in Statement ofFinancial Accounting Standard No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections.” The Andersen report does not extend to these changes.  The revisions to the 2001 financialstatements related to these the adoption of Statement of Financial AccountingStandard No. 145 were reported on by PricewaterhouseCoopers LLP, as stated intheir report appearing herein.

 

**REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS**

 

Tothe Board of Directors of

CornellCompanies, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Cornell Companies,Inc. and subsidiaries as of December 31, 2001 and 2000*, and the relatedconsolidated statements of operations, stockholders’ equity and cash flows foreach of the three years in the period ended December 31, 2001*.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Cornell Companies, Inc. andsubsidiaries as of December 31, 2001* and 2000*, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2001*, in conformity with accounting principles generallyaccepted in the United States.

 
| /s/  ARTHUR ANDERSEN LLP |   |
|--------------------------|--------|
|                     |
| Houston,  Texas          |
| April 16,  2002     |

 

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*       The Company’s consolidated balance sheet as of December 31, 2001and 2000 and the consolidated statements of operations and comprehensiveincome, shareholders’ equity and cash flows for the years endedDecember 31, 2000 and 1999 are not included in this Form 10-K.

 

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**ITEM 8.****           ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands, except share data)**

 
|                                                                                                                                 |   | **December 31,** |    |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|
|                                                                                                                                 |   | **2003**              |    | **2002** |   |
| ASSETS                                                                                                                               |   |                  |    |   |   |
| CURRENT ASSETS:                                                                                                                      |   |                  |    |   |   |
| Cash and cash equivalents                                                                                                            |   | $                     | 40,171  |   | $ | 52,610 |   |
| Accounts receivable - trade (net of allowance for  doubtful accounts of $1,929 and $2,238, respectively)                             |   | 52,772                |    | 57,263 |   |
| Other receivables (net of allowance for doubtful  accounts of $5,386 for 2003                                                        |   | 3,769                 |    | 2,772 |   |
| Restricted assets                                                                                                                    |   | 22,185                |    | 14,767 |   |
| Deferred tax assets                                                                                                                  |   | 3,411                 |    | 3,300 |   |
| Prepaids and other                                                                                                                   |   | 8,789                 |    | 5,528 |   |
| Total current assets                                                                                                                 |   | 131,097               |    | 136,240 |   |
| PROPERTY AND EQUIPMENT, net                                                                                                          |   | 267,903               |    | 255,450 |   |
| OTHER ASSETS:                                                                                                                        |   |                  |    |   |   |
| Debt service reserve fund                                                                                                            |   | 23,800                |    | 24,157 |   |
| Intangible assets, net                                                                                                               |   | 13,287                |    | 13,062 |   |
| Deferred costs and other                                                                                                             |   | 12,070                |    | 12,382 |   |
| Total assets                                                                                                                         |   | $                     | 448,157 |   | $ | 441,291 |   |
|                                                                                                                                 |   |                  |    |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                            |   |                  |    |   |   |
|                                                                                                                                 |   |                  |    |   |   |
| CURRENT LIABILITIES:                                                                                                                 |   |                  |    |   |   |
| Accounts payable and accrued liabilities                                                                                             |   | $                     | 36,577  |   | $ | 32,622 |   |
| Current portion of long-term debt                                                                                                    |   | 8,306                 |    | 7,630 |   |
| Total current liabilities                                                                                                            |   | 44,883                |    | 40,252 |   |
| LONG-TERM DEBT, net of current portion                                                                                               |   | 227,292               |    | 232,258 |   |
| DEFERRED TAX LIABILITIES                                                                                                             |   | 7,006                 |    | 4,954 |   |
| OTHER LONG-TERM LIABILITIES                                                                                                          |   | 2,741                 |    | 3,875 |   |
| Total liabilities                                                                                                                    |   | 281,922               |    | 281,339 |   |
|                                                                                                                                 |   |                  |    |   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                        |   |                  |    |   |   |
|                                                                                                                                 |   |                  |    |   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                           |   |                  |    |   |   |
| Preferred stock, $.001 par value, 10,000,000  shares authorized, none issued                                                         |   | —                |    | — |   |
| Common stock, $.001 par value, 30,000,000 shares  authorized, 14,578,505 and 14,201,038 shares issued and outstanding,  respectively |   | 15                    |    | 14 |   |
| Additional paid-in capital                                                                                                           |   | 143,735               |    | 140,085 |   |
| Retained earnings                                                                                                                    |   | 34,218                |    | 30,248 |   |
| Treasury stock (1,537,583 and 1,429,586 shares of  common stock, respectively, at cost)                                              |   | (12,458               | )       | (11,038 | ) |
| Deferred compensation                                                                                                                |   | (803                  | )       | (811 | ) |
| Notes from shareholders                                                                                                              |   | —                |    | (442 | ) |
| Other comprehensive income                                                                                                           |   | 1,528                 |    | 1,896 |   |
| Total stockholders’ equity                                                                                                      |   | 166,235               |    | 159,952 |   |
| Total liabilities and stockholders’ equity                                                                                      |   | $                     | 448,157 |   | $ | 441,291 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**CORNELL COMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVEINCOME (LOSS)**

**(in thousands, except per share data)**

 
|                                                                                                                                                                   |   | **Year Ended December 31,** |    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|---------|
|                                                                                                                                                                   |   | **2003**                         |    | **2002** |   | **2001** |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| REVENUES                                                                                                                                                               |   | $                                | 271,632 |   | $ | 275,145 |   | $ | 265,250 |   |
| OPERATING EXPENSES                                                                                                                                                     |   | 209,736                          |    | 212,309 |   | 205,805 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                                                                      |   | 3,398                            |    | — |   | 3,858 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                                                          |   | 10,699                           |    | 9,779 |   | 9,278 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                                                                    |   | 23,415                           |    | 21,480 |   | 15,291 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| Income from operations                                                                                                                                                 |   | 24,384                           |    | 31,577 |   | 31,018 |   |
| INTEREST EXPENSE                                                                                                                                                       |   | 19,280                           |    | 20,698 |   | 21,787 |   |
| INTEREST INCOME                                                                                                                                                        |   | (1,626                           | )       | (1,974 | ) | (888 | ) |
| LOSS ON EXTINGUISHMENT OF DEBT                                                                                                                                         |   | —                           |    | — |   | 4,946 |   |
| MINORITY INTEREST IN CONSOLIDATED SPECIAL PURPOSE  ENTITIES                                                                                                            |   | —                           |    | 574 |   | (1,674 | ) |
| Income before provision for income taxes and  cumulative effect of changes in accounting principles                                                                    |   | 6,730                            |    | 12,279 |   | 6,847 |   |
| PROVISION FOR INCOME TAXES                                                                                                                                             |   | 2,760                            |    | 4,952 |   | 2,958 |   |
| Income before cumulative effect of changes in  accounting principles                                                                                                   |   | 3,970                            |    | 7,327 |   | 3,889 |   |
| CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING  PRINCIPLES, NET OF RELATED INCOME TAX PROVISION (BENEFIT) OF APPROXIMATELY  ($671) AND $535 IN 2002 AND 2001, RESPECTIVELY |   | —                           |    | (965 | ) | 770 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| Net income                                                                                                                                                             |   | $                                | 3,970   |   | $ | 6,362 |   | $ | 4,659 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| EARNINGS PER SHARE:                                                                                                                                                    |   |                             |    |   |   |   |   |
| BASIC                                                                                                                                                                  |   |                             |    |   |   |   |   |
| Income before cumulative effect of changes in  accounting principles                                                                                                   |   | $                                | .31     |   | $ | .57 |   | $ | .40 |   |
| Cumulative effect of changes in accounting  principles                                                                                                                 |   | —                           |    | (.08 | ) | .08 |   |
| Net income                                                                                                                                                             |   | $                                | .31     |   | $ | .49 |   | $ | .48 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| DILUTED                                                                                                                                                                |   |                             |    |   |   |   |   |
| Income before cumulative effect of changes in  accounting principles                                                                                                   |   | $                                | .30     |   | $ | .55 |   | $ | .39 |   |
| Cumulative effect of changes in accounting  principles                                                                                                                 |   | —                           |    | (.07 | ) | .07 |   |
| Net income                                                                                                                                                             |   | $                                | .30     |   | $ | .48 |   | $ | .46 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                                                                        |   |                             |    |   |   |   |   |
| BASIC                                                                                                                                                                  |   | 12,941                           |    | 12,911 |   | 9,616 |   |
| DILUTED                                                                                                                                                                |   | 13,263                           |    | 13,232 |   | 10,069 |   |
|                                                                                                                                                                   |   |                             |    |   |   |   |   |
| COMPREHENSIVE INCOME:                                                                                                                                                  |   |                             |    |   |   |   |   |
| Net income                                                                                                                                                             |   | $                                | 3,970   |   | $ | 6,362 |   | $ | 4,659 |   |
| Unrealized gain/(loss) on derivative instruments                                                                                                                       |   | (368                             | )       | 1,896 |   | — |   |
| Comprehensive income                                                                                                                                                   |   | $                                | 3,602   |   | $ | 8,258 |   | $ | 4,659 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements..

 

63

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**CORNELL COMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(in thousands, except share data)**

 
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   | **Notes**   |   | **Other**         |   |
|-----------------------------------------------------------------------------|--------|------------------|--------|----------------|--------|-------------|--------|--------------|--------|--------------|--------|------------------|--------|-------------|--------|-------------------|--------|
|                                                                        |   | **Common Stock** |   | **Additional** |   |        |   |         |   |         |   | **from**         |   | **Compre-** |   |
|                                                                        |   |             |   | **Par**        |   | **Paid-In** |   | **Retained** |   | **Treasury** |   | **Deferred**     |   | **Share-**  |   | **hensive**       |   |
|                                                                        |   | **Shares**       |   | **Value**      |   | **Capital** |   | **Earnings** |   | **Stock**    |   | **Compensation** |   | **holders** |   | **Income/(Loss)** |   |
| BALANCES AT JANUARY 1, 2001                                            |   | 10,161,113       |   | $              | 10     |        | $      | 91,625       |   | $            | 19,227 |             | $      | (5,933      | )      | $                 | — |   | $ | (609 | ) | $ | — |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| EXERCISE OF STOCK OPTIONS                                                   |   | 156,923          |   | —         |   | 886         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |   | —           |   | —         |   | 619         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| DEFERRED COMPENSATION                                                       |   | —           |   | —         |   | 1,088       |   | —       |   | —       |   | (1,088           | )      | —      |   | —            |   |
| AMORTIZATION OF DEFERRED COMPENSATION                                       |   | —           |   | —         |   | —      |   | —       |   | —       |   | 55               |   | —      |   | —            |   |
| PURCHASE OF TREASURY STOCK (154,316 SHARES AT COST)                         |   | —           |   | —         |   | —      |   | —       |   | (2,157       | )      | —           |   | —      |   | —            |   |
| ISSUANCE OF COMMON STOCK IN PUBLIC OFFERING                                 |   | 3,450,000        |   | 4              |   | 43,818      |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK PURCHASE  PLAN                   |   | 46,767           |   | —         |   | 214         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S  STOCK PLAN             |   | 22,387           |   | —         |   | 125         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| EXERCISE OF STOCK WARRANTS                                                  |   | 168,292          |   | —         |   | 603         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | (42         | )      | —            |   |
| NET INCOME                                                                  |   | —           |   | —         |   | —      |   | 4,659        |   | —       |   | —           |   | —      |   | —            |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| BALANCES AT DECEMBER 31, 2001                                          |   | 14,005,482       |   | 14             |   | 138,978     |   | 23,886       |   | (8,090       | )      | (1,033           | )      | (651        | )      | —            |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| EXERCISE OF STOCK OPTIONS                                                   |   | 95,059           |   | —         |   | 201         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |   | —           |   | —         |   | 244         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| DEFERRED COMPENSATION                                                       |   | —           |   | —         |   | (101        | )      | —       |   | —       |   | 101              |   | —      |   | —            |   |
| MARK TO MARKET ADJUSTMENTS FOR DEFERRED BONUS PLAN                          |   | —           |   | —         |   | (551        | )      | —       |   | —       |   | 551              |   | —      |   | —            |   |
| OTHER COMPREHENSIVE INCOME                                                  |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | —      |   | 1,896             |   |
| DEFERRED AND OTHER STOCK COMPENSATION                                       |   | —           |   | —         |   | 144         |   | —       |   | —       |   | 89               |   | —      |   | —            |   |
| PURCHASE OF TREASURY STOCK (277,100 SHARES, AT COST)                        |   | —           |   | —         |   | —      |   | —       |   | (2,429       | )      | —           |   | —      |   | —            |   |
| PURCHASES OF TREASURY STOCK BY DEFERRED BONUS PLAN  (39,665 SHARES AT COST) |   | —           |   | —         |   | 519         |   | —       |   | (519         | )      | (519             | )      | —      |   | —            |   |
| REPAYMENT OF SHAREHOLDER NOTES                                              |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | 250         |   | —            |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK PURCHASE  PLAN                   |   | 82,581           |   | —         |   | 399         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S  STOCK PLAN             |   | 17,916           |   | —         |   | 252         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | (41         | )      | —            |   |
| NET INCOME                                                                  |   | —           |   | —         |   | —      |   | 6,362        |   | —       |   | —           |   | —      |   | —            |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| BALANCES AT DECEMBER 31, 2002                                          |   | 14,201,038       |   | 14             |   | 140,085     |   | 30,248       |   | (11,038      | )      | (811             | )      | (442        | )      | 1,896             |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| EXERCISE OF STOCK OPTIONS                                                   |   | 315,853          |   | 1              |   | 2,069       |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |   | —           |   | —         |   | 575         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| MARK TO MARKET ADJUSTMENTS FOR DEFERRED BONUS PLAN                          |   | —           |   | —         |   | 315         |   | —       |   | —       |   | (315             | )      | —      |   | —            |   |
| OTHER COMPREHENSIVE INCOME/(LOSS)                                           |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | —      |   | (368              | )      |
| DEFERRED AND OTHER STOCK COMPENSATION                                       |   | —           |   | —         |   | —      |   | —       |   | —       |   | 513              |   | —      |   | —            |   |
| PURCHASE OF TREASURY STOCK (106,500 SHARES, AT  COST)                       |   | —           |   | —         |   | —      |   | —       |   | (1,230       | )      | —           |   | —      |   | —            |   |
| PURCHASES OF TREASURY STOCK BY DEFERRED BONUS PLAN  (8,115 SHARES AT COST)  |   | —           |   | —         |   | 190         |   | —       |   | (190         | )      | (190             | )      | —      |   | —            |   |
| REPAYMENT OF SHAREHOLDER NOTES                                              |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | 464         |   | —            |   |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK PURCHASE  PLAN                   |   | 46,486           |   | —         |   | 356         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S  STOCK PLAN             |   | 15,128           |   | —         |   | 145         |   | —       |   | —       |   | —           |   | —      |   | —            |   |
| ACCRUED INTEREST ON NOTES FROM SHAREHOLDERS                                 |   | —           |   | —         |   | —      |   | —       |   | —       |   | —           |   | (22         | )      | —            |   |
| NET INCOME                                                                  |   | —           |   | —         |   | —      |   | 3,970        |   | —       |   | —           |   | —      |   | —            |   |
|                                                                        |   |             |   |           |   |        |   |         |   |         |   |             |   |        |   |              |   |
| BALANCES AT DECEMBER 31, 2003                                          |   | 14,578,505       |   | $              | 15     |        | $      | 143,735      |   | $            | 34,218 |             | $      | (12,458     | )      | $                 | (803   | ) | $ | — |   | $ | 1,528 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

