**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,DC 20549**

 

**FORM 10-K**

 

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

 

| **For fiscal year ended December 31, 2004** | ** ** | **Commission File Number 1-14472** |
|--------------------------------------------------|------------|------------------------------------|

 

**CORNELLCOMPANIES, INC.**

**(Exact nameof 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** | ** ** | **New York  Stock Exchange** |
| **Preferred  Stock Purchase Rights**         | ** ** | **New York  Stock Exchange** |

 

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

 

**NONE**

 

Indicate by check mark whether the Registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

 

Yes  ý     No   o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willbe not contained, to the best of Registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o.

 

Indicate by check mark whether the Registrant is anaccelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes  ý    No   o

 

At March 10, 2005, Registrant had outstanding 13,494,216shares of its common stock.  Theaggregate market value of the Registrant’s voting stock held by non-affiliatesas of June 30, 2004 was approximately $179,057,750 based on the closingprice of $13.60 per share as reported on the New York Stock Exchange.

 

Documents Incorporated by Reference

 
| Portions of the Proxy Statement for 2005 Annual Meeting of  Stockholders. |   | Part III |
|---------------------------------------------------------------------------|--------|----------|

 

 

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**PART I**

 

#### **BUSINESS**

#### ** **

**Company Overview**

 

CornellCompanies, Inc. (Cornell), incorporated in 1991, is a publicly-traded companywhose primary business is in the field of corrections, education,rehabilitation and treatment for adults and juveniles.  We partner with federal, state, county andlocal government agencies to meet their needs through quality, cost-efficientservices and programs, which we believe in turn saves taxpayers’ money.

 

Ourcustomers include the Federal Bureau of Prisons (BOP), U.S. Marshals Service,Department of Homeland Security, Bureau of Immigration and Customs Enforcement,U.S. Department of Justice Office of Detention Trustee, state Departments ofCorrections, county sheriffs, and city, county and state Departments of HumanServices.

 

Weprovide a continuum of care to adults and juveniles in institutional,residential and community-based settings to help the individuals return totheir home communities as productive, responsible citizens.  Our services touch on all areas of anindividual’s life.  To help adults andjuveniles remain out of the justice system, we provide them with the skills andtools that help them overcome barriers and life issues.  Many of the adults and juveniles placed inour programs have intensive and/or multiple and ongoing issues that must beaddressed in order to receive effective treatment to begin the rehabilitationprocess.

 

Weoperate our facilities and programs within the framework of our Seven KeyPrinciples® of Care.  Theseprinciples state that our operations must maintain the safety and security ofthe adults and juveniles placed in our care, our employees and the localcommunity.  They explain how we hold theindividuals in our care accountable for their actions and expect them to takeresponsibility.  Furthermore, we expectour employees to role model appropriate behavior and speech, maintain excellentcommunication between all parties, and treat everyone with dignity andrespect.  Finally, our principles statethat the physical environment of our facilities and programs will be clean andattractive.

 

Weprovide services in a structured and secure environment offered through ourthree operating divisions, which are also our reportable segments: (1) adultsecure institutions; (2) juvenile justice, educational and treatment programs;and (3) adult community-based corrections and treatment programs.  See Note 16 to the Consolidated Financial Statementsfor a discussion concerning our segments. Cornell is the successor of severalentities that began offering services at various times.  While the juvenile operations commenced in1973, our adult community-based corrections service line began operations in1974 and our adult secure service line began in 1984.

 

Asof December 31, our revenue for 2004 was approximately $291.0 million,which represents a 7.1% increase over 2003. Revenue was approximately $271.6 million for 2003 and approximately$275.1 million for 2002.  The adultsecure division made up 39.5% of our 2004 revenue, while the juvenile justicedivision contributed 43.5% and 17.0% was brought in from the adultcommunity-based corrections division. Revenue by division in 2003 was as follows: adult secure, 37.6%;juvenile justice, 43.7%; and adult community-based corrections, 18.7%.  Divisional revenue for 2002 was as follows:adult secure, 36.2%; juvenile justice, 45.4%; and adult community-basedcorrections, 18.4%.

 

***Services offered through our three divisions includeincarceration and detention, transition from incarceration, drug and alcoholcounseling and treatment, behavioral rehabilitation and treatment, vocationaltraining and academic education for grades 3-12.  As of December 31, 2004, we hadoperations in 16 states and the District of Columbia, with the total availablefacility service capacity of 18,228.  Ourfacility service capacity is comprised of the number of beds currentlyavailable for service or available upon***

 

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completion of construction or renovation of residential facilities andthe average program capacity of non-residential community-based programs.

*** ***

***Our website, www.cornellcompanies.com contains additionalinformation on Cornell.  We make availableon our website and upon request free of charge our annual reports on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-K and all amendmentsto those reports as soon as reasonably practical after such material iselectronically filed with or furnished to the Securities and ExchangeCommission (SEC).  Alternatively, reportsfiled with the SEC may be viewed or obtained at the SEC Public Reference Roomin Washington, D.C., or at the SEC’s web site,***www.sec.gov.

*** ***

***Each of our Board of Directors’ standing committee charters,our Corporate Governance Guidelines and our Policy of Business Conduct areavailable, free of charge, through our website or, upon request, in print.  We will post on our internet website allwaivers to or amendments of our Policy of Business Conduct, which are requiredto be disclosed by applicable law and rules of the NYSE listing standards.  Information contained on our website is notpart of this report.***

 

#### **The Private Adult Corrections and JuvenileJustice and Treatment Services Industry**

 

***Incarceration, detention, education and treatment for adultsand juveniles are essential government services.  In the United States, the incarcerated andsentenced populations of adults and juveniles continues to increase while federal,state and local governments face continuing pressures to control costs andimprove service quality. These trends have caused a growing acceptance towards outsourcingessential government services and functions.***

*** ***

***Private-sector companies, like Cornell, offer the same rangeof services that governments have historically provided to house and care foradult and juvenile offenders.  Theyinclude facility design, construction management, and facility and programoperations, such as healthcare and food, security, transportation, education,and rehabilitative programming.***

*** ***

***When government agencies contract with private companies,they usually receive the same services at the same or higher quality and for alower cost than what they can provide. Although outsourcing essential services has faced opposition in theU.S., public and government acceptance has increased as standards of serviceimprove and cost-savings are documented. As fiscal budget tightening continues for government agencies, severalstudies, including “Corrections Privatization Generates Savings and BetterService,” which was conducted by the Rio Grande Foundation, indicate thatprivate prisons not only save money for government entities, but also helpcontain cost increases of state departments that provided similar services.***

*** ***

***Outsourcing has a longer history in the juvenile justice andadult community-based corrections sectors of the industry.  Increasing steadily over the past 50 years,states, counties and local governments have used both for-profit andnot-for-profit organizations to meet the needs of troubled youth and adultsreintegrating into society after a time in residential treatment or prison.***

*** ***

***Recently, governments have sought alternatives to theever-increasing cost of incarceration for offenders who are non-violent andneed treatment, education and rehabilitation. Adult community-based reentry programs as well as education, substanceabuse and behavioral health programs that can successfully divert an offenderfrom prison are highly valued by the government.***

 

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#### **Demand for Adult Secure InstitutionalServices**

#### ** **

***The Re-Entry Policy Council reported that the number ofindividuals released from U.S. prisons was estimated at nearly 650,000 in 2004,while more than 7 million were released from jails across the nation in2004.  Spending on corrections hasoutpaced any other state budget item with the exception of health care.  The report states, “Nationally, correctionsexpenditures have gone from $9 billion in 1982 to $60 billion in 2002.”  Clearly, gaining control over these costs isneeded, and one way government agencies have set out to contain the increasesis through privatization.***

*** ***

Thefederal corrections system continues to operate over capacity.  The Bureau of Justice Statistics (BJS)reports that the BOP operated 39% over capacity in 2003, the last full yeardata is available, which is six percent greater capacity than in 2002.  During 2003, the BOP added more than 9,500prisoners into its system and 12.6% of the all federal inmates were housed inprivately operated facilities.  Toaccommodate the increasing need for bed space, the federal budget for fiscalyear 2005 states, “The BOP is committed to contracting out bed space for lowand minimum security inmates.  This willyield cost savings and represents a more flexible approach than additionalprison construction. The BOP’s total prison population increased by 10 percentbetween 2002 and 2003, but its contract population remained largely static. The2005 Budget places a moratorium on new prison construction while promoting moreaggressive BOP contracting with State, local, and private sector prisonproviders.”

 

Based on these statistics,we believe that targeted strategic development efforts offering solutions forovercrowded prison systems will offer long-term growth opportunities forCornell.

 

***Cornell’s Adult Secure Institutional ServicesDivision***

 

Our adult secureinstitutional services division provides low to maximum-security incarcerationservices.  This division ensures publicsafety through the operation of a physically secure environment, meaning that,among other security and safety measures, the premises are routinely patrolledby correctional officers and surrounded by alarmed fences and razor wire, allactivity is observed through closed circuit camera systems, and offenders stayon the grounds 24 hours a day, seven days a week.  While incarcerated, we provide offenders witha variety of educational, counseling and vocational programs geared toward asuccessful return to the community and a subsequent reduction in recidivism.

 

As of December 31,2004, we operated nine facilities with an aggregate service capacity of 7,940that provide secure services for incarcerated adults.  Within our adult secure institutionalservices division we offer the following:

 

•                                          Lowto maximum-security incarceration facilities.

•                                          Facilitydesign, construction and operation.

•                                          Confinementof juveniles adjudicated as adults.

•                                          Useof modern security technology, including electronic controls and surveillanceequipment.

•                                          Educationcourses, such as preparation and testing for the high school GeneralEquivalency Diploma (GED), English as a Second Language (ESL) classes, andAdult Basic Education (ABE).

•                                          Holistichealthcare services, including medical, dental, vision, psychiatric, andindividual and group counseling services.

•                                          Substanceabuse counseling, including detoxification, testing, counseling, 12-stepprograms and relapse prevention services.

•                                          Lifeskills training, including anger management, hygiene, personal finance,employment and housing issues and parenting skills.

 

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•                                          Religiousopportunities and culturally sensitive programs.

•                                          Foodand laundry service.

•                                          Recreationalactivities, such as exercise programs, hobby and craft, and leisureopportunities.

 

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

 

The juvenile justiceindustry sector includes residential, detention, shelter care, andcommunity-based services, along with education, rehabilitation and treatmentprograms.  This sector is highlyfragmented with several thousand providers across the country.  Most of the private providers are small andoperate in a specific geographic area. Both for-profit and not-for-profit organizations operate within theindustry.  Many states have programs andservices that are regularly put out for competitive bids.  Generally, contract renewals for theseservices are competitive, which enables Cornell to continue to vie for businessin new markets.

 

Juvenile justice issues area growing area of concern for many states due to the increasing number of youthwithin the system and annual expenditures on placement and treatment.  The Office of Juvenile Justice andDelinquency Prevention (OJJDP) reports that nationally as of October 2001,which is the most recent data available, more than 104,000 young people wereassigned to 2,980 residential facilities. These young people were under the age of 21, charged with an offense orcourt-adjudicated for an offense and placed in a residential facility becauseof the offense.  According to a June 2004report by the OJJDP, when comparing privately and publicly operated facilities,private facilities “have a greater proportion of juveniles who have beencommitted to the facility by the court and a smaller proportion of juvenileswho are detained (pending adjudication, disposition, or placement elsewhere).”

 

The OJJDP reports anincreasing need for residential bed space as many facilities report not havingenough standard beds for all of their residents.  Standard beds are considered regular bedspace for residents.  Makeshift beds,such as cots, bedrolls, mattresses and sofas are not standard beds, just asbeds for sick residents in a clinic or segregation beds are not standardbeds.  The most recent OJJDP dataavailable on bed space is December 2002 and it states that “nationally, 39percent of juvenile facilities (privately and publicly operated) reporting bedinformation held more residents than they had standard beds.”

 

In addition to a shortage ofstandard beds, state juvenile justice systems must also deal with the uniqueneeds of specialized populations, such as those with mental health issues.  The National Mental Health Associationpointed out in a 2004 study that the prevalence of youth in the juvenilejustice system with mental disorders was as high as 60 percent compared to 22percent in the general population.  The studyalso pointed out that for those youth who received treatment, the recidivismrate was as much as 25 percent lower than untreated children and teens in studycontrol groups.

 

***Cornell’s Juvenile Justice, Educational andTreatment Services Division***

 

Weprovide a broad array of services to youth, typically between the ages of 10and 17, in residential and community-based settings through our juvenilejustice, educational and treatment services division.  These programs and services are designed torehabilitate juveniles, hold them accountable for their actions and behaviors,and help them successfully re-integrate back into the community.

 

Anunderlying principle of our juvenile programming is the Balanced andRestorative Justice (BARJ) model.  Thisphilosophy incorporates several aspects of our Seven Key Principles® of Care, suchas accountability and responsibility. However, the model provides a restorative component to the victim,whether it is an individual, family or community.  The use of BARJ gives equal emphasis toaccountability, competency development and community protection.

 

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Asof December 31, 2004, we operated 23 residential facilities and 15non-residential community-based programs with a combined total service capacityof 4,877.  Within the juvenile justiceservices division, we offer the following:

 

•                                          Diversetreatment settings, including physically-secure, staff-secure andcommunity-based.

•                                          Specializedtreatment for unique populations, including females, drug sellers, sex offenders,fire starters and families.

•                                          Wildernesstraining programs and nationally accredited ropes course challenges.

•                                          Individualizedtreatment planning and case management.

•                                          Individual,group and family counseling and therapy, cognitive behavior therapy and stressand anger management.

•                                          Substanceabuse counseling and treatment, relapse prevention and education.

•                                          Lifeskills training, such as hygiene, personal finance, employment and housingissues, and parenting skills.

•                                          Accreditedalternative and special education services.

•                                          Holistichealthcare services including medical, dental, behavioral health andpsychiatric services.

•                                          Recreationalactivities, exercise programs, hobby and craft, and leisure opportunities.

 

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

 

Community-based corrections services includessupervising adult parolees and probationers. Parolees are those who have served time in a correctional facility andhave been released due to either mandatory conditional release or a paroleboard decision.  Probationers have beencharged with a crime but were sentenced to probation in lieu ofincarceration.  Some probationers mayviolate the terms of their probation and be sanctioned with a prisonsentence.  Services provided can includetemporary housing, anger management, personal finance training, employmentassistance, academic opportunities, vocational training and substance abuse oraddiction counseling.  The market isfragmented with several thousand providers across the country.  For profit and not-for-profit organizationsprovide these services, however, most of them are small and operate in aspecific geographic area.

 

Just as the other market segments in whichCornell competes have experienced growth, so, too, has community-basedcorrections.  This is not unexpectedsince most incarcerated individuals pass into community-based or paroleprograms after serving a period of time in prison.  Based on currently available statistics bythe BJS, the number of adults supervised on parole or probation reached arecord high of 4,848,575 at year-end 2003. From 2002 to 2003, the U.S. parole population increased 3.1 percent andthe probation population grew 1.2 percent. The BJS reported that the states of Texas and California had a combinedcommunity-based corrections population of more than 1 million people in 2003,which represents approximately 20 percent of all parolees and probationers inthe U.S.

 

The BJS reports that in 2003, 49% ofprobationers had been convicted of a felony offense and 25%  had drug-related offenses. This populationrequires substance abuse counseling and treatment to help them remain out ofthe criminal justice system.  A 2002survey conducted by the Texas Department of Criminal Justice indicated thatnearly 30 percent of Texans under community-based corrections supervisionneeded help with alcohol and other drug usage, and nearly 23 percent neededfinancial management skills.

 

***Cornell’s Adult Community-Based Correctionsand Treatment Services Division***

 

Throughour adult community-based corrections and treatment services division, we serveindividuals who have been granted parole or sentenced to probation.  Probationers are typically placed incommunity-based

 

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correctional settings prior to release into the community.  These individuals usually spend three to ninemonths in such a facility so they can put their lives back together again tolive productively in society.

 

Theadult community-based corrections facilities provide an alternative toincarceration and a focus on transitioning offenders from a correctionalfacility back into society.  Through asystem of education, employment training, treatment, monitoring and accountability,residents are given the necessary tools to make positive life choices that canreduce the incidence of recidivism. Programs include minimum-security residential settings, home confinementand day reporting.

 

Asof December 31, 2004, we operated 15 residential community-based correctionalfacilities and six non-residential community-based programs with a combinedtotal service capacity of 3,897. Within this division, we offer the following:

 

•                                          Minimum-securityand staff-secure residential services.

•                                          Homeconfinement and electronic monitoring.

•                                          Employmenttraining and assistance.

•                                          Education,including preparation and testing for the GED, ABE, computer courses,college-level courses and libraries.

•                                          Vocationaltraining.

•                                          Individual,group and family counseling and therapy, cognitive behavior therapy and stressand anger management;

•                                          Substance-abusecounseling and treatment, including detoxification, testing, 12-step programsand relapse prevention services; and

•                                          Lifeskills training, including anger management, hygiene, housing issues, personalfinance and parenting skills.

 

**Marketing and Business Development**

 

Our principal customers arefederal, state and local government agencies responsible for adult and juvenilecorrections, treatment and educational services.  We manage our business development efforts toaddress opportunities available in all of our divisions and potentialmarkets.  We respond to Requests forProposals (RFPs), but have also positioned ourselves to seek and develop solesource opportunities and pursue accretive acquisitions.

 

Government agenciesgenerally procure services from the private sector through a proposal process,which consists of several steps.  Itbegins with the issuance of an RFP to which numerous companies can respond bysubmitting a written proposal.  Theprocess concludes with the agency awarding the contract, which commences theconstruction or operation of the facility. In addition to costs, government agencies consider numerous otherfactors when awarding contracts including a bidders’ experience andqualifications.

 

If we believe a projectdescribed in an RFP is consistent with our strategic business plan, we willsubmit a proposal.  When responding toRFPs, we incur costs that typically range from $10,000 to $100,000 per proposal.  In order to determine the prospective client’sspecific needs.  Additionally, we mayincur substantial costs to acquire options to lease or purchase land for aproposed facility, lease or purchase an existing building to house a program,and/or engage outside consulting and legal expertise related to a particularRFP.  The preparation of a responseusually requires five to 15 weeks. The award process usually takes anadditional three to nine months.  If theRFP is for managing or operating an existing facility, the selected companygenerally begins operations within 30 days of receiving the award.  If new construction is required by thecontract, the selected company’s operation of the facility generally beginsbetween 18

 

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and 36 months after the award is made.

 

When a contract requiresconstruction of a new facility, our success depends, in part, on our ability toacquire real property on desirable terms and in satisfactory locations.  We anticipate that most new facilities willbe constructed in rural areas.  In caseswhere the contract requires facilities in or near populous areas, we anticipatelegal action and other forms of opposition from local residents surroundingcertain proposed sites.  We may incursignificant expenses in responding to such opposition and there can be noassurance of success.  In addition, wemay choose not to respond to an RFP or may withdraw a submitted proposal iflegal action or other forms of opposition are anticipated or encountered.

 

We pursue sole sourceopportunities in certain markets.  Wemeet with appropriate personnel from potential government agencies to bestdetermine the agency’s distinct needs. We may also receive inquiries from or on behalf of government agenciesconsidering privatization of certain facilities or contracting with privateproviders.  When such an inquiry isreceived, we conduct a due diligence process to determine if a need for ourservices truly exists and if the local community’s legal and political climate supportsprivatization.  We then analyze theprojects costs to determine project feasibility.

 

From time to time, wereceive unsolicited opportunities for acquisitions.  We focus only on those opportunities that webelieve will align with our operating approach and will add to earnings.

 

#### **Contracts**

#### ** **

Our facility operatingcontracts generally provide that we will be compensated at an occupant per diemrate, fees for treatment service, guaranteed take-or-pay or cost-plusreimbursement.  Factors we consider indetermining billing rates include (1) the specified programs provided for bythe contract and the related staffing levels, (2) wage levels customary in therespective geographic area, (3) whether the proposed facility is to be leasedor purchased, and (4) the anticipated average occupancy levels that we believecould reasonably be maintained. Compensation is invoiced in accordance with the applicable contract andis typically paid on a monthly basis. Some of our juvenile education contracts provide for annual payments.

 

We pursue new contracts thatleverage our existing infrastructure and capabilities.  Although the majority of our opportunitiesare other than take-or-pay contracts, we pursue guaranteed take-or-paycontracts.  Take-or-pay contracts providea fixed minimum revenue stream regardless of occupancy, thereby addingincreased stability to our revenue stream. All of the other types of contracts produce revenue that varies with thenumber of individuals housed or served, the types of services provided and/orthe frequency of the service.  At anygiven time, we may have projects in development without a service contract or acommitment for the same in effect and the appropriate divisional management assessesthe market demand of our services and continue to monitor the needs of themarket for opportunities to leverage these projects.

 

#### **Quality of Operations**

#### ** **

Independentaccreditation by various oversight and regulatory organizations demonstratesthat a facility meets nationally accepted professional standards for qualityoperations, facility design, management and maintenance.  Accrediting entities include the AmericanCorrectional Association (ACA) and National Commission on Correctional HealthCare (NCCHC) for the adult secure institution and adult community-basedcorrections and treatment services sectors, and the Joint Commission onAccreditation of Healthcare Organizations (JCAHO), Departments of PublicWelfare, Departments of Protective and Regulatory Services, and Departments ofHuman Services and Education for the juvenile justice, educational andtreatment services sector.

 

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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. Standards have been established for administrative andfiscal controls, staff training and development, physical plant, safety andemergency procedures, sanitation, food service, and rules and discipline.  ACA accreditation is an important indicatorof improved conditions for adult prisons under court order.  Our facilities’ daily operations must performin accordance with ACA accreditation standards as stated in our policies andprocedures.  Accreditation and therequired standards of operation contribute to the public’s increased acceptanceof Cornell and our services.

 

Internal quality control,conducted by our senior facility staff and executive officers, takes the formof periodic operational, programming and fiscal audits; facility inspections;regular review of logs, reports and files; and strict maintenance of personnelstandards, including an active training program.  Each of our facilities develops its owntraining plan that they review, evaluate, and update annually.

 

All adult correctionalofficers undergo a minimum 40-hour orientation upon their hiring and receiveacademy-level training amounting to 120 hours and on-the-job training of up to80 hours.  Each correctional officer alsoreceives up to 40 hours of continuing education and training annually.  All juvenile justice, educational andtreatment employees undergo a minimum 80-hour orientation upon their hiring andalso receive up to 40 hours of continuing education and training annually.

 

**Facilities**

 

As of December 31,2004, we operated 68 facilities and had two facilities under development orconstruction: the Moshannon Valley Correctional Center in Phillipsburg,Pennsylvania, and the New Morgan Academy in Morgantown, Pennsylvania.  Refer to “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Liquidity andCapital Resources – Contractual Uncertainties Related to Certain Facilities”for a detailed discussion concerning the New Morgan Academy.  Refer to “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Significant 2004Events” for a detailed discussion concerning the Moshannon Valley CorrectionalCenter.  In addition to providingmanagement services, we develop, design and/or construct many of ourfacilities.

 

Either through outrightownership or long-term leases, we control operating facilities representing alarge majority of our revenues.  Webelieve that such control increases the likelihood of contract renewal, allowsus to expand existing facilities and thereby realize economies of scale andenhances our ability to win new contracts and control repair costs.  In addition, we believe that long-termcontrol of our operating facilities allows us to better manage cost escalationpressures.

 

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The following tablesummarizes certain additional information with respect to our facilities as of December 31,2004.  As indicated, the majority of thefacilities to which we provide services are either owned or leased underlong-term leases, which are generally under terms ranging from one to 45 years.

 
| **Facility Name and Location**                                                            | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
|                                                                                      |       |                             |       |                            |       |                                        |       |
| ***Adult Secure Institutional Facilities:***                                              |       |                             |       |                            |       |                                        |       |
|                                                                                      |       |                             |       |                            |       |                                        |       |
| Baker  Community Correctional Center                                                      |       | 262                              |       | 1987                            |       | Owned                                       |       |
| Baker,  California                                                                        |       |                             |       |                            |       |                                        |       |
| Big Spring  Correctional Center                                                           |       | 2,646                            |       | (4)                             |       | Leased (5)                                  |       |
| Big Spring,  Texas                                                                        |       |                             |       |                            |       |                                        |       |
| D. Ray James  Prison                                                                      |       | 1,640                            |       | 1998                            |       | Leased (5)                                  |       |
| Folkston,  Georgia                                                                        |       |                             |       |                            |       |                                        |       |
| Donald W.  Wyatt Detention Center                                                         |       | 357                              |       | 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                                                                     |       |                             |       |                            |       |                                        |       |
| Regional  Correctional Center (7)                                                         |       | 970                              |       | 2004                            |       | Leased                                      |       |
| Albuquerque,  New Mexico                                                                  |       |                             |       |                            |       |                                        |       |
| Valencia  County Detention Center                                                         |       | 158                              |       | 2000                            |       | Managed (8)                                 |       |
| Los Lunas,  New Mexico                                                                    |       |                             |       |                            |       |                                        |       |
| Walnut Grove  Youth Correctional Facility                                                 |       | 941                              |       | 2004                            |       | Managed                                     |       |
| Walnut  Grove, Mississippi                                                                |       |                             |       |                            |       |                                        |       |
|                                                                                      |       |                             |       |                            |       |                                        |       |
| ***Juvenile  Justice, Educational and Treatment******Facilities:Residential Facilities*** |       |                             |       |                            |       |                                        |       |
|                                                                                      |       |                             |       |                            |       |                                        |       |
| Alexander  Youth Services Center                                                          |       | 143                              |       | 2001                            |       | Managed                                     |       |
| Alexander,  Arkansas                                                                      |       |                             |       |                            |       |                                        |       |
| Campbell  Griffin Treatment Center                                                        |       | 122                              |       | 1996                            |       | Leased (5)                                  |       |
| San Antonio,  Texas                                                                       |       |                             |       |                            |       |                                        |       |
| Contact                                                                                   |       | 51                               |       | (9)                             |       | 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                                                             |       | 72                               |       | 1999                            |       | Leased                                      |       |
| South  Mountain, Pennsylvania                                                             |       |                             |       |                            |       |                                        |       |

 

*(Tablecontinued on following page)*

 

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| **Facility Name and Location**                                | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| ***Juvenile Justice, Educational and Treatment Facilities:*** |       |                             |       |                            |       |                                        |       |
| ***Residential Facilities (Continued)***                      |       |                             |       |                            |       |                                        |       |
|                                                          |       |                             |       |                            |       |                                        |       |
| Danville  Center for Adolescent Females                       |       | 64                               |       | 1998                            |       | Managed                                     |       |
| Danville,  Pennsylvania                                       |       |                             |       |                            |       |                                        |       |
| DuPage  Adolescent Center                                     |       | 38                               |       | (9)                             |       | Owned                                       |       |
| Hinsdale,  Illinois                                           |       |                             |       |                            |       |                                        |       |
| Erie Residential  Behavioral Health Program                   |       | 17                               |       | 1999                            |       | Owned                                       |       |
| Erie,  Pennsylvania                                           |       |                             |       |                            |       |                                        |       |
| Jos-Arz  Academy                                              |       | 70                               |       | 2003                            |       | Leased                                      |       |
| Washington,  D.C.                                             |       |                             |       |                            |       |                                        |       |
| Leadership  Development Program                               |       | 120                              |       | 1994                            |       | Leased                                      |       |
| South  Mountain, Pennsylvania                                 |       |                             |       |                            |       |                                        |       |
| Maple Creek  Home                                             |       | 8                                |       | (9)                             |       | Owned                                       |       |
| Matteson,  Illinois                                           |       |                             |       |                            |       |                                        |       |
| Psychosocial  Rehabilitation Unit                             |       | 13                               |       | 1994                            |       | Owned                                       |       |
| Erie,  Pennsylvania                                           |       |                             |       |                            |       |                                        |       |
| Residential  School                                           |       | 32                               |       | (9)                             |       | Owned                                       |       |
| Matteson,  Illinois                                           |       |                             |       |                            |       |                                        |       |
| Salt Lake  Valley Detention Center                            |       | 160                              |       | 1996                            |       | Managed                                     |       |
| Salt Lake  City, Utah                                         |       |                             |       |                            |       |                                        |       |
| Schaffner  Youth Center                                       |       | 63                               |       | 2001                            |       | Managed                                     |       |
| Steelton,  Pennsylvania                                       |       |                             |       |                            |       |                                        |       |
| Southern  Peaks Regional Treatment Center                     |       | 160                              |       | 2004                            |       | Owned                                       |       |
| Canon City,  Colorado                                         |       |                             |       |                            |       |                                        |       |
| South  Mountain Secure Treatment Unit                         |       | 56                               |       | 1997                            |       | Managed                                     |       |
| South  Mountain, Pennsylvania                                 |       |                             |       |                            |       |                                        |       |
| Texas  Adolescent Treatment Center                            |       | 124                              |       | 2003                            |       | Leased                                      |       |
| San Antonio,  Texas                                           |       |                             |       |                            |       |                                        |       |
| Woodridge                                                     |       | 163                              |       | (9)                             |       | Owned                                       |       |
| Woodridge,  Illinois                                          |       |                             |       |                            |       |                                        |       |
|                                                          |       |                             |       |                            |       |                                        |       |
| ***Juvenile Justice, Educational and Treatment Facilities:*** |       |                             |       |                            |       |                                        |       |
| ***Non-Residential Facilities***                              |       |                             |       |                            |       |                                        |       |
|                                                          |       |                             |       |                            |       |                                        |       |
| Adams  Behavioral Health Services                             |       | 70                               |       | 1998                            |       | Leased                                      |       |
| Oxford,  Pennsylvania                                         |       |                             |       |                            |       |                                        |       |
| Cornell  Abraxas Parenting Academy                            |       | 36                               |       | 1999                            |       | Leased                                      |       |
| Harrisburg,  Pennsylvania                                     |       |                             |       |                            |       |                                        |       |

 

*(Tablecontinued on following page)*

 

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| **Facility Name and Location**                                    | ** ** | **Total  Service  Capacity (1)** | ** ** | **Initial  Contract  Date (2)** | ** ** | **Company  Owned/  Leased or  Managed (3)** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|
| ** **                                                        | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** **                                  | ** ** |
| ***Juvenile Justice, Educational and Treatment Facilities:***     |       |                             |       |                            |       |                                        |       |
| ***Non-Residential Facilities (Continued)***                      |       |                             |       |                            |       |                                        |       |
|                                                              |       |                             |       |                            |       |                                        |       |
| Delaware  Community-Based Programs                                |       | 66                               |       | 1994                            |       | Leased                                      |       |
| Milford,  Delaware                                                |       |                             |       |                            |       |                                        |       |
| Erie  Behavioral Health Services                                  |       | 50                               |       | 1997                            |       | Owned                                       |       |
| Erie,  Pennsylvania                                               |       |                             |       |                            |       |                                        |       |
| Harrisburg  Community-Based Programs                              |       | 575                              |       | 1996                            |       | Leased                                      |       |
| Harrisburg,  Pennsylvania                                         |       |                             |       |                            |       |                                        |       |
| Harrisburg  Day Treatment                                         |       | 45                               |       | 1996                            |       | Leased                                      |       |
| Harrisburg,  Pennsylvania                                         |       |                             |       |                            |       |                                        |       |
| Leadership  Academy/ACTS Program                                  |       | 600                              |       | 2001                            |       | Managed                                     |       |
| Harrisburg,  Pennsylvania                                         |       |                             |       |                            |       |                                        |       |
| Lebanon  Alternative Education                                    |       | 225                              |       | 2004                            |       | Managed                                     |       |
| Lebanon,  Pennsylvania                                            |       |                             |       |                            |       |                                        |       |
| Lehigh  Valley Community-Based Programs                           |       | 60                               |       | 1992                            |       | Leased                                      |       |
| Lehigh  Valley, Pennsylvania                                      |       |                             |       |                            |       |                                        |       |
| Lycoming/Clinton  Behavioral Health Services                      |       | 50                               |       | 1998                            |       | Leased                                      |       |
| Williamsport,  Pennsylvania                                       |       |                             |       |                            |       |                                        |       |
| Non-Residential  Detention/Non-Residential Treatment              |       | 91                               |       | 1999                            |       | Leased                                      |       |
| Harrisburg,  Pennsylvania                                         |       |                             |       |                            |       |                                        |       |
| Philadelphia  Alternative Education                               |       | 165                              |       | 2004                            |       | Managed                                     |       |
| Philadelphia,  Pennsylvania                                       |       |                             |       |                            |       |                                        |       |
| Philadelphia  Community-Based Programs                            |       | 71                               |       | 1992                            |       | Owned                                       |       |
| Philadelphia,  Pennsylvania                                       |       |                             |       |                            |       |                                        |       |
| Washington  D.C. Community-Based Programs                         |       | 160                              |       | 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                                             |       |                             |       |                            |       |                                        |       |
| Las Vegas  Community Correctional Center                          |       | 100                              |       | 2004                            |       | Leased                                      |       |
| Las Vegas,  Nevada                                                |       |                             |       |                            |       |                                        |       |
| 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                                                |       |                             |       |                            |       |                                        |       |

 

*(Tablecontinued on following page)*

 

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| **Facility Name and Location**                                    | ** **   | **Total  Service  Capacity (1)** | ** **   | **Initial  Contract  Date (2)** | ** **   | **Company  Owned/  Leased or  Managed (3)** | ** **   |
|-------------------------------------------------------------------|--------------|----------------------------------|--------------|---------------------------------|--------------|---------------------------------------------|--------------|
|                                                              |         |                             |         |                            |         |                                        |         |
| ***Adult Community-Based Corrections and Treatment Facilities:*** |         |                             |         |                            |         |                                        |         |
| ***Residential Facilities (Continued)***                          | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| ** **                                                        | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| 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 (10)                                 |         |
| San  Francisco, California                                        |         |                             |         |                            |         |                                        |         |
| Tundra  Center                                                    |         | 85                               |         | 1986                            |         | Leased (5)                                  |         |
| Bethel,  Alaska                                                   |         |                             |         |                            |         |                                        |         |
| *** ***                                                      | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| ***Adult Community-Based Corrections and Treatment Facilities:*** |         |                             |         |                            |         |                                        |         |
| ***Non-Residential Facilities***                                  | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| ** **                                                        | ** **   | ** **                       | ** **   | ** **                      | ** **   | ** **                                  | ** **   |
| Dixon  Correctional Center (11)                                   |         | 68                               |         | 2003                            |         | Managed                                     |         |
| Dixon,  Illinois                                                  |         |                             |         |                            |         |                                        |         |
| East St.  Louis                                                   |         | 164                              |         | (9)                             |         | Leased                                      |         |
| East St.  Louis, Illinois                                         |         |                             |         |                            |         |                                        |         |
| LifeWorks                                                         |         | 116                              |         | (9)                             |         | Leased                                      |         |
| Joliet,  Illinois                                                 |         |                             |         |                            |         |                                        |         |
| Northside  Clinic                                                 |         | 252                              |         | (9)                             |         | Leased                                      |         |
| Chicago,  Illinois                                                |         |                             |         |                            |         |                                        |         |
| Southwestern  Illinois Correctional Center (12)                   |         | 671                              |         | (9)                             |         | Managed                                     |         |
| East St.  Louis, Illinois                                         |         |                             |         |                            |         |                                        |         |
| Southwood                                                         |         | 549                              |         | (9)                             |         | Owned                                       |         |
| Chicago,  Illinois                                                |         |                             |         |                            |         |                                        |         |
|                                                              |         |                             |         |                            |         |                                        |         |
| ***Facilities Under Development, Construction or Renovation***    | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| *** ***                                                      | *** *** | *** ***                     | *** *** | *** ***                    | *** *** | *** ***                                | *** *** |
| Moshannon  Valley Correctional Center                             |         | 1,300                            |         | (13)                            |         | Owned (13)                                  |         |
| Philipsburg,  Pennsylvania                                        |         |                             |         |                            |         |                                        |         |
| New Morgan  Academy                                               |         | 214                              |         | (14)                            |         | Owned (14)                                  |         |
| New Morgan,  Pennsylvania                                         |         |                             |         |                            |         |                                        |         |

 

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(1)                      Residential service capacity is comprised ofthe number of beds currently available for service or available upon thecompletion of construction or renovation of residential facilities. Servicecapacity for non-residential programs is based on either contractual terms orour estimate of the number of clients to be served.  These estimates are updated by us at leastannually based on the program’s budget and other factors.

(2)                      Date from which we, or our predecessor, havehad a contract for services on an uninterrupted basis.

(3)                      We do not incur any facility use costs, suchas debt service, rent or depreciation, for facilities that we have a managementcontract only.  We are responsible forall other facility operating costs at these facilities.

(4)                      The City of Big Spring entered into theIntergovernmental Agreement with the BOP for an indefinite term (until modifiedor terminated) with respect to the Big Spring Correctional Center, which beganoperations during 1989.  The Big SpringOperating Agreement, as amended, has a term through 2047 including renewaloptions at our discretion, pursuant to which we manage the Big SpringCorrectional Center for the City of Big Spring. The portion of the Big Spring Operating Agreement relating to the CedarHill Unit has a term of 30 years with four five-year renewal options at ourdiscretion.

(5)                      Facility was sold on August 14, 2001 toMunicipal Corrections Finance, L.P. (MCF) as part of our 2001 Sale andLeaseback Transaction as discussed in “Financial Statements and SupplementaryData – Note 12.”

(6)                      The prison is operated pursuant to a one-yearcontract with nine one-year renewal options between the Oklahoma Department ofCorrections and the Hinton Economic Development Authority, or HEDA. HEDA inturn has subcontracted the operations to us under a 30-year operating contractwith four five-year renewals.

