** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 

ý**         QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the Quarterly PeriodEnded September 30, 2005**

 

**OR**

 

o**         TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transitionperiod**               **to**               

 

**Commission File Number 1-14472**

 

**CORNELL COMPANIES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                               | ** ** | **76-0433642**       |
|------------------------------------------------------------|------------|----------------------|
| (State or  other jurisdiction                              |       | (I.R.S.  Employer    |
| of  incorporation or organization)                         |       | Identification  No.) |
|                                                       |       |                 |
| **1700 West Loop South,  Suite 1500, Houston, Texas** | ** ** | **77027**            |
| (Address of  Principal Executive Offices)                  |       | (Zip Code)           |

 

Registrant’stelephone number, including area code: **(713)623-0790**

 

Indicateby a check mark whether Registrant (1) has filed all reports required tobe filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months, and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes ý   No o

 

Indicateby a check mark whether Registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).

 

Yes ý   No o

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).

 

Yes o   No ý

 

At October 31, 2005 Registrant hadoutstanding 13,795,233 shares of its Common Stock.

 

----

 

**PART I****                              ****FINANCIAL INFORMATION**

 

**ITEM 1.****                            ****Financial Statements**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

**(in thousands, exceptshare data)**

 
| ** **                                                                                                                                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                            |       |                   |       |                  |       |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **CURRENT ASSETS:**                                                                                                                                                   |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                             |       | $                      | 10,128     |                  | $          | 9,895 |   |
| Investment securities available  for sale                                                                                                                             |       | 20,800                 |       | 51,740                |       |
| Accounts receivable - trade (net  of allowance for doubtful accounts of $2,336 and $3,544, respectively)                                                              |       | 55,273                 |       | 60,174                |       |
| Other receivables (net of  allowance for doubtful accounts of $5,040)                                                                                                 |       | 3,322                  |       | 4,691                 |       |
| Debt service fund and other  restricted assets                                                                                                                        |       | 15,783                 |       | 19,713                |       |
| Deferred tax assets                                                                                                                                                   |       | 5,906                  |       | 8,520                 |       |
| Prepaid expenses and other                                                                                                                                            |       | 8,666                  |       | 9,106                 |       |
| Total current assets                                                                                                                                                  |       | 119,878                |       | 163,839               |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 310,978                |       | 282,255               |       |
| **OTHER ASSETS:**                                                                                                                                                     |       |                   |       |                  |       |
| Debt service reserve fund                                                                                                                                             |       | 23,802                 |       | 23,801                |       |
| Goodwill, net                                                                                                                                                         |       | 10,856                 |       | 7,721                 |       |
| Intangible assets, net                                                                                                                                                |       | 9,620                  |       | 7,026                 |       |
| Deferred costs and other                                                                                                                                              |       | 21,272                 |       | 22,989                |       |
| **Total assets**                                                                                                                                                      |       | $                      | 496,406    |                  | $          | 507,631 |   |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                                        |       |                   |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **CURRENT LIABILITIES:**                                                                                                                                              |       |                   |       |                  |       |
| Accounts payable and accrued  liabilities                                                                                                                             |       | $                      | 46,574     |                  | $          | 47,237 |   |
| Current portion of long-term  debt                                                                                                                                    |       | 9,701                  |       | 9,005                 |       |
| **Total current  liabilities**                                                                                                                                        |       | 56,275                 |       | 56,242                |       |
| LONG-TERM DEBT, net of current portion                                                                                                                                |       | 267,416                |       | 279,528               |       |
| DEFERRED TAX LIABILITIES                                                                                                                                              |       | 6,795                  |       | 8,088                 |       |
| OTHER LONG-TERM LIABILITIES                                                                                                                                           |       | 2,677                  |       | 2,461                 |       |
| **Total liabilities**                                                                                                                                                 |       | 333,163                |       | 346,319               |       |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **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, 15,342,722 and 14,845,107 shares issued and  13,779,735 and 13,297,524 shares outstanding, respectively |       | 15                     |       | 15                    |       |
| Additional paid-in capital                                                                                                                                            |       | 150,415                |       | 145,825               |       |
| Retained earnings                                                                                                                                                     |       | 25,478                 |       | 26,785                |       |
| Treasury stock (1,562,987 and  1,547,583 shares of common stock, at cost, respectively)                                                                               |       | (12,573                | )          | (12,573               | )          |
| Deferred compensation                                                                                                                                                 |       | (1,007                 | )          | (432                  | )          |
| Accumulated other comprehensive  income                                                                                                                               |       | 915                    |       | 1,692                 |       |
| **Total stockholders’  equity**                                                                                                                                  |       | 163,243                |       | 161,312               |       |
| **Total liabilities  and stockholders’ equity**                                                                                                                  |       | $                      | 496,406    |                  | $          | 507,631 |   |

 