64

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**CORNELL COMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

 
|                                                                                     |   | **Year Ended  December 31,** |   |
|------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                     |   | **2003**                          |   | **2002** |   | **2001** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                    |   |                              |   |   |   |   |   |
| Net income                                                                               |   | $                                 | 3,970  |   | $ | 6,362 |   | $ | 4,659 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities — |   |                              |   |   |   |   |   |
| Cumulative effect of changes in accounting  principles                                   |   | —                            |   | 965 |   | (770 | ) |
| Minority interest in consolidated special  purpose entities                              |   | —                            |   | 574 |   | (1,674 | ) |
| Loss on extinguishment of debt                                                           |   | —                            |   | — |   | 4,946 |   |
| Depreciation                                                                             |   | 9,804                             |   | 8,901 |   | 7,753 |   |
| Amortization of intangibles and other  assets                                            |   | 895                               |   | 878 |   | 1,525 |   |
| Amortization of deferred compensation                                                    |   | 502                               |   | 233 |   | 55 |   |
| Amortization of deferred financing costs                                                 |   | 1,157                             |   | 1,113 |   | 2,012 |   |
| Provision for bad debts                                                                  |   | 7,550                             |   | 1,246 |   | 1,339 |   |
| Loss on sale of property and equipment                                                   |   | 50                                |   | — |   | 39 |   |
| Deferred income taxes                                                                    |   | 1,941                             |   | (1,959 | ) | 3,637 |   |
| Change in assets and liabilities:                                                        |   |                              |   |   |   |   |   |
| Accounts receivable                                                                      |   | (583                              | )      | 2,010 |   | (9,368 | ) |
| Restricted assets                                                                        |   | 24                                |   | 1,467 |   | (3,696 | ) |
| Other assets                                                                             |   | (2,283                            | )      | 247 |   | 4,680 |   |
| Accounts payable and accrued liabilities                                                 |   | 4,675                             |   | (74 | ) | (1,230 | ) |
| Deferred revenues and other liabilities                                                  |   | (1,491                            | )      | (2,199 | ) | (2,360 | ) |
| Net cash provided by operating activities                                                |   | 26,211                            |   | 19,764 |   | 11,547 |   |
|                                                                                     |   |                              |   |   |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                    |   |                              |   |   |   |   |   |
| Capital expenditures                                                                     |   | (22,304                           | )      | (11,114 | ) | (14,168 | ) |
| Payments to restricted escrow arrangement,  net                                          |   | (10,385                           | )      | — |   | — |   |
| Proceeds from sales of property and  equipment                                           |   | —                            |   | — |   | 98 |   |
| Return of restricted assets from deferred  bonus plan                                    |   | —                            |   | 1,000 |   | — |   |
| Payments of non-compete agreements                                                       |   | (1,000                            | )      | — |   | — |   |
| Purchases of marketable securities, net                                                  |   | —                            |   | — |   | (23,800 | ) |
| Payments to restricted debt payment  account, net                                        |   | (2,275                            | )      | (2,184 | ) | (10,219 | ) |
| Net cash used in investing activities                                                    |   | (35,964                           | )      | (12,298 | ) | (48,089 | ) |
|                                                                                     |   |                              |   |   |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                    |   |                              |   |   |   |   |   |
|                                                                                     |   |                              |   |   |   |   |   |
| Proceeds from long-term debt and bonds                                                   |   | 24,339                            |   | 1,083 |   | 273,774 |   |
| Payments on long-term debt                                                               |   | (21,000                           | )      | — |   | (220,393 | ) |
| Payments of MCF bonds                                                                    |   | (7,600                            | )      | (6,800 | ) | — |   |
| Payments of capital lease obligations                                                    |   | (31                               | )      | (113 | ) | (42 | ) |
| Proceeds from issuances of common stock                                                  |   | —                            |   | — |   | 43,822 |   |
| Payments of debt issuance and other  financing costs                                     |   | (31                               | )      | — |   | (9,537 | ) |
| Collections of payments of shareholder  notes                                            |   | 440                               |   | 173 |   | (3,650 | ) |
| Proceeds from (distributions to) equity  owners of consolidated special purpose entities |   | —                            |   | (614 | ) | 6,249 |   |
| Proceeds from exercise of stock options and  warrants                                    |   | 2,427                             |   | 600 |   | 1,100 |   |
| Purchases of treasury stock                                                              |   | (1,230                            | )      | (2,429 | ) | (2,157 | ) |
| Net cash (used in) provided by financing  activities                                     |   | (2,686                            | )      | (8,100 | ) | 89,166 |   |
|                                                                                     |   |                              |   |   |   |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                    |   | (12,439                           | )      | (634 | ) | 52,624 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                        |   | 52,610                            |   | 53,244 |   | 620 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                               |   | $                                 | 40,171 |   | $ | 52,610 |   | $ | 53,244 |   |
|                                                                                     |   |                              |   |   |   |   |   |
| SUPPLEMENTAL CASH FLOW DISCLOSURE:                                                       |   |                              |   |   |   |   |   |
| Interest paid, net of amounts capitalized                                                |   | $                                 | 18,690 |   | $ | 19,544 |   | $ | 15,728 |   |
| Income taxes paid                                                                        |   | $                                 | 3,387  |   | $ | 3,369 |   | $ | 516 |   |
|                                                                                     |   |                              |   |   |   |   |   |
| OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:                                      |   |                              |   |   |   |   |   |
| Other comprehensive income (loss)                                                        |   | $                                 | (368   | ) | $ | 1,896 |   | $ | — |   |
| Purchases of treasury stock by deferred  bonus plan                                      |   | 190                               |   | 519 |   | — |   |
| Debt cancelled for stock warrants exercise                                               |   | —                            |   | — |   | 603 |   |
| Common stock issued for board of director  fees                                          |   | 145                               |   | 252 |   | 125 |   |
| Borrowings on capital lease                                                              |   | 3                                 |   | 65 |   | 50 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

65

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED****FINANCIAL STATEMENTS**

 

**1.****    ****DESCRIPTION OF THE BUSINESS**

 

CornellCompanies, Inc. (collectively with its subsidiaries and consolidated specialpurpose entities, the “Company”), a Delaware corporation, provides theintegrated development, design, construction and management of facilities togovernmental agencies within three operating segments: (1) adult secureinstitutional services, (2) juvenile justice, educational and treatmentservices and (3) adult community-based corrections and treatment services.

 

**2.****    ****SIGNIFICANT ACCOUNTING POLICIES**

 

*Consolidation*

 

Theaccompanying consolidated financial statements include the accounts of theCompany, its wholly-owned subsidiaries, and the Company’s activities relativeto two financings of operating facilities. All significant intercompanybalances and transactions have been eliminated.  Minority interest in consolidated special purpose entitiesrepresents equity that other investors have contributed to the special purposeentities.  Minority interest is adjustedfor income and losses allocable to the owners of the special purposeentities.  As the cumulative losses ofthe special purpose entity exceed the equity that is recorded as minorityinterest by the Company, the excess losses are recorded in the Company’sStatements of Operations and Comprehensive Income.

 

*Cash and Cash Equivalents*

 

TheCompany considers all highly liquid unrestricted investments with originalmaturities of three months or less to be cash equivalents.  The Company invests its available cashbalances in short term money market accounts and commercial paper.

 

*Accounts Receivable*

 

TheCompany extends credit to the governmental agencies and other partiescontracted with in the normal course of business.  Further, management of the Company regularly reviews outstandingreceivables, and provides estimated losses through an allowance for doubtfulaccounts.  In evaluating the adequacy ofthis allowance for doubtful accounts, management makes judgments regarding itscustomers’ ability to make required payments, economic events and otherfactors.  As the financial condition ofthese parties change, circumstances develop or additional information becomesavailable, adjustments to the allowance for doubtful accounts may occur.

 

AtDecember 31, 2003, other receivables include approximately $5.7 millionrelated to the misappropriated escrow funds for the Southern Peaks TreatmentCenter. The Company has provided a reserve of approximately $5.4 million onthis balance through an allowance for doubtful accounts due to the uncertaintysurrounding its recovery. Refer to Note 9 to the consolidated financialstatements for a discussion concerning the Southern Peaks Treatment Centerescrow account funding and related transactions.

 

66

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Thechanges in the Company’s allowance for doubtful accounts associated with tradeaccounts receivable for the years ended December 31, 2003, 2002 and 2001are as follows (in thousands):

 

|                            |   | **Year Ended  December 31,** |   |
|---------------------------------|--------|-----------------------------------|--------|
|                            |   | **2003**                          |   | **2002** |   | **2001** |   |
|                            |   |                              |   |   |   |   |   |
| Balance at beginning of period  |   | $                                 | 2,238  |   | $ | 3,068 |   | $ | 2,578 |   |
| Provision for bad debts         |   | 2,165                             |   | 1,246 |   | 1,339 |   |
| Write-offs of bad debt accounts |   | (2,474                            | )      | (2,076 | ) | (849 | ) |
| Balance at end of period        |   | $                                 | 1,929  |   | $ | 2,238 |   | $ | 3,068 |   |

 

AtDecember 31, 2003, other receivables include costs totaling approximately$1.4 million for direct costs incurred by the Company since the issuance of aStop-Work Order by the Federal Bureau of Prisons (BOP) in June 1999 forpayroll and other operating costs related to the Moshannon Valley CorrectionalCenter.  These costs were incurred atthe direction of the BOP with the understanding that such costs would bereimbursed.  The Company is pursuing aclaim for reimbursement of a portion of its expenses incurred in connectionwith issuance of the Stop-Work Order and the delay of the project, includingthe $1.4 million in accounts receivable. This reimbursement claim is independent of the amendment to thecontract – i.e., if the BOP agrees to an amendment of the contract, the Companywill still pursue its claim – and the Company is currently negotiating thisclaim with the BOP.  The Company’sinvested costs in the project total approximately $18.2 million.  The BOP has asserted that it is onlyresponsible for reimbursing a portion of these costs – that portion of theinvestment lost due to the issuance of the Stop-Work Order.  Although the Company believes that the BOPwill reimburse substantially more than the $1.4 million account receivable, itis uncertain how much the BOP will agree to pay in connection with theCompany’s claim for reimbursement.  Anyamounts not reimbursed by the BOP, the Company will expense that portion ofcosts that cannot be capitalized with respect to the Company's remaining realproperty interest.   See Note 12 to theconsolidated financial statements

 

*Restricted Assets*

 

Restrictedassets at December 31, 2003 and 2002 include approximately $14.7 millionand $12.4 million, respectively, of MCF’s restricted cash accounts.  MCF’s restricted accounts are comprisedprimarily of a debt service fund used to segregate rental payment funds fromthe Company to MCF for MCF’s semi-annual debt service.  MCF’s funds are invested in short termcertificates of deposit, money market accounts and commercial paper.

 

Restrictedassets at December 31, 2003 include $5.0 million of funds in a restrictedescrow account related to the Southern Peaks Treatment Center. See Note 9 tothe consolidated financial statements for further discussion concerning thisrestricted escrow account.

 

Forcertain facilities, the Company maintains bank accounts for restricted cashbelonging to facility residents, commissary operations and equipmentreplacement funds used in certain state programs.  Restricted assets at December 31, 2003 and 2002include approximately $2.3 million and $2.1 million, respectively, for theseaccounts.  A corresponding liability forthese obligations is included in accrued liabilities in the accompanyingfinancial statements.

 

Restrictedassets at December 31, 2003 and 2002 include approximately $205,000 and$300,000, respectively, of assets held in a rabbi trust for a deferred bonusplan.  See Note 10 to the consolidatedfinancial statements.

 

*Property and Equipment*

 

Propertyand equipment are recorded at cost.  Ordinarymaintenance and repair costs are expensed, while renewal and betterment costsare capitalized.  Buildings andimprovements are depreciated over their estimated useful lives of 30 to 50years using the straight-line method. Prepaid facility use cost, which resulted from the July 1996acquisition of the Big Spring Correctional Center and the December 1999transfer of ownership of the Great Plains Correctional Facility to a leaseholdinterest, is being amortized over 50 years using the straight-line method.  Furniture and equipment are depreciated overtheir estimated useful lives of 3 to 10 years using the straight-linemethod.  Amortization of leaseholdimprovements is recorded using the straight-line method based upon the shorterof the life of the asset or the term of the respective lease.

 

67

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*Capitalized Interest*

 

TheCompany capitalizes interest on facilities while under development andconstruction.  Interest capitalized forthe years ended December 31, 2003, 2002 and 2001 was approximately$760,000, $823,000 and $1.3 million, respectively, and related primarily to thedesign and development of the Moshannon Valley Correctional Center.

 

*Debt Service Reserve Fund*

 

Thedebt service reserve fund was established at the closing of MCF’s bond issuanceand is to be used solely for MCF’s debt service to the extent that funds inMCF’s debt service accounts are insufficient. The debt service reserve fund is invested in short term commercialinstruments and earns a guaranteed rate of return of 3.0%.  See Note 11 to the consolidated financialstatements.

 

*Intangible Assets*

 

Referenceis made to Note 3 to the consolidated financial statements for a discussion ofthe Company’s policies regarding intangible assets.

 

*Deferred Costs*

 

Costsincurred related to obtaining debt financing are capitalized and amortized overthe term of the related indebtedness. At December 31, 2003 and 2002, the Company and its consolidatedspecial purpose entities had net deferred debt issuance costs of approximately$6.6 million and $7.5 million, respectively. Deferred costs also include costs related to projects actively underdevelopment which are considered to be probable of successful completion at thebalance sheet date.

 

*Realization of Long-Lived Assets*

 

TheCompany assess realization of long-lived assets pursuant to Statement ofFinancial Accounting Standards (SFAS) No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets.”  Forassets held and used in operations, realization is assessed based onmanagement’s estimates of future operating results and cash flows.  As of December 31, 2003, management ofthe Company has evaluated its long-term assets and believes that these assetsare realizable and that no impairment allowance is necessary.

 

*Revenue Recognition*

 

Substantiallyall of the Company’s revenues are derived from contracts with federal, stateand local government agencies, which pay either per diem rates based upon thenumber of occupant days or hours served for the period, on a take-or-pay basis,management fee basis, cost-plus reimbursement or fee-for-service basis.  Revenues are recognized as services areprovided under established contractual agreements to the extent collection isconsidered probable.

 

Managementbelieves the Company’s revenue recognition practices are in conformity with theguidelines prescribed in Securities and Exchange Commission (SEC) StaffAccounting Bulletin No. 104, “Revenue Recognition.”

 

*Pre-opening and start-up costs*

 

The Company incurs pre-opening and start expenses including payroll,benefits, training and other operating costs prior to opening a new or expandedfacility and during the period of operation while occupancy is ramping up.  These costs vary by contract.  Newly opened facilities are staffedaccording to applicable regulatory or contractual requirements when the Companybegins receiving offenders or clients. Offenders or clients are typically assigned to a newly opened facility ona phased-in basis over a one-to-six month period.  The Company’s start-up period for new juvenile operations is 12months from the date the Company begins recognizing revenue unless break-evenoccupancy is achieved before then.  TheCompany’s start-up period for new adult operations is nine months from the datethe Company begins recognizing revenue unless break-even occupancy is achievedbefore then.

 

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*Business Concentration*

 

Contractswith federal, state and local governmental agencies account for nearly all ofthe Company’s revenues.  The loss of, ora significant decrease in, business from one or more of these governmentalagencies could have a material adverse effect on the Company’s financial conditionand results of operations.  For the yearsended December 31, 2003, 2002 and 2001, 21.7%, 20.9% and 20.2%,respectively, of the Company’s consolidated revenues were derived fromcontracts with the Federal Bureau of Prisons (BOP), the only customerconstituting more than 10.0% of revenues during each of these periods.