(7)                      We leased the Regional CorrectionalCenter in January 2003 and have renovated the 970 bed facility which isused to provide adult secure confinement services.   As of December 31, 2004, we operate thefacility and continue to have discussions with various agencies that havedemonstrated a need and expressed interest for the available bed space.  Refer to “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Liquidity andCapital Resources – Contractual Uncertainties Related to Certain Facilities”for a detailed discussion concerning this facility.

(8)                      Our management contract for this facilityterminated effective December 31, 2004.

(9)                      The Cornell Interventions programs/facilitiescontract with numerous agencies throughout Illinois.  Initial contract dates vary by agency andrange from 1974 to 1997.

(10)                Facility was initially financed with oursynthetic lease financing arrangement under our amended 2000 Credit Facility.The amended 2000 Credit Facility was refinanced in 2004 through our issuance ofthe Senior Notes.  Refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources.”

(11)                We manage a 68 bed dual diagnosis programlocated within the Special Treatment Center within the state operated DixonCorrectional Center.

(12)                We manage a therapeutic community drug and alcoholprogram within the state operated Southwestern Illinois Correctional Center.

(13)                We are in the process of constructing theMoshannon Valley Correctional Center.  Referto “Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Significant 2004 Events” for a detailed discussion concerning thisfacility.

(14)                We closed the New Morgan Academy in thefourth quarter of 2002 and are currently considering several optionsranging from the sale or lease of the facility to the utilization of thefacility for another type of program. Refer to “Management’s Discussion and Analysis of Financial Conditionand Results of Operations – Liquidity and Capital Resources – ContractualUncertainties Related to Certain Facilities” for further discussion concerningthis facility.

 

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**Competition**

 

Sinceour services encompass several diverse markets, we view our competition withinmarket segments. We believe our principal competitors in the adult securemarket are Corrections Corporation of America, Inc., The Geo Group, Inc.(formerly Wackenhut Corrections Corporation) and Management and TrainingCorporation.  Although the adultcommunity-based corrections and treatment and juvenile justice, educational andtreatment services markets generally have a large number of smaller operators,some of our main competitors in the juvenile justice, educational and treatmentservices market include Correctional Services Corporation, Inc., Securicor NewCentury, Ramsay Youth Services and other smaller regional operators. Our largercompetitors in the adult community-based corrections and treatment servicesmarket include Bannum, Gateway, Salvation Army, Volunteers of America and othersmaller regional operators.

 

**Employees**

 

At December 31, 2004, we had 3,931 full-timeemployees and 261 part-time employees. We employ management, administrative and clerical, security, educationaland counseling services, health services and general maintenancepersonnel.  Approximately 475 employeesat five of our facilities are represented by unions.

 

**Regulations**

 

The industry in which we operate is subject tofederal, state and local regulations administered by a variety of regulatoryauthorities.  Generally, prospectiveproviders of correctional, detention, educational, treatment andcommunity-based services must comply with a variety of applicable federal,state and local regulations, including education, healthcare and safetyregulations.  Our contracts frequentlyinclude extensive reporting requirements, including mandatory supervision withon-site monitoring by representatives of our contracting government agencies.

 

In addition to regulations requiring certaincontracting government agencies to enter into a competitive bidding procedurebefore awarding contracts, the laws of certain jurisdictions may also requireus to award subcontracts on a competitive basis or to subcontract withbusinesses owned by women or members of minority groups.

 

**Business Concentration**

 

For the years ended December 31, 2004, 2003 and2002, 23.8%, 21.7% and 20.9%, respectively, of our consolidated revenues werederived from multiple contracts with the BOP.

 

**Insurance**

 

We maintain general liability insurance for all ofour operations at an amount equal to $10 million per occurrence per facilityand in the aggregate.  We also maintaininsurance in amounts management deems adequate to cover property and casualtyrisks, workers’ compensation, and directors’ and officers’ liability.

 

Our contracts and the statutes of certain states inwhich we operate typically require us to maintain insurance.  Our contracts provide that, in the event wedo not maintain such insurance, the contracting agency may terminate itsagreement with us.  We believe that weare in compliance in all material respects with these requirements.

 

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

 

We lease office space for our corporate headquartersin Houston, Texas and regional administrative offices in Ventura, California,Pittsburgh, Pennsylvania and Chicago, Illinois. We also lease various facilities we are currently operating ordeveloping.  For a listing of owned andleased facilities, see “Business - Facilities.”

 

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

 

**Southern Peaks Regional Treatment Center**

 

On January 5, 2004, we initiated legalproceedings in the lawsuit styled *CornellCorrections of California, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV-79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center.  Of the funds previously deposited,approximately $5.4 million remains to be recovered at December 31,2004.  In December 2004, thecase was tried before a jury and the jury returned a verdict awarding approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorney’s fees.  Currently,we expect the defendants to move for a new trial and that no judgment will beentered on the verdict until after these motions for a new trial have beenheard and ruled on by the court.  If thecourt denies any filed motions for a new trial and enters a judgment on thejury verdict we expect that the actual damages awarded under the verdict willbe adjusted downward to the $5.4 million actually lost by us and that thepunitive damages award may be adjusted downward because of a Georgia statuteregarding caps on punitive damages awards. The award for compensatory damages accrues pre-judgment interest at arate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Due to the continued uncertainty surroundingany motions for new trial and the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.1 million in an allowance for doubtful accounts.

 

**Shareholder Lawsuits**

 

In March and April 2002, the company,Steven W. Logan (our former President and Chief Executive Officer), and John L.Hendrix (our former Chief Financial Officer), were named as defendants in fourfederal putative class action lawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf of Himselfand All Others Similarly 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 our common stock between March 6, 2001 and March 5,2002 and relate to our restatement in 2002 of certain financialstatements.  The lawsuits involveddisclosures made concerning two prior transactions executed by us: the August 2001sale leaseback 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 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

 

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promulgated under Section 10(b) of the Exchange Act, Section 20(a)of the Exchange Act, Section 11 of the Securities Act of 1933 (the “SecuritiesAct”) 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, our directors, andour former independent auditor Arthur Andersen LLP, were sued in a derivativeaction styled as *William Williams,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 our restatement in2002 of certain financial statements. The lawsuit alleged breaches of fiduciary duty by all of the individualdefendants and asserted breach of contract and professional negligence claimsonly against Arthur Andersen LLP.  Thislawsuit has been dismissed without prejudice by agreement.

 

On January 27, 2004, we received a letter fromWilliam Williams, the plaintiff in the *WilliamWilliams* action discussed above, demanding that we pursue breach offiduciary duty claims against various officers and directors based on the August 2001sale leaseback transaction and the subsequent restatement. We have issued apreliminary response to the letter indicating that the Board will consider therequest and inform Mr. Williams of its decision.

 

In May and June 2002, the company and ourdirectors were sued in three other derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. H-02-1812, in theUnited Stated District Court for the Southern District of Texas, HoustonDivision; (2) *Thomas Pagano, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896,in the United Stated District Court for the Southern District of Texas, HoustonDivision; 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 toour 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 plaintiffs in these cases have notquantified their claim of damages and the outcome of the matters discussedabove cannot be predicted with certainty. However, we believe we have good defenses and intend to vigorouslydefend against the claims asserted in these actions.  We have not recorded any loss accrualsrelated to these claims.

 

***Certain insurance policies held by us to cover potentialdirector and officer liability may limit our cash outflows in the event of adecision adverse to us 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 us in these matters couldhave a material adverse effect on us, our financial condition, results ofoperations and future prospects.***

 

***Other***

*** ***

Additionally,we currently and from time to time are subject to claims and suits arising inthe ordinary course of business, including claims for damages for personalinjuries or for wrongful restriction of or interference with offenderprivileges and employment matters. If an adverse decision in these mattersexceeds

 

17

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our insurance coverage, or if our coverage is deemed not to apply tothese matters, or if the underlying insurance carrier were unable to fulfilltheir obligation under the insurance coverage provided, it could have amaterial adverse effect on our financial position, results of operations orcash flows.

 

During the period of August 2000through May 2003, our general liability and professional liability coverage wasprovided by Specialty Surplus Insurance Company, a Kemper Insurance Company (“Kemper”)group member.  In June 2004, theIllinois Department of Insurance gave Kemper permission to proceed with arun-off plan it has previously submitted. The three-year plan is designed to help Kemper meet its goal ofresolving, the maximum extent possible, all valid policyholder claims.

 

Inview of the risks and uncertainties involved in implementing the plan,including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  At December 31, 2004, we recorded acharge of $0.6 million, and have estimated our range of additional exposure tobe $0.5 million with respect to outstanding claims incurred during this policyperiod with Kemper which would become our obligation to resolve if notpreviously settled through Kemper.

 

Whilethe outcome 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 our financialposition, operating results or cash flow.

 

**Securities and Exchange Commission Investigation**

 

***Following the restatement of our 2001 financial statementsin 2002, the SEC initiated an investigation into the circumstances leading tothis restatement.  The SEC made aninitial inquiry in 2002, and in July 2003, we received additionalinformation requests to which we responded and cooperated in a timelymanner.  In October 2004, wereceived correspondence from the staff of the SEC indicating that the SEC’sinvestigation had been terminated and no enforcement action had beenrecommended.***

*** ***

***ITEM 4.***                             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

*** ***

No matters were submitted to our stockholders duringthe fourth quarter of 2004.

 

18

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**PART II**

** **

**ITEM 5.****       ****MARKET FOR CORNELL COMPANIES, INC. COMMON STOCK, RELATEDSTOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES**

 

Our common stock is currently listed on the New YorkStock Exchange (“NYSE”) under the symbol “CRN.” As of March 10, 2005, there were 39 record holders andapproximately 1,804 beneficial holders of common stock.  The quarterly high and low closing salesprices for our common stock from January 1, 2003 through March 10,2005 are shown below.

 
| ** **                                   | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------------------------------------|------------|----------|------------|---------|------------|
|                                         |       |     |       |    |       |
| 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                               |       | $        | 13.75      |    | $          | 11.36 |   |
| Second  Quarter                              |       | 14.05    |       | 11.20   |       |
| Third  Quarter                               |       | 14.62    |       | 11.75   |       |
| Fourth  Quarter                              |       | 15.33    |       | 12.21   |       |
| 2005:                                        |       |     |       |    |       |
| First  Quarter (through March 10, 2005) |       | $        | 15.64      |    | $          | 13.90 |   |

 

We have never declared or paid cash dividends on ourcapital stock.  We currently intend toretain excess cash flow, if any, for use in the operation and expansion of ourbusiness and do not anticipate paying cash dividends on our common stock in theforeseeable future.  The payment ofdividends is within the discretion of the Board of Directors and is dependentupon, among other factors, our results of operations, financial condition,capital requirements, restrictions, if any, imposed by financing commitmentsand legal requirements. Our 10.75% Senior Notes, as well as our revolvingcredit facility, dated as of June 24, 2004 (the “2004 Credit Facility”),contain certain restrictions on our ability to pay dividends.  See “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations - Liquidity and CapitalResources.”

 

We did not purchase any of our common stock in thefourth quarter of 2004.

 

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The following table summarizes as of December 31,2004, certain information regarding equity compensation to our employees,officers, directors, and other persons under the Company’s plans:

 
| ** **                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | **(C)**                  | ** ** |
|-------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | **Number of**            | ** ** |
| ** **                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | **Securities Remaining** | ** ** |
| ** **                                                  | ** ** | **(A)**                  | ** ** | ** **            | ** ** | **Available for**        | ** ** |
| ** **                                                  | ** ** | **Number of**            | ** ** | **(B)**               | ** ** | **Future Issuance**      | ** ** |
| ** **                                                  | ** ** | **Securities to be**     | ** ** | **Weighted-average**  | ** ** | **Under Equity**         | ** ** |
| ** **                                                  | ** ** | **Issued upon**          | ** ** | **Exercise Price of** | ** ** | **Compensation**         | ** ** |
| ** **                                                  | ** ** | **Exercise of Out-**     | ** ** | **Outstanding**       | ** ** | **Plans (Excluding**     | ** ** |
| ** **                                                  | ** ** | **standing Stock**       | ** ** | **Stock Options**     | ** ** | **Securities Reflected** | ** ** |
| ** **                                                  | ** ** | **Options and Warrants** | ** ** | **and Warrants**      | ** ** | **in Column A)**         | ** ** |
|                                                        |       |                     |       |                  |       |                     |       |
| Plan  Category                                              |       |                     |       |                  |       |                     |       |
| Equity  compensation plans approved by security holders     |       | 726,268                  |       | $                     | 11.51      |                     | 688,744    | (1) |
| Equity  compensation plans not approved by security holders |       | 323,271                  |       | $                     | 8.05       |                     | 252,812    | (2) |
| Total                                                       |       | 1,049,539                |       | $                     | 10.44      |                     | 941,556    |   |

 

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(1)          Includes220,948 shares issuable pursuant to the Company’s Employee Stock Purchase Planand 131,874 shares issuable pursuant to the Company’s 2000 Director StockPlan.  Also includes 335,922 sharesissuable pursuant to the Company’s Amended and Restated 1996 Stock OptionPlan.  The total number of sharesissuable pursuant to the Company’s Amended and Restated 1996 Stock Option Planis equal to the greater of 1,500,000 shares or 15.0% of the number of shares issuedand outstanding immediately after the grant of any option under the Plan.

 

(2)          Includes100,000 shares issuable pursuant to the Company’s Deferred Compensation Planand 152,812 shares issuable pursuant to the Company’s 2000 Broad-Based EmployeePlan.  The number of shares issuablepursuant to the Company’s 2000 Broad-Based Plan is equal to the greater of400,000 shares or 4.0% of the shares issued and outstanding immediately afterthe grant of any option under the Plan.

 

**Equity Compensation Plans Not Approved by SecurityHolders**

 

***DeferredCompensation Plan***

 

We maintain the Cornell Companies, Inc. DeferredCompensation Plan for the purpose of providing deferred compensation foreligible employees.  The DeferredCompensation Plan is a nonqualified plan.

 

A participant in the Deferred Compensation Plan maydefer into an account a percentage of compensation each year up to 75.0% of theparticipant’s compensation received from the Company.  In addition, the Company may makecontributions to the Deferred Compensation Plan on behalf of eachparticipant.  Compensation deferred by aparticipant, or contributions made by the Company on behalf of a participant,will be invested in mutual funds and the common stock of the Company.  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 fiveor ten-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.

 

***Warrants***

 

In conjunction with the issuance of the SubordinatedNotes in July 2000, we issued warrants to purchase 290,370 shares of ourcommon stock at an exercise price of $6.70. The warrants may only be exercised by payment of the exercise price incash to us, by cancellation of an amount of warrants equal to the

 

20

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fair market value of the exercise price, or by the cancellation ofindebtedness owed to the warrant holder. During 2001, 168,292 shares of common stock were issued in conjunctionwith the exercise and cancellation of 217,778 warrants; therefore 72,592,warrants remain outstanding at December 31, 2004.

 

***2000 Broad-BasedEmployee Plan***

 

In December 2000, we adopted the 2000Broad-Based Employee Plan (the “2000 Plan”). Pursuant to the 2000 Plan, we may grant non-qualified stock options toour employees, directors and eligible consultants for up to the greater of400,000 shares or 4.0% of the aggregate number of shares of common stock issuedand outstanding immediately after the grant of any option under the 2000Plan.  The 2000 Plan options vest over aperiod of up to five years and expire ten years from the grant date.  The vesting schedule and term are set bythe Compensation Committee of the Board of Directors.  The exercise price of options issued pursuantto the 2000 Plan can be no less than the market price of our common stock onthe date of grant.

 

Upon notice of an Extraordinary Transaction (asdefined in the 2000 Plan), options granted under the 2000 Plan shall becomefully vested.  Upon consummation of theExtraordinary Transaction, such options, to the extent not previouslyexercised, shall terminate.

 

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

 

The following data has been derived from our auditedfinancial statements, including those included in this Form 10-K for the yearended December 31, 2004 and should be read in conjunction with theconsolidated financial statements and notes thereto and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this report.

 

The consolidated financial statements for the yearsended December 31, 2000 and 2001 were audited by Arthur Andersen LLP who has ceased operations.

 
| ** **                                                                                                            | ** ** | **Year Ended December 31,**           | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                            | ** ** | **2004(1)**                                | ** ** | **2003 (2)** | ** ** | **2002** | ** ** | **2001 (3)** | ** ** | **2000** | ** ** |
| ** **                                                                                                            | ** ** | **(in thousands, except per share  data)** | ** ** |
| **Statements  of Operations Data:**                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                                              |       | $                                          | 291,025    |   | $ | 271,632 |   | $ | 275,145 |   | $ | 265,250 |   | $ | 226,050 |   |
| Income from  operations                                                                                               |       | 10,437                                     |       | 24,384 |   | 31,577 |   | 31,018 |   | 29,653 |   |
| Income  (loss) before provision (benefit) for income taxes and cumulative effect of  changes in accounting principles |       | (12,278                                    | )          | 6,730 |   | 12,279 |   | 6,847 |   | 13,507 |   |
| Income  (loss) before cumulative effect of changes in accounting principles                                           |       | (7,433                                     | )          | 3,970 |   | 7,327 |   | 3,889 |   | 7,969 |   |
| Cumulative  effect of changes in accounting principles, net of related income tax  provision (benefit) (4)            |       | 3⁄4                                     |       | — |   | (965 | ) | 770 |   | –– |   |
|                                                                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Net income  (loss)                                                                                                    |       | $                                          | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   | $ | 4,659 |   | $ | 7,969 |   |
|                                                                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Earnings  (loss) per share:                                                                                           |       |                                       |       |   |   |   |   |   |   |   |   |
| **•**  Basic                                                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| Income  (loss) before cumulative effect of changes in accounting principles                                           |       | $                                          | (.56       | ) | $ | .31 |   | $ | .57 |   | $ | .40 |   | $ | .85 |   |
| Cumulative  effect of changes in accounting principles (4)                                                            |       | $                                          | —     |   | $ | — |   | $ | (.08 | ) | $ | .08 |   | $ | –– |   |
| Net income  (loss)                                                                                                    |       | $                                          | (.56       | ) | $ | .31 |   | $ | .49 |   | $ | .48 |   | $ | .85 |   |
|                                                                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| **•**  Diluted                                                                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| Income  (loss) before cumulative effect of changes in accounting principles                                           |       | $                                          | (.56       | ) | $ | .30 |   | $ | .55 |   | $ | .39 |   | $ | .84 |   |
| Cumulative  effect of changes in accounting principles (4)                                                            |       | $                                          | —     |   | $ | — |   | $ | (.07 | ) | $ | .07 |   | $ | –– |   |
| Net income  (loss)                                                                                                    |       | $                                          | (.56       | ) | $ | .30 |   | $ | .48 |   | $ | .46 |   | $ | .84 |   |
|                                                                                                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Number of  shares used to compute EPS:                                                                                |       |                                       |       |   |   |   |   |   |   |   |   |
| **•**  Basic                                                                                                     |       | 13,203                                     |       | 12,941 |   | 12,911 |   | 9,616 |   | 9,383 |   |
| **•**  Diluted                                                                                                   |       | 13,203                                     |       | 13,342 |   | 13,129 |   | 10,069 |   | 9,495 |   |

 

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| ** **                                                          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                          | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                          | ** ** | **(dollars in thousands)**       | ** ** |
| **Operating  Data:**                                                |       |                             |       |   |   |   |   |   |   |   |   |
| ** **                                                          |       |                             |       |   |   |   |   |   |   |   |   |
| **Residential:**                                                    |       |                             |       |   |   |   |   |   |   |   |   |
| Service  capacity (5)                                               |       | 13,590                           |       | 12,378 |   | 11,267 |   | 11,267 |   | 11,318 |   |
| Contracted  beds in operation (end of period) (6)                   |       | 11,573                           |       | 9,566 |   | 9,289 |   | 9,503 |   | 10,061 |   |
| Average  contract occupancy on contracted beds in operation (7) (8) |       | 98.2                             | %          | 100.1 | % | 98.7 | % | 95.9 | % | 94.3 | % |
| Average  contract occupancy excluding start-up operations (7) (8)   |       | 100.9                            | %          | 100.5 | % | 98.7 | % | 96.3 | % | 96.0 | % |
| **Non-Residential:**                                                | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service  capacity (9)                                               |       | 4,638                            |       | 4,136 |   | 4,177 |   | 4,177 |   | 3,046 |   |
|                                                                |       |                             |       |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                            |       |                             |       |   |   |   |   |   |   |   |   |
| Working  capital                                                    |       | $                                | 107,597    |   | $ | 86,214 |   | $ | 95,988 |   | $ | 97,814 |   | $ | 29,703 |   |
| Total assets                                                        |       | 507,631                          |       | 449,103 |   | 441,291 |   | 444,807 |   | 336,850 |   |
| Long-term  debt, net of current portion                             |       | 279,528                          |       | 227,292 |   | 232,258 |   | 238,768 |   | 191,722 |   |
| Stockholders’  equity                                          |       | 161,312                          |       | 166,235 |   | 159,952 |   | 153,104 |   | 104,320 |   |
|                                                                     |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Notes to Selected Consolidated Financial Data**

 

(1)          Income from operationsfor the year ended December 31, 2004 include charges totaling $10.1million to record an impairment to the carrying values of three of our juveniledivision facilities.  Income (loss)before provision (benefit) for income taxes and cumulative effect of changes inaccounting principles for the year ended December 31, 2004 includes a losson extinguishment of debt of approximately $2.4 million related to the earlyretirement of the Synthetic Lease’s Investor Notes A and B and the revolving lineof credit under our amended 2000 Credit Facility.  Refer to Item 7. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations”, for a detaileddiscussion concerning these charges.

(2)          Income from operationsfor the year ended December 31, 2003 includes a charge of approximately$5.4 million to provide an allowance for an unrecovered escrow deposit.  Refer to Item 3. “Legal Proceedings –Southern Peaks Regional Treatment Center”.

(3)          We adopted the provisions of Statement of Financial AccountingStandard (SFAS) No. 145 as required on January 1, 2003.  Prior to the adoption of the provisions ofSFAS No. 145, we recorded an extraordinary charge of approximately $2.9million, net of income taxes of approximately $2.0 million, in  2001 for the early retirement of debt.  As a result of the adoption of the provisionsof SFAS No. 145, we reclassified total costs of approximately $4.9 million toloss on extinguishment of debt and the related income tax benefit ofapproximately $2.0 million to provision for income taxes.  This reclassification is reflected in the2001 amounts presented in this table.

(4)          For the year ended December 31, 2002, we recognized a cumulativeeffect of a change in accounting principle charge of approximately $1.0million, net of income taxes of approximately $0.7 million, related to theimpairment of goodwill in connection with the adoption of SFAS No. 142 in January 2002.  For the year ended December 31, 2001, werecognized a cumulative effect of a change in accounting principle benefit ofapproximately $0.8 million, net of an income tax provision of approximately$0.5 million, related to a change in our method of accounting for durablesupplies.

(5)          Residential service capacity is comprised of the number of bedscurrently available for service or available upon  the completion of construction or renovationof residential facilities.

(6)          At certain residential facilities, the contracted capacity is lowerthan the facility’s service capacity. We could increase a facility’s contractedcapacity by obtaining additional contracts or by renegotiating existingcontracts to increase the number of beds covered. However, there is noguarantee that we will be able to obtain contracts that provide occupancylevels at a facility’s service capacity or that current contracted capacitiescan be maintained in future periods.

(7)          Occupancy percentages reflect less than normalized occupancy during thestart-up phase of any applicable facility, resulting in a lower average contractoccupancy in periods when we have substantial start-up activities.

 

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**(8)**          Average contract occupancypercentages are calculated based on actual occupancy for the period as apercentage of the contracted capacity for residential facilities in operation.These percentages do not reflect the operations of non-residentialcommunity-based programs. At certain residential facilities, our contractedcapacity is lower than the facility’s service capacity. Additionally, certainfacilities have and are currently operating above the contracted capacities. Asa result, average contract occupancy percentages can exceed 100% if the averageactual occupancy exceeded contracted capacity.

**(9)**          Service capacity fornon-residential programs is based on either contractual terms or an estimate ofthe number of clients to be served. We update these estimates at least annuallybased on the program’s budget and other factors.

 

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**ITEM 7.       MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**General**

 

We are  aleading provider of correctional, treatment and educational services outsourcedby federal, state and local government agencies.  We provide a diversified portfolio ofservices for adults and juveniles through our three operating divisions: (1)adult secure institutional services; (2) juvenile justice, educational andtreatment services and (3) adult community-based corrections and treatmentservices.  At December 31, 2004, weoperated 68 facilities with a total service capacity of 16,714 and had 2facilities under development, construction or renovation with an aggregateservice capacity of 1,514 upon completion.  Our facilities are located in 16states and the District of Columbia.

 

Thefollowing table sets forth for the periods indicated total residential servicecapacity and contracted beds in operation at the end of the periods shown,average contract occupancy percentages and total non-residential servicecapacity.

 
| ** **                                                                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Residential**                                                           |       |                             |       |   |   |   |   |
| Service  capacity (1)                                                     |       | 13,590                           |       | 12,378 |   | 11,267 |   |
| Contracted  beds in operation (end of period) (2)                         |       | 11,573                           |       | 9,566 |   | 9,289 |   |
| Average  contract occupancy based on contracted beds in operation (3) (4) |       | 98.2                             | %          | 100.1 | % | 98.7 | % |
| Average  contract occupancy excluding start-up operations (3) (4)         |       | 100.9                            | %          | 100.5 | % | 98.7 | % |
| **Non-Residential**                                                       |       |                             |       |   |   |   |   |
| Service  capacity (5)                                                     |       | 4,638                            |       | 4,136 |   | 4,177 |   |

 

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(1)          Residential service capacity is comprised of the number of bedscurrently available for service or available upon the completion ofconstruction or renovation of residential facilities.

(2)          At certain residential facilities, the contracted capacity is lowerthan the facility’s service capacity. We could increase a facility’s contractedcapacity by obtaining additional contracts or by renegotiating existingcontracts to increase the number of beds covered.  However, there is no guarantee that we willbe able to obtain contracts that provide occupancy levels at a facility’sservice capacity or that current contracted capacities can be maintained infuture periods.

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

(4)          Average contract occupancy percentages are calculated based on actualoccupancy for the period as a percentage of the contracted capacity forresidential facilities in operation. These percentages do not reflect theoperations of non-residential community-based programs. At certain residentialfacilities, our contracted capacity is lower than the facility’s servicecapacity. Additionally, certain facilities have and are currently operatingabove the contracted capacities. As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

(5)          Service capacity for non-residential programs is based on eithercontractual terms or an estimate of the number of clients to be served. Weupdate these estimates at least annually based on the program’s budget andother factors.

 

We derive substantially all of our revenues fromproviding adult corrections and treatment and juvenile justice, educational andtreatment services outsourced by federal, state and local government agenciesin the United States.  Revenues for ourservices are generally recognized on a per diem rate based upon the number ofoccupant days or hours served for the period, on a guaranteed take-or-pay basisor on a cost-plus reimbursement basis.  For the year ended December 31, 2004, ourrevenue base consisted of 72.4% for services provided under per diem contracts,10.6% for services provided under take-or-pay and management contracts, 9.5%for services provided under cost-plus reimbursement contracts, 5.8% forservices provided under fee-for-service contracts and 1.7% from othermiscellaneous sources.  These percentagesare generally consistent with comparable statistics for the years ended December 31,2003 and 2002.  Revenues can fluctuate from year to year dueto changes in government funding policies, changes in the number of clientsreferred to our facilities by governmental agencies, the opening of new

 

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facilities or the expansion of existing facilities and the terminationof contracts for a facility or the closure of a facility.

 

Revenuesfor our adult secure institutional services division are primarily generatedfrom per diem, take-or-pay and management contracts.  For the years ended December 31, 2002,2003 and 2004, we realized average per diem rates on our adult secureinstitutional facilities of approximately $48.21, $47.79 and $48.45, respectively.The increase in the per diem rate for 2004 as compared to 2003 is due primarilyto the opening of the two-unit Regional Correctional Center in July and December 2004and the acquisition of the Walnut Grove Youth Correctional Facility managementcontract in June 2004. Additionally, we received per diem rate increasesat our Big Spring Correctional Center in September 2003 and March 2004.  The decrease in the average per diem rate in2003 as compared to 2002 is attributable to a reduction in the per diem rate ata large facility in the second half of 2003 as requested by the contractingagency (we mitigated a portion of this rate reduction by negotiating reductionsin the level of service provided).  Wecontinue to experience increasing pressure from contracting governmentalagencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and we anticipate that more governmental agencies mayapproach us about per diem rate concessions. Decreases, or the lack of anticipated increases, in per diem rates couldadversely impact our operating margin.

 

Factors considered in determining billing rates tocharge include: (1) the programs specified by the contract and the relatedstaffing levels, (2) wage levels customary in the respective geographic areas,(3) whether the proposed facility is to be leased or purchased and (4) theanticipated average occupancy levels that could reasonably be maintained.

 

Revenues for our juvenile justice,educational and treatment services division are primarily generated from perdiem, fee-for-service and cost-plus reimbursement contracts.  For the years ended December 31, 2002,2003 and 2004, we realized average per diem rates on our residential juvenilejustice, educational and treatment facilities of approximately $170.98, $164.89and $165.74, respectively.  The increasein the per diem rate for 2004 as compared to 2003 is due to the opening of theSouthern Peaks Regional Treatment Center in August 2004 and rate increasesfor our Pennsylvania programs and facilities in July 2004.  The decrease in the average per diem rate in2003 as compared to 2002 is primarily attributable to the closure of the NewMorgan Academy in the fourth quarter of 2002. For the years ended December 31,2002, 2003 and 2004, we realized average fee-for-service rates for ournon-residential community-based juvenile facilities and programs, includingrates that are limited by Medicaid and other private insurance providers, ofapproximately $28.82, $28.19 and $30.14, respectively. The increase in theaverage fee-for-service rate for 2004 as compared to 2003 is due to changes inthe mix of the services provided by our various juvenile justice, educationaland treatment programs and facilities. The majority of our juvenile services contracts renew annually.

 

Revenues for our adult community-basedcorrections and treatment services division are primarily generated from perdiem contracts and fee-for-service contracts. For the years ended December 31, 2002, 2003 and 2004, we realizedaverage per diem rates on our residential adult corrections and treatmentfacilities of approximately $58.72, $58.69 and $62.10, respectively.  The increase in the per diem rate for 2004 ascompared to 2003 is due to mid-year rate increases at our Alaskan facilitiesand per diem increases at certain other of our adult community-basedresidential facilities due to contract renewals and other contractual rateincreases.   For the years ended December 31,2002, 2003 and 2004, we realized average fee-for-service rates on ournon-residential adult community-based corrections and treatment facilities andprograms of approximately $8.97, $9.67 and $8.59, respectively.  Our average fee-for-service rates fluctuatefrom year to year due to changes in the mix of services provided by our variousadult community-based programs and facilities.

 

We have historically experienced higher operatingmargins in our adult secure institutional services and adult community-basedcorrections and treatment services as compared to the juvenile justice,educational and treatment services division. Additionally, our operating margins within a division can vary fromfacility to facility based on whether a facility is owned or leased, the levelof competition for the contract award, the proposed length of the

 

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contract, the occupancy levels for a facility, the level of capitalcommitment required with respect to a facility, the anticipated changes inoperating costs over the term of the contract, and our ability to increase afacility’s contract revenue.  A declinein occupancy of certain juvenile justice, educational and treatment facilitiescan have a more significant impact on operating results than the adult secureinstitutional services division due to higher per diem rates at certainjuvenile facilities.  We have experiencedand expect to continue to experience interim period operating marginfluctuations due to the number of calendar days in the period, higher payrolltaxes in the first half of the year and salary and wage increases and insurancecost increases that are incurred prior to certain contract rate increases.  Moveover, many of the governmental agencieswith whom we contract are experiencing budget pressures and may approach us tolimit or reduce per diem rates. Decreases in, or the lack of anticipated increases in, per diem ratescould adversely impact our operating margin. Additionally, a decrease in per diem rates without a corresponding decreasein operating expenses could also adversely affect our operating margin.

 

We are responsible for all facility operating costs,except for certain debt service and interest or lease payments for facilitieswhere we have a management contract only. At these facilities, the facility owner is responsible for alldebt service and interest or lease payments related to the facility.  We are responsible for all other operatingexpenses at these facilities. We operated 13 facilities under managementcontracts at December 31, 2002, 10 facilities at December 31, 2003and 12 facilities at December 31, 2004.

 

A majority of our facility operating costs consistsof fixed costs.  These fixed costsinclude lease and rental expense, insurance, utilities and depreciation.  As a result, when we commence operation ofnew or expanded facilities, fixed operating costs increase.  The amount of our variable operating costs,including food, medical services, supplies and clothing, depend on occupancylevels at the facilities we operate.  Ourlargest single operating cost, facility payroll expense and related employmenttaxes and expenses, has both a fixed and a variable component.  We can adjust a facility’s staffing levelsand the related payroll expense to a certain extent based on occupancy at afacility, however a minimum fixed number of employees is required to operateand maintain any facility regardless of occupancy levels.  Personnel costs are subject to increases intightening labor markets based on local economic and other conditions.

 

Weincur pre-opening and start-up expenses including payroll, benefits, trainingand other operating costs prior to opening a new or expanded facility andduring the period of operation while occupancy is ramping up. These costs varyby contract.  Since pre-opening andstart-up costs are generally factored into the revenue per diem rate that ischarged to the contracting agency, we typically expect 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, we may incuradditional post-opening start-up costs. We do not anticipate post-opening start-up costs at any adult secure facilitiesoperated under any future contracts with the BOP because these contracts arecurrently and expected to continue to be take-or-pay contracts, meaning thatthe BOP will pay at least 80.0% of the contractual monthly revenue once thefacility opens, regardless of actual occupancy.

 

Newly opened facilities are staffed according toapplicable regulatory or contractual requirements when we begin receivingoffenders or clients.  Offenders orclients are typically assigned to a newly opened facility on a phased-in basisover a one- to six-month period.  Our start-upperiod for new juvenile operations is 12 months from the date we beginrecognizing revenue unless break-even occupancy levels are achieved beforethen.  Our start-up period for new adultoperations is nine months from the date we begin recognizing revenue unlessbreak-even occupancy levels are achieved before then.  Althoughwe typically recover these upfront costs over the life of the contract,quarterly results can be substantially affected by the timing of the commencementof operations as well as the development and construction of new facilities.

 

Workingcapital requirements generally increase immediately prior to commencingmanagement of a new or expanded facility as we incur start-up costs andpurchases necessary equipment and supplies before facility management revenueis realized.

 

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General and administrative expenses consistprimarily of costs for corporate and administrative personnel who providesenior management, legal, finance, accounting, human resources, payroll andinformation systems, costs of business development and outside professional andconsulting fees.

 

# **Management Overview**

# ** **

***Demand*.**  Our business is driven generally by demandfor incarceration or treatment services, and specifically by demand for privateincarceration or treatment services, within our three primary businesssegments: adult secure institutional services; juvenile justice, educationaland treatment services; and adult community-based corrections and treatmentservices.  The demand for adult andjuvenile corrections and treatment services has generally increased at a steadyrate over the past ten years, largely as a result of increasingly longsentences 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 be emphasized in the futureas alternatives to traditional incarceration. Among other things, we monitor federal, state and industry statisticsrelative to trends in prison populations, juvenile justice statistics andinitiatives, and developments in alternatives to traditional incarceration ordetention of adults.

 

Thefederal government increasingly is turning to private providers for theincarceration of adults whether they are serving prison sentences, detained asillegal aliens, detained in anticipation of pending judicial administration ortransitioning from prison to society. Chief among the federal agencies which use private providers are theBOP, The Bureau of Immigration, Customs and Enforcement, and the U.S. MarshalsService. We provide adult secure and adult community-based services to thefederal government.  Most of the federalinvolvement in juvenile administration in the federal system is handled viaMedicare and Medicaid assistance to state governments. Although there are circumstancesin which we may contract with a federal agency on a sole source basis, theprimary means by which we secure a contract with a federal agency is via theRFP bidding process.  From time to time,we contract to provide management services to a local governmental unit whothen bids on a federal contract.

 

Statesand smaller governmental units are divided on the issue of private prisons andprivate provision of juvenile and community-based programs, although a majorityof states permit private provision for our services.  We anticipate that increasing budget pressureon states and smaller governmental units will cause more states and smallergovernmental units to turn to private providers such as us to provide theseservices on a more economical basis.  Althoughit varies from governmental unit to governmental unit, the primary politicalforces who oppose privatization of prisons are organized labor and religiousgroups.

 

Privatejuvenile and community-based programs are much more widely accepted andutilized by states and local governmental units than private adultprisons.  Many private providers areorganized on a not-for-profit basis, but there are a number of large,for-profit providers of juvenile and community-based programs.  We monitor opportunities in these segmentsvia our corporate and regional development officials.  Many opportunities are not published in anymanner and, accordingly, we believe that taking the initiative at the state andlocal levels is key in developing sole source opportunities, which have becomea focus of our Company.

 

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***Performance*****.** We track a number of factors as we monitor financial performance.  Chief among them are:

 

•                  capacity(the number of beds within each business segment’s facilities)

•                  occupancy(utilization)

•                  perdiem reimbursement rates

•                  operatingexpenses

 

Capacity,commonly expressed in terms of a number of beds, is primarily impacted by thenumber and size of the facilities we own or lease and the facilities which arenot owned or leased but which are operated by us on behalf of a third partyowner or lessee.  We view capacityprimarily as a measure of our development efforts, which may increase capacityby adding new projects or adding to existing projects.  As part of measuring our development efforts,we will assess (a) whether a given development project was brought into servicein accordance with our expectation as to time and expense; and (b) the numberof projects in development at the relevant point in time.  In addition to the focus on new projects,capacity will reflect our success in renewing and maintaining existingcontracts and facilities.  Recently, wehave been confronted with the possibility that state or local budgetarylimitations may cause the contractual commitment to a given facility to bereduced or even eliminated, which would cause us to secure an alternatecustomer or close the operation.