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

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

**(Unaudited)**

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

 
| ** **                                                                                                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| REVENUES                                                                                                                                  |       | $                      | 79,198     |                   | $          | 71,336 |   | $ | 231,340 |   | $ | 203,288 |   |
| OPERATING EXPENSES                                                                                                                        |       | 60,805                 |       | 53,282                 |       | 174,844 |   | 156,234 |   |
| PRE-OPENING AND START-UP  EXPENSES                                                                                                        |       | 1,607                  |       | 3,455                  |       | 8,453 |   | 4,723 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                             |       | 3,834                  |       | 3,335                  |       | 11,379 |   | 9,504 |   |
| GENERAL AND ADMINISTRATIVE  EXPENSES                                                                                                      |       | 4,760                  |       | 5,596                  |       | 15,997 |   | 15,361 |   |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                                    |       | 8,192                  |       | 5,668                  |       | 20,667 |   | 17,466 |   |
| INTEREST EXPENSE                                                                                                                          |       | 5,918                  |       | 6,082                  |       | 18,501 |   | 15,763 |   |
| INTEREST INCOME                                                                                                                           |       | (523                   | )          | (534                   | )          | (1,782 | ) | (1,351 | ) |
| LOSS ON EXTINGUISHMENT OF DEBT                                                                                                            |       | 3⁄4                 |       | 5                      |       | 3⁄4 |   | 2,361 |   |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                      |       | 2,797                  |       | 115                    |       | 3,948 |   | 693 |   |
| PROVISION FOR INCOME TAXES                                                                                                                |       | 1,241                  |       | 24                     |       | 1,861 |   | 260 |   |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS                                                                                                        |       | 1,556                  |       | 91                     |       | 2,087 |   | 433 |   |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF  TAX BENEFIT OF $150 AND $1,827 IN 2005 AND $277 AND $785 IN 2004                                         |       | (279                   | )          | (988                   | )          | (3,394 | ) | (1,721 | ) |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                                                         |       | $                      | 1,277      |                   | $          | (897 | ) | $ | (1,307 | ) | $ | (1,288 | ) |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                                                |       |                   |       |                   |       |   |   |   |   |
| BASIC                                                                                                                                     |       |                   |       |                   |       |   |   |   |   |
| Income from continuing  operations                                                                                                        |       | $                      | .11        |                   | $          | .01 |   | $ | .15 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                            |       | (.02                   | )          | (.08                   | )          | (.25 | ) | (.13 | ) |
| Net income (loss)                                                                                                                         |       | $                      | .09        |                   | $          | (.07 | ) | $ | (.10 | ) | $ | (.10 | ) |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| DILUTED                                                                                                                                   |       |                   |       |                   |       |   |   |   |   |
| Income from continuing  operations                                                                                                        |       | $                      | .11        |                   | $          | .01 |   | $ | .15 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                            |       | (.02                   | )          | (.08                   | )          | (.25 | ) | (.13 | ) |
| Net income (loss)                                                                                                                         |       | $                      | .09        |                   | $          | (.07 | ) | $ | (.10 | ) | $ | (.10 | ) |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER  SHARE COMPUTATION:                                                                                          |       |                   |       |                   |       |   |   |   |   |
| BASIC                                                                                                                                     |       | 13,579                 |       | 13,199                 |       | 13,484 |   | 13,143 |   |
| DILUTED                                                                                                                                   |       | 13,686                 |       | 13,419                 |       | 13,608 |   | 13,360 |   |
|                                                                                                                                      |       |                   |       |                   |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Net income (loss)                                                                                                                         |       | $                      | 1,277      |                   | $          | (897 | ) | $ | (1,307 | ) | $ | (1,288 | ) |
| Unrealized gain (loss) on  derivative instruments, net of tax (benefit) provision of ($168) and ($114)  in 2005 and $627 and $192 in 2004 |       | (241                   | )          | 910                    |       | (165 | ) | 285 |   |
| Comprehensive income (loss)                                                                                                               |       | $                      | 1,036      |                   | $          | 13 |   | $ | (1,472 | ) | $ | (1,003 | ) |

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

 