 

*Insurance Coverage*

 

TheCompany maintains insurance coverage for various aspects of its business andoperations.  The Company retains aportion of the losses that occur through the use of deductibles and retentionunder its self-insurance policies. Management regularly reviews the estimates of reported and unreportedclaims and provides for losses through insurance reserves.  As claims develop and additional informationbecomes available, adjustments to loss reserves may occur.

 

*Accounting for Stock-Based Compensation*

 

TheCompany accounts for its stock-based compensation plans in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (APB No. 25).  Inaccordance with the provisions of APB No. 25, stock-based employee compensationcost is not reflected in net income, as all options granted under those planshad an exercise price equal to or in excess of the market value of theunderlying common stock on the date of grant. The following table illustrates, in accordance with Statement ofFinancial Accounting Standard (SFAS) No. 148, the effect on net income andearnings per share as if the Company had applied the fair value recognitionprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” tostock-based employee compensation (in thousands, expect per share amounts):

 

|                                                                                                                                            |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                                            |   | **2003**                          |   | **2002** |   | **2001** |   |
|                                                                                                                                            |   |                              |   |   |   |   |   |
| Net income, as reported                                                                                                                         |   | $                                 | 3,970  |   | $ | 6,362 |   | $ | 4,659 |   |
| Less: total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects (1) |   | 1,289                             |   | 1,925 |   | 1,636 |   |
| Pro forma net income                                                                                                                            |   | $                                 | 2,681  |   | $ | 4,437 |   | $ | 3,023 |   |
| Earnings per share:                                                                                                                             |   |                              |   |   |   |   |   |
| Basic, as reported                                                                                                                              |   | $                                 | .31    |   | $ | .49 |   | $ | .48 |   |
| Basic, pro forma                                                                                                                                |   | .21                               |   | .34 |   | .31 |   |
| Diluted, as reported                                                                                                                            |   | .30                               |   | .48 |   | .46 |   |
| Diluted, pro forma                                                                                                                              |   | .21                               |   | .34 |   | .30 |   |
|                                                                                                                                            |   |                              |   |   |   |   |   |
| Weighted-average fair value per share of  options granted (1)                                                                                   |   | $                                 | 6.02   |   | $ | 6.87 |   | $ | 6.77 |   |

 

----

(1)   See Note 10 for additionalinformation regarding the computations presented above.

 

***The FASB hasrecently proposed to mandate expense recognition for stock options and othertypes of equity-based compensation based on the fair value of the options atthe grant date.  Additionally, the FASBis evaluating alternatives regarding how to develop a measure of the fair valueof an option.  Based on the final***

 

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***outcome of the FASB proposal, theCompany may be required to recognize expense related to stock options and othertypes of equity-based compensation in future periods.  Additionally, the Company may be required to change its currentmethod for determining the fair value of stock options.  Members of congress have recently introducedlegislation which would limit the proposed standard.***

 

*Income Taxes*

 

TheCompany utilizes the liability method of accounting for income taxes asrequired by SFAS No. 109, “Accounting for Income Taxes.”  Under this method, deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying values of existing assetsand liabilities and their respective tax bases based on enacted tax rates.  In providing for deferred taxes, managementconsiders current tax regulations, estimates of future taxable income andavailable tax planning strategies.  Iftax regulations, operating results or the ability to implement tax planningstrategies vary, adjustments to the carrying value of tax assets andliabilities may occur.

 

*Earnings Per Share*

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the years ended December 31,2003,  2002 and 2001, there were 371,145shares ($12.86 average price), 317,016 shares ($14.48 average price)  and 145,384 shares ($15.80 average price),respectively, of stock options that were not included in the computation ofdiluted EPS because to do so would have been anti-dilutive.

 

*Financial Instruments*

 

The Company considers thefair value of all its financial instruments not to be materially different fromtheir reported carrying values at the end of each year based on management’sestimate of the Company’s ability to borrow funds under terms and conditionssimilar to those of the Company’s existing debt. However, the Company may incura loss if debt is repaid prior to its scheduled maturity.

 

*Derivative Instruments*

 

Derivativeinstruments are recognized in accordance with the provisions of SFAS No. 149,“Amendment of Statement No. 133 on Derivative Instruments and HedgingActivities.”  The Company has onlyentered into derivative contracts that are classified as hedges.  These hedges are recorded at their fairvalue with changes in fair value reported in other comprehensive income.  See Note 11 to the consolidated financialstatements.

 

*Use of Estimates*

 

TheCompany’s financial statements are prepared in accordance with accountingprinciples generally accepted in the United States.  The purpose of these financial statements require that managementmake certain estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses and the disclosures of contingentassets and liabilities.  Management ofthe Company evaluates its estimates on an on-going basis, based on historicalexperience and on various other assumptions that are believed to be reasonablebased on the information available. Actual results could differ from these estimates under differentassumptions or conditions.  Thesignificant estimates made by management in the accompanying financialstatements include the allowance for doubtful accounts, accruals for insuranceand legal claims, accruals for compensated employee absences and therealizability of long-lived tangible and intangible assets.

 

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**3.****    ****CHANGES IN ACCOUNTING PRINCIPLES**

 

*Change in Accounting Principle EffectiveJanuary 1, 2003*

 

***EffectiveJanuary 1, 2003 the Company adopted the new requirements of SFAS No. 145,“Recission of SFAS No. 4, 44, 64, Amendment of FASB Statement No. 13, andTechnical Corrections.”  Among otherthings, SFAS No. 145 requires the gains and losses on the extinguishment ofdebt to no longer be classified as extraordinary items as previously requiredunder SFAS No. 4.  The Company recordedan extraordinary charge of approximately $2.9 million, net of income taxes ofapproximately $2.0 million, in 2001 for the early retirement of debt.  As a result of the adoption of theprovisions of SFAS No. 145, the Company reclassified total costs of approximately$4.9 million to loss on extinguishment of debt and reclassified the related$2.0 million income tax benefit to the provision for income taxes.  These reclassifications are reflected in the2001 amounts on the Consolidated Statements of Operations and ComprehensiveIncome (Loss).***

 

*Change in Accounting Principle EffectiveJanuary 1, 2002*

 

EffectiveJanuary 1, 2002 the Company adopted SFAS No. 141, “Business Combinations”and SFAS No. 142, “Goodwill and Other Intangible Assets”.  The new rules under these statements requirethat the purchase method of accounting be used for all business combinationsand specifies the criteria for the recognition of intangible assets separatelyfrom goodwill.  Under the new rules,goodwill is no longer amortized but is subject to an impairment testannually.  Other intangible assets thatmeet the new criteria under the new rules will continue to be amortized overtheir remaining useful lives.

 

Thefollowing table reflects, on a pro forma basis, the results of operations asthough goodwill was no longer amortized, as a result of the adoption of SFASNo. 142, as of January 1, 2001 (in thousands, except per share amounts):

 
|                                                                          |   | **Year Ended  December 31,** |   |
|-------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                          |   | **2003**                          |   | **2002** |   | **2001** |   |
|                                                                          |   |                              |   |   |   |   |   |
| Reported income before cumulative effect of  changes in accounting principles |   | $                                 | 3,970  |   | $ | 7,327 |   | $ | 3,889 |   |
| Goodwill amortization, net of tax                                             |   | —                            |   | — |   | 518 |   |
| Adjusted income before cumulative effect of  changes in accounting principles |   | $                                 | 3,970  |   | $ | 7,327 |   | $ | 4,407 |   |
|                                                                          |   |                              |   |   |   |   |   |
| Reported net income                                                           |   | $                                 | 3,970  |   | $ | 6,362 |   | $ | 4,659 |   |
| Goodwill amortization, net of tax                                             |   | —                            |   | — |   | 518 |   |
| Adjusted net income                                                           |   | $                                 | 3,970  |   | $ | 6,362 |   | $ | 5,177 |   |
|                                                                          |   |                              |   |   |   |   |   |
| Basic earnings per share:                                                     |   |                              |   |   |   |   |   |
| Adjusted income before cumulative effect of  changes in accounting principles |   | $                                 | .31    |   | $ | .57 |   | $ | .40 |   |
| Adjusted net income                                                           |   | $                                 | .31    |   | $ | .49 |   | $ | .54 |   |
|                                                                          |   |                              |   |   |   |   |   |
| Diluted earnings per share:                                                   |   |                              |   |   |   |   |   |
| Adjusted income before cumulative effect of  changes in accounting principles |   | $                                 | .30    |   | $ | .55 |   | $ | .39 |   |
| Adjusted net income                                                           |   | $                                 | .30    |   | $ | .48 |   | $ | .51 |   |

 

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TheCompany determined the fair market of the applicable reporting unit’s netassets in accordance with SFAS No. 142 and recorded a cumulative effect ofchange in accounting principle charge of approximately $965,000, net of anincome tax benefit of approximately $671,000, at January 1, 2002 for theimpairment of goodwill as a result of the adoption of SFAS No. 142.

 

Therewere no changes to goodwill during the year ended December 31, 2003.  The changes in the

carryingamount of goodwill for the year ended December 31, 2002 was as follows (inthousands):

 

|                                 |   | **Adult  Secure** |   | **Juvenile** |   | **Pre-Release** |   | **Total** |   |
|--------------------------------------|--------|-------------------|--------|--------------|--------|-----------------|--------|-----------|--------|
|                                 |   |              |   |         |   |            |   |      |   |
| Balance as of December 31, 2001 |   | $                 | 1,509  |         | $      | 1,915           |   | $         | 5,933  |   | $ | 9,357 |   |
| Impairment charge                    |   | —            |   | (855         | )      | (781            | )      | (1,636    | )      |
| Balance as of December 31, 2002 |   | $                 | 1,509  |         | $      | 1,060           |   | $         | 5,152  |   | $ | 7,721 |   |

 

Management evaluated its existing goodwill according to the provisionsof SFAS No. 142 and believes there is not an impairment to the Company’s existing goodwill as of December 31,2003.

 

Otherintangible assets at December 31, 2003 and 2002 consisted of the following(in thousands):

 

|                        |   | **2003** |   | **2002** |   |
|-----------------------------|--------|----------|--------|----------|--------|
|                        |   |     |   |     |   |
| Non-compete agreements      |   | $        | 9,420  |     | $      | 8,300 |   |
| Accumulated amortization    |   | (3,854   | )      | (2,959   | )      |
| Non-compete agreements, net |   | $        | 5,556  |     | $      | 5,341 |   |

 

In conjunction with theCompany’s acquisition of the Jos-Arz Residential Treatment Center managementcontract in June 2003, the Company entered into two non-compete agreementstotaling $1.0 million with the previous operators of the facility.  These agreements have terms of 5 years. Forthe year ended December 31, 2003, the Company recognized amortizationexpense of approximately $17,000 related to these agreements.

 

Amortizationexpense for the Company’s non-compete agreements was approximately $895,000 forthe year ended December 31, 2003 and $878,000 for each of the years endedDecember 31, 2002 and 2001. Amortization expense for the Company’s non-compete agreements isexpected to be approximately $1.1 million for each of the next five years.

 

*Change in Accounting Principle EffectiveJanuary 1, 2001*

 

EffectiveJanuary 1, 2001, the Company changed its method of accounting for durablesupplies whereby the Company capitalizes durable operating supply purchasessuch as uniforms, linens and books and amortizes these costs to operatingexpense over an estimated period of benefit of 18 months.  Effective January 1, 2001, the Companycapitalized a portion of previously expensed durable operating supplies and, asa result, recognized a benefit of approximately $770,000 (net of an income taxprovision of approximately $535,000) which has been reflected as a cumulativeeffect of a change in accounting principle in the accompanying ConsolidatedStatements of Operations and Comprehensive Income (Loss).

 

**4.****    ****NEW ACCOUNTING PRONOUNCEMENTS**

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation ofVariable Interest Entities” (FIN 46), which addresses the consolidation ofvariable interest entities as defined in the Interpretation.  The Company’s adoption of FIN 46 did notchange the Company’s accounting for the 2000 synthetic lease

 

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transactionand the 2001 Sale and Leaseback Transaction which are consolidated forreporting purposes.  The Company has noother arrangements subject to the provisions of FIN 46.  It is reasonably possible that the Companymay enter into future arrangements for the development of new facilities or tooperate facilities which may become subject to the provisions of FIN 46 and, insome cases, may be required to consolidate the related activities, facilitiesand financings.

 

InApril 2003, the FASB issued SFAS No. 149 “Amendment of Statement No. 133on Derivative Instruments and Hedging Activities.” This statement amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities under SFASNo. 133.  Other provisions of this statementthat related to SFAS No. 133 implementation issues should continue to beapplied in accordance with their respective effective dates. The Companyadopted SFAS No. 149 on July 1, 2003 and with no significant impact on itsresults of operations or financial position.

 

InMay 2003, the FASB issued SFAS No. 150 “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.”  This statement establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  The Company adopted SFAS No. 150 on June 30, 2003 with nosignificant impact on its results of operations or financial position.

 

InMay 2003, the Emerging Issues Task Force (EITF) reached a consensus on EITF01-8 “Determining Whether an Arrangement Contains a Lease.” EITF 01-8 providesguidance for determining whether an arrangement contains a lease that is withinthe scope of SFAS No. 13. The Company adopted EITF 01-8 on June 30, 2003with no significant impact on its results of operations or financial position.

 

**5.****    ****PROPERTY AND EQUIPMENT**

 

Property and equipment wereas follows (in thousands):

 

|                                      |   | **December 31,** |    |
|-------------------------------------------|--------|-----------------------|---------|
|                                      |   | **2003**              |    | **2002** |   |
|                                      |   |                  |    |   |   |
| Land                                      |   | $                     | 27,168  |   | $ | 26,354 |   |
| Prepaid facility use                      |   | 71,323                |    | 71,323 |   |
| Buildings and improvements                |   | 161,894               |    | 154,910 |   |
| Furniture and equipment                   |   | 25,770                |    | 17,328 |   |
| Construction in progress                  |   | 22,381                |    | 16,364 |   |
|                                      |   | 308,536               |    | 286,279 |   |
| Accumulated depreciation and amortization |   | (40,633               | )       | (30,829 | ) |
|                                      |   | $                     | 267,903 |   | $ | 255,450 |   |

 

***InSeptember 2003, the Company repurchased furniture and equipment leasedunder a sale and leaseback transaction completed in 1999 for approximately $4.8million.  The Company is depreciatingthis furniture and equipment over 3 years.***

 

Constructionin progress at December 31, 2003 consisted primarily of construction andrenovation costs for the Moshannon Valley Correctional Center, the New MexicoRegional Correctional Center, the Southern Peaks Treatment Center, the LasVegas Center, the Central California Treatment Center and information technologyand software development costs. Construction in progress at December 31,2002 consisted primarily of development and construction costs for theMoshannon Valley Correctional Center.

 

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The Company evaluates therealization of property and equipment according to the provisions of SFAS No.144.  In connection with the Company’sevaluation, management makes judgments regarding future operating results andcash flows associated with individual facilities.  Additionally, should management decide to sell a facility,realization is evaluated based on the estimated sales price.  The Company is currently evaluatingalternative uses for the New Morgan Academy and finalizing negotiations on arevised contract with the BOP for the Moshannon Valley CorrectionalCenter.  Realization of the Company’sinvestment in both of these facilities is based on management’s judgements andexpectations related to legislative activities, economic events and otherfactors.  Management has also evaluatedthe realization of its other facilities and does not believe that an impairmentexists related to any of the Company’s facilities as of December 31, 2003including the New Morgan Academy and the Moshannon Valley Correctional Center.  See Note 12.