 

Occupancyis typically expressed in terms of percentage of contract capacityutilized.  We look at occupancy to assessthe efficacy of both our efforts to market our facilities and our efforts toretain existing customers or contracts. Because revenue varies directly with occupancy, occupancy is a driver ofour revenues. Some of our contracts are “take-or-pay,” meaning that the agencymaking use of the facility is obligated to pay for beds even though they arenot used.  Historically, occupancypercentages have been high and we are mindful of the need to maintain highoccupancy levels.  As new developmentprojects are brought into service, occupancy percentages may decline until theprojects reach full utilization.  Wherewe have commitments for utilization before the commencement of operations,occupancy percentages reflects the speed at which a facility achieves fullservice/implementation. However, we may undertake development projects withoutwritten commitments to make full use of a facility. In these instances, we haveperformed our own assessment, based on discussions with local governmentrepresentatives and analysis of other factors, of the demand for services atthe facility.  There is no assurance thatwe will recover our initial investment in these projects.  We will monitor occupancy as a measure of theaccuracy of our estimation of the demand for the services of a developmentfacility.

 

Per diem reimbursementrates are the other key element of our gross revenue and operating margin sinceper diem contracts represent a majority of our revenues (72.4% for the yearended December 31, 2004).  Per diemrates are a function of negotiation between management and a governmental unitat the inception of a contract or through the RFP process.  Actual per diem rates vary dramaticallyacross our business segments, and then within each business segment dependingupon the particular service or program provided. The initial per diem ratesoften change during the term of a contract in accordance with a schedule.  The amount of the change can be a fixedamount set forth within the contract, an amount determined by formulas setforth within the contract or an amount determined by negotiations betweenmanagement and the governmental unit (often these negotiations are along thesame lines as the original per diem negotiation – a review of expenses andapproval of an amount to recompense for expenses and assure the potential of anoperating profit).  In recent years, asbudgetary pressures on governmental units have increased, some of ourgovernmental customers  have negotiatedrelief from formulaic increase provisions within their agreements or havedeclined to include in their appropriation legislation amounts that wouldincrease the per diem rates payable under the contract (needed  in some cases to offset operating expenseincreases).  Although we have mitigated aportion of the impact of these developments by negotiating services provided orobtaining commitments for increased volume, we have taken steps primarily inthe area of legislative and governmental monitoring and lobbying to avoid thesesorts of adverse developments in the future. We will continue to monitor per diem rates as a measure of negotiationskill, customer service, management and maintenance, political and businessastuteness.

 

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We track severaldifferent areas of our 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,financing costs and administrative overhead expenses. Increases or decreases inone or more of these items, such as our recent experience with rising insurancecosts, can have a material effect on our financial performance.  We are particularly monitoring the costs ofcomplying with the Sarbanes-Oxley Act of 2002, both in terms of fees paid tothird parties, such as independent auditors and consultants, as well asinternal administrative costs.

 

Werecognize that our operating margins are subject to pressure from a variety offactors, but most notably rising costs and governmental and agency budgetaryconstraints.  We also believe thatsuccessful development of higher margin and low capital projects is key tomitigating such pressure.  We haveseveral development projects committed and in various stages of completion.Until those projects are completed and brought into full service, we willmonitor operations and existing customer relationships in an attempt tominimize the duration of start-up periods and the related pressure on operatingmargins.

 

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#### **Significant 2004 Events**

 

***Acquisition of the Walnut Grove Youth CorrectionalFacility Management Contract***

 

In June 2004, we acquired a management contractto operate a 976 bed secure youth offender correctional facility in WalnutGrove, Mississippi, the Walnut Grove Youth Correctional Facility, fromTuscolameta, Inc.  This facility houses13-20 year-old males and provides academic and vocational training, along withdrug and alcohol education and treatment. Group and individual counseling and recreational opportunities are alsoprovided. The management contract has a remaining term of 2 1⁄2 years with arenewal option for an additional two-year term.

 

We acquired the management contract and certainassets and liabilities for a total purchase price of approximately $3.0million, which was allocated as follows (in thousands):

 

| Accounts  receivable                      |   | $     | 584    |   |
|-------------------------------------------|--------|-------|--------|--------|
| Contract  value                           |   | 2,405 |   |
| Prepaid  supplies                         |   | 188   |   |
| Fixed assets                              |   | 271   |   |
| Non-compete  agreement                    |   | 300   |   |
| Accounts  payable and accrued liabilities |   | (748  | )      |
| Net assets                                |   | $     | 3,000  |   |

 

The fair market value of the management contract wasdetermined based on projected discounted future cash flows.  We are amortizing the management contractvalue of approximately $2.4 million over the expected useful life of themanagement contract of 4.5 years.  Theexpected useful life of the contract includes two-one year options.  Amortization expense was approximately $0.3million for the year ended December 31, 2004.

 

***SouthernPeaks Regional Treatment Center***

 

On January 5, 2004, we initiated legalproceedings in the lawsuit styled *CornellCorrections of California, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV-79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development and constructionof the Southern Peaks Regional Treatment Center.  Of the funds previously deposited,approximately $5.4 million remains to be recovered at December 31,2004.  In December 2004, thecase was tried before a jury and the jury returned a verdict awarding approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorney’s fees.  Currently,we expect the defendants to move for a new trial and that no judgment will beentered on the verdict until after these motions for a new trial have beenheard and ruled on by the court.  If thecourt denies any filed motions for a new trial and enters a judgment on thejury verdict we expect that the actual damages awarded under the verdict willbe adjusted downward to the $5.4 million actually lost by us and that thepunitive damages award may be adjusted downward because of a Georgia statuteregarding caps on punitive damages awards. The award for compensatory damages accrues pre-judgment interest at arate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Due to the continued uncertainty surroundingany motions for a new trial and the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve on the receivableof approximately $5.1 million in an allowance for doubtful accounts.

 

Construction of the Southern Peaks RegionalTreatment Center was substantially completed in July 2004.  We purchased the property in September 2004and served as the construction supervisor in lieu of the developer and assumedthe developer’s rights and obligations under the construction contract (exceptthat the developer remained as contractor for certain of the infrastructureserving the facility).  As of December 31,2004, we had invested approximately $17.5 million in the property and related furniture and equipment.  The facility began receiving clients in August 2004.  We currently anticipate that the facilitywill be fully ramped up during the second half of 2005.

 

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***NewMorgan Academy***

 

We closed the New Morgan Academy in the fourthquarter of 2002 and are currently considering several options ranging from theutilization of the facility for another type of program or the sale or lease ofthe facility. As of December 31, 2004, we are focusing our efforts on thepossible sale or lease of the facility to certain governmental agencies inPennsylvania, as well as private enterprises. We are maintaining asmall staff to secure and maintain the facility.  We have recognized pre-tax costs of $13.5million (including an impairment charge of $9.3 million as discussed below) inour Consolidated Statements of Operations and Comprehensive Income (Loss) forthe year ended December 31, 2004 for related holding costs (depreciation,interest, property, taxes and other maintenance costs).

 

At December 31, 2004, as a result of ouranalysis pursuant to the requirements of SFAS No. 144, we determined that thecarrying amount of the New Morgan Academy was not fully recoverable and exceededits fair value (as based on current estimates of future cash flows).  The developing inability during late 2004 ofvarious governmental agencies with whom we have been in negotiations to obtainthe level of funding to contract with us for the use of the New Morgan Academyhas indicated an expectation of continuing losses associated with thisfacility.  Accordingly, we believe that,pursuant to the provisions of SFAS No. 144, an impairment charge of $9.3million was required and such charge has been recognized in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the year ended December 31,2004.  The carrying value of the propertyand equipment for the New Morgan Academy, after the impairment charge, wasapproximately $20.4 million at December 31, 2004.

 

***LasVegas Center***

 

In June 2003,the BOP issued a Request for Proposal (RFP) for the operation of a 65 bed adultcommunity-based correctional center in Clark County, Nevada.  We submitted a proposal in September 2003and received requests for clarifications to our proposal in January and February 2004.We purchased a building in January 2004 in anticipation of winning thecontract award.  We were awarded the contract in July 2004and assumed the contract from the previous operator in December 2004.  The initial contract is for two years withthree one-year renewal options and will generate an estimated $1.3 million inannualized revenue. The population for the contract will consist of 10% adultfemales and 90% adult males.  We purchasedand renovated the facility at a cost of approximately $2.6 million and haveincreased the service capacity of the facility to 100 beds.

 

***CentralCalifornia Treatment Center***

 

In January 2004,we purchased a building in Los Angeles, California for approximately $2.5million.  Upon the successful award of acontract to utilize this facility, we anticipate incurring renovation costs ofapproximately $2.0 million.  This newfacility could provide service to 220 inmates in a work-furlough typeprogram.  Although we do not currentlyhave a contract for this facility it has been submitted for consideration inseveral recent proposals.  We believethat due to the growth of the inmate population, severe budget crisis and recentlegal settlements requiring additional community services, this facility willfill a small part of the overall demand in California.  The potential uses for the facility rangefrom a “halfway back” program to a comprehensive drug and alcohol treatmentprogram.

 

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***PlankintonRegional Detention Center***

 

The Plankinton Regional Detention Center, a40 bed juvenile justice center in South Dakota, was activated early in May 2004and the Plankinton Regional Treatment Center was scheduled to open in August 2004.  We based our plans to open and operate theseleased facilities on a commitment from the appropriate state officials tocreate a special rate that would allow us to meet the needs of clients rejectedby other providers in the state. However, we learned we were awarded an initial rate that, wasinsufficient to support the level of care and treatment required for the center’sclients.  As a result, we suspendedoperations at the Detention Center in August 2004 and delayed the openingof the Treatment Center.  In October 2004,we determined that the per diem rate necessary to provide the appropriate levelof services to the clients was not forthcoming and we decided to withdraw fromthe South Dakota market.  The impact ofour decision to withdraw from the South Dakota market with respect to thecarrying value of the related assets was not material to our financialposition, results of operations or cash flows.

 

***MoshannonValley Correctional Center***

 

In March 2003, we reached an agreement with theCommonwealth of Pennsylvania that resolved all outstanding administrativeissues relative to the contract awarded by the BOP to operate the MoshannonValley Correctional Center.  In October 2004,we received the signed Finding of No Significant Impact for the facility.  Construction of the facility, which willhouse 1,300 male federal inmates, began immediately.  We have a three-year contract with the BOP tooperate the facility and the BOP has the option to grant seven one-yearextensions.  The facility is scheduled tobegin operations in early 2006.

 

In September 2004, we resolved our claim withthe BOP for the reimbursement of a portion of the expenses we incurred inconnection with the issuance of the Stop-Work Order and the delay of theproject (included among these expenses was approximately $1.4 million inaccounts receivable for expenses incurred by us after the September 1999issuance of the Stop–Work Order).  Wesettled the claim, as well as the claim for the reimbursement of costs relatedto the original construction efforts incurred beginning in 1999, with the BOPand were reimbursed approximately $7.0 million in September 2004.  The excess reimbursement of approximately$5.6 million over the $1.4 million in accounts receivable was credited againstthe carrying cost of the facility.

 

As of December 31, 2004, we had incurred(net of the BOP reimbursement) approximately $17.1 millionfor the design, construction and development costs and capitalized interestrelated to the Moshannon Valley Correctional Center facility.  We estimate an additional capital investment(including furniture and equipment) of approximately $53.7 million is requiredto complete construction of the facility. We believe that our existing cash and credit facilities will provideadequate funding to complete the construction of the facility.

 

***RegionalCorrectional Center***

 

In January 2003, we executed a five-yearlease for the Regional Correctional Center in Albuquerque, New Mexico.  This 970 bed facility consists of two units,the 528 bed South Tower and the 442 bed North Tower.  We renovated the South Tower and opened theunit in July 2004.  We renovated theNorth Tower and opened the unit in December 2004.  As of December 31, 2004, we had investedapproximately $8.8 million on renovations and furniture and equipment for bothTowers.  For the year ended December 31,2004, we incurred pre-opening and start-up costs of approximately $4.9 millionand recognized revenue of approximately $1.9 million related to thisfacility.  We currently anticipate thatthe facility will reach substantial occupancy during the second half of2005.  However, there can be no assurancethat we will develop enough volume at the facility to assure itsprofitability.  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.

 

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***2004Credit Facility and $112.0 Senior Notes***

 

In June 2004, weentered into a revolving credit facility (the “2004 Credit Facility”) by andamong the Company and other lenders to fund working capital for acquisitions,to refinance existing debt, to fund capital expenditures and general corporatepurposes. Also in June 2004, we issued $112.0 million in principal 10.75%Senior Notes (the “Senior Notes”) due July 1, 2012.  The net proceeds from the sale of the SeniorNotes of approximately $107.2 million were used to repay and refinance theindebtedness under our amended 2000 Credit Facility and the Synthetic LeaseInvestor Notes A and B as of June 24, 2004.  Refer to “Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Liquidity andCapital Resources – Long-Term Credit Facilities” for a detailed discussion concerningthe 2004 Credit Facility and the Senior Notes.

 

***PhiladelphiaAlternative Education***

 

In July 2004, we signed a five-yearagreement to provide alternative education services to 3rd and 4thgrade students in 11 school districts for the School District of Philadelphiabeginning the 2004-2005 academic year which began in August 2004.  Class sizes will be limited to 15 studentsfor a total of 165 students.  Wecurrently estimate annualized revenue of approximately $2.0 million for thisprogram.

 

***LebanonAlternative Education***

 

InSeptember 2004, we signed a three-year agreement to work jointly with theLebanon School District in Lebanon, Pennsylvania to provide alternativeeducation services to 225 students in grades 3-12.  We began providing these services in September 2004.  We currently estimate annual revenues ofapproximately $1.5 million for this program.

 

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#### **Recent Developments**

#### ** **

***CorrectionalSystems, Inc.  Acquisition***

 

InJanuary 2005, we signed a definitive agreement to acquire CorrectionalSystems, Inc. (CSI), a San Diego based provider of privatized jail, communitycorrections and alternative sentencing services.  The purchase price is approximately $10.0million in total consideration to common and preferred shareholders, lesscertain adjustments as described in the merger agreement.  The acquisition is expected to generateannualized revenue of approximately $16.0 million.  We anticipate that the acquisition will becompleted in the second quarter of 2005, subject to customary closingconditions and approval of CSI’s shareholders.

 

Theacquisition includes the operations of eight jails, six community correctionfacilities and five alternative sentencing programs, located in California, NewMexico, Texas and Kansas.  Thetransaction will add 986 corrections beds, as well as alternatives toincarceration services.

 

#### **New Accounting Pronouncements**

#### ** **

The Financial AccountingStandards Board (FASB) issued Interpretation No. 46R, Consolidation of VariableInterest Entities (FIN 46R) which addresses the consolidation of variableinterest entities (VIE’s) by business enterprises that are the primarybeneficiaries.  A VIE is an entity thatdoes not have sufficient equity investment at risk to permit it to finance itsactivities without additional subordinated financial support, or whose equityinvestors lack the characteristics of a controlling financial interest.  The primary beneficiary of a VIE is theenterprise that has the majority of the risks or rewards associated with theVIE.  Our adoption of FIN 46R on January 1,2004 did not change our accounting for the 2001 Sale and Leaseback Transaction,which is consolidated for reporting purposes. We have no other arrangements subject to the provisions of FIN 46R.

 

Wedo not have an equity interest in the variable interest entity that was formedin connection with the 2001 Sale and Leaseback Transaction.  The variable interest entity was formed forthe purpose of owning and leasing certain facilities to us.  Reference is made to the “Non-GuarantorSubsidiary” information included in Note 17 for a summary of the financialinformation related to the variable interest entity.  The debtholders of the variable interestentity have no recourse to our general credit.

 

OnDecember 16, 2004, the FASB issued Statement of Financial AccountingStandard (SFAS) No. 123R, “Share Based Payment,” that requires companies toexpense the value of employee stock options and other types of equity-basedcompensation at the fair value of the options at the award’s grant date basedon the estimated number of awards that are expected to vest.  Compensation cost for awards that vest wouldnot be reversed if the awards expire without being exercised.  When measuring fair value, companies canchoose an option-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions.  Companies will recognizecompensation cost per share based payment awards as they vest, including therelated tax effects.  The effective dateapplies to interim and annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested share based payment awards at theadoption date.  We are currentlyevaluating the alternative transition methods permitted by SFAS No. 123R.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of financial conditionand results of operations are based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States (GAAP). The preparation of these financial statements requires that we makeestimates and judgments that affect our reported amounts of assets,liabilities, revenues and expenses and the related disclosure of contingentassets and liabilities.  We evaluate ourestimates on an on-going basis, based on historical experience and

 

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on various other assumptions that we believe to be reasonable under thecircumstances.  Actual results may differfrom these estimates under different assumptions or conditions.

 

We believe the following critical accountingpolicies affect our more significant accounting policies and estimates used inthe preparation of the accompanying consolidated financial statements.

 

***Consolidation***

 

The accompanying consolidated financial statementsinclude the accounts of Cornell Companies, Inc., our wholly-owned subsidiaries,and activities relative to two financings of operating facilities. Allsignificant intercompany balances and transactions have been eliminated.  Minority interest in consolidated specialpurpose entities represents equity that other investors have contributed to thespecial purpose entities.  Minorityinterest is adjusted for income and losses allocable to the owners of thespecial purpose entities.  As thecumulative losses of the special purpose entity exceed the equity which isrecorded as minority interest by the Company, the excess losses are recorded inour Consolidated Statements of Operations and Comprehensive Income (Loss).

 

***RevenueRecognition***

 

We recognize revenue in accordance with SEC StaffAccounting Bulletin No. 104, “Revenue Recognition in Financial Statements,” asamended.  Substantially all of ourrevenues are derived from contracts with federal, state and local governmentalagencies which pay either per diem rates based upon the number of occupant daysor 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 our established contractual agreements to the extent collectionis considered probable.

 

***AccountsReceivable and Related Allowance for Doubtful Accounts***

 

We extend credit to the governmental agenciescontracted with and other parties in the normal course of business.  We regularly review our outstandingreceivables and historical collection experience, and provide for estimatedlosses through an allowance for doubtful accounts.  In evaluating the adequacy of our allowancesfor doubtful accounts, we make judgments regarding our customers’ ability tomake required payments, economic events and other factors.  As the financial condition of these partieschange, circumstances develop or additional information becomes available,adjustments to the allowance for doubtful accounts may occur.  If, after reasonable collection efforts havebeen made, a receivable is determined to be permanently uncollectible, it willbe written off.

 

***InsuranceReserves***

 

We maintain insurance coverage for various aspectsof our business and operations.  Weretain a portion of losses that occur through the use of deductibles andretention under self-insurance programs. We regularly review our estimates of reported and unreported claims andprovide for these losses through insurance reserves. These reserves areinfluenced by rising costs of health care and other costs, increases in claims,time lags in claims information and levels of insurance coverage carried. Asclaims develop and additional information becomes available to us, adjustmentsto the related loss reserves may occur. Our reserves for medical and worker’s compensation claims are subject tochange based on our estimate of the number and the magnitude of claims to beincurred.

 

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***Impairment orDisposal of Long-Lived Assets***

 

We review our long-lived assets for impairment whenchanges in circumstances or a triggering event indicate that the carryingamount of the asset may not be recoverable in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.”  SFAS No. 144 requires that long-lived assetsto be held and used be reported at the lower of their carrying amount or fairvalue.  Assets to be disposed of by saleare recorded at the lower of their carrying amount or fair value less estimatedcost to sell. We estimate fair value based upon the best information available,which may include discounted expected future cash flows to be produced by theassets and/or available market prices. Factors that significantly influenceestimated future cash flows include the periods and levels of occupancy for thefacility, expected per diem or reimbursement rates, assumptions regarding thelevels of staffing, services and future operating and capital expendituresnecessary to generate forecasted revenues, related costs for these activitiesand future rate of increases or decreases associated with these factors. Wealso consider the results of any appraisals on the properties when assessingfair value. These estimates are highly subjective, particularly incircumstances where there is no current operating contract in place and changesin the assumptions and estimates could result in the recognition of impairmentcharges. The most subjective estimates made in this analysis for 2004 relate tothe New Morgan Academy, the Residential School and the Maple Creek Home and for2003 relate to the New Morgan Academy and the Moshannon Valley CorrectionalCenter. We may be required to record an impairment charge in the future shouldwe not be able to successfully negotiate a contract on any of our facilitiesthat we do currently have an operating contract.

 

***Accounting forStock-Based Compensation***

 

In accordance with the provisions of SFAS No. 123, “Accountingfor Stock Based Compensation,” we have elected to account for our stock-basedcompensation plans under the intrinsic method established by AccountingPrinciples Board Opinion (APB) No. 25, “Accounting for Stock Issued toEmployees.”  In accordance with theprovisions of APB No. 25, stock-based employee compensation cost is notreflected in net income, as all options granted under those plans had anexercise price equal to or in excess of the market value of the underlyingcommon stock on the date of grant. On December 16, 2004, the FASBissued SFAS No.123R, “Share Based Payment,” that requires companies to expensethe value of employee stock options and other types of equity-basedcompensation at the fair value of the options at the award’s grant date basedon the estimated number of awards that are expected to vest.  Compensation cost for awards that vest wouldnot be reversed if the awards expire without being exercised.  When measuring fair value, companies canchoose an option-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions.  Companies will recognizecompensation cost per share based payment awards as they vest, including therelated tax effects.  The effective dateapplies to interim and annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested share based payment awards at theadoption date.  We are currentlyevaluating the alternative transition methods permitted by SFAS No. 123R.

 

***Goodwill***

 

We account for our goodwill in accordance with SFASNo. 142, “Goodwill and Other Intangible Assets,” which states that there willbe no amortization of goodwill or intangible assets with indefinite lives.  Impairment of these assets is assessed atleast annually to determine if the estimated fair value of the reporting unitexceeds the net carrying value of the reporting unit, including the applicablegoodwill.  The estimates of fair marketvalue are based upon our estimates of the present value of future cashflows.  We make assumptions regarding theestimated cash flows and if these estimates or their related assumptionschange, an impairment charge may be incurred.

 

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**Results of Operations**

 

Materialfluctuations in our results of operations are principally the result of thelevel of new contract development activity, the timing and effect of facilityexpansions, occupancy rates, contract terminations and facility closures andnon-recurring charges.

 

The following table sets forth for the periodsindicated the percentages of revenue represented by certain items in ourConsolidated Statements of Operations and Comprehensive Income (Loss).

 
| ** **                                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                          | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                                                            |       | 100.0                            | %          | 100.0 | % | 100.0 | % |
|                                                                                                                |       |                             |       |   |   |   |   |
| Operating  expenses                                                                                                 |       | 77.0                             |       | 77.2 |   | 77.2 |   |
| Pre-opening  and start-up expenses                                                                                  |       | 4.4                              |       | 1.3 |   | 3⁄4 |   |
| Impairment  of long-lived assets                                                                                    |       | 3.5                              |       | 3⁄4 |   | 3⁄4 |   |
| Depreciation  and amortization                                                                                      |       | 4.7                              |       | 3.9 |   | 3.6 |   |
| General and  administrative expenses                                                                                |       | 7.0                              |       | 8.6 |   | 7.8 |   |
| (Gain) loss  on sale of fixed assets                                                                                |       | (0.1                             | )          | 3⁄4 |   | 3⁄4 |   |
| Income from  operations                                                                                             |       | 3.5                              |       | 9.0 |   | 11.4 |   |
| Interest  expense, net                                                                                              |       | 7.0                              |       | 6.5 |   | 6.8 |   |
| Loss on  extinguishment of debt                                                                                     |       | 0.8                              |       | 3⁄4 |   | 3⁄4 |   |
| Minority  interest in consolidated special purpose entities                                                         |       | —                           |       | 3⁄4 |   | 0.2 |   |
| Income  (loss) before provision (benefit) for income taxes and cumulative effect of  change in accounting principle |       | (4.3                             | )          | 2.5 |   | 4.4 |   |
| Provision  (benefit) for income taxes                                                                               |       | (1.7                             | )          | 1.0 |   | 1.8 |   |
| Income  (loss) before cumulative effect of change in accounting principle                                           |       | (2.6                             | )%         | 1.5 | % | 2.6 | % |

 

***Year Ended December 31,2004 Compared to Year Ended December 31, 2003***

*** ***

***Revenues*****.**  Revenuesincreased approximately $19.4 million, or 7.1%, to $291.0 million for the yearended December 31, 2004 from $271.6 million for the year ended December 31,2003.

 

***Adult.***Adult secure institutional division revenuesincreased approximately $12.7 million, or 12.4%, to $114.8 million for the yearended December 31, 2004 from $102.1 million for the year ended December 31,2003 due primarily to (1) per diem rate increases at the Big SpringCorrectional Center in September 2003 and March 2004 which increased2004 revenues by approximately $5.1 million, (2) the acquisition of the WalnutGrove Youth Correctional Facility management contract in June 2004 whichcontributed revenue of approximately $4.8 million, (3) the opening of the twounit Regional Correctional Center in July and December 2004 whichcontributed revenue of approximately $1.9 million and (4) increased occupancyat the Donald D. Wyatt Detention Center which increased 2004 revenues byapproximately $1.2 million.  We openedthe 528 bed South Tower of the Regional Correctional Center in July 2004and the 442 bed North Tower in December 2004.  Revenues attributable to start-up operationswere approximately $1.9 million for the year ended December 31, 2004 andwere attributable solely to the Regional Correctional Center.  There were no revenues attributable tostart-up operations for the year ended December 31, 2003.

 

Our adult secure institutional servicesdivision revenues are generated primarily from contracts with federal and stateagencies.  At December 31, 2004, weoperated nine adult secure facilities with an aggregate service capacity of7,940 and a contracted capacity of 7,679.

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Averagecontract occupancy was 98.8% for the year ended December 31, 2004 comparedto 99.3% for the year ended December 31, 2003.  The decline in the average contract occupancypercentage in 2004 is due to the opening of the Regional Correctional Centerwhich did not operate at full capacity. Excluding the actual occupancy and contract capacity for the start-upactivities of the Regional Correctional Center in 2004, average contractoccupancy was 102.4%.  Although theexclusion of actual occupancy and contract capacity for start-up operations isa non-GAAP measure, we believe it is important to provide average contractoccupancy excluding start-up operations so as to provide more comparableinformation with other periods.  Theaverage per diem rate was $48.45 for the year ended December 31, 2004compared to $47.79 for the year ended December 31, 2003.  The increase in the per diem rate for 2004 ascompared to 2003 is due primarily to the opening of the two-unit RegionalCorrectional Center in July and December 2004 and the acquisition ofthe Walnut Grove Youth Correctional Facility management contract in June 2004.  Additionally, we received rate increases atour Big Spring Correctional Center in September 2003 and March 2004.  We continue to experience increasing pressurefrom contracting governmental agencies to limit or even reduce per diemrates.  Many of these governmentalentities are under severe budget pressures and we anticipate that moregovernmental agencies may approach us about per diem rate concessions.  Decreases, or the lack of anticipatedincreases, in per diem rates could adversely effect our current estimate ofadult secure institutional services division revenues for the year ending December 31,2005.

 

We anticipate a decrease in revenue from ouradult secure institutional division of approximately $3.3 million in the yearended December 31, 2005 due to the non-renewal of the Valencia CountyDetention Center contract as of December 31, 2004.  We anticipate an offsetting increase inrevenue for this division of approximately $16.0 million in 2005 due to theoperations of the Walnut Grove Youth Correctional Facility and the RegionalCorrectional Center.

 

***Juvenile***.  Juvenile justice, education and treatmentservices division revenues increased approximately $8.0 million, or 6.7%, to$126.8 million for the year ended December 31, 2004 from $118.8 millionfor the year ended December 31, 2003. The increase in revenues was due primarily to (1) the opening of theTexas Adolescent Treatment Center in October 2003 which increased 2004revenues by approximately $5.5 million, (2) the acquisition of the Jos-ArzResidential Treatment Center management contract in June 2003 and theopening of the Jos-Arz Therapeutic Public Charter School in December 2003which increased 2004 revenues by approximately $2.1 million, (3) increasedoccupancy at the Cornell Abraxas 1 (A-1) facility which increased 2004 revenuesby approximately $1.7 million, (4) the opening of the Southern Peaks RegionalTreatment Center in August 2004 which contributed revenue of approximately$1.2 million, (5) the commencement of our management contract for thePhiladelphia Alternative Education program in August 2004 whichcontributed revenue of approximately $1.0 million and (6) the commencement ofour management contract for the Lebanon Alternative Education program in September 2004which contributed revenue of approximately $0.5 million.  The increase in revenues due to the above wasoffset, in part, by a decrease in 2004 revenue of approximately $3.8 milliondue to our termination of the Santa Fe County Youth Development Program in January 2004and a decrease in revenues of approximately $1.0 million due to reduced servicehours for our Dauphin Mental Health programs in Pennsylvania.

 

At December 31, 2004, we operated 23residential juvenile facilities with a total service capacity of 1,875 and 15non-residential juvenile community-based programs with a total program capacityof 3,002.  The contracts for our juvenilefacilities and programs are generally with state and local government agenciesand generally renew annually.  During thefourth quarter of 2004, we decided to close certain non-residentialcommunity-based programs in Pennsylvania. The anticipated costs for the shutdown of these programs have been recordedin our accompanying Consolidated Statements of Operations and ComprehensiveIncome (Loss).  In addition, subsequentto December 21, 2004, we have announced the decision to close the ResidentialSchool and Maple Creek Home facilities, both located in Illinois, as well asthe Jos-Arz programs in Washington, D.C. We currently expect that our otherannual juvenile contracts will be renewed in 2005. As a result of thesedecisions, we expect 2005 revenues for our juvenile division to decreaseapproximately $10.6 million.

 

Average contract occupancywas 90.5% for the year ended December 31, 2004 compared to 90.8% for theyear ended December 31, 2003. Excluding the actual occupancy and the contracted capacity of theSouthern Peaks Regional Treatment Center and the Plankinton Regional DetentionCenter for the year ended December 31, 2004

 

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and the actual occupancy and the contracted capacity of the Jos-ArzResidential Treatment Center and the Texas Adolescent Treatment Center for theyear ended December 31, 2003, average contract occupancy was 92.8% for theyear ended December 31, 2004 compared to 93.1% for the year ended December 31,2003.  Although the exclusion of actualoccupancy and contract capacity for start-up operations is a non-GAAP measure,we believe it is important to provide average contract occupancy excludingstart-up operations so as to provide more comparable information with otherperiods.

 

The average per diem ratefor our residential juvenile facilities was approximately $165.74 for the year endedDecember 31, 2004 compared to approximately $164.89 for the year ended December 31,2003.  The increase in the average perdiem rate for 2004 as compared to 2003 is due to the opening of the SouthernPeaks Regional Treatment Center in August 2004 and annual rate increasesfor our Pennsylvania programs received in July 2004.  The average fee-for-service rate for ournon-residential community-based juvenile programs was approximately $30.14 forthe year ended December 31, 2004 compared to approximately $28.19 for theyear ended December 31, 2003.  Theincrease in the average fee-for-service rate for 2004 as compared to 2003 isdue to changes in the mix of services provided by our various non-residentialcommunity-based juvenile programs.

 

Revenues attributable tostart-up operations were approximately $3.5 million for the year ended December 31,2004 and were attributable to the start-up operations of the Southern PeaksRegional Treatment Center, the Jos-Arz Residential Treatment Center, theJos-Arz Therapeutic Public Charter School and the Plankinton Regional DetentionCenter.  Revenues attributable tostart-up operations were approximately $1.4 million for the year ended December 31,2003 and were attributable to the Jos-Arz Residential Treatment Center and theTexas Adolescent Treatment Center.

 

***AdultCommunity-Based. ***Adultcommunity-based corrections and treatment services division revenues decreasedapproximately $1.3 million, or 2.5%, to $49.4 million for the year ended December 31,2004 from $50.7 million for the year ended December 31, 2003 due primarilyto (1) reduced occupancy at the Dallas County Judicial Treatment Center, whichreduced 2004 revenues by approximately $0.9 million (2) our termination of theInglewood Men’s Center contract in September 2003 which reduced 2004revenues by approximately $0.3 million and (3) our termination of the Santa FeCounty Electronic Monitoring Program in January 2004 which reduced 2004revenues by approximately $0.5 million. The decrease in revenues due to the above was offset by a net increase inrevenues of approximately $0.4 million at our other adult community-basedfacilities and programs.

 

At December 31, 2004,we operated 15 residential adult community-based corrections and treatmentfacilities with a total service capacity of 2,261 and six non-residentialcommunity-based corrections and treatment programs with a total servicecapacity of 1,636.  Our contracts forthese services are primarily with federal, state and local governmentalagencies.

 

Average contract occupancywas 103.1% for the year ended December 31, 2004 compared to 110.7% for theyear ended December 31, 2003.  Thedecline in occupancy was primarily due to reduced occupancy at the DallasCounty Judicial Treatment Center.  Weexperienced average contract occupancy percentages in excess of 100.0% due tothe actual occupancy at certain residential facilities exceeding its contractedcapacity.  We currently cannot predictwhether this level of occupancy will continue in future periods.

 

The average per diem ratefor our residential adult community-based facilities was approximately $62.10for the year ended December 31, 2004 compared to approximately $58.69 forthe year ended December 31, 2003. The increase in the average per diemrate for 2004 as compared to 2003 is due to mid-year rate increases at ourAlaskan facilities and per diem rate increases at certain other of ourresidential adult community-based facilities due to contract renewals and othercontractual rate increases.  The averagefee-for-service rate for our non-residential adult community-based programs wasapproximately $8.59 for the year ended December 31, 2004 compared toapproximately $9.67 for the year ended December 31, 2003.  Our average fee-for-service rates fluctuatefrom year to year due to changes in the mix of services provided by our variousnon-residential adult community-based programs.

 

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***Operating Expenses.*** Operating expenses increased approximately $14.4 million, or 6.9%, to $224.1million for the year ended December 31, 2004 from approximately $209.7million for the year ended December 31, 2003.

 

***Adult.***  Adult secure institutional division operatingexpenses increased approximately $7.6 million, or 10.4%, to approximately $80.1 million for theyear ended December 31, 2004 fromapproximately $72.5 million for the year ended December 31, 2003due primarily to (1) the acquisition of the Walnut Grove Youth CorrectionalFacility management contract in June 2004 which incurred operatingexpenses of approximately $3.5 million and (2) an increase in operatingexpenses of approximately $4.6 million resulting from the increased occupancyat the Big Spring Correctional Center and the Donald D. Wyatt Detention Center.

 

As a percentage of segmentrevenues, adult secure institutional services operating expenses were 69.7% forthe year ended December 31, 2004 compared to 71.0% for the year ended December 31,2003.  Excluding $1.9 million of revenueattributable to the start-up operations of the Regional Correctional Center in2004, adult secure institutional services operating expenses, as a percent ofsegment revenues, were 70.9% for the year ended December 31, 2004.  The 2004 operating margin was favorablyimpacted by the September 2003 purchase of furniture and equipment thatwas formerly leased under a sale and leaseback transaction in 1999.  In addition, in April 2004 we purchased theBaker Community Correctional Center building which was formerly leased.  As a result, rent expense decreased,favorably impacting the 2004 operating margin. Furthermore, the acquisition of the Walnut Grove Youth CorrectionalFacility management contract in June 2004 favorably impacted the operatingmargin due to its lower operating capital requirements.

 

***Juvenile.***  Juvenile justice, educational and treatmentservices division operating expenses increased approximately $6.7 million, or6.7%, to $106.1 million for the year ended December 31, 2004 from $99.4million for the year ended December 31, 2003 due primarily to (1) theopening of the Texas Adolescent Treatment Center in October 2003 whichincreased 2004 operating expenses by approximately $3.9 million, (2) anincrease in operating expenses of approximately $1.7 million for the Jos-ArzResidential Treatment Center as such costs were included in start-up expensesin 2003, (3) an increase in operating expenses of approximately $1.1million atthe A-1 facility due to increased occupancy, (4) an increase in the provisionfor bad debts of approximately $0.5 million for certain facilities andprograms  and (5) increase ofapproximately $1.0 million in employee insurance costs.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of approximately$3.1 million due our termination of the Santa Fe County Youth DevelopmentProgram in January 2004.

 

Asa percentage of segment revenues, juvenile division operating expenses were83.7% for each of the years ended December 31, 2004 and 2003.  Excluding $3.5 million of revenueattributable to the start-up operations of the Jos-Arz Residential TreatmentCenter and Therapeutic Public Charter School, the Southern Peaks RegionalTreatment Center and the Plankinton Regional Detention Center for the yearended December 31, 2004 and $1.4 million of revenue attributable to thestart-up operations of the Jos-Arz Residential Treatment Center and the TexasAdolescent Treatment Center for the year ended December 31, 2003, juvenileservices division operating expenses, as a percentage of segment revenues, were86.1% and 84.7% for the years ended December 31, 2004 and 2003,respectively.  The 2004 operating marginwas unfavorably impacted by an increase in the accounts receivable reserve andhigher employee insurance and legal costs in the year ended December 31,2004 as compared to 2003.  The 2004operating margin was favorably impacted by a reduction in rent expense due tothe September 2003 purchase of furniture and equipment that was formerlyleased under a sale and leaseback transaction in 1999.