3

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**CORNELL COMPANIES, INC.**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                        | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                        | ** ** | **September 30,** | ** ** |
| ** **                                                                                                        | ** ** | **2005**               | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                             |       |                   |       |   |   |
| Net loss                                                                                                          |       | $                      | (1,307     | ) | $ | (1,288 | ) |
| Adjustments to reconcile net loss  to net cash provided by operating activities -  Loss on extinguishment of debt |       | —                 |       | 2,361 |   |
| Depreciation                                                                                                      |       | 9,846                  |       | 8,815 |   |
| Amortization of intangibles and  other assets                                                                     |       | 1,664                  |       | 952 |   |
| Amortization of deferred  compensation                                                                            |       | (316                   | )          | 14 |   |
| Amortization of deferred  financing costs                                                                         |       | 1,198                  |       | 998 |   |
| Amortization of Senior Notes  discount                                                                            |       | 138                    |       | 47 |   |
| Provision for bad debts                                                                                           |       | 3,192                  |       | 921 |   |
| (Gain) loss on sale of property  and equipment                                                                    |       | (11                    | )          | 3 |   |
| Deferred income taxes                                                                                             |       | 760                    |       | 295 |   |
| Change in assets and  liabilities:                                                                                |       |                   |       |   |   |
| Accounts receivable                                                                                               |       | 1,169                  |       | (4,059 | ) |
| Other restricted assets                                                                                           |       | (254                   | )          | (58 | ) |
| Other assets                                                                                                      |       | 3,286                  |       | (351 | ) |
| Accounts payable and accrued  liabilities                                                                         |       | (1,312                 | )     | (2,725 | ) |
| Deferred revenues and other  liabilities                                                                          |       | (81                    | )          | 79 |   |
| Net cash provided by operating  activities                                                                        |       | 17,972                 |       | 6,004 |   |
|                                                                                                              |       |                   |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                             |       |                   |       |   |   |
| Capital expenditures                                                                                              |       | (37,331                | )          | (30,429 | ) |
| Purchases of investment  securities                                                                               |       | (905,345               | )          | (63,165 | ) |
| Sales of investment securities                                                                                    |       | 936,285                |       | 29,750 |   |
| Acquisition of a business                                                                                         |       | (9,139                 | )          | — |   |
| BOP claim reimbursement                                                                                           |       | —                 |       | 5,566 |   |
| Receipt from restricted escrow  arrangement                                                                       |       | —                 |       | 5,000 |   |
| Purchase of facility management  contract                                                                         |       | —                 |       | (2,900 | ) |
| Withdrawals from restricted debt  payment account, net                                                            |       | 4,183                  |       | 4,131 |   |
| Proceeds from sale of fixed  assets                                                                               |       | 624                    |       | 163 |   |
| Net cash used in investing  activities                                                                            |       | (10,723                | )          | (51,884 | ) |
|                                                                                                              |       |                   |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                             |       |                   |       |   |   |
| Proceeds from long-term debt and  line of credit                                                                  |       | —                 |       | 69,000 |   |
| Payments on line of credit                                                                                        |       | —                 |       | (71,000 | ) |
| Payments of MCF bonds                                                                                             |       | (9,000                 | )          | (8,300 | ) |
| Payments of acquired debt                                                                                         |       | (1,905                 | )          | — |   |
| Payments of synthetic lease                                                                                       |       | —                 |       | (52,499 | ) |
| Proceeds from Senior Notes, net  of discount                                                                      |       | —                 |       | 110,527 |   |
| Payments for debt issuance and  other financing costs                                                             |       | —                 |       | (5,887 | ) |
| Payments of capital lease  obligations                                                                            |       | (176                   | )          | (7 | ) |
| Proceeds from exercise of stock  options                                                                          |       | 4,065                  |       | 1,454 |   |
| Purchases of treasury stock                                                                                       |       | —                 |       | (116 | ) |
| Net cash (used in) provided by  financing activities                                                              |       | (7,016                 | )          | 43,172 |   |
|                                                                                                              |       |                   |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                              |       | 233                    |       | (2,708 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                                  |       | 9,895                  |       | 40,171 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                                        |       | $                      | 10,128     |   | $ | 37,463 |   |
|                                                                                                              |       |                   |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                                |       |                   |       |   |   |
| Increase (decrease) in fair  value of interest rate swap                                                          |       | $                      | (2,660     | ) | $ | 3,099 |   |
| Other comprehensive income  (loss), net of tax                                                                    |       | (165                   | )          | 285 |   |
| Common stock issued for board of  directors fees                                                                  |       | 266                    |       | 191 |   |

 

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

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

**1.****             ****Basis of Presentation**

 

The accompanying unauditedconsolidated financial statements have been prepared by CornellCompanies, Inc. (the “Company”) pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with generally accepted accountingprinciples in the United States (GAAP) have been condensed or omitted pursuantto such rules and regulations.  Inthe opinion of management, adjustments and disclosures necessary for a fairpresentation of these financial statements have been included.  Estimates were used in the preparation ofthese financial statements.  Actualresults could differ from those estimates. These financial statements should be read in conjunction with thefinancial statements and notes thereto included in our 2004 Annual Report onForm 10-K, as amended, as filed with the Securities and ExchangeCommission.

 

**2.****             ****Accounting Policies**

 

Seea description of our accounting policies in our 2004 Annual Report on Form 10-K,as amended.

 

***AccountingFor Stock-Based Compensation***

 

Inaccordance with the provisions of Statement of Financial Accounting Standard(SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have electedto account for our stock-based compensation plans under the intrinsic valuemethod established by Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees.”  Inaccordance with the provisions of APB No. 25, the fair value of fixedstock options granted to employees is not reflected in net income, as alloptions granted under those plans had an exercise price equal to or in excessof the market value of the underlying common stock on the date of grant.  The following table illustrates, inaccordance with SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure, an Amendment of SFAS No. 123,” the effect onour net income (loss) per share as if we had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation (inthousands, except per share amounts):

 
| ** **                                                                                                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                                  | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                  | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                        |       |                   |       |                   |       |   |   |   |   |
| Net income (loss), as reported                                                                                                              |       | $                      | 1,277      |                   | $          | (897 | ) | $ | (1,307 | ) | $ | (1,288 | ) |
| Add: total stock-based  compensation recorded, net of tax                                                                                   |       | 49                     |       | 43                     |       | 114 |   | 74 |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (619                   | )          | (248                   | )          | (1,415 | ) | (822 | ) |
| Pro forma net income (loss)                                                                                                                 |       | $                      | 707        |                   | $          | (1,102 | ) | $ | (2,608 | ) | $ | (2,036 | ) |
| Income (loss) per share:                                                                                                                    |       |                   |       |                   |       |   |   |   |   |
| Basic, as reported                                                                                                                          |       | $                      | .09        |                   | $          | (.07 | ) | $ | (.10 | ) | $ | (.10 | ) |
| Basic, pro forma                                                                                                                            |       | .05                    |       | (.08                   | )          | (.19 | ) | (.15 | ) |
| Diluted, as reported                                                                                                                        |       | .09                    |       | (.07                   | )          | (.10 | ) | (.10 | ) |
| Diluted, pro forma                                                                                                                          |       | .05                    |       | (.08                   | )          | (.19 | ) | (.15 | ) |
|                                                                                                                                             |            |                        |            |                        |            |  |  |  |  |  |  |  |  |  |  |

 

5

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***New AccountingPronouncements***

*** ***

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFASNo. 123R, “Share Based Payment,” which requires companies to expense thevalue of employee stock options and other types of equity-based compensationbased on the fair value of the options at the award’s grant date based on theestimated number of awards that are expected to vest.  Compensation cost for awards that vest wouldnot be reversed if the awards expired 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 for share-based payment awards as they vest, including therelated tax effects.  The effective dateof SFAS No. 123R, as amended, applies to annual periods beginning afterJune 15, 2005, and applies to all outstanding and unvested share basedpayment awards at the company’s adoption date. We are currently evaluating the alternative transition methods permittedby SFAS No. 123R. Presently we believe we will utilize the Black-Sholesoption pricing model. We currently anticipate that our evaluation process willbe completed during the fourth quarter of 2005, with implementation during thefirst quarter of 2006.