 

**6.****    ****ACCOUNTS PAYABLE AND ACCRUEDLIABILITIES**

 

Accountspayable and accrued liabilities consisted of the following (in thousands):

 

|                     |   | **December 31,** |   |
|--------------------------|--------|-----------------------|--------|
|                     |   | **2003**              |   | **2002** |   |
|                     |   |                  |   |   |   |
| Accounts payable         |   | $                     | 12,353 |   | $ | 10,910 |   |
| Accrued compensation     |   | 7,101                 |   | 6,668 |   |
| Accrued interest payable |   | 6,459                 |   | 6,728 |   |
| Accrued taxes payable    |   | 3,258                 |   | — |   |
| Accrued insurance        |   | 3,268                 |   | 3,598 |   |
| Resident funds           |   | 2,302                 |   | 2,064 |   |
| Other                    |   | 1,836                 |   | 2,654 |   |
|                     |   | $                     | 36,577 |   | $ | 32,622 |   |

 

**7.****    ****INCOME TAXES**

 

The following is an analysisof the Company’s deferred tax assets and liabilities (in thousands):

 

|                               |   | **December 31,** |   |
|------------------------------------|--------|-----------------------|--------|
|                               |   | **2003**              |   | **2002** |   |
| Deferred tax assets:               |   |                  |   |   |   |
| Accrued liabilities and allowances |   | $                     | 4,115  |   | $ | 3,589 |   |
| Deferred compensation              |   | 31                    |   | 427 |   |
| Other                              |   | —                |   | 718 |   |
|                               |   | 4,146                 |   | 4,734 |   |
| Deferred tax liabilities:          |   |                  |   |   |   |
| Depreciation and amortization      |   | 6,591                 |   | 4,894 |   |
| Prepaid expenses                   |   | 734                   |   | 716 |   |
| Other                              |   | 415                   |   | 778 |   |
|                               |   | 7,740                 |   | 6,388 |   |
| Net deferred tax liability         |   | $                     | (3,594 | ) | $ | (1,654 | ) |

 

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The components of the Company’s income tax provision were as follows(in thousands):

 

|                                                   |   | **Year Ended  December 31,** |   |
|--------------------------------------------------------|--------|-----------------------------------|--------|
|                                                   |   | **2003**                          |   | **2002** |   | **2001** |   |
|                                                   |   |                              |   |   |   |   |   |
| Current provision (benefit)                            |   | $                                 | 820    |   | $ | 6,240 |   | $ | (191 | ) |
| Deferred provision (benefit)                           |   | 1,940                             |   | (1,959 | ) | 3,684 |   |
|                                                   |   | $                                 | 2,760  |   | $ | 4,281 |   | $ | 3,493 |   |
|                                                   |   |                              |   |   |   |   |   |
| Continuing operations                                  |   | $                                 | 2,760  |   | $ | 4,952 |   | $ | 2,958 |   |
| Cumulative effect of changes in accounting  principles |   | —                            |   | (671 | ) | 535 |   |
|                                                   |   | $                                 | 2,760  |   | $ | 4,281 |   | $ | 3,493 |   |

 

Thefollowing is a reconciliation of income taxes at the statutory federal incometax rate of 35% to the income tax provision recorded by the Company (inthousands):

 

|                                       |   | **Year Ended  December 31,** |   |
|--------------------------------------------|--------|-----------------------------------|--------|
|                                       |   | **2003**                          |   | **2002** |   | **2001** |   |
|                                       |   |                              |   |   |   |   |   |
| Computed taxes at statutory rate           |   | $                                 | 2,356  |   | $ | 3,725 |   | $ | 2,396 |   |
| Amortization of non-deductible intangibles |   | —                            |   | — |   | 119 |   |
| State income taxes, net of federal benefit |   | 281                               |   | 380 |   | 562 |   |
| Other                                      |   | 123                               |   | 176 |   | 416 |   |
|                                       |   | $                                 | 2,760  |   | $ | 4,281 |   | $ | 3,493 |   |

 

**8.****    ****CREDIT FACILITIES**

 

TheCompany’s long-term debt consisted of the following (in thousands):

 

|                                                                                                     |   | **December 31,** |    |
|----------------------------------------------------------------------------------------------------------|--------|-----------------------|---------|
|                                                                                                     |   | **2003**              |    | **2002** |   |
|                                                                                                     |   |                  |    |   |   |
| **Debt of Cornell  Companies, Inc.:**                                                                    |   |                  |    |   |   |
| Revolving Line of Credit due July 2005  with an interest rate of prime plus 2.0% or LIBOR plus 3.0% |   | $                     | 2,000   |   | $ | — |   |
| Capital lease obligations                                                                                |   | 8                     |    | 37 |   |
| Subtotal                                                                                                 |   | 2,008                 |    | 37 |   |
|                                                                                                     |   |                  |    |   |   |
| **Debt of Special  Purpose Entities:**                                                                   |   |                  |    |   |   |
| Synthetic Lease Investor Note A due  July 2005 with an interest rate of LIBOR plus 3.25%            |   | 42,255                |    | 41,117 |   |
| Synthetic Lease Investor Note B due  July 2005 with an interest rate of LIBOR plus 3.50%            |   | 8,335                 |    | 8,134 |   |
| 8.47% Bonds due 2016                                                                                     |   | 183,000               |    | 190,600 |   |
| Subtotal                                                                                                 |   | 233,590               |    | 239,851 |   |
|                                                                                                     |   |                  |    |   |   |
| Consolidated total debt                                                                                  |   | 235,598               |    | 239,888 |   |
|                                                                                                     |   |                  |    |   |   |
| Less: current maturities                                                                                 |   | (8,306                | )       | (7,630 | ) |
|                                                                                                     |   |                  |    |   |   |
| Consolidated long-term debt                                                                              |   | $                     | 227,292 |   | $ | 232,258 |   |

 

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TheCompany’s 2000 Credit Facility, as amended, originally provided for borrowingsof up to $45.0 million under a revolving line of credit.  The commitment amount is reduced by $1.6million quarterly beginning in July 2002 and by outstanding letters ofcredit.  The available commitment amountunder the amended 2000 Credit Facility was approximately $28.2 million atDecember 31, 2003.  The Company hadoutstanding letters of credit of approximately $5.1 million atDecember 31, 2003.  The amended2000 Credit Facility matures in July 2005 and bears interest, at theelection of the Company, at either the prime rate plus a margin of 2.0%, or arate which is 3.0% above the applicable LIBOR rate.  The amended 2000 Credit Facility is collateralized bysubstantially all of the Company’s assets, including the stock of all of theCompany’s subsidiaries; does not permit the payment of cash dividends; andrequires the Company to comply with certain leverage, net worth and debtservice coverage covenants. Additionally, the Company is limited to $2.5 million annually for therepurchase of its common stock with an aggregate limit of $7.5 million.  The Company has obtained an amendment fromthe lenders under the amended 2000 Credit Facility extending the scheduledconstruction completion date for the Moshannon Valley Correctional Center. Thisamendment is effective through June 30, 2005. The Company and its lendersagreed subsequent to December 31, 2003 to amend the debt covenants tofacilitate compliance despite the loss of the Southern Peaks Treatment Centerescrowed funds (see Note 9 to the consolidated financial statements).  Included in the Company’s cash and cash equivalentsat December 31, 2003 is approximately $39.8 million that is invested in aseparate account that is available to the Company for investment purposes orworking capital with the approval of the lenders under the amended 2000 CreditFacility.  This separate account ismaintained, in part, to assure future credit availability.

 

Additionally,the amended 2000 Credit Facility provides the Company with the ability to enterinto synthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $100.0 million, of which approximately $52.4 million had beenutilized as of December 31, 2003. The Synthetic Lease Investor’s Note A and Note B have total creditcommitments of $81.4 million and $15.1 million, respectively.  The Company pays commitment fees at a rateof 0.5% annually for the unused portion of the synthetic lease financingcapacity.  The Synthetic LeaseInvestor’s Notes A and B are cross-collateralized with the Company’s revolvingline of credit and contain cross-default provisions.

 

OnAugust 14, 2001, MCF issued $197.4 million of 8.47% taxable revenue bondsdue August 1, 2016.  Interest onthe bonds is payable by MCF semi-annually on February 1 and August 1,commencing February 1, 2002, and principal is due in escalating annualinstallments commencing August 1, 2002. In connection with the bonds, the Company would be required to makedeposits into a security deposit fund if the Company failed to maintain specifiedquarterly cash flow coverage ratios. Deposits in the security deposit fundwould be used to pay future principal and interest on the bonds. As ofDecember 31, 2003, the Company was not required to make any such deposits.

 

OnAugust 14, 2001, the Company repaid the $50.0 million of outstanding 7.74%Senior Secured Notes with a portion of the proceeds from the 2001 Sale andLeaseback Transaction.

 

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Scheduledmaturities of the Company’s consolidated long-term debt were as follows (inthousands):

 
|                                  |   | **Cornell  Companies, Inc.** |   | **Synthetic  Lease  Investor** |   | **MCF** |   | **Consolidated** |    |
|---------------------------------------|--------|------------------------------|--------|--------------------------------|--------|---------|--------|------------------|---------|
|                                  |   |                         |   |                           |   |    |   |             |    |
| For the year ending December 31, |   |                         |   |                           |   |    |   |             |    |
| 2004                                  |   | $                            | 6      |                           | $      | —  |   | $                | 8,300   |   | $ | 8,306 |   |
| 2005                                  |   | 2,002                        |   | 50,590                         |   | 9,000   |   | 61,592           |    |
| 2006                                  |   | —                       |   | —                         |   | 9,700   |   | 9,700            |    |
| 2007                                  |   | —                       |   | —                         |   | 10,500  |   | 10,500           |    |
| Thereafter                            |   | —                       |   | —                         |   | 145,500 |   | 145,500          |    |
| Total                                 |   | $                            | 2,008  |                           | $      | 50,590  |   | $                | 183,000 |   | $ | 235,598 |   |

 

**9.****    ****COMMITMENTS ANDCONTINGENCIES**

 

*Financial Guarantee*

 

Duringthe normal course of business, the Company enters into contracts that contain avariety of representations and warranties and provide generalindemnifications.  The Company’s maximumexposure under these arrangements is unknown as this would involve futureclaims that may be made against the Company that have not yet occurred.  However, based on experience, the Companybelieves the risk of loss to be remote.

 

*Operating Leases*

 

TheCompany leases office space, certain facilities and furniture and equipmentunder long-term operating leases.  Rentexpense for all operating leases for the years ended December 31, 2003,2002 and 2001, was approximately $9.9 million, $9.0 million and $11.4 million,respectively.

 

Underthe amended 2000 Credit Facility, the Company entered into operating leaseagreements that are considered to be a virtual special purpose entity for theacquisition or development of operating facilities.  This synthetic lease financing arrangement provides for fundingfrom the virtual special purpose entity under the operating leases of up to$100.0 million, of which approximately $52.4 million had been utilized as ofDecember 31, 2003 for the purchase of a building in California,construction of the New Morgan Academy and construction costs to date for theMoshannon Valley Correctional Center. The leases under this arrangement each have a term of the lesser of fiveyears or July 2005, include purchase and renewal options, and provide forresidual value guarantees for each lease that average 81.4% of the total costand would be due by the Company upon termination of the leases.  Upon termination of a lease, the Companycould either exercise a purchase option, or the facilities could be sold to athird party.  The Company expects thefair market value of the leased facilities to substantially reduce or eliminatethe Company’s potential obligation under the residual value guarantee.  At December 31, 2003, there were twooperating leases under this arrangement. Lease payments under the lease financing arrangements are variable andare adjusted for changes in interest rates. The properties and relatedindebtedness have been consolidated by the Company prior to the effective dateof FIN 46 because the equity holder in the virtual special purpose entity hadinsufficient equity in the project for the Company to meet off-balance sheetfinancing requirements. The treatment did not change subsequent to theeffective date of FIN 46.

 

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Asof December 31, 2003, the Company had the following rental commitmentsunder noncancelable operating leases (in thousands):

 
| For the year ending December 31, |   |   |   |
|---------------------------------------|--------|--------|--------|
| 2004                                  |   | $      | 5,783  |   |
| 2005                                  |   | 4,364  |   |
| 2006                                  |   | 3,855  |   |
| 2007                                  |   | 3,530  |   |
| 2008                                  |   | 2,744  |   |
| Thereafter                            |   | 21,657 |   |
| Total                                 |   | $      | 41,933 |   |

 

*401(k) Plan*

 

TheCompany has a defined contribution 401(k) plan.  The Company’s matching contribution currently represents 50% of aparticipant’s contribution, up to the first 6% of the participant’ssalary.  The Company recordedcontribution expense of approximately $1.2 million for each of the years endedDecember 31, 2003 and 2002  andapproximately $1.1 million for the year ended December 31, 2001.

 

*Legal Proceedings*

 

**Southern Peaks Treatment Center**

 

In June 2003 theCompany entered into an agreement to purchase a correctional facility to bebuilt in Colorado – the Southern Peaks Treatment Center (the “Center”) – uponcompletion of its construction.  In late August 2003, in connectionwith the transaction, the Company deposited approximately $12.9 million of thepurchase price (the “Funds”) into what it believed to be an escrow account toassure the developer’s construction lender of the Company’s ability andwillingness to purchase the Center upon completion.  After funding theaccount, and after repeated unsuccessful attempts by the Company and itscounsel to obtain confirmation of the wire transfer and the interest accruedsince the date of the wire transfer, the Company was informed in earlyDecember 2003 that (1) the bank purportedly serving as escrow agentclaimed that its signature to the escrow agreement had been forged and that theescrow agreement was not an obligation of the bank; (2) the Funds were not heldin an escrow account at the bank, but were held instead in one of theconstruction lender’s bank accounts; and (3) certain of the Funds had beenreleased from such bank account prior to completion of the Center, incontravention of the terms of the escrow agreement.

 

The Company began aninvestigation to locate the Funds and to determine the circumstances thatresulted in their misappropriation.  In the process of trying to locatethe Funds and establish a valid escrow arrangement, the construction lender andthe developer of the Center represented to the Company that the Funds were thenbeing held in a bank in Florida which had agreed to be the escrow agent under anew escrow agreement.  Subsequently, the bank in Florida confirmed to theCompany that an account had been established with deposits totaling $12.9million and that it was willing to serve as the escrow agent under a new escrowagreement.  After executing a new escrow agreement with the Florida bank,the Company learned that the available funds in the new escrow account totaledonly $5.0 million.  The Florida bank later advised the Company that theremaining $7.9 million of deposits in the new escrow account had been depositedin the form of a check drawn on a foreign bank account.  The foreigncheck, although deposited for collection, was never paid.

 

Accordingly, onJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled*Cornell Corrections of California,Inc. v. Longboat Global Advisors, LLC, et al.,*No.2004 CV79761**in the Superior Court of Fulton County,Georgia under theories of fraud, conversion, breach of contract and othertheories to determine the location of and to recover the Funds.  TheCompany has obtained temporary restraining orders

 

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freezing any and all financial accounts of the construction lender, oneof its principals and certain other defendants identified duringdiscovery.  The frozen accounts include one of the construction lender’sbank accounts which contains approximately $250,000.

 

Approximately $2.3 million of the funds have been expended on theproject, which have been classified as construction in progressat December 31, 2003.  There can beno assurances that any of the missing funds will be recovered.  Accordingly, based on current information,the Company believes its potential maximum exposure is approximately $5.4million (which has been recognized as a loss and is included in general andadministrative expenses for the year ended December 31, 2003) plus anyattorneys’ fees and costs associated with its investigation and the legalproceedings discussed above.  The Company is unable at this time todetermine the ultimate outcome of this matter.