 

***Adult Community-Based.***  Adult community-based corrections andtreatment services division operating expenses decreased approximately $0.2million, or 0.4%, to $38.2 million for the year ended December 31, 2004from $38.4 million for the year ended December 31, 2003 due to (1) adecrease in operating expenses of approximately $0.7 million as a result of thereduced occupancy at the Dallas County Judicial Treatment Center, (2)

 

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our termination of the Inglewood Men’s Center contract in September 2003which reduced 2004 operating expenses by approximately $0.4 million and (3) ourtermination of the Santa Fe County Electronic Monitoring Program in January 2004which reduced 2004 operating expenses by approximately $0.4 million.  The decrease in 2004 operating expenses dueto the above was offset, in part, by net increases in operating expenses ofapproximately $1.7 million at our various other adult community-basedfacilities and programs.

 

Asa percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 77.3% for the year ended December 31,2004 compared to 75.7% for the year ended December 31, 2003.  The 2004 operating margin was unfavorablyimpacted by employee severance and other related costs as a result ofcentralizing the operations of our mid-west administrative office into ourcorporate operations.  Additionally, weexperienced increases in certain insurance costs in 2004.  The 2004 operating margin was favorablyimpacted by a reduction in rent expense due to the September 2003 purchaseof furniture and equipment that was formerly leased under a sale and leasebacktransaction in 1999.

 

***Pre-Opening andStart-up Expenses.***** **  Pre-openingand start-up expenses were approximately $12.9 million for the year ended December 31,2004 and were attributable to the pre-opening and start-up activities of the RegionalCorrectional Center, the Jos-Arz Residential Treatment Center and TherapeuticPublic Charter School, the Southern Peaks Regional Treatment Center, thePlankinton Regional Detention Center, the Moshannon Valley Correctional Centerand the Las Vegas Center.  Pre-openingand start-up expenses for the year ended December 31, 2003 wereapproximately $3.4 million and were attributable to the pre-opening andstart-up activities of the Jos-Arz Residential Treatment Center, the SouthernPeaks Regional Treatment Center, the Regional Correctional Center and the TexasAdolescent Treatment Center.  Theseexpenses consisted primarily of personnel and related expenses, building rent,professional and recruiting expenses.

 

***Impairmentof Long-Lived Assets***.  An impairment charge of $0.8 million wasrecorded as of December 31, 2004 pertaining to the Residential Schoolbuilding and Maple Creek Home facility carrying costs as a result of ouranalysis pursuant to the requirements of SFAS No. 144.   Based on recent and projected operations of thesefacilities, we determined that our carrying value of the facility was not fullyrecoverable and exceeded its fair value based on current estimates of futurecash flows.  Additionally, we recorded animpairment charge of $9.3 million as of December 31, 2004 pertaining tothe New Morgan Academy building carrying cost. Based on the current and forecasted operating and cash flow lossesassociated with this facility, we determined that our carrying value for thefacility was not fully recoverable and exceeded its fair value.  These facilities are a part of our juvenilesegment and the impairment charges recorded in 2004 are included in income(loss) from operations from the juvenile segment.

 

***Gain (Loss) on Sale of FixedAssets***.  Forthe year ended December 31, 2004, we recorded a net gain on the sale offixed assets of approximately $0.4 million due to the sale of the Northsidebuilding in Illinois.  This facility andits operations are part of our adult community-based segment and the relatedgain realized in 2004 is included in income (loss) from operations from theadult community-based segment.

 

***Depreciation andAmortization*****.**  Depreciation and amortization increasedapproximately $2.8 million, or 26.6%, to $13.5 million for the year ended December 31,2004 from $10.7 million for the year ended December 31, 2003.  Depreciation and amortization of fixedassets increased approximately $2.4 million, or 24.3%, to approximately $12.2million for the year ended December 31, 2004 from $9.8 million for theyear ended December 31, 2003 due primarily to depreciation expense resultingfrom the September 2003 purchase of furniture and equipment that wasformerly leased under a sale and leaseback transaction in 1999 and depreciationexpense on property and equipment purchased in 2004 and the latter half of2003.

 

Amortization of intangiblesand other assets increased approximately $0.5 million, or 52.5%, toapproximately $1.4 million for the year ended December 31, 2004 comparedto $0.9 million for the year ended December 31, 2003. The increase is dueto amortization expense for the Walnut Grove Youth Correctional FacilityManagement contract that was acquired in June 2004 and for the non-competeagreements entered into in connection with the

 

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acquisition of the Jos-Arz Residential Treatment Center in June 2003and the Walnut Grove Youth Correctional Facility management contract in June 2004.

 

***General andAdministrative Expenses.***  General and administrativeexpenses decreased approximately $3.1 million, or 13.4%, to $20.3 million forthe year ended December 31, 2004 from $23.4 million for the year ended December 31,2003.  General and administrativeexpenses for the year ended December 31, 2003 include a charge ofapproximately $5.4 million to provide an allowance on the unrecovered escrowdeposit related to the Southern Peaks Regional Treatment Center and costs ofapproximately $0.6 million for site acquisition costs and related legalexpenses resulting from our increased development activity, expenses related tovarious financing efforts and other compensation costs.  The increase in 2004 general andadministrative expenses is primarily due to increased professional andconsulting expenses related to, among other things, Sarbanes-Oxley complianceand expenses related to the Southern Peaks Regional Treatment Centerlitigation.  Additionally, we experiencedincreases in certain insurance costs in the year ended December 31, 2004. We anticipate that such insurance costs maycontinue to increase in the year ended December 31, 2005.

 

***Interest.***  Interestexpense, net of interest income, increased approximately $2.7 million to $20.4million for the year ended December 31, 2004 from $17.7 million for theyear ended December 31, 2003.  Theincrease was primarily due to net interest expense of approximately $5.1million associated with the Senior Notes issued in June 2004 (net ofinterest rate swap benefit) offset, in part, by a decrease in interest expenseof approximately $1.2 million due to the repayment of the Synthetic LeaseInvestor Notes A and B in June 2004 and an increase of approximately $1.1million in capitalized interest in the year ended December 31, 2004.  Capitalized interest for the year ended December 31,2004 was approximately $1.8 million and related to the Moshannon Valley CorrectionalCenter, the Regional Correctional Center, the Las Vegas Center and the SouthernPeaks Regional Treatment Center. Capitalized interest for the year ended December 31, 2003 wasapproximately $0.8 million and related solely to the development and constructionof the Moshannon Valley Correctional Center.

 

***Losson Extinguishment of Debt*.**  For the year ended December 31, 2004, werecognized a loss on the extinguishment of debt of approximately $2.4 millionrelated to the write-off of unamortized financing costs and other chargesrelated to the early retirement of our obligations of the Synthetic LeaseInvestor Notes A and B and our amended 2000 Credit Facility in June 2004.

 

***Income Taxes.***** **For the year ended December 31, 2004, we recognized an income taxbenefit at an estimated effective rate of 39.5%.  For the year ended December 31, 2003, werecognized a provision for income taxes at an estimated effective rate of41.0%.  The change in our estimatedeffective tax rate in 2004 is related to a reduction in operating income acrossour business segments and the impact of certain non-deductible expenses such aslobbying.

 

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

 

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

 

***Adult.***Adult secure institutional services divisionrevenues increased 2.6%, or approximately $2.6 million, to $102.1 million forthe year ended December 31, 2003 from $99.5 million for the year ended December 31,2002.  Revenues increased approximately$1.3 million due to improved occupancy at the Baker Community CorrectionalCenter. 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 a termof one year.  Occupancy began ramping upin the third quarter of 2002 but had not reached contract capacity level untillate in the fourth quarter of 2002. Additionally, revenues increasedapproximately $1.9 million due to a 32 bed expansion at the Big Spring CorrectionalCenter completed in April 2003 and a per diem rate increase in June 2003.

 

Our adult secure institutional servicesdivision revenues are primarily generated from contracts with federal and stategovernment agencies.  At December 31,2003, we operated seven adult secure facilities with an aggregate servicecapacity of 5,917 and a contracted capacity of 5,912.  The remaining contract term for thesefacilities range from one to seven years.

 

***Average contract occupancy was 99.3% for the year ended December 31,2003 compared to 97.6% for the year ended December 31, 2002 and theaverage per diem rate was $47.79 for the year ended December 31, 2003compared to $48.21 for the year ended December 31, 2002.  The decrease in the average per diem rate wasdue to a per diem rate reduction at a large facility in the second half of2003.  The rate reduction was requestedby our contracting agency (we mitigated a portion of this rate reduction bynegotiating reductions in the level of service provided).  There were no revenues attributable tostart-up operations for the years ended December 31, 2003 and 2002.  We have noted increasing pressure from stateand local governments to limit increases or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and it is possible that more of our contractinggovernment agencies may approach us about per diem rate concessions.***

*** ***

***Juvenile.***Juvenile justice, educational and treatmentservices division revenues decreased 4.9%, or approximately $6.2 million, to$118.8 million for the year ended December 31, 2003 from $125.0 millionfor the year ended December 31, 2002. Revenues decreasedapproximately $13.3 million due to the closure of the New Morgan Academy in thefourth quarter of 2002.  This decreasewas offset by a net increase in revenue of approximately $7.1 million whichincluded (1) the acquisition of the Jos-Arz Residential Treatment Centermanagement contract in June 2003 which contributed approximately $1.1million to 2003 revenues and (2) a combined increase in revenues ofapproximately $6.0 million due to increased occupancy at various facilitiesincluding the Alexander Youth Center, the Leadership Development Program (LDP),the Cornell Abraxas I facility, the Abraxas Center for Adolescent Females(ACAF), the Danville Mental Health programs and the Campbell Griffin TreatmentCenter.  Additionally, the TexasAdolescent Center, which began operations in October 2003, contributedapproximately $348,000 to 2003 revenues. We did not receive per diem rate increases at our juvenile facilitiesand programs in Pennsylvania in 2003.

 

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At December 31, 2003 we operated 23 residential juvenilefacilities with a total service capacity of 1,971 and 15 non-residentialjuvenile community-based programs with a total program capacity of 2,365.  Our contracts for these facilities andprograms are generally with state and local government agencies and generallyrenew annually.

 

***Average contract capacity for the year ended December 31,2003 was 90.8% compared to 89.8% for the year ended December 31,2002.  Excluding the occupancy andcontract capacity for the New Morgan Academy in 2002 and the start-upactivities of the Jos-Arz Residential Treatment Center and the Texas AdolescentCenter in 2003, average contract occupancy was 93.1% for the year ended December 31,2003 compared to 92.4% for the year ended December 31, 2002.  Although the exclusion of start-up operationsand the operations of the New Morgan Academy is a non-GAAP measure, we believeit is important to provide average contract capacity rates excluding start-upfacilities so as to provide more comparable information with otherperiods.  The average per diem rate forour residential juvenile facilities was approximately $164.89 for the yearended December 31, 2003 compared to approximately $170.98 for the yearended December 31, 2002. The decrease in the average per diem rate wasprimarily due to the closure of the New Morgan Academy in the fourth quarter of2002. Our average rate for our juvenile community-based programs wasapproximately $28.19 for the year ended December 31, 2003 compared toapproximately $28.82 for the year ended December 31, 2002.***

*** ***

***Revenues attributable to start-up operations wereapproximately $1.4 million for the year ended December 31, 2003 and wereattributable to the Jos-Arz Residential Treatment Center and the TexasAdolescent Center.  There were norevenues attributable to start-up operations for the year ended December 31,2002.***

*** ***

***We anticipated that our juvenile services division revenueswill increase in the year ending December 31, 2004 due to the operationsof the Jos-Arz Residential Treatment Center and the Texas Adolescent Center andthe opening of the Jos-Arz Therapeutic Public Charter School which was estimatedto begin operating in the second quarter of 2004.  Operating contracts for these facilities havenot yet been secured. A delay in construction or renovation of these facilitiesor the delay in the execution of operating contracts, or occupancy levels belowmanagement’s current estimates could effect the realization of the projectedrevenue increase. Additionally, we terminated our contract for the Santa FeCounty Juvenile Development Program effective January 28, 2004. Revenuesfor the Santa Fe County Juvenile Development Program were approximately $4.0million for the year ended December 31, 2003.***

*** ***

***AdultCommunity-Based. ***Adult community-based corrections and treatmentservices division revenues increased 0.2%, or approximately $86,000, to $50.7million for the year ended December 31, 2003 from $50.6 million for theyear ended December 31, 2002 due to overall increased occupancy throughoutthe division offset, in part, by a decrease in revenue as a result of ourtermination of the Santa Barbara Center contract in March 2003 and theInglewood Men’s Center contract in June 2003.  These contract terminations decreasedrevenues for the year ended December 31, 2003 by approximately $879,000.

*** ***

At December 31, 2003,we operated 14 residential adult community-based corrections and treatmentfacilities with a total service capacity of 1,977 and seven non-residentialcommunity-based corrections and treatment programs with a total servicecapacity of 1,817.  Our contracts forthese services are primarily with federal, state and local governmentagencies.  The remaining term on thesecontracts ranged from 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 theyear ended December 31, 2002.  Weexperienced occupancy percentages in excess of 100.0% due to actual occupancyat certain residential adult community-based corrections and treatmentfacilities exceeding contracted capacity. We currently cannot predict whether this level of occupancy willcontinue in future periods. There were no revenues attributable to start-upoperations for the years ended December 31, 2003 and 2002.

 

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

 

***Adult.***Adult secure institutional services divisionoperating expenses increased 4.5%, or approximately $3.1 million, to $72.5million for the year ended December 31, 2003 from $69.4 million for theyear ended December 31, 2002 due primarily to the increased occupancy atthe Baker Community Correctional Center as a result of the contract renewal in June 2002and increased occupancy at the Big Spring Correctional Center as a result of anexpansion completed in April 2003.

 

As a percentage of adult secure division revenues,adult secure institutional services division operating expenses were 71.0% forthe year ended December 31, 2003 compared to 69.7% for the year ended December 31,2002.  The decline in the 2003 operatingmargin as compared to 2002 is due to a per diem rate decrease at a largefacility in the second half of 2003.  Additionally,the per 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. We also experiencedhigher medical and worker’s compensation insurance costs in 2003 as compared to2002.

 

***Juvenile. ***Juvenile justice, educational and treatment services division operatingexpenses decreased 5.3%, or approximately $5.5 million, to $99.4 million forthe year ended December 31, 2003 from approximately $105.0 million for theyear ended December 31, 2002 due primarily to the closure of the NewMorgan Academy in the fourth quarter of 2002. Operating expenses for the NewMorgan Academy were approximately $1.6 million for the year ended December 31,2003 compared to approximately $12.0 million in the year ended December 31,2002.  This decrease was offset,in part, by a net increase in operating expenses of approximately $4.8 milliondue primarily to increased occupancy at various facilities including theAlexander Youth Center, LDP, the Cornell Abraxas I facility, ACAF, DanvilleMental Health programs and the Campbell Griffin Treatment Center.

 

As a percentage of juvenile division revenues,excluding start-up operations, juvenile justice, educational and treatmentservices division operating expenses were 84.7% for the year ended December 31,2003 compared to 84.0% for the year ended December 31, 2002.  The decline in the 2003 operating margin isdue to the lack of per diem rate increases at our juvenile facilities andprograms in Pennsylvania coupled with an increase in medical and worker’scompensation insurance expenses in 2003 as compared to 2002.

 

***AdultCommunity-Based.***Adultcommunity-based corrections and treatment services division operating expensesincreased 2.0%, or approximately $0.8 million, to $38.4 million for the yearended December 31, 2003 from $37.6 million for the year ended December 31,2002 due to overall increased occupancy throughout the division offset, inpart, by a decrease in operating expenses as a result of the termination of theSanta Barbara Center contract in March 2003 and the Inglewood Men’s Centercontract in June 2003.

 

As a percentage of adultcommunity-based revenue, adult community-based corrections and treatmentservices division operating expenses were 75.7% for the year ended December 31,2003 compared to 74.3% for the year ended December 31, 2002.  The decline in the 2003 operating margin wasdue primarily to increased medical and worker’s compensation insurance in 2003as compared to 2002.

 

***Pre-Opening andStart-up Expenses.***  Pre-opening and start-up expenses for theyear ended December 31, 2003 were approximately $3.4 million and wereattributable to the pre-opening and start-up costs of the Jos-Arz

 

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Residential Treatment Center, the Southern Peaks Treatment Center, theNew Mexico Regional Correctional Center and the Texas Adolescent Center. Theseexpenses consisted primarily of personnel and related expenses, building rent,professional and recruiting expenses. There were no pre-opening and start-upexpenses for the year ended December 31, 2002.

*** ***

***Depreciationand Amortization*. * *** Depreciation and amortization expense increased9.4%, or $920,000, to approximately $10.7 million for the year ended December 31,2003 from approximately $9.8 million for the year ended December 31, 2002.The increase in depreciation and amortization expense was due primarily todepreciation of current year property and equipment additions of approximately$22.3 million which included, among other things, the repurchase of furnitureand equipment leased under a sale and leaseback transaction in 1999 forapproximately $4.8 million, the purchase and renovation of the Texas AdolescentCenter for approximately $4.3 million, land and construction costs for theSouthern Peaks Treatment Center of approximately $2.3 million, capitalizedinterest and development costs for the Moshannon Valley Correctional Center ofapproximately $2.6 million, renovations to the New Mexico Regional CorrectionalCenter of approximately $1.0 million, an expansion at the Cornell Abraxas Ifacility for approximately $921,000, an expansion at the Salt Lake City Centerfor approximately $491,000, the purchase of a software license agreement forapproximately $424,000 and a 32 bed expansion at the Big Spring CorrectionalCenter for approximately $302,000. Amortization of intangibles was approximately $895,000 and $878,000 forthe years ended December 31, 2003 and 2002, respectively.

 

***Generaland Administrative Expenses.***  General andadministrative expenses increased 9.0%, or approximately $1.9 million, to $23.4million for the year ended December 31, 2003 from $21.5 million for theyear ended December 31, 2002. Included in general and administrativeexpenses for the year ended December 31, 2003 is a charge of approximately$5.4 million to provide an allowance on an unrecovered escrow deposit relatedto the Southern Peaks Treatment Center. Additionally, general and administrative expenses include costs ofapproximately $580,000 for site acquisition costs and legal expenses primarilyassociated with our increased development activity, expenses related to variousfinancing efforts and other compensation costs.

*** ***

***General and administrative expenses for the year ended December 31,2002 included charges totaling approximately $4.4 million for (1) legal andprofessional fees of approximately  $1.9million related to the Special Committee review and the subsequent restatementof our 2001 financial statements and for the defense of the related stockholderlitigation, (2) a write-off of approximately $1.0 million of deferred projectfinancing costs associated with the BOP Southeast Project and (3) thesettlement of a management contract with the Company’s former president whoresigned his position in September 2002 for approximately $1.5 million.***

*** ***

***Interest.*** Interest expense, net of interest income,decreased to approximately $17.7 million for the year ended December 31,2003 from $18.7 million for the year ended December 31, 2002. For the yearended December 31, 2002, interest expense includes approximately $825,000for lenders’ fees and related professional fees incurred to obtain certainwaivers and amendments to our credit agreement in conjunction with therestatement of our 2001

 

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financial statements.  Theremaining decrease in net interest expense of approximately $245,000 isattributable to a reduction in overall borrowings during 2003 as compared to2002 due principally to annual repayments on MCF’s 8.47% Bonds.

*** ***

Wecapitalized interest 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 ourSynthetic Lease Investor Notes.

 

***Minority Interestin Consolidated Special Purpose Entities*****.**  Thecumulative losses of MCF exceeded the recorded minority interest of MCF duringthe first quarter of 2002.  Thecumulative losses of the Synthetic Lease Investor (discussed in more detailunder “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations - Liquidity and Capital Resources - Long-Term Credit Facilities”)exceeded the recorded minority interest of the Synthetic Lease Investor duringthe third quarter of 2001.  Since thecumulative losses of MCF and the Synthetic Lease Investor exceed the equitythat was recorded as minority interest by the Company, the excess losses can nolonger be allocated to the minority interest in our Consolidated Statements ofOperations and Comprehensive Income (Loss). For the year ended December 31, 2002, we recorded a charge ofapproximately $0.6 million as a result of a distribution made by MCF to itsequity investors.

 

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

 

***Cumulative Effectof Change in Accounting Principle.***  We recorded a cumulative effectof a change in accounting principle charge of approximately $965,000, net oftax, for the year ended December 31, 2002 related to the impairment ofgoodwill in accordance with the provisions of SFAS No. 142 related to anacquisition made in November 1999.

 

**Liquidity and Capital Resources**

 

***General*****.**  Ourprimary capital requirements are for (1) purchases, construction or renovationof new facilities, (2) expansions of existing facilities, (3) workingcapital, (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 generallyincrease immediately prior to commencing management of a new facility as weincur start-up costs and purchase necessary equipment and supplies beforefacility management revenue is realized.

 

***Cash Flows FromOperations.*** Cashflows provided by operating activities were approximately $12.1 million for theyear ended December 31, 2004 compared to approximately $26.2 million forthe year ended December 31, 2003.  The decrease was principally due to anincrease in accounts receivable due to increased billings in 2004 plus adecrease in deferred tax liabilities. These cash flow increases were partially offset by other working capitalchanges, including an increase in accounts payable and accrued liabilities dueto the increased operations in 2004 from various start-up facilities.

 

***Cash Flows FromInvesting Activities*****. **Cashused in investing activities was approximately $85.7 million for the year endedDecember 31, 2004 primarily due to the net purchase of $51.7 million of investmentsecurities, and capital expenditures of $40.2 million for the purchase anddevelopment of the Southern Peaks Regional Treatment Center, the Las VegasCenter, the Central California Treatment Center and the Baker CommunityCorrectional Center buildings, renovation of the Regional Correctional Center,the Plankinton Regional Detention Center, capitalized interest on the MoshannonValley Correctional Center, the Regional Correctional Center, the Las VegasCenter and the Southern Peaks Regional Treatment Center and various otherfacility improvements and/or expansions and information technology and softwaredevelopment costs.  Additionally, wepurchased the Walnut Grove Youth Correctional Facility management contract andcertain related assets in June 2004 for $3.0 million.  We received approximately $5.6 million fromthe BOP for

 

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reimbursement of costs incurred subsequent to the Stop-Work Order relatedto the construction of the Moshannon Valley Correctional Center.  We also received $5.0 million from ourrestricted escrow arrangement related to the Southern Peaks Regional TreatmentCenter.  Cash used in investing activities wasapproximately $36.0 million for the year ended December 31, 2003 dueprimarily to capital expenditures of approximately $22.3 million relatedprimarily to (1) the purchase and renovation of the Texas AdolescentCenter for approximately $4.3 million, (2) the repurchase of furniture andequipment previously leased under a sale and leaseback transaction in 1999 forapproximately $4.8 million, (3) renovations to the New Mexico RegionalCorrectional Center of approximately $1.0 million, (4) land and developmentcosts for the Southern Peaks Regional 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, we made net payments ofapproximately $10.4 million related to the Southern Peaks Regional TreatmentCenter’s restricted escrow arrangement.

 

***Cash Flows FromFinancing Activities*****.**  Cash flows provided by financingactivities were approximately $43.4 million for the year ended December 31,2004 due primarily to cash proceeds of $110.5 million from the issuance of theSenior Notes in June 2004 offset by net repayments on our revolving lineof credit under our amended 2000 Credit Facility of $2.0 million and therepayment of the Synthetic Lease Investor Notes A and B of $50.6 million.  Additionally, we made cash payments ofapproximately $1.9 million related to the early retirement of the SyntheticLease Investor Notes A and B, $8.3 million related to the MCF bonds andapproximately $6.1 million related to the issuance of the Senior Notes and our2004 Credit Facility.  Additionally, wehad proceeds from the exercise of stock options of approximately $1.9 million. Cash used in financing activities wasapproximately $2.7 million for the year ended December 31, 2003 dueprimarily to the payments on long-term debt of approximately $28.6 million,offset by borrowings on long-term debt of approximately $24.3 million, and therepurchase of approximately $1.2 million of treasury shares. We had cash providedby financing activities of approximately $2.4 million from the proceeds fromstock option exercises and approximately $440,000 from the repayment ofshareholder notes.

 

***Long-Term CreditFacilities.***  Our 2000 Credit Facility, as amended,provided for borrowings of up to $45.0 million under a revolving line ofcredit.  The commitment amount wasreduced by $1.6 million quarterly beginning in July 2002 and byoutstanding letters of credit.  Theamended 2000 Credit Facility bore interest, at our election, at either theprime rate plus a margin of 2.0%, or a rate which was 3.0% above the applicableLIBOR rate.  Additionally, the amended2000 Credit Facility provided us with the ability to enter into synthetic leaseagreements for the acquisition or development of operating facilities.  This synthetic lease financing arrangementprovided for funding to the lessor under the operating leases of up to $100.0million.  The amended 2000 CreditFacility was repaid with a portion of the net proceeds from the sale of theSenior Notes in June 2004.

 

On June 24, 2004, we entered into a revolvingcredit facility (the “2004 Credit Facility”) by and among the Company, andcertain other lenders to fund working capital for acquisitions, to refinanceexisting debt, to fund capital expenditures and general corporate purposes. The2004 Credit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under the 2004Credit Facility was approximately $52.8 million at December 31, 2004.  We had outstanding letters of credit ofapproximately $7.2 million at December 31, 2004.  Subject to certain requirements, we have theright to increase the aggregate commitments under the 2004 Credit Facility upto an aggregate amount of $100.0 million. The 2004 Credit Facility matures in June 2008 and bears interest,at our election and, depending on our total leverage ratio, at either the primerate plus a margin ranging from 0.75% to 2.00%, or a rate which ranges from2.25% to 3.50% above the applicable LIBOR rate.

 

The 2004 CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. The 2004 Credit Facility is not secured by the assets of MCF.  The 2004 Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend

 

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payments, limitations onmergers and compliance with financial covenants.

 

In June 2004,we issued $112.0 million in principal of 10.75% Senior Notes (the “Senior Notes”)due July 1, 2012.  The Senior Notesare unsecured senior indebtedness and are guaranteed by all of our existing andfuture subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of eachyear, commencing January 1, 2005. On or after July 1, 2008, we may redeem all or a portion of theSenior Notes at the redemption prices (expressed as a percentage of theprincipal amount) listed below, plus accrued and unpaid interest, if any, onthe Senior Notes redeemed, to the applicable date of redemption, if redeemedduring the 12-month period commencing on July 1 of the years indicatedbelow:

 

| **Year**            | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
|                |       |            |       |
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Any time prior to July 1,2007, we may redeem up to 35% of the original aggregate principal amount of theSenior Notes at a redemption price of 110.75% of the principal amount thereofwith the net cash of public offerings of equity, provided that at least 65% ofthe original aggregate principal amount of the Senior Notes remains outstandingafter the redemption and other conditions are met.  Upon the occurrence of specified change ofcontrol events, unless we have exercised our option to redeem all the SeniorNotes as described above, each holder will have the right to require us torepurchase all or a portion of such holder’s Senior Notes at a purchase pricein cash equal to 101% of the aggregate principal amount of the notesrepurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) which limits our ability and our Guarantors to,among other things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

The net proceeds from thesale of the Senior Notes was approximately $107.2 million and was used to repayand refinance the indebtedness under our amended 2000 Credit Facility and oursynthetic lease obligations as of June 24, 2004.  We recognized a charge of approximately $2.4million related to the write-off of unamortized deferred financing costs andcharges related to the extinguishment of the synthetic lease and the amended2000 Credit Facility obligations.

 

In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was to convert future interest due on$84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contractand the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the year ended December 31, 2004, we recorded interest savingsrelated to this interest rate swap of approximately $1.2 million which isreflected as a reduction to interest expense in our accompanying financialstatements.  The swap agreements aremarked to market each quarter with a corresponding mark-to-market adjustmentreflected as either a discount or premium on the Senior Notes.  At December 31, 2004, the fair value ofthis derivative instrument was approximately $3.2 million and is included inother assets.  The carrying value of theSenior Notes as of December 31, 2004 was increased by the sameamount.  Because the swap agreement isconsidered an effective fair-value hedge, there will be no effect on ourresults of operations from the mark-to-market adjustment as long as the swap isin effect.

 

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***Contractual Uncertainties Related toCertain Facilities.***

 

***RegionalCorrectional Center. ***InJanuary 2003, we executed a five-year lease for the Regional CorrectionalCenter in Albuquerque, New Mexico.  This970 bed facility consists of two units, the 528 bed South Tower and the 442 bedNorth Tower.  We renovated the SouthTower and opened the unit in July 2004. We renovated the North Tower and opened the unit in December 2004.    As of December 31, 2004, we hadinvested approximately $8.8 million on renovations and furniture and equipmentfor both Towers. For the year ended December 31, 2004, we incurredpre-opening and start-up expenses of approximately $4.9 million and recognizedrevenue of approximately $1.9 million related to this facility.  We currently anticipate that the facilitywill reach substantial capactity during the second half of 2005.  However, there can be no assurance that wewill develop enough volume at the facility to assure its profitability.  The lease for the facility requires monthlyrental payments of approximately $113,000 for the first two years and $130,000for the last three years of the lease.

 

***New MorganAcademy.***  Weclosed the New Morgan Academy in the fourth quarter of 2002 and arecurrently considering several options ranging from the utilization of thefacility for another type of program or the sale or lease of the facility. Asof December 31, 2004, we are focusing our efforts on the possible sale orlease of the facility to certain governmental agencies in Pennsylvania, as wellas private enterprises.  We are maintaining a small staff to secure andmaintain the facility.  We haverecognized pre-tax costs of $13.5 million (including an impairment charge of$9.3 million as discussed below) in our Consolidated Statements of Operationsand Comprehensive Income (Loss) for the year ended December 31, 2004 forrelated holding costs (depreciation, interest, property, taxes and other maintenancecosts).

 

At December 31, 2004, as a result of ouranalysis pursuant to the requirements of SFAS No. 144, we determined that thecarrying amount of the New Morgan Academy was not fully recoverable andexceeded its fair value (as based on current estimates of future cashflows).  The developing inability duringlate 2004 of various governmental agencies with whom we have been innegotiations to obtain the level of funding to contract with us for the use ofthe New Morgan Academy has indicated an expectation of continuing lossesassociated with this facility. Accordingly, we believe that, pursuant to the provisions of SFAS No.144, an impairment charge of $9.3 million was required and such charge has beenrecognized in our Consolidated Statements of Operations and ComprehensiveIncome (Loss) for the year ended December 31, 2004.  The carrying value of the property andequipment at the New Morgan Academy, after the impairment charge, wasapproximately $20.4 million at December 31, 2004.  This facility is a part of our juvenilesegment.

 

***TreasuryStock/Repurchases.***  We repurchased in the open market 10,000shares of our common stock for approximately $0.1 million in the year ended December 31,2004.  We repurchased in the open market106,500 shares of our common stock for approximately $1.2 million in the yearended December 31, 2003.

 

In 2002, the board of directors authorized therepurchase of an aggregate $10.0 million of the Company’s outstandingshares.  The annual repurchase of shareswas limited to $2.5 million, and an aggregate limit of $7.5 million, under theamended 2000 Credit Facility.  Under theterms of the Senior Notes and the 2004 Credit Facility, we can purchase sharesof our stock subject to certain cumulative restrictions.

 

***Future Liquidity.***  Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our 2004 Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts, including the construction of the Moshannon Valley CorrectionalCenter.  To the extent our cash andcurrent financing arrangements do not provide sufficient financing to fundconstruction costs related to future adult secure institutional contract awardsor significant facility expansions, we anticipate obtaining additional sourcesof financing to fund such activities. However, there can be no assurance that such financing will be availableor will be available on terms favorable to us.

 

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***ContractualObligations and Commercial Commitments*****.**  Wehave assumed various financial obligations and commitments in the ordinarycourse of conducting our business.  Wehave contractual obligations requiring future cash payments under our existingcontractual arrangements, such as management, consulting and non-competitionagreements.

 

We maintain operating leases in the ordinary courseof our business activities.  These leasesinclude those for operating facilities, office space and office and operatingequipment, and the terms of the agreements vary from 2005 until 2075.  As of December 31, 2004, our totalcommitment under these operating leases was approximately $34.7 million.

 

The following table details the known future cashpayments (on an undiscounted basis) related to various contractual obligationsas of December 31, 2004 (in thousands):

 
| ** **                                    | ** ** | **Payments Due by Period** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|
| ** **                                    | ** ** | ** **                 | ** ** | ** ** | ** ** | **2006 -** | ** ** | **2008 -** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Total**                  | ** ** | **2005** | ** ** | **2007** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
| Contractual  Obligations:                     |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term  debt – principal and interest |       |                       |       |   |   |   |   |   |   |   |   |
| **•**  Cornell Companies, Inc.           |       | $                          | 191,911    |   | $ | 9,857 |   | $ | 20,018 |   | $ | 20,012 |   | $ | 142,024 |   |
| **•**  Special Purpose Entities          |       | 285,005                    |       | 23,797 |   | 47,448 |   | 47,482 |   | 166,278 |   |
| Construction  commitments                     |       | 53,700                     |       | 51,000 |   | 2,700 |   | — |   | — |   |
| Capital  lease obligations                    |       |                       |       |   |   |   |   |   |   |   |   |
| **•**  Cornell Companies, Inc.           |       | 6                          |       | 5 |   | 1 |   | — |   | — |   |
| Operating  leases                             |       | 34,719                     |       | 5,995 |   | 9,965 |   | 5,594 |   | 13,165 |   |
| Consultative  and non-competition agreements  |       | 1,076                      |       | 767 |   | 309 |   | — |   | — |   |
| Total  contractual cash obligations           |       | $                          | 566,417    |   | $ | 91,421 |   | $ | 80,441 |   | $ | 73,088 |   | $ | 321,467 |   |

 

The future cash payments on the Cornell Companies,Inc. long-term debt assume an effective rate of 8.37% on the interest rate swapcontract.

 

We enter into letters of credit in the ordinarycourse of operating and financing activities. As of December 31, 2004, we had outstanding letters of credit ofapproximately $7.2 million primarily for certain workers’ compensationinsurance and other operating obligations. The following table details our letter of credit commitments as of December 31,2004 (in thousands):

 
| ** **                 | ** ** | ** **    | ** ** | **Amount of Commitment Expiration  Per Period** | ** ** |
|----------------------------|------------|---------------|------------|-------------------------------------------------|------------|
| ** **                 | ** ** | **Total**     | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amounts**   | ** ** | **Less than**                                   | ** ** | **Over** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Committed** | ** ** | **1 Year**                                      | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
| Commercial  Commitments:   |       |          |       |                                            |       |   |   |   |   |   |   |
| Standby  letters of credit |       | $             | 7,241      |                                            | $          | 7,241 |   | $ | — |   | $ | –– |   | $ | –– |   |
|                            |            |               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Related Party Transactions**

 

One of our directors is a partner in a law firm thatprovides legal services to us. We pay legal fees for such services.  Legal fees paid to this law firm wereapproximately $2.0 million, $1.1 million and $1.5 million for the years ended December 31,2004, 2003 and 2002, respectively.  Thisdirector has notified us that he will not stand for reelection at the nextstockholders meeting.

 

In July 1996, we entered into promissory noteswith the Company’s former president and the Company’s founder, a director ofthe Company until October 2003.  Thepromissory notes bore interest at an annual rate of 6.63%, were scheduled tomature in June 2004 with no interim interest or principal payments, werefull recourse and were collateralized by shares of our common stock.  These notes were repaid in total prior to December 31,2003.

 

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In October 2003, the principal andrelated accrued interest receivable related to the Company founder’s notes of$270,000 and $129,000, respectively, was repaid.  We recognized approximately $17,000 and$29,000 of interest income related to these notes for the years ended December 31,2003, and 2002.

 

Effective September 1, 1999, we entered into aconsulting agreement with the Company’s founder, who was a director of theCompany through October 2003.  Ascompensation for consulting services, we agreed to an annual payment of atleast $255,000 for each of the first four years of the seven-year initial termof the consulting agreement with an annual payment of at least $180,000 foreach of the last three years of the seven-year initial term of the consultingagreement.  We have an option to renewthe 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, we agreed to anannual bonus, subject to certain limitations, equal to $75,000 during the firstfour years of the seven-year initial term and an annual bonus of $60,000 duringthe last three years of the seven-year initial term and during any renewalterm.  We also agreed to grant options topurchase an aggregate 120,000 shares of our common stock in four equal annualinstallments beginning September 1, 2000. The options have an exercise price equal to the fair market value of ourcommon stock on the date of grant and vest at the time such options aregranted, subject to certain limitations on exercise.  For the year ended December 31, 2003,the Company’s founder accepted a $100,000 cash payment in lieu of unexercisedoptions. This payment was expensed by us in 2003.

 

As part of the consulting agreement discussed above,we entered into a non-compete agreement with the Company’s founder.  The non-compete agreement has a term of 10years and requires us to pay a monthly fee of $10,000 for the seven-year initial term of the consultingagreement.  We capitalize the monthlypayments and amortize the amounts over the 10-year term of the consultingagreement. We recognized amortization expense related to this agreement ofapproximately $84,000 for each of the years ended December 31, 2004, 2003and 2002.

 

We maintain a life insurance policy for the Company’sfounder and made payments related to this policy of approximately $0.2 millionfor each of the years ended December 31, 2004, 2003 and 2002.

 

We also compensated the Company’s founder for boardof director fees in the amounts of $12,000 and $30,000 for the years ended December 31,2003 and 2002, respectively.  We did notpay director fees in 2004 as the Company’s founder resigned as a director in October 2003.

 

Total payments made for the above consulting andnon-compete agreements, board of director fees and expense reimbursements forthe Company’s founder were approximately $0.7 million for the year ended December 31,2004 and $0.5 million for each of the years ended December 31, 2003 and2002.