 

Under SFAS No. 123R,compensatory employee stock purchase plans (ESPP) are required to recognizecompensation cost over the requisite service period for grants made under theESPP.  The criteria that an ESPP mustmeet to be considered non-compensatory are more restrictive under SFASNo. 123R than they were under APB No. 25.  We are currently evaluating the impact on ourESPP by SFAS No. 123R.

 

The FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections — a replacement of APB Opinion No. 20 and FASB StatementNo. 3.”  SFAS No. 154 iseffective, and will be adopted, for accounting changes made in fiscal yearsbeginning after December 15, 2005 and is to be applied retroactively.  SFAS No. 154 requires that retroactiveapplication of a change in accounting principle be limited to the directeffects of the change.  Our adoption ofSFAS No. 154 is not expected to have a material effect on our financialposition, results of operations or cash flows.

 

***Reclassifications***

 

Certain reclassificationshave been made to the prior year financial statements contained herein toconform to current year presentation.

 

**3.****             ****DiscontinuedOperations and Management Restructuring**

 

We classify as discontinued operations those components of our businessthat we hold for sale or that have been disposed and have cash flows that areclearly distinguishable operationally and for financial reporting purposes fromthe rest of our operations. For those components, we have no significantcontinuing involvement after disposal and their operations are eliminated fromour ongoing operations.  During the ninemonths ended September 30, 2005, we classified certain components asdiscontinued operations. This was the result of a management decision to closecertain facilities in the first and second quarter of 2005.  These facilities and programs include theResidential School, the Maple Creek Home and our mental health wrap programs inPennsylvania in the first quarter of 2005. In the second quarter of 2005, we closed the Northside Clinic and theJos-Arz Academy.  Notifications were madeto the required contracting entities regarding the termination of the relatedprograms.  At September 30, 2005, wehad net property and equipment of approximately $0.1 million pertaining tothese operations.   These discontinuedoperations generated revenues of approximately $3.4 million in the three monthsended September 30, 2004 (none in the three months ended September 30,2005) and revenues of approximately $2.6 million and $10.7 million in the ninemonths ended September 30, 2005 and 2004, respectively.

 

During the first quarter of 2005, a review was performed of ourmanagement structure and, as a result, approximately 14 positions wereeliminated.  In conjunction with thisaction, a charge of approximately $2.1 million was recorded in the firstquarter of 2005.  Approximately $1.0million of this charge was reflected in operating expenses and $1.1 million ingeneral and administrative expenses.  Theaccrued liability pertaining to this charge was approximately $1.0 million atSeptember 30, 2005.  There are nosignificant additional costs expected to be incurred in conjunction with thisactivity in future periods.

 

6

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**4.             Acquisition of CorrectionalSystems, Inc.**

InApril 2005, we completed our acquisition of CorrectionalSystems, Inc. (CSI), a San Diego-based provider of privatized jail,community corrections and alternative sentencing services.  The transaction was consummated in cash ofapproximately $9.1 million, net of cash acquired, all of which was paidApril 1, 2005.  The acquisition includedthe operations of eight jails, six adult community-based correction facilitiesand five alternative sentencing programs located in California, New Mexico,Texas and Kansas.  The acquisition addedapproximately 986 corrections beds, as well as alternatives to incarcerationservices.  The results of operations forCSI subsequent to the date of acquisition are included in our consolidatedfinancial statements.

We acquired substantially allof CSI’s assets and assumed all of their liabilities.  The excess of the purchase price over thefair value of the assets acquired and liabilities assumed was allocated togoodwill.  Our purchase price allocationsare preliminary pending final appraisals and assessment of liabilities assumed.  We currently do not anticipate anysignificant differences between current book values and the fair values uponthe completion of these assessments.  Theinitial purchase price allocations may be adjusted within the shorter of a definedallocation period or one year of the purchase date for changes in the estimatesof the fair values of assets acquired and liabilities assumed.   The following table summarizes the estimatedfair values of the assets acquired and liabilities assumed as of September 30,2005 (in thousands).

 

| Receivables                              |   | $      | 1,769  |   |
|------------------------------------------|--------|--------|--------|--------|
| Prepaids and other assets                |   | 305    |   |
| Property and equipment                   |   | 2,344  |   |
| Contract value                           |   | 4,121  |   |
| Other assets                             |   | 1,351  |   |
| Goodwill                                 |   | 2,748  |   |
| Assets acquired                          |   | 12,638 |   |
|                                     |   |   |   |
| Accounts payable and accrued liabilities |   | $      | 1,076  |   |
| Long-term debt                           |   | 2,293  |   |
| Other long-term liabilities              |   | 130    |   |
| Liabilities assumed                      |   | 3,499  |   |
| Net assets acquired                      |   | $      | 9,139  |   |
|                                          |        |        |        |        |  |

Webelieve that the CSI acquisition resulted in the recognition of goodwillbecause of its industry position, operational strength and potential to provideadditional growth opportunities for us. During the three months ended September 30, 2005, we adjusted goodwillby approximately $0.3 million due to adjustments to the cost basis of theproperty acquired based on final property appraisals and for certainpost-closing acquisition costs.