 

**Shareholder Lawsuits**

 

InMarch and April 2002, the Company, Steven W. Logan (the Company’sformer President and Chief Executive Officer), and John L. Hendrix (the Company’sChief Financial Officer), were named as defendants in four federal putativeclass action lawsuits styled as follows: (1) *GraydonWilliams, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc, et al.*, No. H-02-0866, in the United States DistrictCourt for the Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*, No.H-02-1075, in the United States District Court for the Southern District ofTexas, Houston Division; (3) *Louis A. Daly,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits were putative class action lawsuits brought on behalfof all purchasers of the Company’s common stock between March 6, 2001 andMarch 5, 2002 and relate to the Company’s restatement in 2002 of certainfinancial statements.  The lawsuitsinvolved disclosures made concerning two prior transactions executed by theCompany: the August 2001 sale leaseback transaction and the 2000 syntheticlease transaction.  These four lawsuitswere consolidated into the *Graydon Williams*action and Flyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court has allowed plaintiffsto file an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of the Exchange Act,Section 11 of the Securities Act of 1933 (the “Securities Act”) and/orSection 15 of the Securities Act. The amended consolidated complaint seeks, among other things,restitution damages, compensatory damages, rescission or a rescissory measureof damages, costs, expenses, attorneys’ fees and expert fees.  A motion to dismiss is currently pending.

 

InMarch 2002, the Company, its directors, and its former independent auditorArthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas.  The lawsuit related tothe Company’s restatement in 2002 of certain financial statements.  The lawsuit alleged breaches of fiduciaryduty by all of the individual defendants and asserted breach of contract andprofessional negligence claims only against Arthur Andersen LLP.  This lawsuit has been dismissed withoutprejudice by agreement.

 

InMay and June 2002, the Company and its directors were sued in three otherderivative lawsuits styled as follows: (1) *JuanGuitierrez, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.,* No. H-02-1812, in the United Stated District Courtfor the Southern District of Texas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896,

 

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in the United Stated District Court for the Southern District of Texas,Houston Division; and (3) *Jesse Menning,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of HarrisCounty, Texas.  These lawsuits relate tothe Company’s restatement in 2002 of certain financial statements.  These lawsuits all allege breaches offiduciary duty and waste of corporate assets by all of the defendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

***The plaintiffsin these cases have not quantified their claim of damages and the outcome ofthe matters discussed above cannot be predicted with certainty.  However, the Company believes it has gooddefenses and intends to vigorously defend against the claims asserted in theseactions.  The Company has not recordedany loss accruals related to these claims as of December 31, 2003.***

 

OnJanuary 27, 2004, the Company received a letter from William Williams, theplaintiff in the *William Williams*action discussed above, demanding that the Company pursue breach of fiduciaryduty claims against various officers and directors based on theAugust 2001 sale leaseback transaction and the subsequentrestatement.  The Company has issued apreliminary response to the letter indicating that the Board will consider therequest and inform Mr. Williams of its decision.

 

***Certaininsurance policies held by the Company to cover potential director and officerliability may limit the Company’s cash outflows in the event of a decisionadverse to the Company in the matters discussed above.  However, if an adverse decision in thesematters exceeds the insurance coverage or if the insurance coverage is deemednot to apply to these matters, an adverse decision to the Company in thesematters could have a material adverse effect on the Company, its financialcondition, its results of operations and its future prospects.***

 

**Securities and Exchange Commission Investigation**

 

Following the restatement of the Company’s 2001 financial statements in2002, the SEC initiated an investigation into the circumstances leading to thisrestatement.  Following the SEC’sinitial inquiry in 2002 the SEC made no further inquiry with respect to theinvestigation until July 2003. Since July 2003, the Company has received additional informationrequests from the SEC.  The Company hascooperated, and intends to continue to fully cooperate, with the SEC’sinvestigation.

 

***Depending onthe scope, timing and result of the SEC investigation, management’s attentionand the Company’s resources could be diverted from operations, which couldadversely affect the Company’s operating results and contribute to future stockprice volatility.  The SEC investigationcould also require that the Company take other actions not currentlycontemplated.  In addition, the SECinvestigation or its outcome may increase the costs of defending or resolvingcurrent litigation.***

 

***The SEC has notgiven the Company any indication as to the outcome of its investigation.  If the SEC makes a determination adverse tothe Company, the Company and its officers and directors may face penalties,***

*** ***

***Other***

*** ***

***Additionally,the Company currently and from time to time is subject to claims and suitsarising in the ordinary course of business, including claims for damages forpersonal injuries or for wrongful restriction of or interference with offenderprivileges and employment matters.  Theoutcome of such matters cannot be predicated with certainty, based on theinformation known to date, management believes that the ultimate resolution ofthese matters will not have a material adverse effect on the Company’sfinancial position, operating results or cash flow.***

*** ***

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*** ***

including, but not limited to, monetary fines and injunctiverelief.  The Company has not recorded aloss accrual as of December 31, 2003 related to this matter.  In addition, in the event of an adversedetermination by the SEC against the Company or its officers or directors,federal and/or state agencies may be reluctant to enter into or prohibited fromentering into contracts for the Company’s services.  Any such reaction from the Company’s customer base could have amaterial adverse effect on its business.

*** ***

**10.**** ****STOCKHOLDERS’ EQUITY**

 

*Common Stock Offering*

 

On November 30, 2001,the Company completed an offering of its common stock.  Net proceeds to the Company from the sale ofthe 3,450,000 shares of newly issued Common Stock were approximately $43.8million.  Proceeds from the offeringwere used to repay indebtedness of $39.4 million with the remainder for generalworking capital purposes.

 

*Stockholder Rights Plan*

 

OnMay 1, 1998, the Company adopted a stockholder rights plan.  Under the plan, each stockholder of recordat the close of the business day on May 11, 1998, received one Preferred StockPurchase Right (Right) for each share of common stock held.  The Rights expire on May 1, 2008.  Each Right initially entitles thestockholder to purchase one one-thousandth of a Series A Junior ParticipatingPreferred Share for $120.00.  EachPreferred Share has terms designed to make it economically equivalent to onethousand common shares.  The Rights willbecome exercisable only in the event a person or group acquires 15% or more ofthe Company’s common stock or commences a tender or exchange offer which, ifconsummated, would result in that person or group owning 15% or more of theCompany’s common stock.  If a person orgroup acquires a 15% or more position in the Company, each Right (except thoseheld by the acquiring party) will then entitle its holder to purchase, at theexercise price, common stock of the Company having a value of twice theexercise price.  The effect will be toentitle the holder to buy the common stock at 50% of the market price.  Also, if following an acquisition of 15% ormore of the Company’s common stock, the Company is acquired by that person orgroup in a merger or other business combination transaction, each Right wouldthen entitle its holder to purchase common stock of the acquiring companyhaving a value of twice the exercise price. The effect will be to entitle the Company’s stockholders to buy stock inthe acquiring company at 50% of the market price.  The Company may redeem the Rights at $0.01 per Right at any timeprior to the acquisition of 15% or more of its common stock by a person orgroup.

 

*Preferred Stock*

 

Preferredstock may be issued from time to time by the Board of Directors of the Company,which is responsible for determining the voting, dividend, redemption,conversion and liquidation features of any preferred stock.

 

*Options*

 

InDecember 2000, the Company adopted the 2000 Broad-Based Employee Plan(2000 Plan).  Pursuant to the 2000 Plan,the Company may grant non-qualified stock options to its employees, directorsand eligible consultants for up to the greater of 400,000 shares or 4% of theaggregate number of shares of common stock issued and outstanding immediatelyafter grant of any option under the 2000 Plan. The 2000 Plan options vest up to five years and expire ten years fromthe grant date.  In May 1996, theCompany adopted the 1996 Stock Option Plan and amended and restated the plan inApril 1998 (1996 Plan).  Pursuantto the 1996 Plan, the Company may grant non-qualified and incentive stockoptions for up to the greater of 1,932,119 shares or 15.0% of the aggregatenumber of shares of common stock outstanding. The 1996 Plan options vest up to

 

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seven years and expire seven to ten years from the grant date.  The Compensation Committee of the Board ofDirectors, which is comprised of independent directors,  is responsible for determining the exerciseprice and vesting terms for the granted options.  The 1996 Plan and 2000 Plan option exercise prices can be no lessthan the market price of the Company’s common stock on the date of grant.

 

Inconjunction with the issuance of the Subordinated Notes in July 2000, theCompany issued warrants to purchase 290,370 shares of the common stock at anexercise price of $6.70.  The Companyrecognized the fair value of these warrants of $1.1 million as additionalpaid-in capital.  The warrants may onlybe exercised by payment of the exercise price in cash to the Company, bycancellation of an amount of warrants equal to the fair market value of theexercise price, or by the cancellation of Company indebtedness owed to thewarrant holder.  During 2001, 168,292shares of Common Stock were issued in conjunction with the exercise andcancellation of 217,778 warrants. At December 31, 2003, 72,592 warrantsremained outstanding.

 

Thefollowing is a summary of the status of the Company’s 2000 Plan, 1996 Plan andother options at December 31, 2003, 2002 and 2001, and changes during theyears then ended:

 
|                                            |   | **2003**   |   | **2002**                               |   | **2001**   |      |
|-------------------------------------------------|--------|------------|--------|----------------------------------------|--------|------------|-----------|
|                                            |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |      | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
|                                            |   |       |   |                                   |   |       |      |   |   |   |   |   |   |
| Outstanding at beginning of year                |   | 1,409,845  |   | $                                      | 9.20   |       | 1,178,624 |   | $ | 7.98 |   | 1,294,048 |   | $ | 7.70 |   |
| Granted                                         |   | 215,475    |   | 10.02                                  |   | 388,400    |      | 10.87 |   | 70,000 |   | 9.76 |   |
| Exercised                                       |   | (327,695   | )      | 6.50                                   |   | (95,059    | )         | 2.11 |   | (156,923 | ) | 5.64 |   |
| Forfeited or canceled                           |   | (165,661   | )      | 12.63                                  |   | (62,120    | )         | 13.99 |   | (28,501 | ) | 12.26 |   |
| Outstanding at end of year                      |   | 1,131,964  |   | 9.55                                   |   | 1,409,845  |      | 9.20 |   | 1,178,624 |   | 7.98 |   |
|                                            |   |       |   |                                   |   |       |      |   |   |   |   |   |   |
| Exercisable at end of year                      |   | 615,701    |   | 9.55                                   |   | 681,787    |      | 8.65 |   | 602,839 |   | 7.61 |   |
|                                            |   |       |   |                                   |   |       |      |   |   |   |   |   |   |
| Weighted average fair value of options  granted |   |       |   | $                                      | 6.02   |       |      |   | $ | 6.87 |   |   |   | $ | 6.77 |   |

 

Thefollowing table summarizes information about the Company’s outstanding stockoptions at December 31, 2003:

 
| **Range of Exercise Prices** |   | **Number  Outstanding** |   | **Weighted  Average  Remaining  Life (Years)** |    | **Weighted  Average  Exercise  Price** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise  Price** |    |
|------------------------------|--------|-------------------------|--------|------------------------------------------------|---------|----------------------------------------|--------|-------------------------|--------|----------------------------------------|---------|
|                         |   |                    |   |                                           |    |                                   |   |                    |   |                                   |    |
| $3.75                        | to     | $5.64                   |   |                                           | 250,211 |                                   | 6.9    |                    | $      | 4.56                                   |    | 169,328 |   | $ | 4.64 |   |
| 7.59                         | to     | 9.99                    |   |                                           | 335,650 |                                   | 8.3    |                    | 8.95   |                                   | 207,560 |   | 8.70 |   |
| 10.13                        | to     | 15.19                   |   |                                           | 466,700 |                                   | 6.9    |                    | 11.80  |                                   | 159,410 |   | 12.80 |   |
| 15.60                        | to     | 24.38                   |   |                                           | 79,403  |                                   | 5.6    |                    | 15.73  |                                   | 79,403  |   | 15.73 |   |
|                         |   |                    |   | 1,131,964                                      |    | 7.2                                    |   | 9.63                    |   | 615,701                                |    | 9.55 |   |
|                              |        |                         |        |                                                |         |                                        |        |                         |        |                                        |         |  |  |  |  |  |

 

Forpurposes of the pro forma disclosures in Note 2, under SFAS No. 123, the fairvalue of each option grant was estimated on the date of grant using theBlack-Scholes option pricing model.  Thefollowing weighted average assumptions were used for grants in 2003, 2002 and2001, respectively:  risk-free interestrates of 3.6%, 5.1% and 5.0%; dividend rates of $0, $0 and $0; expected livesof 7.0, 7.0 and 10.0 years; expected volatility of 56.43%, 57.58% and 53.35%.

 

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***TheBlack-Scholes option pricing model and other existing models were developed foruse in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. In addition, option valuation models require the input of, and arehighly sensitive to, subjective assumptions including the expected stock pricevolatility.  The Company’s employeestock options have characteristics significantly different from those of tradedoptions, and changes in the subjective input assumptions can materially affectthe fair value estimate. The FASB has recently proposed to mandate expenserecognition for stock options and other types of equity-based compensationbased on the fair value of the options at the grant date.  Additionally, the FASB is evaluatingalternatives regarding how to develop a measure of the fair value of an option.Based on the final outcome of the FASB proposal, the Company may be required torecognize expense related to stock options and other types of equity-basedcompensation in future periods. Additionally, the Company may be required to change its current methodfor determining the fair value of stock options.  Members of congress have recently introduced legislation whichwould limit the proposed standard.***

 

*Notes from Shareholders*

 

OnJuly 8, 1996, the Company’s former president (see below) and the Companyfounder, a director of the Company until October 2003, each exercisedoptions to purchase an aggregate 82,750 and 137,110, respectively, of shares ofClass A Common Stock and Class B Common Stock at an aggregate price of $180,638and $274,220, respectively.  Inconnection with each exercise, each former officer entered into a promissorynote with the Company for the respective aggregate exercise amounts.  The promissory notes bore interest at anannual rate of 6.63%.  InSeptember 2002, the Company purchased at fair value 35,000 shares of itscommon stock from the Company’s former president at a cost of approximately$283,000.  In connection with that stockpurchase, the Company’s former president repaid $283,000 representing theaccrued interest and a portion of the outstanding related principal loanbalance.  In December 2002 theCompany’s former president surrendered stock options with a fair value ofapproximately $77,000 which was used to repay a portion of his remainingbalance.  The fair value of these stockoptions were expensed by the Company in the year ended December 31,2002.  In 2003 the Company’sformer president surrendered stock options with a fair value of approximately$23,000 which was used to repay the remaining balance of his note.  In October 2003, the Company’s founderrepaid the principal and accrued interest of approximately $441,000 outstandingon his note. The Companyrecognized approximately $22,000, $41,000 and $42,000 of interest incomerelated to these shareholder notes for the years ended December 31, 2003,2002 and 2001, respectively. As of December 31, 2003, all notes fromshareholders had been repaid.

 

*Treasury Stock*

 

Duringthe years ended December 31, 2003 and 2002, the Company repurchased in theopen market 106,500 and 242,100 shares, respectively, of its common stock undera share repurchase program at an aggregate cost of $1.2 million and $2.2million, respectively.  Additionally, inSeptember 2002, the Company purchased at fair value 35,000 shares of its commonstock from the Company’s former president at a cost of approximately$283,000.  In 2002, the Board ofDirectors authorized the repurchase of an aggregate $10.0 million of theCompany’s outstanding shares.  The annualrepurchase of shares is limited to $2.5 million, and an aggregate limit of $7.5million, under the Company’s amended 2000 Credit Facility.  As of December 31, 2003, the Companycan purchase additional shares of treasury stock valued at approximately $0.8million.