 

We also had a non-compete agreement with a directorof the Company in connection with the acquisition of The Abraxas Group, Inc. inSeptember 1997.  Under thisagreement, we were required to pay annual installments of $60,000 beginning January 2,1998.  These payments could and wereaccelerated upon the mutual agreement of the director and us.  As of December 31, 2003, the balance onthis non-compete agreement had been paid in full.  We made payments under this agreement of  $200,000 and $80,000 for the years ended December 31,2003 and 2002, respectively.  Thisdirector resigned from the board of directors in June 2004.

 

Subsequent to their resignation, we entered into aconsulting agreement with this former director for a term which expires inDecember 2008.  Total payments under thisagreement, which has a termination fee incorporated for a termination prior to maturity,totaled $0.2 million in 2004.  Thetermination fee at December 2004 was $0.4 million.

 

**Inflation**

 

Other than personnel, offender medical costs atcertain facilities, and employee medical and worker’s compensation insurancecosts, we believe that inflation has not had a material effect on our resultsof operations during the past three years. Most of our facility management contracts provide for payments of eitherfixed per diem fees or per diem fees that increase by only small amounts duringthe term of the contracts. Inflation could substantially increase our personnelcosts (the largest component of our operating expenses), medical and insurancecosts or other operating expenses at rates faster than any increases incontract revenues.

 

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

 

This report contains or incorporates by referenceforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  These statements are based on current plansand actual future activities and results of operations may be materiallydifferent from those set forth in the forward-looking statements. Importantfactors that could cause actual results to differ include, among others, (1)the outcomes of pending putative class action shareholder and derivativelawsuits, and related insurance coverage, (2) our ability to win new contractsand to execute our growth strategy, (3) risks associated with acquisitions andthe integration thereof (including the ability to achieve administrative andoperating cost savings and anticipated synergies), (4) the timing and costs ofthe opening of new programs and facilities or the expansions of existingfacilities, (5) our ability to negotiate contracts at those facilities forwhich we currently do not have an operating contract, (6) significant chargesto expense of deferred costs associated with financing and other projects indevelopment if we determine that one or more of such projects is unlikely to besuccessfully concluded, (7) results from alternative deployment or sale offacilities such as the New Morgan Academy or the inability to do so, (8) ourability to complete the construction of the Moshannon Valley CorrectionalCenter as anticipated, (9) changes in governmental policy and/or funding todiscontinue or not renew existing arrangements, to eliminate or discourage theprivatization of correctional, detention and pre-release services in the UnitedStates, or to eliminate rate increase, (10) the availability of financing onterms that are favorable to us and (11) fluctuations in operating resultsbecause of occupancy levels and/or mix, competition (including competition fromtwo competitors that are substantially larger than us), increases in cost ofoperations, fluctuations in interest rates and risks of operations.

 

Where any forward-looking statement includes astatement of the assumptions or bases underlying the forward-looking statement,we caution that, while we believe these assumptions or bases to be reasonableand in good faith, assumed facts or bases almost always vary from the actualresults, and differences between assumed facts or bases and actual results canbe material, depending upon the circumstances. Where, in any forward-lookingstatement, we express an expectation or belief as to future results, thatexpectation or belief is expressed in good faith and is believed to have areasonable basis. We 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 our forward-lookingstatements, whether written or oral, are expressly qualified by thesecautionary statements and any other cautionary statements that may accompanysuch forward-looking statements.  Inaddition, we disclaim any obligation to update any forward-looking statementsto reflect events or circumstances after the date of this report.

 

With this in mind, you should consider the risksdiscussed below and elsewhere in this report and other documents we file withthe Commission from time to time and the following important factors that couldcause actual results to differ materially from those expressed in anyforward-looking statement made by us or on our behalf.

 

***Resistance to privatizationof correctional and detention facilities could result in our inability toobtain new contracts or the loss of existing contracts.***

*** ***

Management of correctional and detention facilities,particularly of adult secure 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, religiousorganizations and groups believing that correctional and detention facilityoperations should only be conducted by government agencies.  Changes in the dominant political party inany market in which correctional facilities are located could have an adverseimpact on privatization.  Furthermore,some government agencies are not legally permitted to delegate theirtraditional management responsibilities for correctional and detentionfacilities to private companies.

 

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In addition, as a private prison manager, we aresubject to government legislation and regulation restricting the ability ofprivate prison managers to house certain types of inmates, such as inmates fromother jurisdictions or inmates at medium or higher security levels.  Legislation has been enacted in severalstates, and has previously been proposed in the United States House ofRepresentatives, containing such restrictions. Any such legislation may have a material adverse affect on us.

 

Any of these resistances may make it more difficultfor us to renew or maintain existing contracts, to obtain new contracts orsites on which to operate new facilities or to develop or purchase facilitiesand lease them to government or private entities, any or all of which couldhave a material adverse effect on our business.

 

***We are subject to the short-termnature of government contracts.***

 

Many governmental agencies are legally limited intheir ability to enter into long-term contracts that would bind electedofficials responsible for future budgets. Therefore, many contracts with government agencies typically either havea very short term or are subject to termination on short notice without cause.The majority of our contracts have primary terms of one to three years.  In addition, our contracts with governmentalagencies may contain one or more renewal options that may be exercised only bythe contracting government agency.  Noassurance can be given that any agency will exercise a renewal option in thefuture.

 

Some of these contracts may not be renewed by thecorresponding governmental agency and no assurance can be given that any agencywill exercise a renewal option in the future. The non-renewal or termination of any of our significant contracts withgovernmental agencies could materially adversely affect our financialcondition, results of operation and liquidity, including our ability to securenew facility management contracts from others. To the extent we have made significant capital expenditures and have short-termcontracts with our customers that are not renewed or extended, we may notrecover our entire capital investment.

 

***Budgetary pressure onfederal, state and local governments may result in contract cancellation or areduction in per diem rates, which would reduce our profitability.***

*** ***

Our cash flow is subject to the receipt ofsufficient funding of and timely payment by contracting governmentalentities.  If the appropriate governmentagency does not receive sufficient appropriations to cover its contractualobligations, a contract may be terminated or the amounts payable to us may bedeferred or reduced.

 

Federal, state and local governments haveencountered, and are expected to continue to encounter, significant budgetaryconstraints that may result in a reduction of spending on the outsourcedservices that we provide.  Such budgetarylimitations may cause the contractual commitments to be reduced or eveneliminated, which would make it unprofitable to continue operating a certainfacility and require us to find alternate customers or close such facility.

 

Many states are facing significant budget deficitsand are under pressure to reduce current levels of spending or controladditional spending.  As a result of thisincreased budgetary pressure, we have granted a few of our customers relieffrom formulaic increase provisions in their agreements and some of ourcustomers have not included in their appropriation legislation amounts thatwould increase the per diem rates payable to us.  Contractual rate increases are generallyintended to offset increases in expenses and inflation.  To the extent rates are not increased or arereduced, our profitability will be adversely affected.

 

***Our ability to win new contracts todevelop and manage correctional, detention and treatment facilities depends onmany factors outside our control.***

 

Our growth is generally dependent upon our abilityto win new contracts to develop and manage new correctional, detention andtreatment facilities.  This depends on anumber of factors we cannot control, including crime rates and sentencingpatterns in various jurisdictions. Accordingly, the demand for our facilities could be adversely affectedby the relaxation of enforcement efforts, leniency in conviction and sentencingpractices or

 

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through the legal decriminalization of certain activities that arecurrently proscribed by criminal laws. For instance, changes in laws relating to drugs and controlledsubstances or illegal immigration could reduce the number of persons arrested,convicted and sentenced, thereby potentially reducing demand for correctionalfacilities to house them and community-based services to transition offendersback into the community. Similarly, reductions in crime rates could lead toreductions in arrests, convictions and sentences requiring correctionalfacilities.

 

When seeking bids, most governmental entitiesevaluate the financial strength of the bidders. To the extent they believe we do not have sufficient financialresources, we will be unable to effectively compete for bids.  Additionally, our success in obtaining newawards and contracts may depend, in part, upon our ability to locate land thatcan be leased or acquired on favorable terms. Furthermore, desirable locationsmay be in or near populated areas and, therefore, may generate legal action orother forms of opposition from residents in areas surrounding a proposed site.

 

***Our profitability may suffer if thenumber of offenders occupying our correctional, detention and treatmentfacilities decreases or there is a shift in occupancy among our divisions .***

 

Our correctional, detention and treatment facilitiesare dependent upon governmental agencies supplying offenders and we do notcontrol occupancy levels at our facilities. We believe the rate of growth experienced in the adult secure sectorduring the late 1980s and early 1990s is stabilizing.

 

Historically, a substantial portion of our revenueshas been generated under contracts that specify a net rate per day perresident, or a per diem rate, sometimes with no minimum guaranteed occupancylevels, even though most correctional facility cost structures are relativelyfixed.  Under such a per diem rate structure,a decrease in occupancy levels at a particular facility could have a materialadverse effect on the financial condition and results of operations at suchfacility.  A decrease in the occupancy ofcertain juvenile justice, education and treatment facilities would have a moresignificant impact on our operating results than a decrease in occupancy in theadult secure institutional services division due to higher per diem revenue atcertain juvenile facilities.

 

Recent suggestions by social commentators andvarious political or governmental representatives suggest that community-basedcorrections of adults may be emphasized in the future as alternatives totraditional incarceration.  We havehistorically experienced higher operating margins in the adult secureinstitutional services and the adult community-based corrections and treatmentservices sectors than in the juvenile services sector.  A shift in occupancy among our segments ofbusiness operations could result in a decrease in our profitability.

 

***A failure to comply with existingregulations could result in material penalties or non-renewal or termination ofour facility management contracts.***

 

Our industry is subject to a variety of federal,state and local regulations, including education, environmental, health careand safety regulations, which are administered by various regulatoryauthorities.  We may not alwayssuccessfully comply with these regulations, and failure to comply could resultin material penalties or non-renewal or termination of facility managementcontracts.  The contracts typicallyinclude extensive reporting requirements and supervision and on-site monitoringby representatives of contracting governmental agencies.  Corrections officers are customarily requiredto meet certain training standards, and in some instances facility personnelare required to be licensed and subject to background investigation. Certainjurisdictions also require that subcontracts be awarded on a competitive basisor that we subcontract with businesses owned by members of minority groups.  The failure to comply with any applicablelaws, rules or regulations and the loss of any required license could adverselyaffect the financial condition and results of operations at our affectedfacilities.

 

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***Governmental agencies mayinvestigate and audit our contracts and, if any improprieties are found, we maybe required to refund revenues we have received, and/or to forego anticipatedrevenues and may be subject to penalties and sanctions, including prohibitionson our bidding in response to requests for proposals, or RFPs.***

 

Governmental agencies we contract with have theauthority to audit and investigate our contracts with them.  As part of that process, some governmentalagencies review our performance on the contract, our pricing practices, ourcost structure and our compliance with applicable laws, regulations andstandards.  If the agency determines thatwe have improperly allocated costs to a specific contract, we may not bereimbursed for those costs and we could be required to refund the amount of anysuch costs that have been reimbursed.  Ifa government audit uncovers improper or illegal activities by us or weotherwise determine that these activities have occurred, we 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 our ability to bid in response to RFPs in one or morejurisdictions and significantly reduce the probability of our success in thebid process for future contracts.

 

***If we fail to satisfy ourcontractual obligations, our ability to compete for future contracts and ourfinancial condition may be adversely affected.***

 

Our failure to comply with contract requirements orto meet our client’s performance expectations when performing a contract couldmaterially and adversely affect our financial performance and our reputation,which, in turn, would impact our ability to compete for new contracts.  Our failure to meet contractual obligationscould also result in substantial actual and consequential damages.  In addition, our contracts often require usto indemnify clients for our failure to meet performance standards. Some of ourcontracts contain liquidated damages provisions and financial penalties relatedto performance failures.  Although wehave liability insurance, the policy limits may not be adequate to provideprotection against all potential liabilities.

 

***Competitors in our industry mayadversely affect the profitability of our business.***

 

We must compete with government entities and otherprivate operators on the basis of cost, quality and range of services offered,experience in managing facilities, reputation of personnel and ability todesign, 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. Certain areas ofour operation may not pose a significant barrier to entry into the market by privateoperators.  For example, privateoperators may not find it as difficult to bid for juvenile treatment,educational and detention services and pre-release correctional and treatmentservices as they do adult secure institutional, correctional and detentionservices.

 

Further, our government customers may assumethe management of a facility currently managed by us upon the termination ofthe corresponding management contract or, if such customers have capacity attheir facilities, may take inmates currently housed in our facilities andtransfer them to government run facilities. The resulting decrease in occupancylevels would reduce our revenue due to the per diem rate structure and couldresult in a significant decrease in the profitability of our business.

 

***A disturbance or violent occurrencein one of our facilities could result in closure of a facility or harm to ourbusiness.***

 

An escape, riot, disturbance or violent occurrenceat one of our facilities could adversely affect the financial condition,results of operations and liquidity of our operations. Among other things, thenegative publicity generated as a result of an event could adversely affect ourability to retain an existing contract or obtain future ones. In addition, ifsuch an event were to occur, there is a possibility that the facility where theevent occurred may be shut down by the relevant governmental agency.  A closure of certain of our facilities couldadversely affect the financial condition, results of operations and liquidity ofour operations.  Such negative events mayalso result in a significant increase in our liability insurance costs.

 

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***Negative media coverage, includinginaccurate or misleading information, could adversely affect our reputation andour ability to bid for government contracts.***

 

The media frequently focuses its attention onprivate operators’ contracts with governmental agencies.  If the media coverage of private operators isnegative, it could influence government officials to slow the pace ofoutsourcing government services, which could reduce the number of RFPs.  The media may also focus its attention on theactivities of political consultants engaged by us, even when their activitiesare unrelated to our business, and we may be tainted by adverse media coverageabout their activities.  Moreover,inaccurate, misleading or negative media coverage about us could harm ourreputation and, accordingly, our ability to bid for and win governmentcontracts.

 

***We often incur significant costsbefore receiving related revenues, which could result in cash shortfalls and arisk of not recovering our investment.***

 

When we are awarded a contract to manage a newfacility, we may incur significant expenses before we receive contractpayments. These expenses include purchasing real estate, constructing newfacilities, leasing office space, purchasing office equipment and hiring andtraining personnel. As a result, when the government does not fund a facility’spre-opening and start-up costs, we may be required to invest significant sumsof money before receiving related contract payments.  In addition, payments due to us fromgovernmental agencies may be delayed due to billing cycles or as a result offailures by our governmental customers to attain necessary budget approvals andfinalize contracts in a timely manner. Several juvenile services contracts related to educational servicesprovide for annual collection several months after a school year iscompleted.  In addition, a contract maybe terminated prior to its scheduled expiration and as a result we may notrecover these expenses or realize any return on our investment.

 

We may choose to undertake development projectswithout written commitments to make use of such facilities.  We may not be able to obtain contracts forthese facilities in a timely fashion, if at all.  To the extent we do not obtain contracts, wecould be unable to recover our investment and our financial condition andresults of operations would be adversely affected.

 

***We may be unable to attract andretain sufficient qualified personnel necessary to sustain our business.***

 

Our delivery of services is labor-intensive.  When we are awarded a contract, we must hireoperating management, security, case management and other personnel.  The success of our business requires that weattract, develop, motivate and retain these personnel.  Our ability to recruit and retain qualifiedindividuals varies by facility and is related to the socio-economic factors inthe particular community in which the facility operates. Often the Departmentof Labor wages we offer our employees are higher than wages they may obtainelsewhere in the community.  However, ifthe local economy where a facility is located is robust and unemployment islow, we may have difficulty hiring and retaining qualified personnel.  This was one of the factors that contributedto our closure of the New Morgan Academy. In addition, there are inherent risks associated with the nature of theservices we provide and this could cause certain qualified individuals to seekother employment opportunities.  We haveexperienced high turnover of personnel in our juvenile facilities within thefirst year of their employment.  Ourinability to hire sufficient personnel on a timely basis or the loss ofsignificant numbers of personnel could adversely affect our business.

 

***If we do not successfully integratethe businesses that we acquire, our results of operations could be adverselyaffected.***

 

We may be unable to manage businesses that we mayacquire profitably or integrate them successfully without incurring substantialexpenses, delays or other problems that could negatively impact our results ofoperations.  Acquisitions generallyrequire the integration of facilities, some of which may be located in statesin which we do not currently have operations. We announced the signing of a definitive agreement on January 24,2005 to acquire

 

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Correctional Systems, Inc. for approximately $10.0 million.  We anticipate that the transaction will becompleted in the second quarter of 2005. This acquisition would require us to integrate a company that has operationsin multiple states.

 

Moreover, business combinations involve additionalrisks, including:

 

•                  diversionof management’s attention;

•                  lossof key personnel;

•                  assumptionof unanticipated legal or financial liabilities;

•                  ourbecoming significantly leveraged as a result of the incurrence of debt tofinance an acquisition;

•                  unanticipatedoperating, accounting or management difficulties in connection with theacquired entities;

•                  amortizationor charges of acquired intangible assets, including goodwill; and

•                  dilutionto our earnings per share.

 

Also, client dissatisfaction or performance problemswith an acquired business could materially and adversely affect our reputationas a whole.  Further, the acquiredbusinesses may not achieve the revenues and earnings we anticipated.

 

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

 

Our facilities, and any facilities that we mayacquire in the future, may be subject to unforeseen environmental risks. Thefederal Comprehensive Environmental Response, Compensation, and Liability Act,as amended, or CERCLA, imposes strict, as well as joint and several, liabilityfor certain environmental cleanup costs on several classes of potentiallyresponsible parties, including current owners and operators of theproperty.  Other federal and state lawsin certain circumstances may impose liability for environmental remediation,which costs may be substantial.  Further,the operation of our facilities, and the development of new facilities, requiresthat we obtain, and comply with, permits and other authorizations underenvironmental laws.  Obtaining suchpermits and authorizations can prove to be difficult and time consuming.

 

***We are the subject of class actionlawsuits that, if decided against us, could have a negative effect on ourfinancial condition, results of operations, cash flows and future prospects.***

 

In March and April 2002, we, our former President and ChiefExecutive Officer and our former Chief Financial Officer were named asdefendants in four federal putative class action lawsuits. These lawsuits werebrought on behalf of all purchasers of our common stock between March 6,2001 and March 5, 2002 and relate to our restatement in 2002 of certainfinancial statements.  The lawsuitsinvolved disclosures made concerning two prior transactions executed by us: the2001 Sale and Leaseback Transaction and the 2000 synthetic leasetransaction.  These four lawsuits wereconsolidated into one action and an amended consolidated complaint was filed.  The amended consolidated complaint seeks,among other things, restitution damages, compensatory damages, rescission or arescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.

 

In May and June 2002, we and our directors were sued in certainother derivative lawsuits.  Theselawsuits relate to our restatement in 2002 of certain financialstatements.  These lawsuits all allegebreaches of fiduciary duty and waste of corporate assets by all of thedefendants.

 

The plaintiffs in these cases have notquantified their claim of damages and the outcome of the matters discussedabove cannot be predicted with certainty. If an adverse decision in these matters exceeds our insurance coverageor

 

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if our insurance coverage is deemed not to apply to these matters, anadverse decision  could have a materialadverse effect onus, our financial condition, our results of operations and ourfuture prospects.

 

***We have in the pastincurred, and may continue to incur, significant expenses for facilities thatwe no longer operate.***

 

If we close a facility, we may remain committed toperform our obligations under the applicable lease, which would include, amongother things, payment of the base rent for the balance of the lease term.  We may also be required to incur otherexpenses with respect to such facilities. The potential losses associated with our inability to cancel leases mayresult in our keeping open underperforming facilities.  As a result, ongoing lease operations atclosed or under performing facilities could impair our results of operations.

 

***We depend on a limitednumber of governmental customers for significant portion of our revenues.***

 

We currently derive, and expect to continueto derive, a significant portion of our revenues from the Bureau of Prisons andvarious state agencies.  The loss of, ora significant decrease in, business from the Bureau of Prisons or those stateagencies could seriously harm our financial condition and results of operations.The Bureau of Prisons accounted for approximately 23.8% of our total revenuesfor the fiscal year ended December 31, 2004 ($69.2 million) and 21.7% forthe fiscal year ended December 31, 2003 ($59.0 million).  We expect to continue to depend upon theBureau of Prisons and a relatively small group of other governmental customersfor a significant percentage of our revenues.

 

***We may continue to operateunder unprofitable contracts at facilities that we own to offset expensesassociated with ownership of the facility.***

 

If we close a facility that we own, we willremain obligated for expenses associated with the facility.  If our operations are unprofitable at aleased facility or if the leased facility is performing significantly belowtargeted levels, we would typically terminate the contract and the lease.However, we may continue to operate our contract at an owned facility to offsetthe expenses associated with ownership. Continued performance of such a contract could have a material adverseeffect on our business and results of operations.

*** ***

***Because our revenues canfluctuate from period to period, we may face short-term funding shortfalls fromtime to time.***

 

Revenues can fluctuate from year to year dueto changes in government funding policies, changes in the number of clientsreferred to our 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.  Our revenues fluctuate from quarter toquarter, based on the number of contracted days in each quarter. Because ourrevenues can vary, we may face short-term funding shortfalls from time totime.  In addition, full-year results arenot likely to be a direct multiple of any particular quarter or combination ofquarters.

 

***We are subject tosignificant insurance costs.***

 

Worker’s compensation, employee health and generalliability insurance represent significant costs to us.  We continue to incur increasing insurancecosts due to adverse claims experience and rising healthcare costs ingeneral.  Due to concerns over corporategovernance and recent corporate accounting scandals, liability and other typesof insurance have become more difficult and costly to obtain.  In addition, as a result of the stockholderlawsuits brought within the last few years, our directors and officersliability insurance has increased. Unanticipated additional insurance costs could adversely impact ourresults of operations and cash flows, and the failure to obtain or maintain anynecessary insurance coverage or the inability of an insurance carrier toperform under its obligations through issued coverage could have a materialadverse effect on us.

 

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***We may be adversely affectedby inflation.***

 

Many of our facility management contracts providefor fixed management fees or fees that increase by only small amounts duringtheir term.  If, due to inflation orother causes, our operating expenses, such as wages and salaries of ouremployees, and insurance, medical and food costs, increase at rates faster thanincreases, if any, in our management fees, then our profitability would beadversely affected.

 

***We are subject to risksassociated with ownership of real estate.***

 

Our ownership of correctional and detentionfacilities subjects us to risks typically associated with investments in realestate, and in particular, correctional and detention facilities, arerelatively illiquid and, therefore, our ability to divest ourselves of one ormore of our facilities promptly in response to changed conditions islimited.  Investments in correctional anddetention facilities subject us to risks involving potential exposure toenvironmental liability and uninsured loss. Our operating costs may be affected by the obligation to pay for thecost of complying with existing environmental laws, ordinances and regulations,as well as, the cost of complying with future legislation.  In addition, although we maintain insurancefor many types of losses, there are certain types of losses, such as lossesfrom earthquakes, riots and acts of terrorism, which may be either uninsurableor for which it may not be economically feasible to obtain insurancecoverage.  As a result, we could loseboth our capital invested in, and anticipated profits from, one or more of thefacilities we own.  Further, it ispossible to experience losses that may exceed the limits of insurance coverage.

 

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**ITEM 7A.**                                            **QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

**Quantitative and Qualitative Disclosures about MarketRisk**

 

In the normal course of business, we are exposed tomarket risk, primarily from changes in interest rates.  We continually monitor exposure to marketrisk and develop appropriate strategies to manage this risk.  We are not exposed to any other significantmarket risks, including commodity price risk, foreign currency exchange risk orinterest rate risks from the use of derivative financial instruments.  In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap of $84.0 million related tothe interest obligations under the Senior Notes in effect converting them to afloating rate based on six-month LIBOR.

 

**Interest Rate Exposure**

 

Our exposure tochanges in interest rates primarily results from our long-term debt with bothfixed and floating interest rates.  Thedebt on our consolidated financial statements with fixed interest rates consistof the 8.47% Bonds issued by MCF in August 2001 in connection with the2001 Sale and Leaseback Transaction and approximately $28.0 million of theSenior Notes (not hedged by the interest rate swap).  At December 31, 2004, 29.3% of ourconsolidated long-term debt ($84.0 million of debt outstanding on the SeniorNotes issued in June 2004) was subject to variable interest rates.  The detrimental effect of a hypothetical 100basis point increase in interest rates would be to reduce income beforeprovision for income taxes by approximately $0.8 million for the year ended December 31,2004.  At December 31, 2004, thefair value of our consolidated fixed rate debt approximated carrying valuebased upon discounted future cash flows using current market prices.

 

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| **ITEM 8.** | ** ** | **FINANCIAL STATEMENTS AND  SUPPLEMENTAL DATA** |
|-------------|------------|-------------------------------------------------|
|        |       |                                            |
| 1.          |       | Financial statements                            |
|        |       |                                            | Management’s  Report on Internal Control over Financial Reporting |
|        |       |                                            | Report  of Independent Registered Public Accounting Firm |
|        |       |                                            | Consolidated Balance  Sheets - December 31, 2004 and 2003 |
|        |       |                                            | Consolidated  Statements of Operations and Comprehensive Income/(Loss) for the years ended December 31,  2004, 2003 and 2002 |
|        |       |                                            | Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |
|        |       |                                            | Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002 |
|        |       |                                            | 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. |

 

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**Management’s Report on Internal Control over Financial Reporting**

 

The management of Cornell Companies isresponsible for establishing and maintaining adequate internal control overfinancial reporting.  Cornell’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.  Cornell’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the Company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the Company are being made only in accordance with authorizationsof management and directors of the Company; and, (iii) provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use, or disposition of the Company’s assets that could have a material effecton the financial statements.

 

Due to its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

We have assessed the effectiveness of ourinternal control over financial reporting as of December 31, 2004.  To make this assessment we used the criteriafor effective internal control over financial reporting described in InternalControl – Integrated Framework, issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).  Our assessment included an evaluation of thedesign of our internal control.  Based onour assessment, we have concluded that, as of December 31, 2004, theCompany’s internal control over financial reporting was effective.

 

Our management’s assessment of theeffectiveness of the Company’s internal control over financial reporting as of December 31,2004 has been audited by PricewaterhouseCoopers LLP, an independent registeredpublic accounting firm, as stated in their report which appears herein.

 

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors and Stockholders of

Cornell Companies, Inc.

 

We have completed an integrated audit ofCornell Companies, Inc.’s 2004 consolidated financial statements and of itsinternal control over financial reporting as of December 31*,*2004 and audits of its 2003 and 2002 consolidatedfinancial statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Our opinions, based on our audits,are presented below.

 

Consolidated financial statements

 

In our opinion, the accompanying consolidated balance sheets and the related consolidatedstatements of operations and comprehensive income (loss), stockholders’ equityand cash flows listed in the accompanyingindex present fairly, in all material respects, the financial positionof Cornell Companies, Inc. and its subsidiaries (collectively, the Company) at December 31,2004 and 2003, and the results of their operations and their cash flows for eachof the three years in the period ended December 31, 2004****in conformity with accounting principles generally acceptedin the United States of America.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements****based on ouraudits.  We conducted our audits of thesestatements in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit of financialstatements includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

As described in Note 2 to the consolidatedfinancial statements, the Company changed its method of accounting for goodwilland other intangible assets effective January 1, 2002.

 

Internal control over financial reporting

 

Also, in our opinion, management’sassessment, included in the accompanying Management’s Report on InternalControl over Financial Reporting, that the Company maintained effectiveinternal control over financial reporting as of December 31, 2004, basedon criteria established in *Internal Control-IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2004, based on criteria established in *InternalControl-Integrated Framework* issued by COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

 

65

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A company’s internal control over financialreporting is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples.  A company’s internal controlover financial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assetsof the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements in accordancewith generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and(iii) provide reasonable assurance regarding prevention or timelydetection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

 

PricewaterhouseCoopers LLP

Houston, Texas

March 16, 2005

 

66

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(inthousands, except share data)**

 
| ** **                                                                                                                           | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ASSETS                                                                                                                               |       |                  |       |   |   |
| CURRENT  ASSETS:                                                                                                                     |       |                  |       |   |   |
| Cash and  cash equivalents                                                                                                           |       | $                     | 9,895      |   | $ | 40,171 |   |
| Investment  securities, available for sale                                                                                           |       | 51,740                |       | — |   |
| Accounts  receivable - trade (net of allowance for doubtful accounts of $3,198 and  $1,929, respectively)                            |       | 60,174                |       | 52,772 |   |
| Other  receivables (net of allowance for doubtful accounts of $5,039 and $5,386,  respectively)                                      |       | 4,691                 |       | 4,715 |   |
| Restricted  assets                                                                                                                   |       | 19,713                |       | 22,185 |   |
| Deferred tax  assets                                                                                                                 |       | 8,520                 |       | 3,411 |   |
| Prepaids and  other                                                                                                                  |       | 9,106                 |       | 8,789 |   |
| Total  current assets                                                                                                                |       | 163,839               |       | 132,043 |   |
| PROPERTY AND  EQUIPMENT, net                                                                                                         |       | 282,255               |       | 267,903 |   |
| OTHER  ASSETS:                                                                                                                       |       |                  |       |   |   |
| Debt service  reserve fund                                                                                                           |       | 23,801                |       | 23,800 |   |
| Goodwill,  net                                                                                                                       |       | 7,721                 |       | 7,721 |   |
| Intangible  assets, net                                                                                                              |       | 7,026                 |       | 5,566 |   |
| Deferred  costs and other                                                                                                            |       | 22,989                |       | 12,070 |   |
| Total assets                                                                                                                         |       | $                     | 507,631    |   | $ | 449,103 |   |
|                                                                                                                                 |       |                  |       |   |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                           |       |                  |       |   |   |
|                                                                                                                                 |       |                  |       |   |   |
| CURRENT  LIABILITIES:                                                                                                                |       |                  |       |   |   |
| Accounts  payable and accrued liabilities                                                                                            |       | $                     | 47,237     |   | $ | 37,523 |   |
| Current  portion of long-term debt                                                                                                   |       | 9,005                 |       | 8,306 |   |
| Total  current liabilities                                                                                                           |       | 56,242                |       | 45,829 |   |
| LONG-TERM  DEBT, net of current portion                                                                                              |       | 279,528               |       | 227,292 |   |
| DEFERRED TAX  LIABILITIES                                                                                                            |       | 8,088                 |       | 7,006 |   |
| OTHER  LONG-TERM LIABILITIES                                                                                                         |       | 2,461                 |       | 2,741 |   |
| Total  liabilities                                                                                                                   |       | 346,319               |       | 282,868 |   |
|                                                                                                                                 |       |                  |       |   |   |
| 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, 14,845,107 and  14,578,505 shares issued and outstanding, respectively |       | 15                    |       | 15 |   |
| Additional  paid-in capital                                                                                                          |       | 145,825               |       | 143,735 |   |
| Retained  earnings                                                                                                                   |       | 26,785                |       | 34,218 |   |
| Treasury  stock (1,547,583 and 1,537,583 shares of common stock, respectively, at cost)                                              |       | (12,573               | )          | (12,458 | ) |
| Deferred  compensation                                                                                                               |       | (432                  | )          | (803 | ) |
| Accumulated  other comprehensive income                                                                                              |       | 1,692                 |       | 1,528 |   |
| Total  stockholders’ equity                                                                                                     |       | 161,312               |       | 166,235 |   |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                     | 507,631    |   | $ | 449,103 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

67

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS****AND COMPREHENSIVE INCOME (LOSS)**

**(inthousands, except per share data)**

 
| ** **                                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                           | ** ** | **2004**                         | ** ** | **2003** |   | **2002** |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| REVENUES                                                                                                             |       | $                                | 291,025    |   | $ | 271,632 |   | $ | 275,145 |   |
| OPERATING EXPENSES                                                                                                   |       | 224,116                          |       | 209,686 |   | 212,309 |   |
| PRE-OPENING AND START-UP  EXPENSES                                                                                   |       | 12,938                           |       | 3,398 |   | 3⁄4 |   |
| IMPAIRMENT OF LONG-LIVED  ASSETS                                                                                     |       | 10,100                           |       | 3⁄4 |   | 3⁄4 |   |
| (GAIN) LOSS ON SALE OF  FIXED ASSETS                                                                                 |       | (397                             | )          | 50 |   | 3⁄4 |   |
| DEPRECIATION AND  AMORTIZATION                                                                                       |       | 13,547                           |       | 10,699 |   | 9,779 |   |
| GENERAL AND ADMINISTRATIVE  EXPENSES                                                                                 |       | 20,284                           |       | 23,415 |   | 21,480 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| Income from operations                                                                                               |       | 10,437                           |       | 24,384 |   | 31,577 |   |
| INTEREST EXPENSE                                                                                                     |       | 22,298                           |       | 19,280 |   | 20,698 |   |
| INTEREST INCOME                                                                                                      |       | (1,944                           | )          | (1,626 | ) | (1,974 | ) |
| LOSS ON EXTINGUISHMENT OF  DEBT                                                                                      |       | 2,361                            |       | — |   | 3⁄4 |   |
| MINORITY INTEREST IN  CONSOLIDATED  SPECIAL PURPOSE ENTITIES                                                    |       | —                           |       | 3⁄4  |   | 574 |   |
| Income (loss) before  provision for income taxes and  cumulative  effect of change in accounting principle      |       | (12,278                          | )          | 6,730 |   | 12,279 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| PROVISION (BENEFIT) FOR  INCOME TAXES                                                                                |       | (4,845                           | )          | 2,760 |   | 4,952 |   |
| Income (loss) before  cumulative effect of change in accounting principle                                            |       | (7,433                           | )          | 3,970 |   | 7,327 |   |
| CUMULATIVE EFFECT OF  CHANGE IN ACCOUNTING  PRINCIPLE, NET OF  RELATED INCOME TAX BENEFIT OF APPROXIMATELY $671 |       | —                           |       | 3⁄4 |   | (965 | ) |
|                                                                                                                 |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                                    |       | $                                | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                           |       |                             |       |   |   |   |   |
| BASIC                                                                                                                |       |                             |       |   |   |   |   |
| Income (loss) before  cumulative effect of change in accounting principle                                            |       | $                                | (.56       | ) | $ | .31 |   | $ | .57 |   |
| Cumulative effect of  change in accounting principle                                                                 |       | —                           |       | 3⁄4 |   | (.08 | ) |
| Net income (loss)                                                                                                    |       | $                                | (.56       | ) | $ | .31 |   | $ | .49 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| DILUTED                                                                                                              |       |                             |       |   |   |   |   |
| Income (loss) before  cumulative effect of change in accounting principle                                            |       | $                                | (.56       | ) | $ | .30 |   | $ | .55 |   |
| Cumulative effect of  change in accounting principle                                                                 |       | —                           |       | 3⁄4 |   | (.07 | ) |
| Net income (loss)                                                                                                    |       | $                                | (.56       | ) | $ | .30 |   | $ | .48 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| NUMBER OF  SHARES USED IN PER SHARE COMPUTATION:                                                                     |       |                             |       |   |   |   |   |
| BASIC                                                                                                                |       | 13,203                           |       | 12,941 |   | 12,911 |   |
| DILUTED                                                                                                              |       | 13,203                           |       | 13,342 |   | 13,129 |   |
|                                                                                                                 |       |                             |       |   |   |   |   |
| COMPREHENSIVE  INCOME (LOSS):                                                                                        |       |                             |       |   |   |   |   |
| Net income (loss)                                                                                                    |       | $                                | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   |
| Unrealized gain (loss) on  derivative instruments, net of tax                                                        |       | 164                              |       | (368 | ) | 1,896 |   |
| Comprehensive income  (loss)                                                                                         |       | $                                | (7,269     | ) | $ | 3,602 |   | $ | 8,258 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

68

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS****’ EQUITY**

**(inthousands, except share data)**

 
| ** **                                                                  | ** ** | ** **     | ** ** | ** ** | ** ** | **Additional  Paid-In  Capita** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Deferred  Compensation** | ** ** | **Notes  from  Share-  holders** | ** ** | **Accumulated  Other  Compre-  hensive  Income/(Loss)** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------|------------|------------|------------|---------------------------------|------------|------------------------|------------|---------------------|------------|----------------------------|------------|----------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                  | ** ** | ** **     |
| **Common Stock**                                                            |
| **Shares**                                                                  | ** ** | **Par  Value** |
|                                                                        |       |           |       |       |       |                            |       |                   |       |                |       |                       |       |                             |       |                                                    |       |
| BALANCES AT JANUARY 1, 2002                                            |       | 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                       | )          | 3⁄4                           |       | 1,528                                                   |       |
|                                                                        |       |           |       |       |       |                            |       |                   |       |                |       |                       |       |                             |       |                                                    |       |
| EXERCISE OF STOCK OPTIONS                                                   |       | 213,694        |       | 3⁄4     |       | 1,521                           |       | —                 |       | —              |       | —                     |       | —                           |       | —                                                  |       |
| INCOME TAX BENEFITS FROM STOCK OPTIONS EXERCISED                            |       | —         |       | —     |       | 312                             |       | —                 |       | —              |       | —                     |       | —                           |       | —                                                  |       |
| MARK TO MARKET ADJUSTMENTS FOR DEFERRED BONUS PLAN                          |       | —         |       | —     |       | (306                            | )          | —                 |       | —              |       | 306                        |       | —                           |       | —                                                  |       |
| OTHER COMPREHENSIVE INCOME                                                  |       | —         |       | —     |       | —                          |       | —                 |       | —              |       | —                     |       | —                           |       | 164                                                     |       |
| DEFERRED AND OTHER STOCK COMPENSATION                                       |       | —         |       | —     |       | —                          |       | —                 |       | —              |       | 65                         |       | —                           |       | —                                                  |       |
| PURCHASE OF TREASURY STOCK (10,000 SHARES, AT COST)                         |       | —         |       | —     |       | —                          |       | —                 |       | (115                | )          | —                     |       | —                           |       | —                                                  |       |
| ISSUANCE OF COMMON STOCK TO EMPLOYEE STOCK PURCHASE  PLAN                   |       | 40,213         |       | —     |       | 323                             |       | —                 |       | —              |       | —                     |       | —                           |       | —                                                  |       |
| ISSUANCE OF COMMON STOCK UNDER 2000 DIRECTOR’S STOCK  PLAN             |       | 12,695         |       | —     |       | 240                             |       | —                 |       | —              |       | —                     |       | —                           |       | —                                                  |       |
| NET LOSS                                                                    |       | —         |       | —     |       | —                          |       | (7,433                 | )          | —              |       | —                     |       | —                           |       | —                                                  |       |
|                                                                        |       |           |       |       |       |                            |       |                   |       |                |       |                       |       |                             |       |                                                    |       |
| BALANCES AT DECEMBER 31, 2004                                          |       | 14,845,107     |       | $          | 15         |                            | $          | 145,825                |       | $                   | 26,785     |                       | $          | (12,573                          | )          | $                                                       | (432       | ) | $ | — |   | $ | 1,692 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