Our amortization period foracquired contracts is the greater of the acquired contract life or seven years.

On an unaudited basis, the effects of the CSI acquisition werenot significant to our results of operations had they been included in priorperiods.

**5.****             ****IntangibleAssets**

Intangible assets at September 30,2005 and December 31, 2004 consisted of the following (in thousands):

| ** **                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2005**               | ** ** | **2004**              | ** ** |
|                        |       |                   |       |                  |       |
| Non-compete agreements      |       | $                      | 9,930      |                  | $          | 9,840 |   |
| Acquired contract value     |       | 6,442                  |       | 2,405                 |       |
| Accumulated amortization    |       | (6,752                 | )          | (5,219                | )          |
| Identified intangibles, net |       | 9,620                  |       | 7,026                 |       |
| Goodwill, net               |       | 10,856                 |       | 7,721                 |       |
| Total intangibles, net      |       | $                      | 20,476     |                  | $          | 14,747 |   |

 

Amortization expense for our non-competeagreements was approximately $0.3 million for the three months ended September 30,2005 and 2004 and approximately $0.9 million and $0.8 million for the ninemonths ended September 30, 2005 and 2004, respectively.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the next fouryears ended December 31 and approximately $0.7 million for the fifth year.

Amortization expense for our acquiredcontract value was approximately $0.3 million and $0.7 million for the three and

 

7

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ninemonths ended September 30, 2005. Amortization expense for our acquired contract value was approximately$0.1 million for the three and nine months ended September 30, 2004.  Amortization expense for our acquiredcontract value is expected to be approximately $1.1 million for each of thenext four years ended December 31 and approximately $0.6 million for thefifth year.

 

**6.****               ****Credit Facilities**

 

Ourlong-term debt at September 30, 2005 and December 31, 2004 consistedof the following (in thousands):

 

| ** **                                                                                                                                                          | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                          | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **Debt of Cornell Companies, Inc.:**                                                                                                                           |       |                   |       |                  |       |
| Senior Notes, unsecured, due  July 2012 with an interest rate of 10.75%, net of discount                                                                       |       | $                      | 110,757    |                  | $          | 110,619 |   |
| Fair-value adjustment of Senior  Notes as a result of interest rate swap                                                                                            |       | 548                    |       | 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% (the “2004 Credit Facility”) |       | —                 |       | 3⁄4                |       |
| Capital lease obligations                                                                                                                                           |       | 112                    |       | 6                     |       |
| Subtotal                                                                                                                                                            |       | 111,417                |       | 113,833               |       |
| ** **                                                                                                                                                          | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Debt of Special Purpose Entity:**                                                                                                                                 |       |                   |       |                  |       |
| 8.47% Bonds due 2016                                                                                                                                                |       | 165,700                |       | 174,700               |       |
|                                                                                                                                                                |       |                   |       |                  |       |
| Total consolidated debt                                                                                                                                             |       | 277,117                |       | 288,533               |       |
|                                                                                                                                                                |       |                   |       |                  |       |
| Less: current maturities                                                                                                                                            |       | (9,701                 | )          | (9,005                | )          |
|                                                                                                                                                                |       |                   |       |                  |       |
| Consolidated long-term debt                                                                                                                                         |       | $                      | 267,416    |                  | $          | 279,528 |   |

 

***Long-Term Credit Facilities.***  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 $50.6 million at September 30, 2005.  We had no outstanding borrowings on the 2004Credit Facility at September 30, 2005, but we had outstanding letters ofcredit of approximately $9.4 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 2004Credit Facility is collateralized by substantially all of our assets, includingthe assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured bythe assets of Municipal Corrections Finance, LP (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.

 

MCFis obligated for the outstanding balance of its 8.47% Taxable Revenue Bonds,Series 2001.  The bonds bearinterest at a rate of 8.47% per annum and are payable in semi-annualinstallments of interest and annual installments of principal.  All unpaid principal and accrued interest onthe bonds is due on the earlier of August 1, 2016 (maturity) or as notedunder the bond documents.  The bonds arelimited, nonrecourse obligations of MCF and secured by the property andequipment, bond reserves, assignment of subleases and substantially all assetsrelated to the facilities included in the 2001 Sale and LeasebackTransaction.  The bonds are notguaranteed by the Company.

 

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes(Senior Notes) due July 1, 2012. The Senior Notes are unsecured senior indebtedness and are guaranteed byall of our existing and future subsidiaries (collectively, theGuarantors).  The Senior Notes are not guaranteedby MCF (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:

 

8

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| **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 theoriginal aggregate principal amount of the Senior Notes at a redemption priceof 110.75% of the principal amount thereof with the net cash of publicofferings of equity, provided that at least 65% of the original aggregateprincipal amount of the Senior Notes remains outstanding after the redemptionand other conditions are met.  Upon theoccurrence of specified change of control events, unless we have exercised ouroption to redeem all the Senior Notes as described above, each holder will havethe right to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under an indenture(the “Indenture”) which limits our ability and the ability of our Guarantorsto, among other things, incur additional indebtedness, pay dividends or makeother distributions, make other restricted payments and investments, createliens, incur restrictions on the ability of the Guarantors to pay dividends orother payments to us, enter into transactions with affiliates, and engage inmergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and 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 three and nine months ended September 30, 2005, we recordedinterest savings related to this interest rate swap of approximately $0.2million and $1.0 million, respectively, which is reflected as a reduction tointerest expense in our accompanying financial statements.  For the three and nine months ended September30, 2004, we recorded interest savings related to this interest rate swap ofapproximately $0.6 million and $0.7 million, respectively.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either adiscount or premium on the Senior Notes. At September 30, 2005 and December 31, 2004, the fair value ofthis derivative instrument was approximately $0.5 million and $3.2 million, respectively,and is included in other assets in our Consolidated Balance Sheets.  The carrying value of the Senior Notes as ofthese dates was adjusted accordingly by the same amount. Because the swapagreement is considered an effective fair-value hedge, there will be no effecton our results of operations from the mark-to-market adjustment as long as theswap is in effect.