 

*Employee Stock Purchase Plan*

 

Effectiveas of January 1, 2000, the Company has an employee stock purchase planwhereby employees can make contributions to purchase the Company’s commonstock.  Purchases of common stock aremade annually at the lower of the beginning or end of year market value, less a15.0% discount.  For the years endedDecember 31, 2003, 2002 and 2001, employee contributions of approximately$356,000, $399,000 and $214,000 were used to purchase 46,486, 82,581 and 46,767shares, respectively, of the Company’s common stock.

 

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*Deferred Bonus Plan*

 

Inthe fourth quarter of 2001, the Company established a deferred bonus plan forcertain employees.  Pursuant to theplan, approximately $4.7 million was deposited on behalf of individualparticipants into a rabbi trust account, which included approximately $3.6million in cash and $1.1 million in Company treasury stock.  The treasury stock portion of the rabbitrust is to remain as treasury stock, while the participants may giveinvestment directions to the trustee as to the cash portion, subject to certainlimitations.  The investments of therabbi trust represent assets of the Company and are included in theaccompanying Consolidated Balance Sheets based on the nature of the assetsheld.  Assets placed into the rabbitrust are irrevocable; therefore they are restricted as to the Company’s useunder the terms of the trust and the deferred bonus plan.  Amounts held in the rabbi trust aregenerally distributable upon vesting. At December 31, 2003, restricted assets and other current assetsincluded approximately $205,000 and $176,000, respectively, of deposits in arabbi trust.  For the year endedDecember 31, 2002, approximately $1.3 million was paid from plan assets asa result of the withdrawal of the Company’s former president from the plan dueto his resignation as president in September 2002.  Additionally, approximately $1.0 million ofdeferred bonus plan assets were forfeited and returned to the Company as aresult of his resignation.

 

Theplan generally vests 100.0% upon the achievement of an aggregate amount ofmonthly credits (based on a fixed monthly earnings milestone) expected to occurat the end of five years beginning October 1, 2001.  Vesting will accelerate to 60.0% at the endof three years if certain earnings targets are achieved.  Based on the expected earnings period,compensation expense and the related compensation liability for the aggregateplan value are being recognized over five years.  To the extent the vesting is extended or accelerated based on theachievement of the financial milestones, recognition of compensation expensewill be adjusted on a prospective basis. For the years ended December 31, 2003 and 2002, the Companyexpensed approximately $502,000 and $92,000, respectively, under the deferredbonus plan.

 

Whileperiodic gains on the value of each participant’s investments held in the rabbitrust are recorded currently in income, an equal amount of compensation expenseand related compensation liability is recorded, since participants are fullyvested in such gains.  Periodic lossesincurred by participants in their invested balances are recorded asincurred.  Such losses in excess of aparticipant’s recorded compensation expense are guaranteed by the participantswith a full-recourse obligation to the Company.  These guarantees function to offset the loss on investments tothe extent the obligations are not reserved for collectibility by the Company.

 

Amountsheld in treasury stock have been recorded at cost.  An equal amount has been established as deferred compensation andadditional paid-in capital in the accompanying statement of stockholders’equity.  The balance in the deferredbonus plan is amortized to compensation expense over the expected vestingperiod of five years.

 

**11.**** ****DERIVATIVE FINANCIAL INSTRUMENTS AND GUARANTEES**

 

*Debt Service Reserve Fund and Debt Service Fund*

 

InAugust 2001, MCF completed a bond offering to finance the 2001 Sale andLeaseback Transaction.  In connectionwith this bond offering, two reserve fund accounts were established by MCFpursuant to the terms of the indenture: (1) MCF’s Debt Service Reserve Fund,aggregating $23.8 million at December 31, 2003, was established to makepayments on MCF’s outstanding bonds in the event the Company (as lessee) shouldfail to make the scheduled rental payments to MCF and (2) MCF’s Debt ServiceFund, aggregating $14.7 million at December 31, 2003, used to accumulatethe monthly lease payments that MCF receives from the Company until such fundsare used to pay MCF’s semi-annual bond interest and annual bond principalpayments.  Both reserve fund accountsare subject to the agreements with the MCF Equity Investors whereby guaranteedrates

 

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of return of 3.0% and 5.08%, respectively, are provided for in thebalance of the Debt Service Reserve Fund and the Debt Service Fund.  The guaranteed rates of return arecharacterized as cash flow hedge derivative instruments.  At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a deferred liability in the accompanying Consolidated BalanceSheets.  Changes in the fair value ofthe derivative instruments are recorded as an adjustment to deferred liabilityand reported as other comprehensive income in the accompanying ConsolidatedStatements of Operations and Comprehensive Income.  At December 31, 2003, the fair value of these derivativeinstruments was approximately $2.5 million. As a result, the accompanying Consolidated Statements of Operations andComprehensive Income/(Loss) include accumulated other comprehensive income(loss) of approximately ($368,000) and $1.9 million for the years endedDecember 31, 2003 and 2002, respectively. There is no difference betweennet income and comprehensive income for 2001.

 

Inconnection with MCF’s bond offering, the MCF Equity Investor provided aguarantee of the Debt Service Reserve Fund if a bankruptcy of the Company wereto occur and a trustee for the estate of the Company were to include the DebtService Reserve Fund as an asset of the Company’s estate.  This guarantee is characterized as aninsurance contract and is being amortized to expense over the life of the debt.

 

**12.**** ****PROJECTS UNDER DEVELOPMENT, CONSTRUCTION OR RENOVATION**

 

In January 2003, the Company executed a five-year lease for theNew Mexico Regional Correctional Center in Albuquerque, New Mexico.  The 1,000 bed facility consists of twounits, the South Tower and the North Tower, which each have a service capacityof 500 beds.  The Company is currentlyrenovating the South Tower and anticipates opening the 500 bed unit inJuly 2004.  The Company will thenrenovate the North Tower.  Managementcurrently anticipates that the facility will reach full capacity of 1,000 bedsby December 2004.  As ofDecember 31, 2003, the Company had spent approximately $1.0 million onrenovations and expects to spend an additional $2.8 million to complete therenovations of both units.  For the yearended December 31, 2003, the Company incurred pre-opening and start-upexpenses of approximately $321,000.

 

In June 2003, theCompany entered into an agreement with a developer to purchase a 160 bedresidential treatment center for juveniles, named the Southern Peaks TreatmentCenter, upon completion of construction of the facility by the developer.  In August 2003, the Company fundedapproximately $12.9 million into an escrow account for the purchase of the realproperty.  The Company recognized acharge of approximately $5.4 million to general and administrative expenses inthe fourth quarter of 2003 related to the portion of these funds which werediverted and have not been recovered.

 

In September 2003, theCompany entered into negotiations with the state of South Dakota to the leasethe former State Training School in Plankinton, South Dakota to operate a 40bed juvenile justice center, the Plankinton Regional Detention Center, and a 82bed residential juvenile treatment center, the Plankinton Regional TreatmentCenter.  The Company will make someminor renovations to the facilities at an estimated cost of approximately$400,000.  As of December 31, 2003,the Company had not finalized the lease agreements or obtained contracts forservices at the facilities.  However,management believes there is demand for the Company services to be provided atthese facilities and anticipates operating the detention center in April 2004and the treatment center in August 2004.

 

The Company closed the NewMorgan Academy in the fourth quarter of 2002 and is currently consideringseveral options ranging from the sale of the facility to the utilization of thefacility for another type of program. As of December 31, 2003, management ofthe Company is focusing its efforts on reactivating the facility.  The primary use currently underconsideration is using the facility to house illegal non-criminal adultdetainees or to house non-criminal juvenile aliens. Management is discussingthese opportunities with the Bureau of Immigration and Customs Enforcement(BICE), who has indicated a level of interest but necessary budget

 

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appropriations have not been made and the parties have not progressedto contract phase. There can be no assurance that the Company will besuccessful in securing a contract with BICE. Further, before the Company could house adult detainees, the Companywill likely need to obtain a change in the zoning of the Academy, which iscurrently zoned only for the housing of juveniles. There can be no assurancesthat the Company will be able to secure the contemplated zoning change or to doso on terms favorable to the Company. Management of the Company believes that there is a market for theservices the Company could provide at per diem rates that will support therecovery of the cost structure of the facility.  However, the Company will continue to evaluate any offers to buyor lease the facility.  The Company is maintaining a small staff tosecure and maintain the facility while the Company considers its options forthe use or sale of the facility.  TheCompany expects to incur operating expenses of approximately $150,000 per monthfor payroll, property taxes and other operating costs until the facility isutilized for an alternative program or until the facility is sold.  Additionally, the Company is incurringinterest expense of approximately $140,000 per month related to the borrowingsfor the facility and depreciation expense of approximately $46,000 per monthfor the building.

 

The carrying value of theproperty and equipment at the New Morgan Academy was approximately $30.4million at December 31, 2003. Management performed a probability-weighted recoverability analysis andbelieves that, based on its analysis, the long-lived assets at the New MorganAcademy are recoverable from the range of alternative courses of action.  Accordingly, pursuant to the provisions ofSFAS No. 144, an impairment allowance is not deemed necessary as ofDecember 31, 2003.  However,management estimates that, were the Company to sell the facility, it isreasonably possible that the Company would not be able to fully recover thecarrying value of its long-lived assets for this facility.

 

In March 2003, the Company reached an agreement with theCommonwealth of Pennsylvania that resolved all outstanding administrativeissues relative to the contract awarded to the Company by the BOP to operatethe Moshannon Valley Correctional Center. In October 2003, the Companyreceived final approval from the BOP of a revised building design for thefacility. Construction plans are being developed for the new design and work isexpected to begin in the second quarter of 2004. In the interim, the Company isnegotiating a contract amendment with the BOP to accommodate the revisedfacility design and update the contract for changes since it was originallysigned. If and when an amendment to the contract with the BOP is successfullynegotiated, the agreement would allow the Company to move forward with theconstruction and operation of the facility.

 

Asof December 31, 2003, the Company had incurred approximately $18.2 millionfor design, construction and land development costs and capitalized interestrelated to the Moshannon Valley Correctional Center contract. The Company is inthe process of submitting a claim to the BOP for reimbursement of costs relatedto the original construction efforts incurred beginning in 1999. The Companyestimates additional capital investment of approximately $74.0 million tocomplete construction of the facility. Financing of the facility is subject to re-approval of the project bythe lenders under the Company’s amended 2000 Credit Facility and agreement bysuch lenders to amend certain financial covenants and provisions of the amended2000 Credit Facility. In the event the Company’s lenders are unwilling tore-approve the project or to adopt the necessary amendments, or if theCompany’s cash and current financing arrangements do not provide sufficientfinancing to fund construction costs related to the project, the Companyanticipates that it will need to obtain additional sources of financing.

 

According to the BOP contract, as amended, the Company was required tocomplete the construction of the project by January 15, 2004. The Companydid not complete construction by that date and anticipates obtaining anotherlong-term contract amendment from the BOP extending the construction deadline.In the event the Company is not able to negotiate a contract amendment with theBOP, then the BOP may have the right to assert that the Company has notcompleted construction of the facility within the time frame provided in theBOP contract, as amended. Management expects that the contract will be amendedto address cost and construction timing matters resulting from the extendeddelay. In the event that the BOP decides not to continue with the constructionof the Moshannon Valley Correctional Center and terminates the contract,

 

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management believes that the Company has the right to and will recoverits invested costs. In the event any portion of these costs are determined notto be recoverable upon contract termination by the BOP, such costs would be chargedto expense.

 

Separate from a possible recovery in the event that the BOP terminatesthe Moshannon Valley Correctional Center contract, the Company is pursuing aclaim for reimbursement of a portion of its expenses incurred in connectionwith the issuance of the Stop-Work Order and the delay of the project (includedamong these expenses is approximately $1.4 million in accounts receivable forexpenses incurred by the Company after the June 1999 issuance of the Stop–Work Order).  This reimbursement claimis independent of the amendment to the contract – i.e., if the BOP agrees to anamendment of the contract, the Company will still pursue its claim – and theCompany is currently negotiating this claim with the BOP.  The BOP has asserted that it is onlyresponsible for reimbursing a portion of these costs – that portion of theinvestment lost due to the issuance of the Stop-Work Order.  Although the Company believes that the BOPwill reimburse substantially more than the $1.4 million in account receivableat December 31, 2003, it is uncertain how much the BOP will agree to pay inconnection with the Company’s claim for reimbursement.  Any amounts not reimbursed by the BOP, theCompany will expense that portion of costs that cannot be capitalized with respectto the Company's remaining real property interest.

 

**13.**** ****RELATED PARTY TRANSACTIONS**

 

Oneof the directors of the Company is a partner in a law firm that provides legalservices to the Company. The Company pays legal fees for such services.  Legal fees paid to this law firm wereapproximately $1.1 million, $1.5 million and $2.7 million for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

InJuly 1996, the Company entered into promissory notes with the Company’sformer president and the Company’s founder, a director of the Company untilOctober 2003.  The promissory notesbear interest at an annual rate of 6.63%, mature in June 2004 with nointerim interest or principal payments, are full recourse and collateralized byshares of the Company’s common stock. These notes were repaid prior toDecember 31, 2003.

 

In connection with the Company president’s resignation inSeptember 2002, the outstanding principal and interest balance ofapproximately $76,000 and $35,000, respectively, was repaid. InOctober 2003, the principal and related accrued interest receivablerelated to the Company founder’s note of $270,000 and $129,000, respectively,was repaid. The Company recognized approximately $17,000, $29,000 and $29,000of interest income related to these notes for the years ended December 31,2003, 2002 and 2001.

 

EffectiveSeptember 1, 1999, the Company entered into a consulting agreement withthe Company’s founder, who was a director of the Company throughOctober 2003.  As compensation forconsulting services, the Company agreed to an annual payment of at least$255,000 for each of the first four years of the seven-year initial term of theconsulting agreement with an annual salary of at least $180,000 for each of thelast three years of the seven-year initial term of the consultingagreement.  The Company has an option torenew the consulting agreement for an additional three-year term at an annualsalary of at least $300,000 for each of the three years of the renewalterm.  As additional compensation, theCompany agreed to an annual bonus, subject to certain limitations, equal to$75,000 during the first four years of the seven-year initial term and anannual bonus of $60,000 during the last three years of the seven-year initialterm and during any renewal term.  TheCompany also agreed to grant options to purchase an aggregate 120,000 shares ofthe Company’s common stock in four equal annual installments beginningSeptember 1, 2000.  The optionshave an exercise price equal to the fair market value of the Company’s commonstock on the date of grant and vest at the time such options are granted,subject to certain limitations on exercise. For the year ended December 31, 2003, the Company’s founder accepteda $100,000 cash payment in lieu of unexercised options. This payment wasexpensed by the Company in 2003.

 

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Aspart of the consulting agreement discussed above, the Company entered into anon-compete agreement with the Company’s founder.  The non-compete agreement has a term of 10 years and requires theCompany to pay a monthly fee of $10,000 for the seven-year initial term of theconsulting agreement.  The Companycapitalized the monthly payments and amortizes the amounts over the 10-yearterm of the consulting agreement. The Company recognized amortization expenserelated to this agreement of approximately $84,000 for each of the years endedDecember 31, 2003, 2002 and 2001.