69

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**CORNELLCOMPANIES, INC.**

#### **CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

 
| ** **                                                                                             | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                             | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                                 |       |                             |       |   |   |   |   |
| Net income  (loss)                                                                                     |       | $                                | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities  –– |       |                             |       |   |   |   |   |
| Impairment of  long-lived assets                                                                       |       | 10,100                           |       | 3⁄4 |   | 3⁄4 |   |
| Loss on  extinguishment of debt                                                                        |       | 2,361                            |       | –– |   | 3⁄4 |   |
| Cumulative  effect of change in accounting principle                                                   |       | 3⁄4                           |       | 3⁄4 |   | 965 |   |
| Minority  interest in consolidated special purpose entities                                            |       | 3⁄4                           |       | 3⁄4 |   | 574 |   |
| Depreciation                                                                                           |       | 12,183                           |       | 9,804 |   | 8,901 |   |
| Amortization  of intangibles and other assets                                                          |       | 1,364                            |       | 895 |   | 878 |   |
| Amortization  of deferred compensation                                                                 |       | 65                               |       | 502 |   | 233 |   |
| Amortization  of deferred financing costs                                                              |       | 1,437                            |       | 1,157 |   | 1,113 |   |
| Amortization  of Senior Note Discount                                                                  |       | 92                               |       | 3⁄4 |   | 3⁄4 |   |
| Provision  for bad debts                                                                               |       | 2,371                            |       | 7,550 |   | 1,246 |   |
| (Gain) loss  on sale of fixed assets                                                                   |       | (397                             | )          | 50 |   | 3⁄4 |   |
| Deferred  income taxes                                                                                 |       | (4,154                           | )          | 1,941 |   | (1,959 | ) |
| Change in  assets and liabilities:                                                                     |       |                             |       |   |   |   |   |
| Accounts  receivable                                                                                   |       | (12,206                          | )          | (583 | ) | 2,010 |   |
| Restricted  assets                                                                                     |       | (66                              | )          | 24 |   | 1,467 |   |
| Other assets                                                                                           |       | (260                             | )          | (2,283 | ) | 247 |   |
| Accounts  payable and accrued liabilities                                                              |       | 6,625                            |       | 4,675 |   | (74 | ) |
| Deferred  revenues and other liabilities                                                               |       | 11                               |       | (1,491 | ) | (2,199 | ) |
| Net cash  provided by operating activities                                                             |       | 12,093                           |       | 26,211 |   | 19,764 |   |
|                                                                                                   |       |                             |       |   |   |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                                 |       |                             |       |   |   |   |   |
| Capital  expenditures                                                                                  |       | (40,243                          | )          | (22,304 | ) | (11,114 | ) |
| Payments to  restricted escrow arrangement, net                                                        |       | 3⁄4                           |       | (10,385 | ) | 3⁄4 |   |
| Purchases of  investment securities                                                                    |       | (471,410                         | )          | 3⁄4 |   | 3⁄4 |   |
| Sales of  investment securities                                                                        |       | 419,670                          |       | 3⁄4 |   | 3⁄4 |   |
|                                                                                                   |       |                             |       |   |   |   |   |
| Receipt from  restricted escrow arrangement                                                            |       | 5,000                            |       | 3⁄4 |   | –– |   |
| BOP claim  reimbursement                                                                               |       | 5,566                            |       | 3⁄4 |   | –– |   |
| Purchase of  facility management contract                                                              |       | (3,000                           | )          | 3⁄4 |   | –– |   |
| Proceeds  from sale of fixed assets                                                                    |       | 1,137                            |       | –– |   | 3⁄4 |   |
| Return of  restricted assets from deferred bonus plan                                                  |       | 3⁄4                           |       | 3⁄4 |   | 1,000 |   |
| Payments of  non-compete agreements                                                                    |       | 3⁄4                           |       | (1,000 | ) | –– |   |
| Payments to  restricted debt payment account, net                                                      |       | (2,463                           | )          | (2,275 | ) | (2,184 | ) |
| Net cash  used in investing activities                                                                 |       | (85,743                          | )          | (35,964 | ) | (12,298 | ) |
|                                                                                                   |       |                             |       |   |   |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                                 |       |                             |       |   |   |   |   |
| Proceeds  from long-term debt and line of credit                                                       |       | 69,000                           |       | 24,339 |   | 1,083 |   |
| Payments on  line of credit                                                                            |       | (71,000                          | )          | (21,000 | ) | 3⁄4 |   |
| Payments on  MCF bonds                                                                                 |       | (8,300                           | )          | (7,600 | ) | (6,800 | ) |
| Payments on  synthetic lease                                                                           |       | (52,499                          | )          | 3⁄4 |   | 3⁄4 |   |
| Payments of  capital lease obligations                                                                 |       | (7                               | )          | (31 | ) | (113 | ) |
| Proceeds  from Senior Notes, net of discount                                                           |       | 110,527                          |       | –– |   | 3⁄4 |   |
| Payments of  debt issuance and other financing costs                                                   |       | (6,076                           | )          | (31 | ) | 3⁄4 |   |
| Collections  of payments of shareholder notes                                                          |       | 3⁄4                           |       | 440 |   | 173 |   |
| Distributions  to equity owners of consolidated special purpose entities                               |       | 3⁄4                           |       | 3⁄4 |   | (614 | ) |
| Proceeds  from exercise of stock options and warrants                                                  |       | 1,844                            |       | 2,427 |   | 600 |   |
| Purchases of  treasury stock                                                                           |       | (115                             | )          | (1,230 | ) | (2,429 | ) |
| Net cash  provided by (used in) financing activities                                                   |       | 43,374                           |       | (2,686 | ) | (8,100 | ) |
|                                                                                                   |       |                             |       |   |   |   |   |
| NET  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                           |       | (30,276                          | )          | (12,439 | ) | (634 | ) |
| CASH AND  CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                      |       | 40,171                           |       | 52,610 |   | 53,244 |   |
| CASH AND  CASH EQUIVALENTS AT END OF PERIOD                                                            |       | $                                | 9,895      |   | $ | 40,171 |   | $ | 52,610 |   |

 

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| ** **                                                                                               | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| SUPPLEMENTAL  CASH FLOW DISCLOSURE:                                                                      |       |                             |       |   |   |   |   |
| Interest  paid, net of amounts capitalized                                                               |       | $                                | 16,054     |   | $ | 18,690 |   | $ | 19,544 |   |
| Income taxes  paid                                                                                       |       | $                                | 400        |   | $ | 3,387 |   | $ | 3,369 |   |
|                                                                                                     |       |                             |       |   |   |   |   |
| OTHER  NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                      |       |                             |       |   |   |   |   |
| Other  comprehensive income (loss)                                                                       |       | $                                | 164        |   | $ | (368 | ) | $ | 1,896 |   |
| Purchases of  treasury stock by deferred bonus plan                                                      |       | 3⁄4                           |       | 190 |   | 519 |   |
| Purchases  and additions to property and equipment included in accounts payable and  accrued liabilities |       | 2,904                            |       | — |   | — |   |
| Common stock  issued for board of director fees                                                          |       | 240                              |       | 145 |   | 252 |   |
| Borrowings  on capital lease                                                                             |       | 3⁄4                           |       | 3 |   | 65 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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**CORNELLCOMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Cornell Companies, Inc. (collectively with itssubsidiaries and consolidated special purpose entities, the “Company”), aDelaware corporation, provides the integrated development, design, constructionand management of facilities to governmental agencies within three operatingsegments: (1) adult secure institutional services, (2) juvenilejustice, educational and treatment services and (3) adult community-basedcorrections and treatment services.

 

**2.****             ****SIGNIFICANT ACCOUNTINGPOLICIES**

 

***Consolidation***

 

The accompanying consolidated financial statementsinclude the accounts of the Company, our wholly-owned subsidiaries, and ouractivities relative to two financings of operating facilities. All significantintercompany balances and transactions have been eliminated.  Minority interest in consolidated specialpurpose entities represents equity that other investors have contributed to thespecial purpose entities.  Minorityinterest is adjusted for income and losses allocable to the owners of thespecial purpose entities.  As thecumulative losses of the special purpose entity exceed the equity that isrecorded as minority interest, the excess losses are recorded in our Statementsof Operations and Comprehensive Income (Loss).

 

***Cash and CashEquivalents***

 

We consider all highly liquid unrestrictedinvestments with original maturities of three months or less to be cashequivalents.  We invest our availablecash balances in short term money market accounts, short term certificates ofdeposit and commercial paper.

 

***InvestmentSecurities***

 

The Company’s marketable securities arecategorized as available-for-sale securities, as defined by the Statement ofFinancial Accounting Standards No. 115, “Accounting for Certain Investments inDebt and Equity Securities.” Unrealized marketable securities gains and lossesare reflected as a net amount under the caption of accumulated othercomprehensive income within the statement of stockholders’ equity. Realizedgains and losses are recorded within the statement of income under the captioninterest income or interest expense. For the purpose of computing realizedgains and losses, cost is identified on a specific identification basis.

 

At December 31, 2004, all investment securitieswere held in auction rate municipal bonds. Our investment in these securities is recorded at cost, whichapproximates fair market value due to their variable interest rates, whichtypically reset every 7 to 35 days, and, despite the long-term nature of theirstated contractual maturities, we have the ability to quickly liquidate thesesecurities.  As a result, we had no grossunrealized holding gains (losses) or gross realized gains (losses) from our investmentsecurities for the year ended December 31, 2004.

 

***AccountsReceivable and Related Allowance for Doubtful Accounts***

 

We extend credit to the governmental agencies andother parties we contract within the normal course of business.  We regularly review our outstandingreceivables and historical collection experience, and provide for estimatedlosses through an allowance for doubtful accounts.  In evaluating the adequacy of our allowancesfor doubtful accounts, we make judgments regarding our customers’ ability tomake required payments, economic events and other factors.  As the financial condition of these partieschange, circumstances develop or additional information becomes available,adjustments to the allowance for doubtful accounts may occur.  If after reasonable collection efforts havebeen made, a receivable is determined to be permanently uncollectible, it willbe written off.

 

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At December 31, 2004, other receivables includeapproximately $5.4 million related to the misappropriated escrow funds for theSouthern Peaks Regional Treatment Center. We have provided a reserve ofapproximately $5.1 million on this balance through an allowance for doubtfulaccounts due to the uncertainty surrounding its recovery. Refer to Note 10 tothe consolidated financial statements for a discussion concerning the SouthernPeaks Regional Treatment Center escrow account funding and relatedtransactions.

 

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Thechanges in allowance for doubtful accounts associated with trade accountsreceivable for the years ended December 31, 2004, 2003 and 2002 are asfollows (in thousands):

 

| ** **                            | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|
| ** **                            | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                  |       |                             |       |   |   |   |   |
| Balance at  beginning of period       |       | $                                | 1,929      |   | $ | 2,238 |   | $ | 3,068 |   |
| Provision  for bad debts              |       | 2,371                            |       | 2,165 |   | 1,246 |   |
| Write-offs  of uncollectible accounts |       | (1,102                           | )          | (2,474 | ) | (2,076 | ) |
| Balance at  end of period             |       | $                                | 3,198      |   | $ | 1,929 |   | $ | 2,238 |   |

 

InSeptember 2004, we resolved our claim with the Bureau of Prisons (BOP) forthe reimbursement of a portion of the expenses incurred in connection with theissuance of the Stop-Work Order and the delay of the Moshannon ValleyCorrectional Center project (included among these expenses was approximately$1.4 million in accounts receivable for expenses incurred by us after the September 1999issuance of the Stop–Work Order).  Wesettled the claim, as well as the claim for the reimbursement of costs relatedto the original construction efforts incurred beginning in 1999 with the BOP,and were reimbursed approximately $7.0 million in September 2004.  The excess reimbursement of approximately$5.6 million over the $1.4 million in accounts receivable was credited againstthe carrying cost of the facility.

 

***Restricted Assets***

 

Restricted assets at December 31, 2004 and 2003include approximately $17.1 million and $14.7 million, respectively, ofMunicipal Correctional Finance, LP’s (MCF) restricted cash accounts.  MCF’s restricted accounts are comprisedprimarily of a debt service fund used to segregate rental payment funds from usto MCF for MCF’s semi-annual debt service. MCF’s funds are invested in short term certificates of deposit, moneymarket accounts and commercial paper. The balances are current as the debt service in the coming year isgreater than the balance in these funds.

 

Restricted assets at December 31, 2003 include$5.0 million of funds in a restricted escrow account related to the SouthernPeaks Regional Treatment Center.  Thesefunds were released from escrow and returned to us in the second quarter of2004. See Note 10 to the consolidated financial statements for furtherdiscussion concerning this restricted escrow account.

 

At certain facilities, we maintain bank accounts forrestricted cash belonging to facility residents, commissary operations andequipment replacement funds used in certain state programs.  Restricted assets at December 31,2004 and 2003 include approximately $2.5 million and $2.3 million,respectively, for these accounts.  Acorresponding liability for these obligations is included in accruedliabilities in the accompanying financial statements.

 

Restricted assets at December 31, 2004 and 2003include approximately $0.1 million and $0.2 million, respectively, of assetsheld in a rabbi trust for a deferred bonus plan.  See Note 11 to the consolidated financialstatements.

 

***Property and Equipment***

 

Property and equipment are recorded at cost.  Ordinary maintenance and repair costs areexpensed, while renewal and betterment costs are capitalized.  Buildings and improvements are depreciatedover their estimated useful lives of 30 to 50 years using the straight-linemethod.  Prepaid facility use cost, whichresulted from the July 1996 acquisition of the Big Spring CorrectionalCenter and the December 1999 transfer of ownership of the Great PlainsCorrectional Facility to a leasehold interest, is being amortized over 50 yearsusing the straight-line method. Furniture and equipment are depreciated over their estimated usefullives of 3 to 10 years 

 

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using the straight-line method. Amortization of leasehold improvements (including those funded bylandlord incentives or allowances) is recorded using the straight-line methodbased upon the shorter of the economic life of the asset or the term of therespective lease.  Landlord incentives orallowances under operating leases are recorded as deferred rent and amortizedas a reduction of rent expense over the lease term.  See Note 6 to the Consolidated FinancialStatements for further details concerning our property and equipment balancesat December 31, 2004 and 2003.

 

***CapitalizedInterest***

 

We capitalize interest on facilities while underdevelopment and construction.  Interestcapitalized for the year ended December 31, 2004 was approximately $1.8million and related to the Moshannon Valley Correctional Center, the RegionalCorrectional Center, the Las Vegas Center and the Southern Peaks RegionalTreatment Center.  Interestcapitalized for each of the years ended December 31, 2003 and 2002 wasapproximately $0.8 million and related primarily to the design and developmentof the Moshannon Valley Correctional Center.

 

***Debt ServiceReserve Fund***

 

The debt service reserve fund was established at theclosing of MCF’s bond issuance and is to be used solely for MCF’s debt serviceto the extent that funds in MCF’s debt service accounts are insufficient.  The debt service reserve fund is invested inshort term commercial instruments and earns a guaranteed rate of return of3.0%.  See Note 12 to the Consolidated FinancialStatements.

 

***Intangible Assets***

 

EffectiveJanuary 1, 2002, we adopted the provisions of Statements of FinancialAccounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.”  In accordance with this statement, goodwillis no longer amortized but is subject to an impairment test annually.  Other intangible assets that meet thecriteria under SFAS No. 142 will continue to be amortized over their remaininguseful lives.  

 

Wedetermine the fair market value of the applicable reporting units’ net assetsin accordance with SFAS No. 142 and recorded a cumulative effect of change inaccounting principle charge of approximately $1.0 million, net of an income taxbenefit of $0.7, at January 1, 2002 for the impairment of goodwill as a resultof the adoption of SFAS No. 142.  We haveevaluated the carrying value of our existing goodwill according to theprovisions of SFAS No. 142 and we believe there has not been an impairment tothe carrying value of our existing goodwill as of December 31, 2004.  See Note 4 to the consolidated financialstatements for further details concerning our intangible assets.

 

***Deferred Costs***

 

Costs incurred related to obtaining debt financingare capitalized and amortized over the term of the related indebtedness.  At December 31, 2004 and 2003, we hadnet deferred debt issuance costs of approximately $11.0 million and $6.6million, respectively.  Deferred costsalso include costs related to projects actively under development which areconsidered to be probable of successful completion at the balance sheet date.

 

***Realization ofLong-Lived Assets***

 

We assess the realization of our long-lived assetspursuant to SFAS No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets.”  For assets held andused in operations, realization is assessed based on our estimate of futureoperating results and cash flows.  As of December 31,2004, we have evaluated our long-lived assets and believe that these assets,other than the three facilities for which we recognized impairment charges ofapproximately $10.1 million, are realizable and that no additional impairmentsto the carrying value of these assets exists. See Note 6 to the Consolidated Financial Statements for furtherdiscussion concerning these impairment charges.

 

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***RevenueRecognition***

 

We recognize revenue in accordance with SEC staffAccounting Bulletin No. 104, “Revenue Recognition in Financial Statements, asamended.”  Substantially all of ourrevenues are derived from contracts with federal, state and local governmentalagencies which pay either per diem rates based upon the number of occupant daysor 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 are providedunder our established contractual agreements to the extent collection isconsidered probable.

 

***Pre-opening andStart-up Expenses***

 

We incur pre-opening and start-up expensesincluding payroll, benefits, training and other operating costs prior to openinga new or expanded facility and during the period of operation while occupancyis ramping up. These costs vary by contract. Newly opened facilities are staffed according to applicable regulatoryor contractual requirements when we begin receiving offenders or clients.  Offenders or clients are typically assignedto a newly opened facility on a phased-in basis over a one-to-six month period.Our start-up period for new juvenile operations is 12 months from the date webegin recognizing revenue unless break-even occupancy is achieved beforethen.  Our start-up period for new adultoperations is nine months from the date we begin recognizing revenue unlessbreak-even occupancy is achieved before then.

 

***BusinessConcentration***

 

Contracts with federal, state and local governmentalagencies account for nearly all of our revenues.  The loss of, or a significant decrease in,business from one or more of these governmental agencies could have a materialadverse effect on our financial condition and results of operations.  For the years ended December 31, 2004,2003 and 2002, 23.8%, 21.7% and 20.9%, respectively, of our consolidatedrevenues were derived from contracts with the Federal Bureau of Prisons (BOP),the only customer constituting more than 10.0% of our revenues during each ofthese periods.

 

***Self InsuranceReserves***

 

Wemaintain insurance coverage for various aspects of our business andoperations.  We retain a portion oflosses that occur through the use of deductibles and retention underself-insurance programs.  We regularlyreview our estimates of reported and unreported claims and provide for theselosses through insurance reserves. These reserves are influenced by risingcosts of health care and other costs, increases in claims, time lags in claimsinformation and levels of insurance coverage carried. As claims develop andadditional information becomes available to us, adjustments to the related lossreserves may occur.  Our reserves formedical and worker’s compensation claims are subject to change based on ourestimate of the number and the magnitude of claims to be incurred. See Note 10to the consolidated financial statements.

 

Duringthe period of August 2000 through May 2003, our general liability andprofessional liability coverage was provided by Specialty Surplus InsuranceCompany, a Kemper Insurance Company  (“Kemper”)group member.  In June 2004, theIllinois Department of Insurance gave Kemper permission to proceed with arun-off plan it had previously submitted. The three-year plan is designed to help Kemper meet its goal ofresolving, to the maximum extent possible, all valid policyholder claims.

 

Inview of the risks and uncertainties involved in implementing the plan,including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  At December 31, 2004, we recorded acharge of $0.6 million, and have estimated our range of additional exposure tobe $0.5 million with respect to outstanding claims incurred during this policyperiod with Kemper which would become our obligation to resolve if notpreviously settled through Kemper.

 

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***Accounting forStock-Based Compensation***

 

In accordancewith the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,”we have elected to account for our stock-based compensation plans under theintrinsic value method established by Accounting Principles Board Opinion (APB)No. 25, “Accounting for Stock Issued to Employees.”  In accordance with the provisions of APB No.25, the fair value of fixed stock options granted to employees is not reflectedin net income, as all options granted under those plans had an exercise priceequal to or in excess of the market value of the underlying common stock on thedate of grant.  The following tableillustrates, in accordance with SFAS No. 148, “Accounting for Stock-BasedCompensation – Transition and Disclosure, an Amendment of SFAS No. 123,” theeffect on net income (loss) and earnings (loss) per share as if we had appliedthe fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,expect per share amounts):

 

| ** **                                                                                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                      | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income  (loss), as reported                                                                                                                 |       | $                                | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   |
| Add: total  stock-based compensation recorded, net of tax                                                                                       |       | 146                              |       | 94 |   | 151 |   |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects (1) |       | 1,022                            |       | 1,383 |   | 2,076 |   |
| Pro forma  net income (loss)                                                                                                                    |       | $                                | (8,309     | ) | $ | 2,681 |   | $ | 4,437 |   |
| Earnings  (loss) per share:                                                                                                                     |       |                             |       |   |   |   |   |
| Basic, as  reported                                                                                                                             |       | $                                | (.56       | ) | $ | .31 |   | $ | .49 |   |
| Basic, pro  forma                                                                                                                               |       | (.63                             | )          | .21 |   | .34 |   |
| Diluted, as  reported                                                                                                                           |       | (.56                             | )          | .30 |   | .48 |   |
| Diluted, pro  forma                                                                                                                             |       | (.63                             | )          | .20 |   | .34 |   |
|                                                                                                                                            |       |                             |       |   |   |   |   |
| Weighted-average  fair value per share of options granted (1)                                                                                   |       | $                                | 7.94       |   | $ | 6.02 |   | $ | 6.87 |   |

 

----

(1)          See Note 11 to the Consolidated Financial Statements for additionalinformation regarding the computations presented above.

 

On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued SFAS No. 123R, “Share Based Payment,”that requires companies to expense the value of employee stock options andother types of equity-based compensation at the fair value of the options atthe award’s grant date based on the estimated number of awards that areexpected to vest.  Compensation cost forawards that vest would not be reversed if the awards expire without beingexercised.  When measuring fair value,companies can choose an option-pricing model (e.g., Black-Sholes or binominalmodels) that approximately reflects their specific circumstances and theeconomics of their transactions. Companies will recognize compensation cost per share based paymentawards as they vest, including the related tax effects.  The effective date applies to interim andannual periods beginning after June 15, 2005, and applies to alloutstanding and unvested share based payment awards at the company’s adoptiondate.  We are currently evaluating thealternative transition methods permitted by SFAS No. 123R.

 

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***Income Taxes***

 

We utilize the liability method of accounting forincome taxes as required 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, we considercurrent tax regulations, estimates of future taxable income and available taxplanning strategies.  If tax regulations,operating results or the ability to implement tax planning strategies vary,adjustments to the carrying value of tax assets and liabilities may occur.  See Note 8 to the Consolidated FinancialStatements.

 

***Earnings PerShare***

 

Basic earnings per share (EPS) is computed bydividing net income by the weighted average number of shares of common stockoutstanding during the period.  DilutedEPS reflects the potential dilution from common stock equivalents such as stockoptions and warrants.  For the yearsended December 31, 2004, 2003 and 2002, there were 437,078 shares ($13.01 averageprice), 371,145 shares ($12.86 average price) and 317,016 shares ($14.48average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

 

The followingtable summarizes the calculation of net earnings (loss) and the weightedaverage common shares and common equivalent shares outstanding for purposes ofthe computation of earnings (loss) per share (in thousands, except per sharedata):

 
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                               | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                                                                     |       |                             |       |   |   |   |   |
| Net earnings (loss)                                                      |       | $                                | (7,433     | ) | $ | 3,970 |   | $ | 6,362 |   |
|                                                                     |       |                             |       |   |   |   |   |
| Weighted average common share outstanding                                |       | 13,203                           |       | 12,941 |   | 12,911 |   |
| Weighted average common share equivalents  outstanding                   |       | 3⁄4                           |       | 401 |   | 218 |   |
|                                                                     |       |                             |       |   |   |   |   |
| Weighted average common shares and common  share equivalents outstanding |       | 13,203                           |       | 13,342 |   | 13,129 |   |
|                                                                     |       |                             |       |   |   |   |   |
| Basic earnings (loss) per share                                          |       | $                                | (.56       | ) | $ | .31 |   | $ | .49 |   |
|                                                                     |       |                             |       |   |   |   |   |
| Diluted earnings (loss) per share                                        |       | $                                | (.56       | ) | $ | .30 |   | $ | .48 |   |

 

***FinancialInstruments***

 

Thecarrying amounts of our financial instruments, including cash and cashequivalents, investment securities, accounts receivable and accounts payableand accrued expenses, approximate fair value due to the short maturities ofthese financial instruments.  At December 31,2004, the carrying amount of long-term debt was $288.5 million, and theestimated fair value was $305.5 million. At December 31, 2003, the carrying amount was $235.6 million, andthe estimated fair value was $235.9 million. The estimated fair value of long-term debt is based primarily on quotedmarket prices for the same or similar issues.

 

***DerivativeInstruments***

 

Derivative instruments are recognized in accordancewith the provisions of SFAS No. 149, “Amendment of Statement No. 133 onDerivative Instruments and Hedging Activities.” We have only entered into

 

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derivative contracts that are classified as hedges.  These hedges are recorded at their fair valuewith changes in the fair value recorded as adjustments to the related liabilityand other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income (Loss). See Note 12 to the Consolidated Financial Statements.

 

***Use of Estimates***

 

Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States, whichrequire that we make certain estimates and judgments that affect our reportedamounts of assets, liabilities, revenues and expenses and the disclosures ofcontingent assets and liabilities.  Weevaluate our estimates on an on-going basis, based on historical experience andon various other assumptions that we believe to be reasonable based on theinformation available.  Actual resultscould differ from these estimates under different assumptions orconditions.  The significant estimatesmade by us in the accompanying consolidated financial statements include theallowance for doubtful accounts, accruals for insurance and legal claims,accruals for compensated employee absences and the realizability of long-livedtangible and intangible assets.

 

***Reclassifications***

 

Certain reclassifications have been made to theprior period financial statements contained herein to conform to current yearpresentation.

 

**3.****             ****ACQUISITION OF FACILITYMANAGEMENT CONTRACT**

 

In June 2004, we acquired a management contractto operate a 976 bed secure youth offender correctional facility in WalnutGrove, Mississippi, the Walnut Grove Youth Correctional Facility, fromTuscolameta, Inc.  This facility houses13-20 year-old males and provides academic and vocational training, along withdrug and alcohol education and treatment. Group and individual counseling and recreational opportunities are alsoprovided. The management contract has a remaining term of 2 1⁄2 years with arenewal option for an additional two-year term.

 

We acquired the management contract and certain otherassets and liabilities for a total purchase price of  $3.0 million, which was allocated as follows(in thousands):

 
| Accounts  receivable                      |   | $     | 584    |   |
|-------------------------------------------|--------|-------|--------|--------|
| Contract  value                           |   | 2,405 |   |
| Prepaid  supplies                         |   | 188   |   |
| Fixed assets                              |   | 271   |   |
| Non-compete  agreement                    |   | 300   |   |
| Accounts  payable and accrued liabilities |   | (748  | )      |
| Net assets                                |   | $     | 3,000  |   |

 

The fair market value of the management contract wasdetermined based on discounted future cash flows.  We are amortizing the management contractvalue of $2.4 million over the expected useful life of the management contractof 4.5 years.  The expected useful lifeof the contract includes two one-year options. Amortization expense was approximately $0.3 million for the year endedDecember 31, 2004.

 

**4.****           ****INTANGIBLE ASSETS**

 

Intangible assets at December 31, 2004 and 2003consisted of the following (in thousands):

 

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| ** **               | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                     |       |                        |       |                        |       |
| Non-compete agreements   |       | $                           | 9,840      |                        | $          | 9,420 |   |
| Acquired contract value  |       | 2,405                       |       | —                      |       |
| Accumulated amortization |       | (5,219                      | )          | (3,854                      | )          |
| Intangibles assets, net  |       | 7,026                       |       | 5,566                       |       |
| Goodwill, net            |       | 7,721                       |       | 7,721                       |       |
| Total intangibles, net   |       | $                           | 14,747     |                        | $          | 13,287 |   |

 

In conjunction with theacquisition of the Walnut Grove Youth Correctional Facility management contractin June 2004, we purchased a contract with an adjusted value of $2.4million as of December 31, 2004 and we entered into a non-compete agreementtotaling $0.3 million with the previous operators of the facility.  This agreement has a term of five years.  Amortization expense for the contract valueis expected to be approximately $0.5 million for each of the next four years.

 

Amortization expense for our non-compete agreementswas approximately $1.1 million for the year ended December 31, 2004 and$0.9 million for each of the years ended December 31, 2003 and 2002.  Amortization expense for our non-competeagreements is expected to be approximately $1.1million for each of the next four years and$0.7 million for the fifth year.

 

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**5.****             ****NEW ACCOUNTINGPRONOUNCEMENTS**

 

The Financial Accounting Standards Board (FASB)issued Interpretation No. 46R, “Consolidation of Variable Interest Entities”(FIN 46R) which addresses the consolidation of variable interest entities (VIE’s)by business enterprises that are the primary beneficiaries.  A VIE is an entity that does not havesufficient equity investment at risk to permit it to finance its activitieswithout additional subordinated financial support, or whose equity investorslack the characteristics of a controlling financial interest.  The primary beneficiary of a VIE is theenterprise that has the majority of the risks or rewards associated with theVIE.  Our adoption of FIN 46R on January 1,2004 did not change our accounting for the 2001 Sale and Leaseback Transaction,which is consolidated for reporting purposes. We have no other arrangements subject to the provisions of FIN 46R.

 

We do not have an equity interest in the variableinterest entity that was formed in connection with the 2001 Sale and LeasebackTransaction.  The variable interestentity was formed for the purpose of owning and leasing certain facilities tous.  Reference is made to the “Non-GuarantorSubsidiary” information included in Note 17 for a summary of the financialinformation related to the variable interest entity.  The debtholders of the variable interestentity have no recourse to our general credit.

 

On December 16, 2004, the FASB issued Statementof Financial Accounting Standard (SFAS) No. 123R, “Share Based Payment,” whichrequires companies to expense the value of employee stock options and othertypes of equity-based compensation at the fair value of the options at theaward’s grant date based on the estimated number of awards that are expected tovest.  Compensation cost for awards thatvest would not be reversed if the awards expire without being exercised.  When measuring fair value, companies canchoose an option-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions.  Companies will recognizecompensation cost per share based payment awards as they vest, including therelated tax effects.  The effective dateapplies to interim and annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested shares based payment awards at theadoption date.  We are currentlyevaluating the alternative transition methods permitted by SFAS No. 123R.

 

**6.****             ****PROPERTY AND EQUIPMENT**

 

Property and equipment were as follows (inthousands):

 
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                       |       |                  |       |   |   |
| Land                                       |       | $                     | 31,448     |   | $ | 27,168 |   |
| Prepaid  facility use                      |       | 71,323                |       | 71,323 |   |
| Buildings  and improvements                |       | 174,702               |       | 161,894 |   |
| Furniture  and equipment                   |       | 30,942                |       | 25,770 |   |
| Construction  in progress                  |       | 22,444                |       | 22,381 |   |
| Sub-total                                  |       | 330,859               |       | 308,536 |   |
| Accumulated  depreciation and amortization |       | (48,604               | )          | (40,633 | ) |
| Total  property and equipment              |       | $                     | 282,255    |   | $ | 267,903 |   |

 

Significant purchases/additions to propertyand equipment made in the year ended December 31, 2004 include  (1) the construction of the Southern PeaksRegional Treatment Center for approximately $14.2 million,  (2) renovations to the Regional CorrectionalCenter of approximately $7.8 million, (3) construction costs and capitalizedinterest related to the Moshannon Valley Correctional Center for approximately6.2 million, (4) the purchase and partial renovation of the Central CaliforniaTreatment Center for  approximately $2.7million,  (5) the purchase and renovationof the Las Vegas Center for approximately $2.6 million and (6) the purchase ofthe Baker Community Correctional Center building for approximately $2.0

 

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million.  We previously leased theBaker Community Correctional Center.

 

***In September 2003, we repurchased furniture andequipment leased under a sale and leaseback transaction completed in 1999 forapproximately $4.8 million.  We aredepreciating this furniture and equipment over 3 years.***

*** ***

Construction in progress at December 31, 2004consisted primarily of construction and renovation costs for the MoshannonValley Correctional Center, the Regional Correctional Center and the CentralCalifornia Treatment Center. Construction in progress at December 31, 2003 consisted primarilyof construction and renovation costs for the Moshannon Valley CorrectionalCenter, the Regional Correctional Center, the Southern Peaks Regional TreatmentCenter, the Las Vegas Center, the Central California Treatment Center andinformation technology and software development costs.

 

Weevaluate the realization of our long-lived assets according to the provisionsof SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” when changes in circumstances or a specific triggering event indicatesthat the carrying value of the asset may not be recoverable.  As a part of our evaluation, we makejudgments regarding the potential future operating results and cash flowsassociated with individual facilities. Additionally, should we decide to sell a facility, realization isevaluated based on the estimated sales price based on the best marketinformation available.

 

Weclosed the New Morgan Academy in the fourth quarter of 2002 and are currentlyevaluating alternative uses for this facility. We are focusing our efforts on the possible lease or sale of thefacility to certain governmental agencies in Pennsylvania, as well as privateenterprises.  Based on current period andforecasted operating and cash flow losses associated with this facility, inaccordance with the provisions of SFAS No. 144, we determined that our carryingvalue of the facility was not fully recoverable and exceeded its fair valueand, as a result, we recorded an impairment charge of $9.3 million in the yearended December 31, 2004.  Thischarge was determined based on the results of our probability-weighted cashflow analysis.

 

Inaddition, as a result of our review of our other long-lived assets based oncurrent and forecasted operating and cash flow losses associated with theseassets, we determined that our carrying values for two of our juvenileresidential facilities was not fully recoverable and exceeded its fair valueand, as a result, we recorded an impairment charge of $0.8 million in the yearended December 31, 2004 related to one of our juvenile facilities.  This charge was estimated based on the bestmarket information available.

 

**7.****             ****ACCOUNTS PAYABLE AND ACCRUEDLIABILITIES**

 

Accounts payable and accrued liabilities consisted ofthe following (in thousands):

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                                            |       |                  |       |   |   |
| Accounts  payable                               |       | $                     | 11,057     |   | $ | 12,353 |   |
| Accrued  compensation                           |       | 6,426                 |       | 7,101 |   |
| Accrued  interest payable                       |       | 12,565                |       | 6,459 |   |
| Accrued  taxes payable                          |       | 3,615                 |       | 3,258 |   |
| Accrued  insurance                              |       | 6,116                 |       | 3,651 |   |
| Accrued  legal                                  |       | 3,334                 |       | 1,942 |   |
| Resident  funds                                 |       | 2,451                 |       | 2,302 |   |
| Other                                           |       | 1,673                 |       | 457 |   |
| Total  accounts payable and accrued liabilities |       | $                     | 47,237     |   | $ | 37,523 |   |

 

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**8.****             ****INCOME TAXES**

 

Thefollowing is an analysis of our deferred tax assets and liabilities (inthousands):

 
| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2003** |   |
| Deferred tax assets:               |       |                  |       |   |   |
| Accrued liabilities and allowances |       | $                     | 4,856      |   | $ | 4,115 |   |
| State operating loss carryforwords |       | 1,625                 |       | 3⁄4 |   |
| Deferred compensation              |       | 25                    |       | 31 |   |
| Other                              |       | 49                    |       | 3⁄4 |   |
| Total deferred tax assets          |       | 6,555                 |       | 4,146 |   |
|                               |       |                  |       |   |   |
| Deferred tax liabilities:          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Depreciation and amortization      |       | 3,165                 |       | 6,591 |   |
| Prepaid expenses                   |       | 845                   |       | 734 |   |
| Other                              |       | 488                   |       | 415 |   |
| Total deferred tax liabilities     |       | 4,498                 |       | 7,740 |   |
|                               |       |                  |       |   |   |
| Valuation allowance                |       | (1,625                | )          | 3⁄4 |   |
|                               |       |                  |       |   |   |
| Net deferred tax asset (liability) |       | $                     | 432        |   | $ | (3,594 | ) |

 

As of December 31,2004, we have net operating losses for state income taxes of approximately$34.6 million.  Our tax returns aresubject to periodic audit by the various jurisdictions in which weoperate.  These audits, including thosecurrently underway, can result in adjustments of taxes due or adjustments ofthe NOLs which are available to offset future taxable income.