 

**7.****             ****Projects Under Development, Construction orRenovation**

 

***Moshannon Valley Correctional Center***

** **

In March 2003, wereached an agreement with the Commonwealth of Pennsylvania that resolved alloutstanding administrative issues relative to the contract awarded by theBureau of Prisons (BOP) to operate the Moshannon Valley Correctional Center. InOctober 2004, we received the signed Finding of No Significant Impact forthe facility.  Construction of thefacility, which will house 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.

 

9

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Asof September 30, 2005, we had incurred (net of the BOP reimbursement)approximately $52.0million for the design,construction and development costs and capitalized interest related to theMoshannon Valley Correctional Center facility. We believe that our existing cash and credit facility will provideadequate funding to complete the construction of the facility.

 

***New Morgan Academy***

** **

Weclosed the New Morgan Academy in the fourth quarter of 2002 and are currentlyconsidering several options including the utilization of the facility foranother type of program or the sale or lease of the facility. As ofSeptember 30, 2005, we are principally focusing our efforts on thepotential insertion of a program in 2006. We are maintaining a small staff to secure and maintainthe facility.  We recognized pre-taxcosts of approximately $0.9 million and $2.6 million in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the three and ninemonths ended September 30, 2005, respectively, and pre-tax costs of $1.2million and $2.8 million for the three and nine months ended September 30,2004, respectively, for related holding costs (depreciation, interest,property, taxes and other maintenance costs).

 

The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of SFAS No. 144, atDecember 31, 2004.  As ofSeptember 30, 2005, we believe that, pursuant to the provisions of SFASNo. 144, no additional impairment allowance is necessary. The carryingvalue of the property and equipment for the New Morgan Academy, after theimpairment charge, was approximately $20.0 million and $20.4 million atSeptember 30, 2005 and December 31, 2004, respectively.

 

***CentralCalifornia Treatment Center***

** **

In January 2004, wepurchased a building in Los Angeles, California for which our carrying valuewas approximately $2.7 million at September 30, 2005.  This facility could provide service to 220inmates in a work-furlough type program. Although we do not currently have a contract for this facility, thefacility has been submitted and is under consideration in severalproposals.  We believe that due to thegrowth of the inmate population, severe budget crisis and recent legalsettlements requiring additional community services, this facility would fill asmall part of the overall demand in California. The potential uses for the facility range from a “halfway back” programto a comprehensive drug and alcohol treatment program.

 

In addition, during the third quarter of 2005 we received notice from alocal governmental agency of a possible intent to acquire the facility.  The amount of the preliminary offer slightlyexceeds our carrying value.  It is expectedthat a final decision from the agency regarding their intent to acquire thefacility from us will be rendered within the next six months.

 

***Campbell Griffin Treatment Center***

 

In October 2005, we initiated the temporary closure of this leasedfacility in San Antonio, Texas, and transferred the residents to our TexasAdolescent Treatment Center (also located in San Antonio).  It is our intent to reactivate this facilityduring the first quarter of 2006. Accordingly, it has not been included indiscontinued operations.

 

**8.****             ****Earnings Per Share**

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended September 30,2005 and 2004, there were 102,643 shares ($15.24 average price) and 235,052shares ($14.63 average price), respectively, of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.  For the nine months endedSeptember 30, 2005 and 2004 there were 160,637 shares ($14.70 averageprice) and 217,003 shares ($14.64 average price), respectively, of stockoptions that were not included in the computation of diluted EPS because to doso would have been anti-dilutive.

 

10

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The following table summarizes the calculation of net income (loss) andweighted average common shares and common share equivalents outstanding forpurposes of computating income (loss) per share (in thousands, except per sharedata):

 
| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                               | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                               | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income from continuing operations                                        |       | $                      | 1,556      |                   | $          | 91 |   | $ | 2,087 |   | $ | 433 |   |
| Loss from discontinued  operations, net of tax                           |       | (279                   | )          | (988                   | )          | (3,394 | ) | (1,721 | ) |
| Net income (loss)                                                        |       | $                      | 1,277      |                   | $          | (897 | ) | $ | (1,307 | ) | $ | (1,288 | ) |
|                                                                     |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares  outstanding                              |       | 13,579                 |       | 13,199                 |       | 13,484 |   | 13,143 |   |
| Weighted average common share  equivalents outstanding                   |       | 107                    |       | 220                    |       | 124 |   | 217 |   |
|                                                                     |       |                   |       |                   |       |   |   |   |   |
| Weighted average common shares  and common share equivalents outstanding |       | 13,686                 |       | 13,419                 |       | 13,608 |   | 13,360 |   |
|                                                                     |       |                   |       |                   |       |   |   |   |   |
| Basic income (loss) per share:                                           |       |                   |       |                   |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                      | .11        |                   | $          | .01 |   | $ | .15 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.02                   | )          | (.08                   | )          | (.25 | ) | (.13 | ) |
| Net income (loss)                                                        |       | $                      | .09        |                   | $          | (.07 | ) | $ | (.10 | ) | $ | (.10 | ) |
|                                                                     |       |                   |       |                   |       |   |   |   |   |
| Diluted income (loss) per share:                                         |       |                   |       |                   |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                      | .11        |                   | $          | .01 |   | $ | .15 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.02                   | )          | (.08                   | )          | (.25 | ) | (.13 | ) |
| Net income (loss)                                                        |       | $                      | .09        |                   | $          | (.07 | ) | $ | (.10 | ) | $ | (.10 | ) |