 

TheCompany maintains a life insurance policy for the Company’s founder and madepayments related to this policy of approximately $223,000, $214,000 and$215,000 for the years ended December 31, 2003, 2002 and 2001,respectively.

 

TheCompany also compensated the Company’s founder for director fees in amounts of$12,000, $30,000 and $22,000 for the years ended December 31, 2003, 2002and 2001, respectively.

 

Totalpayments made for the above consulting and non-compete agreements, board ofdirector fees and expense reimbursements for the Company’s founder wereapproximately $531,000, $477,000 and $428,000 for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

TheCompany also has a non-compete agreement with a director of the Company inconnection with the acquisition of The Abraxas Group, Inc. inSeptember 1997.  Under thisagreement, the Company is required to pay annual installments of $60,000beginning January 2, 1998.  Thesepayments can and have been accelerated upon the mutual agreement of thedirector and the Company.  As ofDecember 31, 2003, the balance of this non-compete agreement had been paidin full. The Company made payments under this agreement of  $200,000, $80,000, and $200,000 for theyears ended December 31, 2003, 2002 and 2001, respectively

 

**14.**** ****SEGMENT DISCLOSURE**

 

TheCompany’s three operating divisions are its reportable segments.  The adult secure institutional servicessegment consists of the operation of secure adult incarcerationfacilities.  The juvenile segment consistsof providing residential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems.  The adult community-based corrections andtreatment services segment consists of providing pre-release and halfway houseprograms for adult offenders who are either on probation or serving the lastthree to six months of their sentences on parole and preparing for re-entryinto society at large as well as community-based treatment and educationprograms as an alternative to incarceration. All of the Company’s customers and long-lived assets are located in theUnited States of America.  Theaccounting policies of the Company’s reportable segments are the same as thosedescribed in the summary of significant accounting policies in Note 2 to theconsolidated financial statements. Intangible assets are not included in each segment’s reportable assets,and the amortization of intangible assets is not included in the determinationof a segment’s operating income.  TheCompany evaluates performance based on income or loss from operations beforegeneral and administrative expenses, incentive bonuses, amortization ofintangibles, interest and income taxes. Corporate and other assets are comprised primarily of cash, accountsreceivable, deposits, property and equipment, deferred taxes, deferred costsand other assets.

 

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The only significant noncashitems reported in the respective segments’ income from operations is depreciationand amortization (excluding intangibles) (in thousands).

 
|                                    |   | **Year Ended  December 31,** |    |
|-----------------------------------------|--------|-----------------------------------|---------|
|                                    |   | **2003**                          |    | **2002** |   | **2001** |   |
|                                    |   |                              |    |   |   |   |   |
| Revenue:                                |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 102,120 |   | $ | 99,549 |   | $ | 99,791 |   |
| Juvenile                                |   | 118,797                           |    | 124,967 |   | 116,262 |   |
| Adult community-based                   |   | 50,715                            |    | 50,629 |   | 49,197 |   |
| Total revenue                           |   | $                                 | 271,632 |   | $ | 275,145 |   | $ | 265,250 |   |
|                                    |   |                              |    |   |   |   |   |
| Pre-opening and start-up expenses:      |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 321     |   | $ | — |   | $ | — |   |
| Juvenile                                |   | 3,077                             |    | — |   | 3,858 |   |
| Adult community-based                   |   | —                            |    | — |   | — |   |
| Total pre-opening and start-up expenses |   | $                                 | 3,398   |   | $ | — |   | $ | 3,858 |   |
|                                    |   |                              |    |   |   |   |   |
| Depreciation and amortization:          |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 3,868   |   | $ | 3,558 |   | $ | 3,222 |   |
| Juvenile                                |   | 2,698                             |    | 2,615 |   | 2,149 |   |
| Adult community-based                   |   | 1,538                             |    | 1,391 |   | 1,451 |   |
| Amortization of intangibles             |   | 895                               |    | 878 |   | 1,525 |   |
| Corporate and other                     |   | 1,700                             |    | 1,337 |   | 931 |   |
| Total depreciation and amortization     |   | $                                 | 10,699  |   | $ | 9,779 |   | $ | 9,278 |   |
|                                    |   |                              |    |   |   |   |   |
| Income from operations:                 |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 25,396  |   | $ | 26,586 |   | $ | 22,347 |   |
| Juvenile                                |   | 13,598                            |    | 17,402 |   | 16,857 |   |
| Adult community-based                   |   | 10,789                            |    | 11,609 |   | 10,514 |   |
| Subtotal                                |   | 49,783                            |    | 55,597 |   | 49,718 |   |
| General and administrative expenses     |   | (23,415                           | )       | (21,480 | ) | (15,291 | ) |
| Incentive bonuses                       |   | —                            |    | — |   | (1,000 | ) |
| Amortization of intangibles             |   | (895                              | )       | (878 | ) | (1,525 | ) |
| Corporate and other                     |   | (1,089                            | )       | (1,662 | ) | (884 | ) |
| Total income from operations            |   | $                                 | 24,384  |   | $ | 31,577 |   | $ | 31,018 |   |
|                                    |   |                              |    |   |   |   |   |
| Capital expenditures:                   |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 5,742   |   | $ | 4,098 |   | $ | 4,083 |   |
| Juvenile                                |   | 11,176                            |    | 1,566 |   | 7,117 |   |
| Adult community-based                   |   | 2,173                             |    | 2,006 |   | 675 |   |
| Corporate and other                     |   | 3,213                             |    | 3,444 |   | 2,293 |   |
| Total capital expenditures              |   | $                                 | 22,304  |   | $ | 11,114 |   | $ | 14,168 |   |
|                                    |   |                              |    |   |   |   |   |
| Assets:                                 |   |                              |    |   |   |   |   |
| Adult secure institutional              |   | $                                 | 152,229 |   | $ | 156,315 |   | $ | 155,085 |   |
| Juvenile                                |   | 110,748                           |    | 96,239 |   | 102,766 |   |
| Adult community-based                   |   | 57,787                            |    | 58,071 |   | 57,962 |   |
| Intangible assets, net                  |   | 13,287                            |    | 13,062 |   | 15,456 |   |
| Corporate and other                     |   | 114,106                           |    | 117,604 |   | 113,538 |   |
| Total assets                            |   | $                                 | 448,157 |   | $ | 441,291 |   | $ | 444,807 |   |

 

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**15.**** ****SELECTED QUARTERLY FINANCIAL DATA (Unaudited)**

 
|                                                                              |   | **1stQuarter** |   | **2ndQuarter** |   | **3rdQuarter** |   | **4thQuarter** |   | **Year** |   |
|-----------------------------------------------------------------------------------|--------|----------------|--------|----------------|--------|----------------|--------|----------------|--------|----------|--------|
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| **2003:**                                                                         |   |           |   |           |   |           |   |           |   |     |   |
| Revenues                                                                          |   | $              | 66,026 |           | $      | 67,586         |   | $              | 68,642 |     | $      | 69,378 |   | $ | 271,632 |   |
| Income from operations                                                            |   | 7,779          |   | 8,196          |   | 6,732          |   | 1,677          | (2)    | 24,384   |   |
| Net income (loss)                                                                 |   | 1,957          |   | 2,177          |   | 1,442          |   | (1,606         | )(2)   | 3,970    |   |
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| Earnings (loss) per share:                                                        |   |           |   |           |   |           |   |           |   |     |   |
| -  Basic                                                                |   | $              | .15    |           | $      | .17            |   | $              | .11    |     | $      | (.12 | ) | $ | .31 |   |
| -  Diluted                                                              |   | $              | .15    |           | $      | .17            |   | $              | .11    |     | $      | (.12 | ) | $ | .30 |   |
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| **2002:**                                                                         |   |           |   |           |   |           |   |           |   |     |   |
| Revenues                                                                          |   | $              | 68,475 |           | $      | 69,077         |   | $              | 69,634 |     | $      | 67,959 |   | $ | 275,145 |   |
| Income from operations                                                            |   | 6,375          |   | 7,888          |   | 7,992          |   | 9,322          |   | 31,577   |   |
| Income before cumulative effect of changes  in accounting principles (1)          |   | 635            |   | 1,974          |   | 1,793          |   | 2,925          |   | 7,327    |   |
| Net income (loss)                                                                 |   | (330           | )      | 1,974          |   | 1,793          |   | 2,925          |   | 6,362    |   |
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| Earnings per share before cumulative effect  of changes in accounting principles: |   |           |   |           |   |           |   |           |   |     |   |
| -  Basic                                                                |   | $              | .05    |           | $      | .15            |   | $              | .14    |     | $      | .23 |   | $ | .57 |   |
| -  Diluted                                                              |   | $              | .05    |           | $      | .15            |   | $              | .14    |     | $      | .21 |   | $ | .55 |   |
| Earnings per share:                                                               |   |           |   |           |   |           |   |           |   |     |   |
| -  Basic                                                                |   | $              | (.03   | )              | $      | .15            |   | $              | .14    |     | $      | .23 |   | $ | .49 |   |
| -  Diluted                                                              |   | $              | (.03   | )              | $      | .15            |   | $              | .14    |     | $      | .22 |   | $ | .48 |   |
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| **2003 Balance Sheet  Data:**                                                     |   |           |   |           |   |           |   |           |   |     |   |
| Working capital                                                                   |   | $              | 99,003 |           | $      | 101,065        |   | $              | 89,122 |     | $      | 86,214 |   | $ | 86,214 |   |
| Total assets                                                                      |   | 435,139        |   | 443,988        |   | 445,664        |   | 448,157        |   | 448,157  |   |
| Long-term debt, net of current portion                                            |   | 232,254        |   | 232,894        |   | 234,594        |   | 227,292        |   | 227,292  |   |
| Stockholders’ equity                                                         |   | 162,375        |   | 167,246        |   | 167,351        |   | 166,235        |   | 166,235  |   |
|                                                                              |   |           |   |           |   |           |   |           |   |     |   |
| **2002 Balance Sheet  Data:**                                                     |   |           |   |           |   |           |   |           |   |     |   |
| Working capital                                                                   |   | $              | 99,915 |           | $      | 100,277        |   | $              | 92,749 |     | $      | 95,988 |   | $ | 95,988 |   |
| Total assets                                                                      |   | 435,836        |   | 438,838        |   | 428,237        |   | 441,291        |   | 441,291  |   |
| Long-term debt, net of current portion                                            |   | 239,310        |   | 239,310        |   | 231,724        |   | 232,258        |   | 232,258  |   |
| Stockholders’ equity                                                         |   | 153,024        |   | 154,745        |   | 158,330        |   | 159,952        |   | 159,952  |   |

 

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(1)   The Company adopted SFAS No. 142 inJanuary 2002 and recorded a net-of-tax charge of approximately $1.0million as a cumulative effect of a change in accounting principle.  See Note 3 to the consolidated financialstatements.

(2)   Includes a loss of approximately $5.4 millionrelated to the Southern Peaks Treatment Center escrow deposit.  The after tax effect of the loss reduced netincome by approximately $3.2 million. See Note 12 to the consolidated financialstatements.

 

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**ITEM 9.****                                  ****CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A.****                         ****CONTROLS AND PROCEDURES**

 

TheCompany maintains disclosure controls and procedures designed to ensure thatinformation disclosed in its annual and periodic reports is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms. In addition, the Companydesigned these disclosure controls and procedures to ensure that thisinformation is accumulated and communicated to management, including the chiefexecutive officer (CEO) and chief financial officer (CFO), to allow timelydecisions regarding required disclosures. SEC rules require that the Company disclosethe conclusions of its CEO and CFO about the effectiveness of the Company’sdisclosure controls and procedures.

 

TheCompany does not expect that its disclosure controls and procedures willprevent all errors or fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. In addition, the design of disclosurecontrols and procedures must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitation in a cost-effective control system,misstatements due to error or fraud could occur and not be detected.

 

Under the supervision and with the participation of the Company’smanagement, including its principal executive officer and principal financialofficer, the Company has evaluated the effectiveness of the design andoperation of its disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (theExchange Act) as of the end of the period required by this report. Based onthat evaluation, the Company’s principal executive officer and principalfinancial officer have concluded that these controls and procedures areeffective as of that date.

 

In connection with the evaluation described above, there have been nochanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under Exchange Act) during itsfiscal quarter ended December 31, 2003 that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART III**

 

Items10, 11, 12, 13 and 14 of Part III have been omitted from this report becausethe Company will file with the Securities and Exchange Commission, not laterthan 120 days after the close of its fiscal year, a definitive proxy statementor a Form 10-K/A.  The informationrequired by Items 10, 11, 12,  13 and 14of this report, which will appear in the definitive proxy statement and/or theForm 10-K/A, is incorporated by reference into Part III of this report.

 

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**PART IV**

 

**ITEM 15.****  ****EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ONFORM 8-K**

 

(a)        **Financial Statements, Schedules and Exhibits**

 
| 1.     |   | Financial  statements and reports of PricewaterhouseCoopers LLP and Arthur Andersen LLP                                                                   |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | Report of Independent Auditors                                                                                                                            |
|   |   | Consolidated Balance Sheets -  December 31, 2003 and 2002                                                                                            |
|   |   | Consolidated Statements of  Operations and Comprehensive Income/(Loss) for the years ended  December 31, 2003, 2002 and 2001                         |
|   |   | Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2003, 2002 and  2001                                          |
|   |   | Consolidated Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                                                          |
|   |   | Notes to consolidated financial  statements                                                                                                               |
| 2.     |   | Financial  statement schedules                                                                                                                            |
|   |   | All schedules are omitted because they are not  applicable or because the required information is included in the financial  statements or notes thereto. |
|   |   |                                                                                                                                                      |
| 3.     |   | Exhibits                                                                                                                                                  |

 

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                      |   | **Incorporated by Reference** |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|
| 3.1              |   | Restated  Certificate of Incorporation of the Company.                                                                                                                                                                                                                               |   | 1                             |
| 3.2              |   | Amended  and Restated Bylaws of the Company.                                                                                                                                                                                                                                         |   | 19                            |
| 4.1              |   | Certificate  representing Common Stock.                                                                                                                                                                                                                                              |   | 2                             |
| 4.2              |   | Registration  Rights Agreement dated as of March 31, 1994, as amended, among the  Company and the stockholders listed on the signature pages thereto.                                                                                                                           |   | 2                             |
| 4.3              |   | Rights  Agreement dated as of May 1, 1998 between the Company and the stockholders  listed on the signature pages thereto.                                                                                                                                                           |   | 7                             |
| 9.1              |   | Stock  Transfer and Voting Agreement dated November 23, 1994 between David M.  Cornell and Jane B. Cornell.                                                                                                                                                                     |   | 2                             |
| 10.1             |   | Cornell  Corrections, Inc. Amended and Restated 1996 Stock Option Plan. (a)                                                                                                                                                                                                          |   | 6                             |
| 10.2             |   | Employment  Agreement dated as of September 9, 1997 between Abraxas Group, Inc. and  Arlene R. Lissner. (a)                                                                                                                                                                     |   | 3                             |
| 10.3             |   | Covenant  Not to Compete Agreement dated as of September 9, 1997 by and between  the Company and Arlene R. Lissner. (a)                                                                                                                                                         |   | 3                             |
| 10.4             |   | Form  of Indemnification Agreement between the Company and each of its directors  and executive officers.                                                                                                                                                                            |   | 2                             |
| 10.5             |   | Stockholders  Agreement among certain stockholders named therein dated September 15,  1997.                                                                                                                                                                                     |   | 3                             |
| 10.6             |   | Professional  Management Agreement between the Company and Central Falls Detention Facility  Corporation dated July 15, 1992.                                                                                                                                                   |   | 2                             |
| 10.7             |   | Operating  Agreement by and between each of MidTex Detentions, Inc., the City of Big  Spring, Texas (“Big Spring”) and Cornell Corrections of Texas, Inc. (“CCTI”)  dated as of July 1, 1996 and related Assignment and Assumption of  Operating Agreement. |   | 2                             |
| 10.8             |   | Contract  between CCCI and the CDC (No. R92.132) for the Live Oak, California Facility  dated March 1, 1993, as amended.                                                                                                                                                        |   | 2                             |