 

Valuationallowances of $1.6 million have been established for uncertainties in realizingthe benefit of certain state income tax loss carryforwards.  In assessing the realizability ofcarryforwards, we consider whether it is more likely than not that some portionor all of the deferred tax assets will be realized.  The valuation allowance will be adjusted inthe periods that we determine it is more likely than not that deferred taxassets will or will not be realized.

 

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The components of our income tax provision were as follows (inthousands):

 
| ** **                                           | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                           | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** |   |
|                                                 |       |                             |       |   |   |   |   |
| Federal current provision                            |       | $                                | (453       | ) | $ | 477 |   | $ | 5,031 |   |
| State current provision                              |       | $                                | (238       | ) | $ | 342 |   | $ | 1,209 |   |
| Total current provision                              |       | $                                | (691       | ) | $ | 819 |   | $ | 6,240 |   |
|                                                 |       |                             |       |   |   |   |   |
| Federal Deferred provision                           |       | $                                | (4,483     | ) | $ | 1,604 |   | $ | (1,690 | ) |
| State Deferred provision                             |       | $                                | 329        |   | $ | 337 |   | $ | (269 | ) |
| Total Deferred provision                             |       | $                                | (4,154     | ) | $ | 1,941 |   | (1,959 | ) |
|                                                 |       |                             |       |   |   |   |   |
| Total Provision                                      |       | $                                | (4,845     | ) | $ | 2,760 |   | $ | 4,281 |   |
|                                                 |       |                             |       |   |   |   |   |
| Continuing operations                                |       | $                                | (4,845     | ) | $ | 2,760 |   | $ | 4,952 |   |
| Cumulative effect of change in accounting  principle |       | 3⁄4                           |       | 3⁄4 |   | (671 | ) |
|                                                 |       | $                                | (4,845     | ) | $ | 2,760 |   | $ | 4,281 |   |

 

Asof December 31, 2004, we have net operating losses for state income taxesof approximately $34.6 million that begin to expire in 2018.  Valuation allowances of $1.6 millionhave been established for uncertainties in realizing the benefit of certainstate income tax loss carryforwards.  Inassessing the realizability of carryforwards, we consider whether it is morelikely than not that some portion or all of the deferred tax assets will berealized.  The valuation allowance willbe adjusted in the periods that we determine it is more likely than not thatdeferred tax assets will or will not be realized.

 

Ourtax returns are subject to periodic audit by the various jurisdictions in whichwe operate.  These audits including thosecurrently underway, can result in adjustments of taxes due or adjustments ofthe NOLs which are available to offset future taxable income.

 

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

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                 | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Computed taxes at statutory rate           |       | $                                | (4,297     | ) | $ | 2,356 |   | $ | 3,725 |   |
| State income taxes, net of federal benefit |       | (617                             | )          | 281 |   | 380 |   |
| Other                                      |       | 69                               |       | 123 |   | 176 |   |
|                                       |       | $                                | (4,845     | ) | $ | 2,760 |   | $ | 4,281 |   |

 

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**9.****             ****CREDIT FACILITIES**

 

Ourlong-term debt consisted of the following (in thousands):

 
| ** **                                                                                                                         | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                         | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Debt of  Cornell Companies, Inc.:**                                                                                              |       |                  |       |   |   |
| Senior Notes, unsecured, due July 2012  with an interest rate of 10.75%, net of discount                                      |       | $                     | 110,619    |   | $ | — |   |
| Fair-value adjustment of Senior Notes as  result of interest rate swap                                                             |       | 3,208                 |       | — |   |
| Revolving Line of Credit due June 2008  with an interest rate of LIBOR plus 2.25% to 3.5% or prime plus 0.75% to  2.00%       |       | 3⁄4                |       | — |   |
| Revolving Line of Credit due July 2005  with an interest rate of prime plus 2.0% or LIBOR plus 3.0%, repaid in June 2004 |       | 3⁄4                |       | 2,000 |   |
| Capital lease obligations                                                                                                          |       | 6                     |       | 8 |   |
| Subtotal                                                                                                                           |       | 113,833               |       | 2,008 |   |
|                                                                                                                               |       |                  |       |   |   |
| **Debt of  Special Purpose Entities:**                                                                                             |       |                  |       |   |   |
| Synthetic Lease Investor Note A due July 2005  with an interest rate of LIBOR plus 3.25%, repaid June 2004               |       | 3⁄4                |       | 42,255 |   |
| Synthetic Lease Investor Note B due July 2005  with an interest rate of LIBOR plus 3.50%, repaid June 2004               |       | 3⁄4                |       | 8,335 |   |
| 8.47% Bonds due 2016                                                                                                               |       | 174,700               |       | 183,000 |   |
| Subtotal                                                                                                                           |       | 174,700               |       | 233,590 |   |
|                                                                                                                               |       |                  |       |   |   |
| Total consolidated debt                                                                                                            |       | 288,533               |       | 235,598 |   |
|                                                                                                                               |       |                  |       |   |   |
| Less: current maturities                                                                                                           |       | (9,005                | )          | (8,306 | ) |
|                                                                                                                               |       |                  |       |   |   |
| Consolidated long-term debt                                                                                                        |       | $                     | 279,528    |   | $ | 227,292 |   |

 

***Long-Term Credit Facilities.***  Our 2000Credit Facility, as amended, provided for borrowings of up to $45.0 millionunder a revolving line of credit.  Thecommitment amount was reduced by $1.6 million quarterly beginning in July 2002and by outstanding letters of credit. The amended 2000 Credit Facility bore interest, at our election, ateither the prime rate plus a margin of 2.0%, or a rate which was 3.0% above theapplicable LIBOR rate.  Additionally, theamended 2000 Credit Facility provided us with the ability to enter intosynthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provided for funding to the lessor under operating leasesof up to $100.0 million.  The amended2000 Credit Facility was repaid with the net proceeds from the sale of theSenior Notes in June 2004.

 

MCF is obligated for the outstandingbalance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 7.00%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds is due on the earlier of August 1,2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by us.

 

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OnJune 24, 2004, we entered into a revolving credit facility (the “2004Credit Facility”) by and among the Company, and certain lenders to fund workingcapital for acquisitions, to refinance existing debt, to fund capital expendituresand general corporate purposes. The 2004 Credit Facility provides forborrowings of up to $60.0 million under a revolving line of credit, and isreduced by outstanding letters of credit. The available commitment under the 2004 Credit Facility wasapproximately $52.8 million at December 31, 2004.  We had no outstanding borrowings on the 2004Credit Facility at December 31, 2004, but we had outstanding letters ofcredit of approximately $7.2 million. Subject to certain requirements, we have the right to increase theaggregate commitments under the 2004 Credit Facility up to an aggregate amountof $100.0 million.  The 2004 CreditFacility matures in June 2008 and bears interest, at our election,depending on our total leverage ratio, at either the prime rate plus a marginranging from 0.75% to 2.00%, or a rate which ranges from 2.25% to 3.50% abovethe applicable LIBOR rate. The 2004 Credit Facility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries.  The2004 Credit Facility is not secured by the assets of MCF.  The 2004 Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

 

In June 2004, we issued $112.0million in principal of 10.75% Senior Notes (the “Senior Notes”) due July 1,2012.  The Senior Notes are unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (collectively, the “Guarantors”). The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”).    Interest on the Senior Notes is payablesemi-annually on January 1 and July 1 of each year, commencing January 1,2005.  On or after July 1, 2008, wemay redeem all or a portion of the Senior Notes at the redemption prices(expressed as a percentage of the principal amount) listed below, plus accruedand unpaid interest, if any, on the Senior Notes redeemed, to the applicabledate of redemption, if redeemed during the 12-month period commencing on July 1of the years indicated below:

 
| **Year**             | ** ** | **Percentages** | ** ** |
|----------------------|------------|-----------------|------------|
|                 |       |            |       |
| 2008                 |       | 105.375         | %          |
| 2009                 |       | 102.688         | %          |
| 2010  and thereafter |       | 100.000         | %          |

 

Any time prior to July 1,2007, we may redeem up to 35% of the original aggregate principal amount of theSenior Notes at a redemption price of 110.75% of the principal amount thereofwith the net cash of public offerings of equity, provided that at least 65% ofthe original aggregate principal amount of the Notes remains outstanding afterthe redemption and other conditions are met. Upon the occurrence of specified change of control events, unless wehave exercised our option to redeem all the Senior Notes as described above, eachholder will have the right to require us to repurchase all or a portion of suchholder’s Senior Notes at a purchase price in cash equal to 101% of theaggregate principal amount of the notes repurchased plus accrued and unpaidinterest, if any, on the Senior Notes repurchased, to the applicable date ofpurchase.  The Senior Notes were issuedunder an indenture (the “Indenture”) which limits our ability  and the ability of our Guarantors to, amongother things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets. The net proceeds from the sale ofthe Senior Notes was approximately $107.2 million, which was used to repay andrefinance the indebtedness under our amended 2000 Credit Facility and syntheticlease obligations as of June 24, 2004. We recognized a charge of approximately $2.4 million related to thewrite-off of unamortized deferred financing costs and charges related to theextinguishment of the synthetic lease and the amended 2000 Credit Facilityobligations.

 

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In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was to convert future interest due on$84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contractand the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, the Company pays on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceives a fixed-rate interest of 10.75%. For the year ended December 31, 2004, we recorded interest savingsrelated to this interest rate swap of approximately $1.2 million which isreflected as a reduction to interest expense in the accompanying financialstatements.  The swap agreements aremarked to market each quarter with a corresponding mark-to-market adjustmentreflected as either a discount or premium on the Senior Notes.  At December 31, 2004 the fair value ofthis derivative instrument was approximately $3.2 million and is included inother assets.  The carrying value of theSenior Notes as of December 31, 2004 was increased by the sameamount.  Because the swap agreement isconsidered an effective fair-value hedge, there will be no effect on ourresults of operations from the mark-to-market adjustment as long as the swap isin effect.

 

Scheduledmaturities of our consolidated long-term debt were as follows (in thousands):

 
| ** **                            | ** ** | **Cornell  Companies, Inc.** | ** ** | **MCF**    | ** ** | **Consolidated** | ** ** |
|---------------------------------------|------------|------------------------------|------------|------------|------------|------------------|------------|
| ** **                            | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **       | ** ** |
| For the year ending December 31, | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **       | ** ** |
| 2005                                  |       | 5                            |       | 9,000      |       | 9,005            |       |
| 2006                                  |       | 1                            |       | 9,700      |       | 9,701            |       |
| 2007                                  |       | —                       |       | 10,500     |       | 10,500           |       |
| 2008                                  |       | —                       |       | 11,400     |       | 11,400           |       |
| 2009                                  |       | —                       |       | 12,400     |       | 12,400           |       |
| Thereafter                            |       | 112,000                      |       | 121,700    |       | 233,700          |       |
| Total                                 |       | $                            | 112.006    |       | $          | 174.700          |       | $ | 286,706 |   |
|                                       |            |                              |            |            |            |                  |            |  |  |  |

 

**10.****      ****COMMITMENTS ANDCONTINGENCIES**

 

***Financial Guarantee***

 

Duringthe normal course of business, we enter into contracts that contain a varietyof representations and warranties and provide general indemnifications.  Our maximum exposure under these arrangementsis unknown as this would involve future claims that may be made against us thathave not yet occurred.  However, based onexperience, we believe the risk of loss to be remote.

 

***Operating Leases***

 

Welease office space, certain facilities and furniture and equipment under long-termoperating leases.  Rent expense for alloperating leases for the years ended December 31, 2004, 2003 and 2002, wasapproximately $7.4 million, $9.9 million and $9.0 million, respectively.  The decrease in 2004 rent expense as comparedto 2003 was primarily due to the September 2003 purchase of furniture andequipment that was previously leased under sale and leaseback transaction in1999.

 

Underthe amended 2000 Credit Facility, we entered into operating lease agreementsthat were considered to be a virtual special purpose entity for the acquisitionor development of operating facilities. This synthetic lease financing arrangement provided for funding from thevirtual special purpose entity under the operating leases of up to $100.0million, of which approximately $52.4 million had been utilized as of December 31,

 

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2003for the purchase of a building in California, construction of the New MorganAcademy and construction costs to date for the Moshannon Valley CorrectionalCenter.  The leases under thisarrangement each had a term of the lesser of five years or July 2005,included purchase and renewal options, and provided for residual valueguarantees for each lease that average 81.4% of the total cost and would havebeen due by us upon termination of the leases. Upon termination of a lease, we could either exercise a purchase option,or the facilities could be sold to a third party.  In June 2004, we repaid the outstandingbalances related to the synthetic lease financing with proceeds from theissuance of the $112.0 million Senior Notes and terminated these leases.

 

Asof December 31, 2004, we had the following rental commitments undernoncancelable operating leases (in thousands):

 
| For the year ending December 31, |   |   |   |
|---------------------------------------|--------|--------|--------|
| 2005                                  |   | $      | 5,995  |   |
| 2006                                  |   | 5,245  |   |
| 2007                                  |   | 4,720  |   |
| 2008                                  |   | 3,586  |   |
| 2009                                  |   | 2,008  |   |
| Thereafter                            |   | 13,165 |   |
| Total                                 |   | $      | 34,719 |   |

 

***401(k) Plan***

 

Wehave a defined contribution 401(k) plan. Our matching contribution currently represents 50% of a participant’scontribution, up to the first 6% of the participant’s salary.  We recorded contribution expense of approximately $1.2 million for each ofthe  years ended December 31, 2004,2003 and 2002.

 

***Legal Proceedings***

 

**Southern Peaks Regional Treatment Center**

 

OnJanuary 5, 2004, we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v. LongboatGlobal Advisors, LLC, et al*., No.2004 CV-79761 in the Superior Courtof Fulton County, Georgia under theories of fraud, conversion, breach ofcontract and other theories to determine the location of and to recover fundspreviously deposited by us into what we believed to be an escrow account inconnection with the development and construction of the Southern Peaks RegionalTreatment Center.  Of the fundspreviously deposited, approximately $5.4 million remains to be recovered at December 31,2004.  In December 2004, thecase was tried before a jury and the jury returned a verdict awarding approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorney’s fees.  Currently,we expect the defendants to move for a new trial and that no judgment will beentered on the verdict until after these motions for a new trial have beenheard and ruled on by the court.  If thecourt denies any filed motions for a new trial and enters a judgment on thejury verdict we expect that the actual damages awarded under the verdict willbe adjusted downward to the $5.4 million actually lost by us and that thepunitive damages award may be adjusted downward because of a Georgia statuteregarding caps on punitive damages awards. The award for compensatory damages accrues pre-judgment interest at arate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Due to the continued uncertainty surroundingany motions for a new trial and the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.4 million in an allowance for doubtful accounts.

 

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**Shareholder Lawsuits**

 

InMarch and April 2002, the company, Steven W. Logan (our formerPresident and Chief Executive Officer), and John L. Hendrix (our former ChiefFinancial Officer), were named as defendants in four federal putative classaction 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 our common stock between March 6, 2001 and March 5,2002 and relate to our restatement in 2002 of certain financialstatements.  The lawsuits involveddisclosures made concerning two prior transactions executed by us: the August 2001sale leaseback 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 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 under Section 10(b)of the Exchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act.  The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees.  A motion to dismiss iscurrently pending.

 

InMarch 2002, the company, our directors, and our 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 toour 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.

 

OnJanuary 27, 2004, we received a letter from William Williams, the plaintiffin the *William Williams* actiondiscussed above, demanding that we pursue breach of fiduciary duty claimsagainst various officers and directors based on the August 2001 saleleaseback transaction and the subsequent restatement.  We have issued a preliminary response to theletter indicating that the Board will consider the request and inform Mr.Williams of its decision.

 

InMay and June 2002, the company and our 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, in theUnited Stated District Court for the Southern District of Texas, HoustonDivision; 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 toour restatement in 2002 of certain financial statements.  These lawsuits all allege breaches of fiduciaryduty and waste of corporate assets by all of the defendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed.

 

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Thecourt dismissed the *Pagano* actionas 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 plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty.  However, we believe we havegood defenses and intend to vigorously defend against the claims asserted inthese actions.  We have not recorded anyloss accruals related to these claims.

 

***Certain insurance policies held by us to cover potentialdirector and officer liability may limit our cash outflows in the event of adecision adverse to us 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 us in these matters couldhave a material adverse effect on us, our financial condition, results of operationsand future prospects.***

*** ***

***Other***

*** ***

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier were unableto fulfill their obligation under the insurance coverage provided, it couldhave a material adverse effect on our financial position, results of operationsor cash flows.

 

During the period of August 2000 through May 2003, our generalliability and professional liability coverage was provided by Specialty SurplusInsurance Company, a Kemper Insurance Company (“Kemper”) group member.  In June 2004, the Illinois Department ofInsurance gave Kemper permission to proceed with a run-off plan it hadpreviously submitted.  The three-yearplan is designed to help Kemper meet its goal of resolving, to the maximumextent possible, all valid policyholder claims.

 

In view of the risks and uncertainties involved in implementing theplan, including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulations, no assurancecan be given that the plan will be successfully implemented by Kemper.  At December 31, 2004, we recorded acharge of $0.6 million, and have estimated our range of additional exposure to$0.5 million with respect to outstanding claims incurred during this policyperiod with Kemper which would become our obligation to resolve if not settledthrough Kemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialposition, operating results or cash flow.

 

**Securities and Exchange Commission Investigation**

 

***Following the restatement of our 2001 financial statementsin 2002, the SEC initiated an investigation into the circumstances leading tothis restatement.  The SEC made aninitial inquiry in 2002, and in July 2003, we received additionalinformation requests to which we responded and cooperated in a timelymanner.  In October 2004, wereceived correspondence from the staff of the SEC indicating that the SEC’sinvestigation had been terminated and no enforcement action had beenrecommended.***

 

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**11.****      ****STOCKHOLDERS’ EQUITY**

 

***Stockholder Rights Plan***

 

OnMay 1, 1998, we adopted a stockholder rights plan.  Under the plan, each stockholder of record atthe 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 the stockholderto purchase one one-thousandth of a Series A Junior Participating PreferredShare for $120.00.  Each Preferred Sharehas terms designed to make it economically equivalent to one thousand commonshares.  The Rights will becomeexercisable only in the event a person or group acquires 15% or more of ourcommon stock or commences a tender or exchange offer which, if consummated,would result in that person or group owning 15% or more of our commonstock.  If a person or group acquires a15% or more position in the Company, each Right (except those held by theacquiring party) will then entitle its holder to purchase, at the exerciseprice, our common stock having a value of twice the exercise price.  The effect will be to entitle the holder tobuy the common stock at 50% of the market price.  Also, if following an acquisition of 15% ormore of our common stock, we are acquired by that person or group in a mergeror other business combination transaction, each Right would then entitle itsholder to purchase common stock of the acquiring company having a value oftwice the exercise price.  The effectwill be to entitle our stockholders to buy stock in the acquiring company at50% of the market price.  We may redeemthe Rights at $0.01 per Right at any time prior to the acquisition of 15% ormore of our common stock by a person or group.

 

***Preferred Stock***

 

Preferredstock may be issued from time to time by our Board of Directors, which isresponsible for determining the voting, dividend, redemption, conversion andliquidation features of any preferred stock.

 

***Options***

 

InDecember 2000, we adopted the 2000 Broad-Based Employee Plan (2000Plan).  Pursuant to the 2000 Plan, we maygrant non-qualified stock options to our employees, directors and eligibleconsultants for up to the greater of 400,000 shares or 4% of the aggregate numberof shares of common stock issued and outstanding immediately after grant of anyoption under the 2000 Plan.  The 2000Plan options vest up to five years and expire ten years from the grantdate.  In May 1996, we adopted the 1996Stock Option Plan and amended and restated the plan in April 1998 (1996Plan).  Pursuant to the 1996 Plan, we maygrant non-qualified and incentive stock options for up to the greater of1,932,119 shares or 15.0% of the aggregate number of shares of common stockoutstanding.  The 1996 Plan options vestup to 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 fordetermining the exercise price and vesting terms for the granted options.  The 1996 Plan and 2000 Plan option exerciseprices can be no less than the market price of our common stock on the date ofgrant.

 

Inconjunction with the issuance of the Subordinated Notes in July 2000, weissued warrants to purchase 290,370 shares of the common stock at an exerciseprice of $6.70.  We recognized the fairvalue of these warrants of $1.1 million as additional paid-in capital.  The warrants may only be exercised by paymentof the exercise price in cash to us, by cancellation of an amount of warrantsequal to the fair market value of the exercise price, or by the cancellation ofour indebtedness owed to the warrant holder. During 2001, 168,292 shares of Common Stock were issued in conjunctionwith the exercise and cancellation of 217,778 warrants. At December 31,2004 and 2003, 72,592 warrants remained outstanding.

 

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Thefollowing is a summary of the status of our 2000 Plan, 1996 Plan and otheroptions at December 31, 2004, 2003 and 2002, and changes during the yearsthen ended:

 
| ** **                                      | ** ** | **2004**   | ** ** | **2003**                               | ** ** | **2002**   | ** ** |
|-------------------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Outstanding at beginning of year                |       | 1,131,964  |       | $                                      | 9.55       |       | 1,409,845  |   | $ | 9.20 |   | 1,178,624 |   | $ | 7.98 |   |
| Granted                                         |       | 167,150    |       | 13.46                                  |       | 215,475    |       | 10.02 |   | 388,400 |   | 10.87 |   |
| Exercised                                       |       | (196,852   | )          | 7.16                                   |       | (327,695   | )          | 6.50 |   | (95,059 | ) | 2.11 |   |
| Forfeited or canceled                           |       | (125,315   | )          | 10.12                                  |       | (165,661   | )          | 12.63 |   | (62,120 | ) | 13.99 |   |
| Outstanding at end of year                      |       | 976,947    |       | 10.72                                  |       | 1,131,964  |       | 9.55 |   | 1,409,845 |   | 9.20 |   |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Exercisable at end of year                      |       | 514,165    |       | 10.31                                  |       | 615,701    |       | 9.55 |   | 681,787 |   | 8.65 |   |
|                                            |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Weighted average fair value of options  granted |       |       |       | $                                      | 7.94       |       |       |   | $ | 6.02 |   |   |   | $ | 6.87 |   |

 

Thefollowing table summarizes information about our outstanding stock options at December 31,2004:

 
| **Range  of Exercise Prices** |           | **Number  Outstanding** |   | **Weighted  Average  Remaining  Life (Years)** |   | **Weighted  Average  Exercise  Price** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise  Price** |    |
|-------------------------------|----------------|-------------------------|--------|------------------------------------------------|--------|----------------------------------------|--------|-------------------------|--------|----------------------------------------|---------|
| $3.75                         |   to | $5.62                   |   | 134,507                                        |   | 6.0                                    |   | $                       | 4.49   |                                   | 115,467 |   | $ | 4.57 |   |
| 5.63                          |   to | 8.44                    |   | 89,289                                         |   | 8.1                                    |   | 8.40                    |   | 60,417                                 |    | 8.40 |   |
| 8.45                          |   to | 12.65                   |   | 449,900                                        |   | 6.2                                    |   | 10.69                   |   | 172,280                                |    | 10.61 |   |
| 12.66                         |   to | 18.75                   |   | 303,251                                        |   | 7.5                                    |   | 14.21                   |   | 166,001                                |    | 14.69 |   |
|                          |           |                    |   | 976,947                                        |   | 6.7                                    |   | 10.72                   |   | 514,165                                |    | 10.31 |   |
|                               |                |                         |        |                                                |        |                                        |        |                         |        |                                        |         |  |  |  |  |

 

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 2004, 2003 and2002, respectively:  risk-free interestrates of 4.33%, 3.60% and 5.10%; dividend rates of $0, $0 and $0; expectedlives of 7.0, 7.0 and 7.0 years; expected volatility of 52.89%, 56.43% and57.58%.

 

The Black-Scholes option pricing model and other existing models weredeveloped for use in estimating the fair value of traded options that have novesting restrictions and are fully transferable.  In addition, option valuation models requirethe input of, and are highly sensitive to, subjective assumptions including theexpected stock price volatility.  Ouremployee stock options have characteristics significantly different from thoseof traded options, and changes in the subjective input assumptions canmaterially affect the fair value estimate.

 

***Treasury Stock***

 

Duringthe years ended December 31, 2004 and 2003, we repurchased in the openmarket 10,000 and 106,500 shares, respectively, of our common stock under ashare repurchase program at an aggregate cost of $0.1 million and $1.2 million,respectively.  In 2002, the Board ofDirectors authorized the repurchase of an aggregate $10.0 million of ouroutstanding shares.  The annualrepurchase of shares was limited to $2.5 million, and with an aggregate limitof $7.5 million, under our amended 2000 Credit Facility.  Under the terms

 

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ofthe Senior Notes and the 2004 Credit Facility, we can purchase shares of ourstock subject to certain cumulative restrictions.

 

***Employee Stock Purchase Plan***

 

Effectiveas of January 1, 2000, we have an employee stock purchase plan wherebyemployees can make contributions to purchase our common stock.  Purchases of common stock are made annuallyat the lower of the beginning or end of year market value, less a 15.0%discount.  For the years ended December 31,2004, 2003 and 2002, employee contributions of approximately $323,000, $356,000and $399,000 were used to purchase 40,213, 46,486 and 82,581 shares,respectively, of our common stock.

 

***Deferred Bonus Plan***

 

Inthe fourth quarter of 2001, we established a deferred bonus plan for certainemployees.  Pursuant to the plan,approximately $4.7 million was deposited on behalf of individual participantsinto a rabbi trust account, which included approximately $3.6 million in cashand $1.1 million in our treasury stock. The treasury stock portion of the rabbi trust is to remain as treasurystock, while the participants may give investment directions to the trustee asto the cash portion, subject to certain limitations.  The investments of the rabbi trust representour assets and are included in our accompanying Consolidated Balance Sheetsbased on the nature of the assets held. Assets placed into the rabbi trust are irrevocable; therefore they arerestricted as to our use under the terms of the trust and the deferred bonusplan.  Amounts held in the rabbi trustare generally distributable upon vesting. At December 31, 2004, restricted assets and other current assetsincluded approximately $121,000 and $147,000, respectively, of deposits in arabbi trust.

 

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 oraccelerated based on the achievement of the financial milestones, recognitionof compensation expense will be adjusted on a prospective basis.  In the event of a change of control (asdefined in the plan), the amounts in each participants account will be paid tothe participant in a lump sum.  For theyears ended December 31, 2004, 2003 and 2002, we expensed approximately $0.07,$0.5 million and $0.09 million, respectively, under the deferred bonus 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 us. These guarantees function to offset the loss on investments to theextent the obligations are not reserved for collectibility by us.

 

Amountsheld in treasury stock have been recorded at cost.  An equal amount has been established asdeferred compensation and additional paid-in capital in our ConsolidatedStatements of Stockholders’ Equity.  Thebalance in the deferred bonus plan is amortized to compensation expense overthe expected vesting period of five years.

 

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**12.****      ****DERIVATIVE FINANCIALINSTRUMENTS AND GUARANTEES**

 

***Debt Service Reserve Fund and DebtService 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, 2004, was established to makepayments on MCF’s outstanding bonds in the event we (as lessee) should fail tomake the scheduled rental payments to MCF and (2) MCF’s Debt Service Fund,aggregating $17.1 million at December 31, 2004, used to accumulate themonthly lease payments that MCF receives from us until such funds are used topay MCF’s semi-annual bond interest and annual bond principal payments.  Both reserve fund accounts are subject to theagreements with the MCF Equity Investors whereby guaranteed rates of return of 3.0%and 5.08%, respectively, are provided for in the balance of the Debt ServiceReserve Fund and the Debt Service Fund. The guaranteed rates of return are characterized as cash flow hedgederivative instruments.  At inception,the derivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets.  Changes inthe fair value of the derivative instruments are recorded as an adjustment toother long-term liabilities and reported as other comprehensive income (loss)in our Consolidated Statements of Operations and Comprehensive Income(Loss).  At December 31, 2004, thefair value of these derivative instruments was approximately $2.2 million.  As a result, our Consolidated Statements ofOperations and Comprehensive Income (Loss) include accumulated othercomprehensive income (loss) of approximately $0.2 million, ($0.4) million and$1.9 million for the years ended December 31, 2004, 2003 and 2002,respectively.

 

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.

 

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

 

Weclosed the New Morgan Academy in the fourth quarter of 2002 and arecurrently considering several options ranging from the utilization of thefacility for another type of program or the sale or lease of the facility. Asof December 31, 2004, we are focusing our efforts on the possible lease orsale of the facility to certain governmental agencies in Pennsylvania, as wellas private enterprises.  We are maintaining a small staff to secure andmaintain the facility.  We haverecognized pre-tax costs (including an impairment charge of $9.3 milliondiscussed below) of approximately $13.5 million in our Consolidated Statementsof Operations and Comprehensive Income (Loss) for the year ended December 31,2004 for related holding costs (depreciation, interest, property, taxes andother maintenance costs).

 

AtDecember 31, 2004, as a result of our analysis pursuant to the provisionsof SFAS No. 144, we determined that the carrying amount of the New MorganAcademy was not fully recoverable and exceeded its fair value (as based oncurrent estimates of future cash flows). The developing inability during late 2004 of various governmentalagencies with whom we have been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy has indicated anexpectation of continuing losses associated with this facility.  Accordingly, we believe that, pursuant to theprovisions of SFAS No. 144, an impairment charge of $9.3 million was requiredand such charge has been recognized in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the year ended December 31,2004.  The carrying value of the propertyand equipment for the New Morgan Academy, after the impairment charge, was approximately$20.4 million at December 31, 2004.

 

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In March 2003, wereached an agreement with the Commonwealth of Pennsylvania that resolved alloutstanding administrative issues relative to the contract awarded to us by theBOP to operate the Moshannon Valley Correctional Center. In October 2004,we received the signed Finding of No Significant Impact for the facility.  Construction of the facility, which willhouse 1,300 male federal inmates, began immediately.  We have a three-year contract with the BOP tooperate the facility and the BOP has the option to grant seven one-yearextensions.  The facility is scheduled tobegin operations in early 2006.

 

InSeptember 2004, we resolved our claim with the BOP for the reimbursementof a portion of the expenses we incurred in connection with the issuance of theStop-Work Order and the delay of the project (included among these expenses wasapproximately $1.4 million in accounts receivable for expenses incurred by usafter the September 1999 issuance of the Stop–Work Order).  We settled the claim, as well as the claimfor the reimbursement of costs related to the original construction effortsincurred beginning in 1999, with the BOP and were reimbursed approximately $7.0million in September 2004.  Theexcess reimbursement of approximately $5.6 million over the $1.4 million inaccounts receivable was credited against the carrying cost of the facility.

 

As of December 31, 2004, we had incurred (net of the BOP reimbursement)approximately $17.1 million for the design, construction and development costsand capitalized interest related to the Moshannon Valley Correctional Centerfacility.  We estimate an additionalcapital investment (including furniture and equipment) of approximately $53.7million is required to complete construction of the facility.  We believe that our existing cash and creditfacilities will provide adequate funding to complete the construction of thefacility.

 

**14.****      ****RELATED PARTY TRANSACTIONS**

 

Oneof our directors is a partner in a law firm that provides legal services tous.  We pay legal fees for suchservices.  Legal fees paid to this lawfirm were approximately $2.0 million, $1.1 million and $1.5 million for theyears ended December 31, 2004, 2003 and 2002, respectively.  The director has notified us that he will notstand for reelection at the next stockholders’ meeting.

 

InJuly 1996, we entered into promissory notes with the Company’s formerpresident and the Company’s founder, a director of the Company until October 2003.  The promissory notes bore interest at anannual rate of 6.63%, were scheduled to mature in June 2004 with nointerim interest or principal payments, were full recourse and collateralizedby shares of our common stock. These notes were repaid in full prior to December 31,2003.  We recognized approximately$17,000 and $29,000 of interest income related to these notes for the yearsended December 31, 2003 and 2002.

 

EffectiveSeptember 1, 1999, we entered into a consulting agreement with the Company’sfounder, who was a director of the Company through October 2003.  As compensation for consulting services, weagreed to an annual payment of at least $255,000 for each of the first fouryears of the seven-year initial term of the consulting agreement with an annualsalary of at least $180,000 for each of the last three years of the seven-yearinitial term of the consulting agreement. We have an option to renew the consulting agreement for an additionalthree-year term at an annual salary of at least $300,000 for each of the threeyears of the renewal term.  As additionalcompensation, we agreed to an annual bonus, subject to certain limitations,equal to $75,000 during the first four years of the seven-year initial term andan annual bonus of $60,000 during the last three years of the seven-yearinitial term and during any renewal term. We also agreed to grant options to purchase an aggregate 120,000 sharesof our common stock in four equal annual installments beginning September 1,2000.  The options have an exercise priceequal to the fair market value of our common stock on the date of grant andvest at the time such options are granted, subject to certain limitations onexercise.  For the year ended December 31,2003, the Company’s founder accepted a $0.1 million cash payment in lieu ofunexercised options. This payment was expensed by us in 2003.

 

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Aspart of the consulting agreement discussed above, we entered into a non-competeagreement with the Company’s founder. The non-compete agreement has a term of 10 years and requires us to paya monthly fee of $10,000 for the seven-year initial term of the consultingagreement.  We capitalize the monthlypayments and amortize the amounts over the 10-year term of the consultingagreement. We recognized amortization expense related to this agreement ofapproximately $84,000 for each of the years ended December 31, 2004, 2003and 2002.

 

Wemaintain a life insurance policy for the Company’s founder and made paymentsrelated to this policy of approximately $0.2 million for each of the yearsended December 31, 2004, 2003 and 2002.

 

Wealso compensated the Company’s founder for director fees in the amounts of$12,000 and $30,000 for the years ended December 31, 2003 and 2002,respectively.  We did not pay the Company’sfounder director fees in 2004 because he resigned as a director in October 2003.

 

Totalpayments made for the above consulting and non-compete agreements, board ofdirector fees and expense reimbursements for the Company’s founder wereapproximately $0.7 million for the year ended December 31, 2004 and $0.5million for each of the years ended December 31, 2003 and 2002.

 

Wealso have a non-compete agreement with a former director of the Company inconnection with the acquisition of The Abraxas Group, Inc. in September 1997.  Under this agreement, we were required to payannual installments of $60,000 beginning January 2, 1998.  These payments could and were acceleratedupon the mutual agreement of the former director and us.  As of December 31, 2003, the balance ofthis non-compete agreement had been paid in full.  We made payments under this agreement of  $0.2 million and $0.1 million for the yearsended December 31, 2003 and 2002, respectively.  This director resigned in June 2004.

 

Subsequentto their resignation, we entered into a consulting agreement with this formerdirector for a term which expires in December 2008.  Total payments under this agreement, whichhas a termination fee incorporated for a termination prior to maturity, totaled$0.2 million in 2004.  The terminationfee at December 2004 was $0.4 million.

 

**15.****      ****SUBSEQUENT EVENT**

 

***CorrectionalSystems, Inc.  Acquisition***

 

In January 2005, wesigned a definitive agreement to acquire Correctional Systems, Inc. (CSI), aSan Diego based provider of privatized jail, community corrections andalternative sentencing services.  Thepurchase price is approximately $10.0 million in total consideration to commonand preferred shareholders, less certain adjustments as described in the mergeragreement.  The transaction is expectedto generate annualized revenue of approximately $16.0 million.  We currently anticipate that the transactionwill be completed in the second quarter of 2005, subject to customary closingconditions and approval of CSI’s shareholders.

 

The acquisition includes theoperations of eight jails, six community correction facilities and fivealternative sentencing programs located in California, New Mexico, Texas andKansas.  The transaction will add 986corrections beds, as well as alternatives to incarceration services.