 

**9.****             ****Commitments and Contingencies**

 

## **LegalProceedings**

 

##### ***LincolnCounty Detention Center***

##### * *

On August 22, 2005, alawsuit was filed by a detainee at the Lincoln County Detention Center (LCDC)in the U.S. District Court of New Mexico (Santa Fe).  The lawsuit relates to the former LCDC policythat required strip searches for all detainees and inmates and alleges thatsuch policy violates a detainee’s Fourth Amendment right.  The lawsuit was filed as aputative class action lawsuit brought on behalf of all inmates who were searchedat the facility from May 2002 to July 2005. This lawsuitis in its early stages and no discovery has been conducted. The ultimateoutcome of the lawsuit cannot be determined at this time. However, we intend toaggressively defend this lawsuit. We have not recorded any loss accrualsrelated to this lawsuit.

## ** **

##### ***SouthernPeaks Regional Treatment Center***

##### * *

On January 5, 2004,we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v. Longboat GlobalAdvisors, LLC, et al*., No.2004 CV79761 in the Superior Court ofFulton County, Georgia under theories of fraud, conversion, breach of contractand other theories to determine the location of and to recover funds previouslydeposited by us into what we believed to be an escrow account in connectionwith the development and construction of the Southern Peaks Regional TreatmentCenter.  Of the funds previouslydeposited, approximately $5.3 million remains to be recovered atSeptember 30, 2005.  InDecember 2004, the case was tried before a jury and the jury verdictawarded approximately $6.5 million in compensatory damages and approximately$1.4 million in punitive damages, plus attorneys’ fees.  We expect that the actual damages awardedunder the verdict will be adjusted downward to the $5.4 million actually lostby us and that the punitive damages award may be adjusted downward because of aGeorgia statute regarding caps on punitive damages awards.  No judgment has yet been entered on thisverdict.  The award for compensatory damagesaccrues pre-judgment interest at a rate of 7 percent from the date of lossthrough the date of judgment.  Following the jury verdicts, wecollected approximately $0.4 million in January 2005 in funds which hadbeen previously frozen under a temporary restraining order issued at the timethat we commenced this litigation. Currently, certain of the defendants have filed motions to move for anew trial. No judgment will be entered on the verdict until after these motionsfor a new trial have been heard and ruled on by the court.  Due to the continued uncertainty surroundingthe ultimate recovery of the funds previously deposited, we will continue tomaintain our existing reserve of approximately $5.0 million in an allowance fordoubtful accounts.

 

11

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**ShareholderLawsuits**

 

In March andApril 2002, the Company, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe 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 SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits were putative class action lawsuits broughton behalf of all purchasers of our common stock between March 6, 2001 andMarch 5, 2002 and relate to our restatement in 2002 of certain financialstatements.  The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic leasetransaction.  These four lawsuits wereconsolidated into the *Graydon Williams*action and Flyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs tofile an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of theExchange 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.  The Company filed a motion todismiss the lawsuit.  In an order enteredApril 1, 2005, the court granted the motion to dismiss with respect to theplaintiffs’ securities fraud claims pursuant to Sections 10(b) and20(a) of the Exchange Act and Rule 10b-5.  The court denied the motion to dismiss as tothe remaining claims covering the Company’s secondary offering in 2001.  Subject to court approval and documentation,the parties have agreed to settle this matter. Under the proposed settlement agreement, the Company has not admittedany wrongdoing.  Settlement in the amountof $7 million will be funded through the Company’s directors’ and officers’liability insurance.  The Company has notreached settlement in the pending derivative litigation discussed below.

 

In March 2002, theCompany, our directors, and our former independent auditor Arthur Andersen LLP,were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant CornellCompanies, 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.

 

On January 27, 2004, wereceived a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that we pursue breach of fiduciary duty claims against variousofficers and directors based on the August 2001 sale leaseback transactionand the subsequent restatement.  We haveissued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision.

 

In May andSeptember 2002, the Company and our then directors were sued in threeother 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 the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, 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 court granted the motion todismiss the *Guitierrez* action andthe plantiffs have appealed that ruling. The *Menning* action hasbeen dismissed, but with an agreement that the plaintiff’s claims as to Cornellare tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

12

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The plaintiffs in these caseshave not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, management believes the Company hasgood defenses and intends 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 potential director andofficer liability may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations 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 our insurance coverage, or if our coverage is deemed not to apply tothese matters, or if the underlying insurance carrier was unable to fulfill itsobligation under the insurance coverage provided, it could have a materialadverse effect on our financial position, results of operations or cash flows.

 

During the period ofAugust 2000 through May 2003, our general liability and professionalliability coverage was provided by Specialty Surplus Insurance Company, aKemper 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 regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  In the year ended December 31, 2004, werecorded a reserve of $0.6 million, and estimated our range of additionalexposure to be approximately $0.5 million with respect to outstanding claimsincurred during this policy period with Kemper which would become ourobligation to resolve if not settled through Kemper.