 

93

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| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                       |   | **Incorporated by Reference** |
|------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|
| 10.9             |   | Asset  Purchase Agreement dated as of January 31, 1997 by and between CCTI and  Interventions Co.                                                                                                                |   | 4                             |
| 10.10            |   | Asset  Purchase Agreement dated as of August 14, 1997 by and between the  Company and Abraxas Group, Inc., Foundation for Abraxas, Inc., Abraxas  Foundation, Inc., Abraxas Foundation of Ohio and Abraxas, Inc. |   | 3                             |
| 10.11            |   | Contract  between Texas Alcoholism Foundation, Inc. and the Texas Department of  Criminal Justice, Parole Division for the Reid Facility dated  January 31, 1996, as amended.                                    |   | 2                             |
| 10.12            |   | Form  of Contract between CCCI and the Utah State Department of Human Services,  Division of Youth Corrections for the Salt Lake City, Utah Juvenile Facility.                                                        |   | 2                             |
| 10.13            |   | Asset  Purchase Agreement among CCTI, Texas Alcoholism Foundation, Inc. and the  Texas House Foundation, Inc. dated May 14, 1996.                                                                                     |   | 2                             |
| 10.14            |   | Asset  Purchase Agreement among CCTI, the Company, Ed Davenport, Johnny Rutherford  and MidTex Detentions, Inc. dated May 22, 1996.                                                                                   |   | 2                             |
| 10.15            |   | Lease  Agreement between CCCI and Baker Housing Company dated August 1, 1987  for the Baker, California facility.                                                                                                |   | 2                             |
| 10.16            |   | Lease  Agreement between Big Spring and Ed Davenport dated as of July 1, 1996  for the Interstate Unit and related Assignment and Assumption of Leases.                                                          |   | 2                             |
| 10.17            |   | Secondary  Sublease Agreement between Big Spring and Ed Davenport dated as of  July 1, 1996 for the Airpark Unit and related Assignment and Assumption  of Leases.                                               |   | 2                             |
| 10.18            |   | Secondary  Sublease Agreement between Big Spring and Ed Davenport dated as of  July 1, 1996 for the Flightline Unit and related Assignment and  Assumption of Leases.                                            |   | 2                             |
| 10.19            |   | Stock  Option Agreement between the Company and CEP II dated July 9, 1996.                                                                                                                                       |   | 2                             |
| 10.20            |   | Form  of Option Agreement between the Company and the Optionholder listed therein  dated as of November 1, 1995.                                                                                                 |   | 10                            |
| 10.21            |   | Senior  Note Agreement by and between the Company and the Note Purchasers dated  July 15, 1998.                                                                                                                  |   | 8                             |
| 10.22            |   | Asset  Purchase Agreement dated as of November 17, 1997 by and between Foresite  Capital Facilities Corporation and the Hinton Economic Development Authority.                                                   |   | 5                             |
| 10.23            |   | Amendment  dated December 10, 1997 to Asset Purchase Agreement dated as of  November 17, 1997.                                                                                                              |   | 5                             |
| 10.24            |   | Amendment  No. 2 dated January 6, 1998 to Asset Purchase Agreement dated as of  November 17, 1997.                                                                                                          |   | 5                             |
| 10.25            |   | Assignment  of Agreement of Purchase and Sale dated as of January 5, 1998 by and  between Foresite Capital Facilities Corporation and Cornell Corrections of  Oklahoma, Inc.                                     |   | 5                             |
| 10.26            |   | Allvest  Asset Purchase Agreement dated as of June 20, 1998 by and between the  Company and Allvest, Inc., St. John Investments, and William C. Weimar.                                                          |   | 9                             |
| 10.26a           |   | Subordinated  Bridge Loan Agreement by and between the Company and ING dated  October 14, 1999.                                                                                                                  |   | 11                            |
| 10.27            |   | Asset  Purchase Agreement by and among the Company and Interventions and IDDRS  Foundation dated May 10, 1999.                                                                                                        |   | 11                            |
| 10.28            |   | Extension  of Asset Purchase Agreement by and among the Company and Interventions and  IDDRS Foundation dated September 30, 1999.                                                                                |   | 11                            |

 

94

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| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                     |   | **Incorporated by Reference** |
|------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|
| 10.29            |   | Asset  Purchase Agreement by and among BHS Consulting Corp., its Shareholders and  the Company dated May 10, 1999.                                                                                                                                                                                                                                  |   | 11                            |
| 10.30            |   | Extension  of Asset Purchase Agreement by and among BHS Consulting Corp., its  Shareholders and the Company dated September 30, 1999.                                                                                                                                                                                                          |   | 11                            |
| 10.31            |   | Amendment  to Asset Purchase Agreement by and among BHS Consulting Corp., its  Shareholders and the Company dated November 12, 1999.                                                                                                                                                                                                           |   | 11                            |
| 10.32            |   | Participation  Agreement among the Company and certain of its subsidiaries and Heller  Financial Leasing, Inc. dated November 23, 1999.                                                                                                                                                                                                        |   | 12                            |
| 10.33            |   | Lease  Agreement between First Security Bank, National Association, and the Company  and certain of its subsidiaries dated November 23, 1999.                                                                                                                                                                                                  |   | 12                            |
| 10.34            |   | Lease  Agreement by and among Hinton Economic Development Authority, the Town of  Hinton, Oklahoma, and Cornell Corrections of Oklahoma, Inc. dated  December 31, 1999.                                                                                                                                                                        |   | 12                            |
| 10.35            |   | Consulting  Agreement between the Company and David M. Cornell dated December 15,  1999. (a)                                                                                                                                                                                                                                                   |   | 12                            |
| 10.36            |   | Form  of Severance Agreement executed by John Hendrix, Arlene Lissner, Thomas  Jenkins, Thomas Rathjen, Patrick Perrin and Steven Logan. (a)                                                                                                                                                                                                        |   | 12                            |
| 10.37            |   | Fourth  Amended and Restated Credit Agreement among the Company, certain subsidiaries  of the Company, Atlantic Financial Group, Ltd., the Lenders and ING (U.S.)  Capital LLC, as Administrative Agent, dated as of July 21, 2000.                                                                                                            |   | 13                            |
| 10.38            |   | Amended  and Restated Master Agreement among the Company, certain subsidiaries of the  Company, Atlantic Financial Group, Ltd., the Lenders, ING (U.S.) Capital LLC,  as Administrative Agent, Bank of America N.A., as Syndication Agent, and  Suntrust Equitable Securities Corporation, as Documentation Agent, dated as  of July 21, 2000. |   | 13                            |
| 10.39            |   | Note  and Equity Purchase Agreement among the Company, American Capital Strategies,  Ltd. and Teachers Insurance and Annuity Association of America, dated as of  July 21, 2000.                                                                                                                                                               |   | 13                            |
| 10.40            |   | Warrant  issued by the Company to American Capital Strategies, Ltd. dated as of  July 21, 2000.                                                                                                                                                                                                                                                |   | 13                            |
| 10.41            |   | Warrant  issued by the Company to Teachers Insurance and Annuity Association of  America, dated as of July 21, 2000.                                                                                                                                                                                                                           |   | 13                            |
| 10.42            |   | Cornell  Corrections, Inc. Employee Stock Purchase Plan. (a)                                                                                                                                                                                                                                                                                        |   | 14                            |
| 10.42a           |   | Cornell  Companies, Inc. Deferred Compensation Plan (a)                                                                                                                                                                                                                                                                                             |   | 14                            |
| 10.43            |   | Cornell  Companies, Inc. 2000 Director Stock Plan. (a)                                                                                                                                                                                                                                                                                              |   | 15                            |
| 10.44            |   | Cornell  Companies, Inc. 2000 Broad-Based Employee Plan. (a)                                                                                                                                                                                                                                                                                        |   | 16                            |
| 10.44a           |   | Cornell  Companies, Inc. Deferred Bonus Plan                                                                                                                                                                                                                                                                                                        |   | 21                            |
| 10.45            |   | Premises  Transfer Agreement dated August 14, 2001 among Cornell Company, Inc.,  Cornell Corrections of Georgia, L.P., Cornell Corrections of Oklahoma, Inc.,  Cornell Corrections of Texas, Inc., WBP Leasing, Inc., and Municipal Corrections  Finance, L.P.                                                                                 |   | 17                            |
| 10.46            |   | Master  Lease Agreement (with addenda) dated August 14, 2001 between Municipal  Corrections Finance, L.P. and Cornell Companies, Inc.                                                                                                                                                                                                          |   | 17                            |
| 10.47            |   | Master  Lease Agreement dated December 3, 1998 between Atlantic Financial Group  and WBP Leasing, Inc. and certain other subsidiaries of Cornell Corrections,  Inc.                                                                                                                                                                            |   | 18                            |
| 10.48            |   | Amendment  No. 1 to Credit Agreement dated January 31, 2001.                                                                                                                                                                                                                                                                                   |   | 18                            |
| 10.49            |   | Amendment  No. 2 to Credit Agreement and Amendment No. 1 to Master Agreement dated  August 9, 2001.                                                                                                                                                                                                                                            |   | 18                            |

 

95

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| **Exhibit  No.** |   | **Description**                                                                                                                                              |   | **Incorporated by Reference** |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|
| 10.50            |   | First  Amendment to Note and Equity Purchase Agreement dated August 9, 2001.                                                                            |   | 18                            |
| 11.1             |   | Computation  of Per Share Earnings.                                                                                                                          |   | 21                            |
| 21.1             |   | Subsidiaries  of the Company.                                                                                                                                |   | 21                            |
| 23.1             |   | Consent  of PricewaterhouseCoopers LLP.                                                                                                                      |   | *                             |
| 23.2             |   | Information  Regarding Consent of Arthur Andersen LLP.                                                                                                       |   | 21                            |
| 31.1             |   | Section 302  Certification of Chief Executive Officer                                                                                                   |   | *                             |
| 31.2             |   | Section 302  Certification of Chief Financial Officer                                                                                                   |   | *                             |
| 32.1             |   | Section 906  Certification of Chief Executive Officer                                                                                                   |   | *                             |
| 32.2             |   | Section 906  Certification of Chief Financial Officer                                                                                                   |   | *                             |
| 99.1             |   | Letter  from Cornell Companies, Inc. to the Securities and Exchange Commission dated  April 15, 2002 regarding representation from Arthur Andersen LLP. |   | 20                            |
| 99.2             |   | Letter  Agreement dated September 5, 2001, as amended, between Cornell  Companies, Inc. and Lehman Brothers, Inc.                                       |   | 20                            |

 

----

| (a)  |   | Management  compensatory plan or contract.                                                    |
|------|--------|-----------------------------------------------------------------------------------------------|
| (1)  |   | Annual  Report on Form 10-K of the Company for the year ended December 31, 1996          |
| (2)  |   | Registration  Statement on Form S-1 of the Company (Registration No. 333-08243).              |
| (3)  |   | Registration  Statement on Form S-1 of the Company (Registration No. 333-35807).              |
| (4)  |   | Current  Report on Form 8-K of the Company dated January 31, 1997.                       |
| (5)  |   | Current  Report on Form 8-K of the Company dated January 6, 1998.                        |
| (6)  |   | Definitive  Proxy Statement dated March 9, 1998.                                         |
| (7)  |   | Registration  Statement on Form 8-A of the Company filed May 11, 1998.                        |
| (8)  |   | Quarterly  Report on Form 10-Q of the Company for the quarter ended June 30, 1998.       |
| (9)  |   | Current  Report on Form 8-K of the Company dated August 13, 1998.                        |
| (10) |   | Annual  Report on Form 10-K of the Company for the year ended December 31, 1998.         |
| (11) |   | Quarterly  Report on Form 10-Q of the Company for the quarter ended September 30,  1999. |
| (12) |   | Annual  Report on Form 10-K of the Company for the year ended December 31, 1999.         |
| (13) |   | Quarterly  Report on Form 10-Q of the Company for the quarter ended June 30, 2000.       |
| (14) |   | Registration  Statement on Form S-8 of the Company (Registration No. 333-80187).              |
| (15) |   | Registration  Statement on Form S-8 of the Company (Registration No. 333-42444).              |
| (16) |   | Registration  Statement on Form S-8 of the Company (Registration No. 333-52236).              |
| (17) |   | Current  Report on Form 8-K of the Company dated August 14, 2001.                        |
| (18) |   | Quarterly  Report on Form 10-Q of the Company for the quarter ended September 30,  2001. |
| (19) |   | Quarterly  Report on Form 10-Q of the Company for the quarter ended March 31, 2001.      |
| (20) |   | Annual  Report on Form 10-K of the Company for the year ended December 31, 2001.         |
| (21) |   | Annual  Report on Form 10-K of the Company for the year ended December 31, 2002          |
| *    |   | Filed  herewith                                                                               |

 

(b)           **Reports on Form 8-K**

 

TheCompany furnished a Current Report on Form 8-K dated November 11, 2003with a press release announcing its financial results for the third quarterended September 30, 2003.

 

96

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, Registrant has duly caused this annual report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|   |                 | CORNELL  COMPANIES, INC. |
|--------|----------------------|--------------------------|
|   |                 |                     |
| Dated: | March 15,  2004 | By:                      | /s/  Harry J. Phillips, Jr. |   |
|   |                 |                     | Harry  J. Phillips, Jr. |
|   |                 |                     | Chief  Executive Officer and |
|   |                 |                     | Chairman  of the Board |
|   |                 |                     |   |

 
| **SIGNATURE**               |   | **TITLE**                         |                          | **DATE** |
|-----------------------------|--------|-----------------------------------|-------------------------------|----------|
|                        |   |                              |                          |     |
| /s/  HARRY J. PHILLIPS, JR. |   |                              | Chief  Executive Officer and  |     | March 15,  2004 |
| Harry  J. Phillips, Jr.     |   | Chairman  of the Board            |                          |     |
|                        |   | (Principal  Executive Officer)    |                          |     |
|                        |   |                              |                          |     |
| /s/  JOHN L. HENDRIX        |   |                              | Executive  Vice President and |     | March 15,  2004 |
| John  L. Hendrix            |   | Chief  Financial Officer          |                          |     |
|                        |   | (Principal  Financial Officer and |                          |     |
|                        |   | Principal  Accounting Officer)    |                          |     |
|                        |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  ANTHONY R. CHASE       |   |                              | Director                      |     | March 15,  2004 |
| Anthony  R. Chase           |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  ARLENE R. LISSNER      |   |                              | Director                      |     | March 15,  2004 |
| Arlene  R. Lissner          |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  D. STEPHEN SLACK       |   |                              | Director                      |     | March 15,  2004 |
| D.  Stephen Slack           |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  TUCKER TAYLOR          |   |                              | Director                      |     | March 15,  2004 |
| Tucker  Taylor              |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  ROBERT F. VAGT         |   |                              | Director                      |     | March 15,  2004 |
| Robert  F. Vagt             |   |                              |                          |     |
|                        |   |                              |                          |     |
| /s/  MARCUS A. WATTS        |   |                              | Director                      |     | March 15,  2004 |
| Marcus  A. Watts            |   |                              |                          |     |

 

 

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