 

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**16.****      ****SEGMENT DISCLOSURE**

 

Ourthree operating divisions are our reportable segments.  The adult secure institutional servicessegment consists of the operations of secure adult incarcerationfacilities.  The juvenile segmentconsists of 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 our customers and long-lived assets are located in the UnitedStates of America.  The accountingpolicies of our reportable segments are the same as those described in thesummary of significant accounting policies in Note 2 to the ConsolidatedFinancial Statements.  Intangible assetsare not included in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome.  We evaluate performance based onincome or loss from operations before general and administrative expenses,incentive bonuses, amortization of intangibles, impairment charges onlong-lived assets, 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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Theonly significant non-cash items reported in the respective segments’ incomefrom operations is depreciation and amortization (excluding intangibles) andimpairment of long-lived assets (in thousands).

 
| ** **                              | ** ** | **Year Ended December 31,** | ** **   |
|-----------------------------------------|------------|----------------------------------|--------------|
| ** **                              | ** ** | **2004**                         | ** **   | **2003** | ** ** | **2002** | ** ** |
|                                    |       |                             |         |   |   |   |   |
| Revenue:                                |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 114,818      |   | $ | 102,120 |   | $ | 99,549 |   |
| Juvenile                                |       | 126,775                          |         | 118,797 |   | 124,967 |   |
| Adult community-based                   |       | 49,432                           |         | 50,715 |   | 50,629 |   |
| Total revenue                           |       | $                                | 291,025      |   | $ | 271,632 |   | $ | 275,145 |   |
|                                    |       |                             |         |   |   |   |   |
| Pre-opening and start-up expenses:      |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 4,971        |   | $ | 321 |   | $ | — |   |
| Juvenile                                |       | 7,925                            |         | 3,077 |   | 3⁄4 |   |
| Adult community-based                   |       | 42                               |         | — |   | — |   |
| Total pre-opening and start-up expenses |       | $                                |  12,938 |   | $ |  3,398 |   | $ | — |   |
|                                    |       |                             |         |   |   |   |   |
| Impairment of long-lived assets:        |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | —       |   | $ | — |   | $ | — |   |
| Juvenile                                |       | 10,100                           |         | 3⁄4 |   | 3⁄4 |   |
| Adult community-based                   |       | 3⁄4                           |         | — |   | — |   |
| Total impairment of long-lived assets   |       | $                                | 10,100       |   | $ | — |   | $ | — |   |
|                                    |       |                             |         |   |   |   |   |
| Depreciation and amortization:          |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 4,965        |   | $ | 3,868 |   | $ | 3,558 |   |
| Juvenile                                |       | 3,614                            |         | 2,698 |   | 2,615 |   |
| Adult community-based                   |       | 1,812                            |         | 1,538 |   | 1,391 |   |
| Amortization of intangibles             |       | 1,365                            |         | 895 |   | 878 |   |
| Corporate and other                     |       | 1,791                            |         | 1,700 |   | 1,337 |   |
| Total depreciation and amortization     |       | $                                | 13,547       |   | $ | 10,699 |   | $ | 9,779 |   |
|                                    |       |                             |         |   |   |   |   |
| Income from operations:                 |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 24,752       |   | $ | 25,396 |   | $ | 26,586 |   |
| Juvenile                                |       | (904                             | )            | 13,598 |   | 17,402 |   |
| Adult community-based                   |       | 9,812                            |         | 10,789 |   | 11,609 |   |
| Subtotal                                |       | 33,660                           |         | 49,783 |   | 55,597 |   |
| General and administrative expenses     |       | (20,284                          | )            | (23,415 | ) | (21,480 | ) |
| Amortization of intangibles             |       | (1,365                           | )            | (895 | ) | (878 | ) |
| Corporate and other                     |       | (1,574                           | )            | (1,089 | ) | (1,662 | ) |
| Total income from operations            |       | $                                | 10,437       |   | $ | 24,384 |   | $ | 31,577 |   |
|                                    |       |                             |         |   |   |   |   |
| Capital expenditures:                   |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 17,406       |   | $ | 5,742 |   | $ | 4,098 |   |
| Juvenile                                |       | 14,790                           |         | 11,176 |   | 1,566 |   |
| Adult community-based                   |       | 6,703                            |         | 2,173 |   | 2,006 |   |
| Corporate and other                     |       | 1,294                            |         | 3,213 |   | 3,444 |   |
| Total capital expenditures              |       | $                                | 40,193       |   | $ | 22,304 |   | $ | 11,114 |   |
|                                    |       |                             |         |   |   |   |   |
| Assets:                                 |       |                             |         |   |   |   |   |
| Adult secure institutional              |       | $                                | 172,793      |   | $ | 152,229 |   | $ | 156,315 |   |
| Juvenile                                |       | 123,890                          |         | 110,748 |   | 96,239 |   |
| Adult community-based                   |       | 62,984                           |         | 57,787 |   | 58,071 |   |
| Intangible assets, net                  |       | 14,747                           |         | 13,287 |   | 13,062 |   |
| Corporate and other                     |       | 133,217                          |         | 115,052 |   | 117,604 |   |
| Total assets                            |       | $                                | 507,631      |   | $ | 449,103 |   | $ | 441,291 |   |

 

98

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**17.****      ****Guarantor Disclosures**

 

We completed an offering of $112.0million of Senior Notes in June 2004. The Senior Notes are guaranteed by each of our subsidiaries (GuarantorSubsidiaries).  MCF does not guaranteethe Senior Notes (Non-Guarantor Subsidiary). These guarantees are joint and several obligations of the GuarantorSubsidiaries.  The following condensedconsolidating financial information presents the financial condition, resultsof operations and cash flows of us, the Guarantor Subsidiaries and theNon-Guarantor Subsidiary, together with the consolidating adjustments necessaryto present our results on a consolidated basis.

 

# **Condensed Consolidating Balance Sheet as of December 31,2004 (in thousands)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                            |       |             |       |             |       |
| Current  assets:                                 |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash  and cash equivalents                       |       | $          | 9,559      |                        | $          | 296                             |       | $                | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment  securities                           |       | 51,740     |       | —                      |       | —                          |       | —           |       | 51,740           |       |
| Accounts  receivable                             |       | 3,298      |       | 61,189                      |       | 378                             |       | 3⁄4           |       | 64,865           |       |
| Restricted  assets                               |       | 121        |       | 2,451                       |       | 17,141                          |       | 3⁄4           |       | 19,713           |       |
| Prepaids  and other                              |       | 15,664     |       | 1,962                       |       | 3⁄4                          |       | 3⁄4           |       | 17,626           |       |
| Total  current assets                            |       | 80,382     |       | 65,898                      |       | 17,559                          |       | 3⁄4           |       | 163,839          |       |
| Property  and equipment, net                     |       | 672        |       | 128,965                     |       | 158,863                         |       | (6,245           | )          | 282,255          |       |
| Other  assets                                    |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt  service reserve fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,801                          |       | 3⁄4           |       | 23,801           |       |
| Deferred  costs and other                        |       | 39,392     |       | 19,225                      |       | 9,362                           |       | (30,243          | )          | 37,736           |       |
| Investment  in subsidiaries                      |       | 20,613     |       | 1,856                       |       | 3⁄4                          |       | (22,469          | )          | 3⁄4           |       |
| Total  assets                                    |       | $          | 141,059    |                        | $          | 215,944                         |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities  and Stockholders’ Equity**   |       |       |       |                        |       |                            |       |             |       |             |       |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Current  liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $          | 36,191     |                        | $          | 7,369                           |       | $                | 6,197      |             | $          | (2,520 | ) | $ | 47,237 |   |
| Current  portion of long-term debt               |       | 3⁄4     |       | 5                           |       | 9,000                           |       | 3⁄4           |       | 9,005            |       |
| Total  current liabilities                       |       | 36,191     |       | 7,374                       |       | 15,197                          |       | (2,520           | )          | 56,242           |       |
| Long-term  debt, net of current portion          |       | 113,827    |       | 1                           |       | 165,700                         |       | 3⁄4           |       | 279,528          |       |
| Deferred  tax liabilities                        |       | 7,966      |       | 3⁄4                      |       | 3⁄4                          |       | 122              |       | 8,088            |       |
| Other  long-term liabilities                     |       | 5,846      |       | 80                          |       | 28,546                          |       | (32,011          | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total  liabilities                               |       | (20,253    | )          | 191,538                     |       | 209,443                         |       | (34,409          | )          | 346,319          |       |
| Stockholders’  equity                       |       | 161,312    |       | 24,406                      |       | 142                             |       | (24,548          | )          | 161,312          |       |
| Total  liabilities and stockholders’ equity |       | $          | 141,059    |                        | $          | 215,944                         |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |

 

99

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# **Condensed Consolidating Balance Sheet as of December 31,2003 (in thousands)**

# ** **

| ** **                                       | ** ** | **Parent**   | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|--------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |         |       |                        |       |                            |       |             |       |             |       |
| Current  assets:                                 |       |         |       |                        |       |                            |       |             |       |             |       |
| Cash  and cash equivalents                       |       | $            | 39,827     |                        | $          | 289                             |       | $                | 55         |             | $          | –– |   | $ | 40,171 |   |
| Accounts  receivable                             |       | 1,056        |       | 55,980                      |       | 451                             |       | ––     |       | 57,487           |       |
| Restricted  assets                               |       | 205          |       | 7,301                       |       | 14,679                          |       | ––     |       | 22,185           |       |
| Prepaids  and other                              |       | 10,472       |       | 1,728                       |       | ––                    |       | ––     |       | 12,200           |       |
| Total  current assets                            |       | 51,560       |       | 65,298                      |       | 15,185                          |       | ––     |       | 132,043          |       |
| Property  and equipment, net                     |       | 2,443        |       | 108,916                     |       | 163,086                         |       | (6,542           | )          | 267,903          |       |
| Other  assets:                                   |       |         |       |                        |       |                            |       |             |       |             |       |
| Debt  service reserve fund                       |       | –– |       | ––                |       | 23,800                          |       | ––     |       | 23,800           |       |
| Deferred  costs and other                        |       | 23,133       |       | 15,340                      |       | 9,952                           |       | (23,068          | )          | 25,357           |       |
| Investment  in subsidiaries                      |       | 38,777       |       | 1,856                       |       | ––                    |       | (40,633          | )          | ––     |       |
| Total  assets                                    |       | $            | 115,913    |                        | $          | 191,410                         |       | $                | 212,023    |             | $          | (70,243 | ) | $ | 449,103 |   |
|                                             |       |         |       |                        |       |                            |       |             |       |             |       |
| **Liabilities  and Stockholders’ Equity**   |       |         |       |                        |       |                            |       |             |       |             |       |
|                                             |       |         |       |                        |       |                            |       |             |       |             |       |
| Current  liabilities:                            |       |         |       |                        |       |                            |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $            | 27,858     |                        | $          | 5,248                           |       | $                | 6,512      |             | $          | (2,095 | ) | $ | 37,523 |   |
| Current  portion of long-term debt               |       | 5            |       | 1                           |       | 8,300                           |       | ––     |       | 8,306            |       |
| Total  current liabilities                       |       | 27,863       |       | 5,249                       |       | 14,812                          |       | (2,095           | )          | 45,829           |       |
| Long-term  debt, net of current portion          |       | 2,000        |       | 50,592                      |       | 174,700                         |       | ––     |       | 227,292          |       |
| Deferred  tax liabilities                        |       | 7,006        |       | ––                |       | ––                    |       | ––     |       | 7,006            |       |
| Other  long-term liabilities                     |       | 6,176        |       | 68                          |       | 19,888                          |       | (23,391          | )          | 2,741            |       |
| Intercompany                                     |       | (93,367      | )          | 93,367                      |       | ––                    |       | ––     |       | ––     |       |
| Total  liabilities                               |       | (50,322      | )          | 149,276                     |       | 209,400                         |       | (25,486          | )          | 282,868          |       |
| Stockholders’  equity                       |       | 166,235      |       | 42,134                      |       | 2,623                           |       | (44,757          | )          | 166,235          |       |
| Total  liabilities and stockholders’ equity |       | $            | 115,913    |                        | $          | 191,410                         |       | $                | 212,023    |             | $          | (70,243 | ) | $ | 449,103 |   |

 

100

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# **Condensed Consolidating Statement ofOperations for the year ended December 31, 2004**(in thousands)

# ** **

| ** **                                                 | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                       |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                   |       | $          | 18,272     |                        | $          | 326,759                         |       | $                | 18,008     |             | $          | (72,014 | ) | $ | 291,025 |   |
| Operating  expenses                                        |       | 24,480     |       | 270,744                     |       | 52                              |       | (71,160          | )          | 224,116          |       |
| Pre-opening  and start-up expenses                         |       | 3⁄4     |       | 12,938                      |       | 3⁄4                          |       | 3⁄4           |       | 12,938           |       |
| Impairment  of long-lived assets                           |       | 3⁄4     |       | 10,100                      |       | 3⁄4                          |       | 3⁄4           |       | 10,100           |       |
| Depreciation  and amortization                             |       | 84         |       | 9,549                       |       | 4,222                           |       | (308             | )          | 13,547           |       |
| (Gain)  loss or sale of fixed assets                       |       | 3⁄4     |       | (408                        | )          | 3⁄4                          |       | 11               |       | (397             | )          |
| General  and administrative expenses                       |       | 20,209     |       | 3⁄4                      |       | 75                              |       | 3⁄4           |       | 20,284           |       |
| Income  (loss) from operations                             |       | (26,501    | )          | 23,836                      |       | 13,659                          |       | (557             | )          | 10,437           |       |
| Overhead  allocations                                      |       | (33,851    | )          | 33,851                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest,  net                                             |       | (304       | )          | 5,974                       |       | 14,641                          |       | 43               |       | 20,354           |       |
| Loss  on extinguishment of debt                            |       | 3⁄4     |       | 2,361                       |       | 3⁄4                          |       | 3⁄4           |       | 2,361            |       |
| Equity  earnings in subsidiaries                           |       | (18,328    | )          | 3⁄4                      |       | 3⁄4                          |       | 18,328           |       | 3⁄4           |       |
| Income  (loss) before provision (benefit) for income taxes |       | (10,675    | )          | (18,350                     | )          | (982                            | )          | 17,728           |       | (12,278          | )          |
| Provision  (benefit) for income taxes                      |       | (3,241     | )          | (1,166                      | )          | 3⁄4                          |       | (438             | )          | (4,845           | )          |
| Net  income (loss)                                         |       | $          | (7,433     | )                           | $          | (17,184                         | )          | $                | (982       | )                | $          | 18,166 |   | $ | (7,433 | ) |

 

# **Condensed Consolidating Statement ofOperations for the year ended December 31, 2003 (in thousands)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                         |       | $          | 18,124     |                        | $          | 304,812                         |       | $                | 18,001     |             | $          | (69,305 | ) | $ | 271,632 |   |
| Operating  expenses                              |       | 21,222     |       | 257,457                     |       | 32                              |       | (68,975          | )          | 209,736          |       |
| Pre-opening  and start-up expenses               |       | 3⁄4     |       | 3,398                       |       | 3⁄4                          |       | 3⁄4           |       | 3,398            |       |
| Depreciation  and amortization                   |       | 84         |       | 6,563                       |       | 4,222                           |       | (170             | )          | 10,699           |       |
| General  and administrative expenses             |       | 23,289     |       | 3⁄4                      |       | 126                             |       | 3⁄4           |       | 23,415           |       |
| Income  (loss) from operations                   |       | (26,471    | )          | 37,394                      |       | 13,621                          |       | (160             | )          | 24,384           |       |
| Overhead  allocations                            |       | (25,270    | )          | 25,270                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest,  net                                   |       | (4,672     | )          | 6,912                       |       | 15,371                          |       | 43               |       | 17,654           |       |
| Equity  earnings in subsidiaries                 |       | 4,416      |       | 3⁄4                      |       | 3⁄4                          |       | (4,416           | )          | 3⁄4           |       |
| Income  (loss) before provision for income taxes |       | 7,887      |       | 5,212                       |       | (1,750                          | )          | (4,619           | )          | 6,730            |       |
| Provision  (benefit) for income taxes            |       | 3,917      |       | (357                        | )          | 3⁄4                          |       | (800             | )          | 2,760            |       |
| Net  income (loss)                               |       | $          | 3,970      |                        | $          | 5,569                           |       | $                | (1,750     | )                | $          | (3,819 | ) | $ | 3,970 |   |

 

101

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# **Condensed Consolidating Statement ofOperations for the year ended December 31, 2002 (in thousands)**

# ** **

| ** **                                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                      |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                  |       | $          | 18,243     |                        | $          | 321,714                         |       | $                | 18,008     |             | $          | (82,820 | ) | $ | 275,145 |   |
| Operating  expenses                                                       |       | 17,992     |       | 276,791                     |       | 28                              |       | (82,502          | )          | 212,309          |       |
| Depreciation  and amortization                                            |       | (39        | )          | 5,662                       |       | 4,222                           |       | (66              | )          | 9,779            |       |
| General  and administrative expenses                                      |       | 21,374     |       | 3⁄4                      |       | 106                             |       | 3⁄4           |       | 21,480           |       |
| Income  (loss) from operations                                            |       | (21,084    | )          | 39,261                      |       | 13,652                          |       | (252             | )          | 31,577           |       |
| Overhead  allocations                                                     |       | (26,754    | )          | 26,754                      |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest,  net                                                            |       | (4,398     | )          | 7,162                       |       | 15,960                          |       | 574              |       | 19,298           |       |
| Equity  earnings in subsidiaries                                          |       | 3,946      |       | 3⁄4                      |       | 3⁄4                          |       | (3,946           | )          | 3⁄4           |       |
| Income  (loss) before provision for income taxes                          |       | 14,014     |       | 5,345                       |       | (2,308                          | )          | (4,772           | )          | 12,279           |       |
| Provision  (benefit) for income taxes                                     |       | 6,687      |       | (441                        | )          | 3⁄4                          |       | (1,294           | )          | 4,952            |       |
| Income  (loss) before cumulative effect of change in accounting principal |       | $          | 7,327      |                        | $          | 5,786                           |       | $                | (2,308     | )                | $          | (3,478 | ) | $ | 7,327 |   |
| Cumulative  effect of change in accounting principle, net                 |       | (965       | )          | (965                        | )          | 3⁄4                          |       | 965              |       | (965             | )          |
| Net  income (loss)                                                        |       | $          | 6,362      |                        | $          | 4,821                           |       | $                | (2,308     | )                | $          | (2,513 | ) | $ | 6,362 |   |

 

102

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# **Condensed Consolidating Statement of CashFlows for the year ended December 31, 2004 (in thousands)**

 
| ** **                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Net  cash provided by (used in) operating activities         |       | $          | (87,701    | )                           | $          | 89,046                        |       | $                | 10,748     |   | $ | 12,093 |   |
| **Cash flows from investing activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Capital  expenditures                                        |       | —     |       | (40,193                     | )          | —                        |       | (40,193          | )          |
| Purchase  of investment securities                           |       | (471,410   | )          | —                      |       | —                        |       | (471,410         | )          |
| Sales  of investment securities                              |       | 419,670    |       | —                      |       | —                        |       | 419,670          |       |
| Purchase  of facility management contract                    |       | —     |       | (3,000                      | )          | —                        |       | (3,000           | )          |
| Refund  from restricted escrow arrangement                   |       | 5,000      |       | —                      |       | —                        |       | 5,000            |       |
| BOP  claim reimbursement                                     |       | —     |       | 5,566                       |       | —                        |       | 5,566            |       |
| Payments to restricted debt payment  account, net            |       | —     |       | —                      |       | (2,463                        | )          | (2,463           | )          |
| Proceeds  from sale of fixed assets                          |       | —     |       | 1,087                       |       | —                        |       | 1,087            |       |
| Net  cash provided by (used in) investing activities         |       | (46,740    | )          | (36,540                     | )          | (2,463                        | )          | (85,743          | )          |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from financing activities:**                    |       |       |       |                        |       |                          |       |             |       |
| Proceeds  from long-term debt and line of credit             |       | 69,000     |       | —                      |       | —                        |       | 69,000           |       |
| Payments  on line of credit                                  |       | (71,000    | )          | —                      |       | —                        |       | (71,000          | )          |
| Payments  on synthetic lease                                 |       | —     |       | (52,499                     | )          | —                        |       | (52,499          | )          |
| Proceeds  from Senior Notes, net of discount                 |       | 110,527    |       | —                      |       | —                        |       | 110,527          |       |
| Payments  on MCF Bonds                                       |       | —     |       | —                      |       | (8,300                        | )          | (8,300           | )          |
| Payment  for debt issuance and other financing costs         |       | (6,076     | )          | —                      |       | —                        |       | (6,076           | )          |
| Payments  on capital lease obligations                       |       | (7         | )          | —                      |       | —                        |       | (7               | )          |
| Proceeds  from exercise of stock options                     |       | 1,844      |       | —                      |       | —                        |       | 1,844            |       |
| Purchases  of treasury stock                                 |       | (115       | )          | —                      |       | —                        |       | (115             | )          |
| Net  cash provided by (used in) financing activities         |       | 104,173    |       | (52,499                     | )          | (8,300                        | )          | 43,374           |       |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Net  increase (decrease) in cash and cash****equivalents** |       | (30,268    | )          | 7                           |       | (15                           | )          | (30,276          | )          |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at beginning of  period**        |       | 39,827     |       | 289                         |       | 55                            |       | 40,171           |       |
|                                                         |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at end of period**               |       | $          | 9,559      |                        | $          | 296                           |       | $                | 40         |   | $ | 9,895 |   |

 

103

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# **Condensed Consolidating Statement of CashFlows for the year ended December 31, 2003 (in thousands)**

# ** **

| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                 |       |       |       |                        |       |                          |       |             |       |
| Net  cash (used in) provided by operating activities      |       | $          | (4,633     | )                           | $          | 20,960                        |       | $                | 9,884      |   | $ | 26,211 |   |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from investing activities:**                 |       |       |       |                        |       |                          |       |             |       |
| Capital  expenditures                                     |       | (1,137     | )          | (21,167                     | )          | 3⁄4                        |       | (22,304          | )          |
| Payments  to restricted escrow arrangement, net           |       | (10,385    | )          | 3⁄4                      |       | 3⁄4                        |       | (10,385          | )          |
| Payments of non-compete agreements                        |       | 3⁄4     |       | (1,000                      | )          | 3⁄4                        |       | (1,000           | )          |
| Payments to restricted debt payment  account, net         |       | 3⁄4     |       | 3⁄4                      |       | (2,275                        | )          | (2,275           | )          |
| Net  cash used in investing activities                    |       | (11,522    | )          | (22,167                     | )          | (2,275                        | )          | (35,964          | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from financing activities:**                 |       |       |       |                        |       |                          |       |             |       |
| Proceeds  from long-term debt and line of credit          |       | 23,000     |       | 1,339                       |       | 3⁄4                        |       | 24,339           |       |
| Payments  on line of credit                               |       | (21,000    | )          | 3⁄4                      |       | 3⁄4                        |       | (21,000          | )          |
| Payments  on capital lease obligations                    |       | (31        | )          | 3⁄4                      |       | 3⁄4                        |       | (31              | )          |
| Payments  of debt issuance and other financing costs      |       | (31        | )          | 3⁄4                      |       | 3⁄4                        |       | (31              | )          |
| Collections  of payments of shareholder notes             |       | 440        |       | 3⁄4                      |       | 3⁄4                        |       | 440              |       |
| Payments  on MCF Bonds                                    |       | 3⁄4     |       | 3⁄4                      |       | (7,600                        | )          | (7,600           | )          |
| Proceeds  from exercise of stock options and warrants     |       | 2,427      |       | 3⁄4                      |       | 3⁄4                        |       | 2,427            |       |
| Purchases  of treasury stock                              |       | (1,230     | )          | 3⁄4                      |       | 3⁄4                        |       | (1,230           | )          |
| Net  cash provided by (used in) financing activities      |       | 3,575      |       | 1,339                       |       | (7,600                        | )          | (2,686           | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Net (decrease) increase in cash and cash  equivalents** |       | (12,580    | )          | 132                         |       | 9                             |       | (12,439          | )          |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash and  cash equivalents at beginning of****period**  |       | 52,407     |       | 157                         |       | 46                            |       | 52,610           |       |
|                                                      |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at end of period**            |       | $          | 39,827     |                        | $          | 289                           |       | $                | 55         |   | $ | 40,171 |   |

 

104

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# **Condensed Consolidating Statement of CashFlows for the year ended December 31, 2002 (in thousands)**

 
| ** **                                                             | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                              |       |       |       |                        |       |                          |       |             |       |
| Net  cash provided by operating activities                             |       | $          | 366        |                        | $          | 8,741                         |       | $                | 10,657     |   | $ | 19,764 |   |
|                                                                   |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from investing activities:**                              |       |       |       |                        |       |                          |       |             |       |
| Capital  expenditures                                                  |       | 3⁄4     |       | (10,075                     | )          | (1,039                        | )          | (11,114          | )          |
| Payments  to restricted debt payment account, net                      |       | 3⁄4     |       | 3⁄4                      |       | (2,184                        | )          | (2,184           | )          |
| Return of restricted assets from deferred  bonus plan                  |       | 1,000      |       | 3⁄4                      |       | 3⁄4                        |       | 1,000            |       |
| Net  cash provided by (used in) investing activities                   |       | 1,000      |       | (10,075                     | )          | (3,223                        | )          | (12,298          | )          |
|                                                                   |       |       |       |                        |       |                          |       |             |       |
| **Cash flows from financing activities:**                              |       |       |       |                        |       |                          |       |             |       |
| Proceeds  from long-term debt and line of credit                       |       | 3⁄4     |       | 1,083                       |       | 3⁄4                        |       | 1,083            |       |
| Payments  on MCF bonds                                                 |       | 3⁄4     |       | 3⁄4                      |       | (6,800                        | )          | (6,800           | )          |
| Payments  on capital lease obligations                                 |       | (113       | )          | 3⁄4                      |       | 3⁄4                        |       | (113             | )          |
| Collections of  payments of  shareholder notes                         |       | 173        |       | 3⁄4                      |       | 3⁄4                        |       | 173              |       |
| Distributions  to equity owners of consolidated special purpose entity |       | 3⁄4     |       | 3⁄4                      |       | (614                          | )          | (614             | )          |
| Proceeds  from exercise of stock options and warrants                  |       | 600        |       | 3⁄4                      |       | 3⁄4                        |       | 600              |       |
| Purchases  of treasury stock                                           |       | (2,429     | )          | 3⁄4                      |       | 3⁄4                        |       | (2,429           | )          |
| Net  cash (used in) provided by financing activities                   |       | (1,769     | )          | 1,083                       |       | (7,414                        | )          | (8,100           | )          |
|                                                                   |       |       |       |                        |       |                          |       |             |       |
| **Net (decrease) increase in cash and cash  equivalents**              |       | (403       | )          | (251                        | )          | 20                            |       | (634             | )          |
|                                                                   |       |       |       |                        |       |                          |       |             |       |
| **Cash and  cash equivalents at beginning of****period**               |       | 52,810     |       | 408                         |       | 26                            |       | 53,244           |       |
|                                                                   |       |       |       |                        |       |                          |       |             |       |
| **Cash and cash equivalents at end of period**                         |       | $          | 52,407     |                        | $          | 157                           |       | $                | 46         |   | $ | 52,610 |   |

 

105

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**18****.****      ****SELECTED QUARTERLY FINANCIALDATA (Unaudited)**

 
| ** **                             | ** ** | **1stQuarter** | ** ** | **2ndQuarter** | ** ** | **3rdQuarter** | ** ** | **4thQuarter** | ** ** | **Year** | ** ** |
|----------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------|------------|
| **2004:**                              |       |           |       |           |       |           |       |           |       |     |       |
| Revenues                               |       | $              | 69,324     |           | $          | 69,993         |       | $              | 74,693     |     | $          | 77,015 |   | $ | 291,025 |   |
| Income from (loss) operations          |       | 5,845          |       | 4,710          |       | 4,404          |       | (4,522         | )          | 10,437   |       |
| Net income (loss)                      |       | 706            |       | (1,099         | )(1)       | (897           | )          | (6,143         | )(2)       | (7,433   | )          |
|                                   |       |           |       |           |       |           |       |           |       |     |       |
| Earnings (loss) per share:             |       |           |       |           |       |           |       |           |       |     |       |
| **•**  Basic                      |       | $              | .05        |           | $          | (.08           | )          | $              | (.07       | )        | $          | (.46 | ) | $ | (.56 | ) |
| **•**  Diluted                    |       | $              | .05        |           | $          | (.08           | )          | $              | (.07       | )        | $          | (.46 | ) | $ | (.56 | ) |
| ** **                             |       |           |       |           |       |           |       |           |       |     |       |
| **2003:**                              |       |           |       |           |       |           |       |           |       |     |       |
| Revenues                               |       | $              | 66,026     |           | $          | 67,586         |       | $              | 68,642     |     | $          | 69,378 |   | $ | 271,632 |   |
| Income from operations                 |       | 7,779          |       | 8,196          |       | 6,732          |       | 1,677          | )(3)       | 24,384   |       |
| Net income (loss)                      |       | 1,957          |       | 2,177          |       | 1,442          |       | (1,606         | )(3)       | 3,970    |       |
|                                   |       |           |       |           |       |           |       |           |       |     |       |
| Earnings (loss) per share:             |       |           |       |           |       |           |       |           |       |     |       |
| **•**  Basic                      |       | $              | .15        |           | $          | .17            |       | $              | .11        |     | $          | (.12 | ) | $ | .31 |   |
| **•**  Diluted                    |       | $              | .15        |           | $          | .17            |       | $              | .11        |     | $          | (.12 | ) | $ | .30 |   |
|                                   |       |           |       |           |       |           |       |           |       |     |       |
| **2004  Balance Sheet Data:**          |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                        |       | $              | 93,434     |           | $          | 118,933        |       | $              | 105,674    | (4)      | $          | 107,597 | (4)  | $ | 107,597 |   |
| Total assets                           |       | 453,630        |       | 503,060        |       | 500,243        |       | 507,631        |       | 507,631  |       |
| Long-term debt, net of current portion |       | 239,292        |       | 284,852        |       | 279,373        |       | 279,528        |       | 279,528  |       |
| Stockholders’ equity              |       | 168,139        |       | 166,354        |       | 166,586        |       | 161,312        |       | 161,312  |       |
|                                   |       |           |       |           |       |           |       |           |       |     |       |
| **2003  Balance Sheet Data:**          |       |           |       |           |       |           |       |           |       |     |       |
| Working capital                        |       | $              | 99,003     |           | $          | 101,065        |       | $              | 89,122     |     | $          | 86,214 |   | $ | 86,214 |   |
| Total assets                           |       | 435,139        |       | 443,988        |       | 445,664        |       | 449,103        |       | 449,103  |       |
| 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  |       |

 

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(1)          Includes a loss on the extinguishment of debtof approximately $2.4 million for the early retirement of the Synthetic Lease  NotesA and B and the revolving line of credit under our amended 2000 Credit Facilityin June 2004.

 

(2)          Includes impairment charges on our long-livedassets of approximately $10.1 million.

 

(3)          Includes a loss of approximately $5.4 millionrelated to the Southern Peaks Regional Treatment Center escrow deposit.  The  after tax effect of the lossreduced net income by approximately $3.2 million.

 

(4)          In connection with the preparation of thisreport, we concluded that it was appropriate to classify our auction ratemunicipal bonds as current investments. Previously, such investments had been classified as cash and cashequivalents.  Accordingly, we haverevised the classification for the quarterly period ended September 30, 2004 toreport $33.4 million of these securities as current investments in a separateline item on our Consolidated Balance Sheet. We have also made corresponding adjustments to our ConsolidatedStatement of Cash Flows for the quarterly period ended September 30, 2004 toreflect the gross purchases and sales of these securities as investingactivities rather than as a component of cash and cash equivalents.  For the quarterly period ended September 30,2004 net cash used in investing activities related to these current investmentsof $33.4 million was previously included in cash and cash equivalents in ourConsolidated Statement of Cash Flows. This change in classification does not affect previously reported cashflows from operations or from financing activities, or our previously reportedConsolidated Statements of Income for any period.

 

106

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**ITEM 9.****       ****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE**

 

None.

 

#### **ITEM9A.  CONTROLS AND PROCEDURES**

#### ** **

Wemaintain disclosure controls and procedures designed to ensure that informationdisclosed in our annual and periodic reports is recorded, processed, summarizedand reported, within the time periods specified in the Securities and ExchangeCommission’s rules and forms. In addition, we designed these disclosurecontrols and procedures to ensure that this information is accumulated andcommunicated to management, including the chief executive officer (CEO) andchief financial officer (CFO), to allow timely decisions regarding requireddisclosures. SEC rules require that we disclose the conclusions of our CEO andCFO about the effectiveness of our disclosure controls and procedures.

 

Wedo not expect that our disclosure controls and procedures will prevent allerrors or fraud. A control system, no matter how well conceived and operated,can provide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. In addition, the design of disclosure controls andprocedures must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitation in a cost-effective control system, misstatements due toerror or fraud could occur and not be detected.

 

Under the supervision and with the participation of our management,including our principal executive officer and principal financial officer, andas required by paragraph (b) of Rules 13a-15 and 15d-15 of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) we have evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) asof the end of the period required by this report. Based on that evaluation, ourprincipal executive officer and principal financial officer have concluded thatthese controls and procedures are effective as of that date.

 

In connection with the evaluationas required by paragraph (d) of Rules 13a-15 and 15d-15 of the Exchange Act, wehave not identified any change in internal control over financial reporting (assuch term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)that occurred during our fiscal quarter ended December 31, 2004 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

#### **ITEM9B.  OTHER INFORMATION**

 

None.

 

107

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#### **PART III**

#### ** **

Items10, 11, 12, 13 and 14 of Part III have been omitted from this report because wewill file with the Securities and Exchange Commission, not later than 120 daysafter the close of our fiscal year, a definitive proxy statement or a Form10-K/A.  The information required byItems 10, 11, 12, 13 and 14 of this report, which will appear in the definitiveproxy statement and/or the Form 10-K/A, is incorporated by reference into PartIII of this report.

 

108

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**PART IV**

 

**ITEM 15.****                ****EXHIBITS, FINANCIALSTATEMENT SCHEDULES**

 

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

 
| 1.     |   | Financial  statements          |
|--------|--------|--------------------------------|
|   |   |                           | Report  of Independent Registered Public Accounting Firm |
|   |   |                           | Consolidated Balance  Sheets - December 31, 2004 and 2003 |
|   |   |                           | Consolidated  Statements of Operations and Comprehensive Income/(Loss) for the years ended December 31,  2004, 2003 and 2002 |
|   |   |                           | Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |
|   |   |                           | Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002 |
|   |   |                           | 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** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| 2.1              |       | Agreement and Plan of Merger, dated as of January 24, 2005, among  Cornell Companies, Inc., Correctional Systems, Inc., Cornell Acquisition  Corp. and Infrastructure and Environmental Private Equity Fund III, L.P.                                                                |       | 22                            |
| 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                             |

 

109

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| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                       | ** ** | **Incorporated by Reference** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| 10.8             |       | Contract  between CCCI and the CDC (No. R92.132) for the Live Oak, California Facility  dated March 1, 1993, as amended.                                                                                         |       | 2                             |
| 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                            |

 

110

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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                            |

 

111

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| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                      | ** ** | **Incorporated by Reference** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
| 10.50            |       | First  Amendment to Note and Equity Purchase Agreement dated August 9, 2001.                                                                                                                                                    |       | 18,23                         |
| 10.51            |       | Credit  Agreement dated as of June 24, 2004 among Cornell Companies, Inc., as  Borrower, such subsidiaries of the Borrower as named therein, JPMorgan Chase  Bank, as Administrative Agent, and such other lenders as named therein. |       |                          |
| 11.1             |       | Computation  of Per Share Earnings.                                                                                                                                                                                                  |       | 21                            |
| 21.1             |       | Subsidiaries  of the Company.                                                                                                                                                                                                        |       | *                             |
| 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                            |

 

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  (a)  Management compensatory plan or contract.

  (1)  AnnualReport 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 forthe year ended December 31, 1998.

(11)  Quarterly Report on Form 10-Q of the Companyfor the quarter ended September 30, 1999.

(12)  Annual Report on Form 10-K of the Company forthe year ended December 31, 1999.

(13)  Quarterly Report on Form 10-Q of the Companyfor the quarter ended June 30, 2000.

(14)  Registration Statement on Form S-8 of theCompany (Registration No. 333-80187).

(15)  Registration Statement on Form S-8 of theCompany (Registration No. 333-42444).

(16)  Registration Statement on Form S-8 of theCompany (Registration No. 333-52236).

(17) Current Report on Form 8-K of theCompany dated August 14, 2001.

(18) Quarterly Report on Form 10-Q of theCompany for the quarter ended September 30, 2001.

(19) Quarterly Report on Form 10-Q of theCompany for the quarter ended March 31, 2001.

(20) Annual Report on Form 10-K of theCompany for the year ended December 31, 2001.

(21) Annual Report on Form 10-K of theCompany for the year ended December 31, 2002.

(22)  Current Report on Form 8-K of the Companydated January 24, 2005.

(23)  Current Report on Form 8-K of the Companydated June 25, 2004.

  *     Filed herewith

 

112

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**SIGNATURES**

 

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

 
|   |                 | CORNELL  COMPANIES, INC. |
|--------|----------------------|--------------------------|
|   |                 |                     |   |
| Dated: | March 16,  2005 | By:                      | /s/  James E. Hyman |   |
|   |                 |                     | James  E. Hyman |
|   |                 |                     | Chief  Executive Officer and |
|   |                 |                     | Chairman  of the Board |

 

 
| **SIGNATURE**                 | ** ** | **TITLE**                         | ** **                   | **DATE**             |
|-------------------------------|------------|-----------------------------------|------------------------------|----------------------|
|                          |       |                              |                         |                 |
| /s/  James E. Hyman           |       |                              | Chief  Executive Officer and |                 | March 16,  2005 |
| James  E. Hyman               |       | Chairman  of the Board            |                         |                 |
|                          |       | (Principal  Executive Officer)    |                         |                 |
|                          |       |                              |                         |                 |
| /s/  John R. Nieser           |       |                              | Chief  Financial Officer     |                 | March 16,  2005 |
| John  R. Nieser               |       | (Principal  Financial Officer and |                         |                 |
|                          |       | Principal  Accounting Officer)    |                         |                 |
|                          |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  ANTHONY R. CHASE         |       | Director                          |                         | March 16,  2005 |
| Anthony  R. Chase             |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  ISABELLA C.M. CUNNINGHAM |       | Director                          |                         | March 16,  2005 |
| Isabella  C.M. Cunningham     |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  D. STEPHEN SLACK         |       | Director                          |                         | March 16,  2005 |
| D.  Stephen Slack             |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  TUCKER TAYLOR            |       | Director                          |                         | March 16,  2005 |
| Tucker  Taylor                |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  ROBERT F. VAGT           |       | Director                          |                         | March 16,  2005 |
| Robert  F. Vagt               |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  MARCUS A. WATTS          |       | Director                          |                         | March 16,  2005 |
| Marcus  A. Watts              |       |                              |                         |                 |
|                          |       |                              |                         |                 |
| /s/  HARRY J. PHILLIPS, JR.   |       | Director                          |                         | March 16,  2005 |
| Harry  J. Phillips, Jr.       |       |                              |                         |                 |
|                               |            |                                   |                              |                      |  |  |

 

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