 

Duringthe nine months ended September 30, 2005, Kemper continued to implementits run-off plan.  As a result, severalof our significant claims were settled by Kemper in the second quarter of 2005.In conjunction with these settlements, we recorded a charge against ourexisting reserve in the amount of $0.3 million. We believe that the uncertainty surrounding the ability of Kemper tosettle our remaining outstanding claims still exists. Based on our analysis ofthe claims activity during the third quarter, we felt it necessary to record anadditional reserve in the amount of approximately $0.2 million at September 30,2005.  We believe our estimated range ofexposure, above our existing $0.5 million reserve, to be approximately $0.1million related to the outstanding claims which could become our obligation toresolve if not settled through Kemper.

 

Whilethe outcome of such matters cannot be predicated with certainty, based on theinformation known to date, we believe that the ultimate resolution of thesematters will not have a material adverse effect on our financial position,operating results or cash flow.

 

13

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**10.****      ****DerivativeFinancial Instruments and Guarantees**

 

***Debt Service Reserve Fund and Debt ServiceFund***

 

In August 2001, MCF completeda bond offering to finance the 2001 Sale and Leaseback Transaction.  In connection with this bond offering, tworeserve fund accounts were established by MCF pursuant to the terms of theindenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 millionat September 30, 2005 and December 30, 2004, was established to makepayments on MCF’s outstanding bonds in the event the Company (as lessee) shouldfail to make the scheduled rental payments to MCF and (2) MCF’s DebtService Fund, aggregating approximately $13.0 million and $17.1 million atSeptember 30, 2005 and December 31, 2004, respectively, used toaccumulate the monthly lease payments that MCF receives from the Company untilsuch funds are used to pay MCF’s semi-annual bond interest and annual bondprincipal payments.  Both reserve fundaccounts are subject to the agreements with the MCF Equity Investors wherebyguaranteed rates of return of 3.0% and 5.08%, respectively, are provided for inthe balance of the Debt Service Reserve Fund and the Debt Service Fund.  The guaranteed rates of return arecharacterized as cash flow hedge derivative instruments.  At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a deferred liability in our Consolidated Balance Sheets.Changes in the fair value of the derivative instruments are recorded as anadjustment to other long-term liabilities and reported as other comprehensiveincome (loss) in our Consolidated Statements of Operations and ComprehensiveIncome (Loss).

 

At September 30, 2005 andDecember 31, 2004, the fair value of these derivative instruments wasapproximately $2.5 million and $2.2 million, respectively.  As a result, our Consolidated Statements ofOperations and Comprehensive Income (Loss) include other comprehensive income(loss) of approximately ($0.2) million and $0.9 million for the three months endedSeptember 30, 2005 and 2004, respectively, and ($0.2) million and $0.3million for the nine months ended September 30, 2005 and 2004,respectively.  The $0.2 millionunrealized loss reported in comprehensive income (loss) for the nine months endedSeptember 30, 2005 includes an adjustment of $0.6 million for the taxeffect of changes in fair value during the years ended December 31, 2002and 2003. This adjustment decreased accumulated other comprehensive income andincreased deferred tax liabilities in our Consolidated Balance Sheet as of September 30,2005.

 

In connection with MCF’sbond offering, the MCF Equity Investor provided a guarantee of the Debt ServiceReserve Fund if a bankruptcy of the Company were to occur and a trustee for theestate of the Company were to include the Debt Service Reserve Fund as an assetof the Company’s estate.  This guaranteeis characterized as an insurance contract and the cost is being amortized toexpense over the life of the debt.

 

**11.****      ****SegmentDisclosure**

 

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of 10 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 our 2004 Annual Report on Form 10-K,as amended.  Intangible assets are notincluded 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, investmentsecurities available for sale, accounts receivable, debt service fund,deposits, property and equipment, deferred taxes, deferred costs and otherassets.  Corporate and other income fromoperations primarily consists of depreciation and amortization on the corporateoffice facilities and equipment, and is presented separately as such chargescannot be readily identified for allocation to a particular segment.

 

14

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The following table excludes the resultsof discontinued operations for the revenue, pre-opening and start-up expensesand income from operations categories for all periods presented.  The only significant non-cash item reportedin the respective segment’s income from operations is depreciation andamortization (excluding intangibles) (in thousands).

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                        | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Revenues                                          |       |                   |       |                   |       |   |   |   |   |
| Adult secure institutional                        |       | $                      | 33,275     |                   | $          | 30,529 |   | $ | 96,428 |   | $ | 83,040 |   |
| Juvenile                                          |       | 30,052                 |       | 28,751                 |       | 90,506 |   | 84,108 |   |
| Adult community-based                             |       | 15,871                 |       | 12,056                 |       | 44,406 |   | 36,140 |   |
| Total revenues                                    |       | $                      | 79,198     |                   | $          | 71,336 |   | $ | 231,340 |   | $ | 203,288 |   |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Pre-opening and start-up expenses                 |       |                   |       |                   |       |   |   |   |   |
| Adult secure institutional                        |       | $                      | 1,607      |                   | $          | 1,918 |   | $ | 6,650 |   | $ | 2,588 |   |
| Juvenile                                          |       | —                 |       | 1,495                  |       | 1,803 |   | 2,093 |   |
| Adult community-based                             |       | —                 |       | 42                     |       | — |   | 42 |   |
| Total pre-opening and start-up expenses           |       | $                      | 1,607      |                   | $          | 3,455 |   | $ | 8,453 |   | $ | 4,723 |   |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Income from operations                            |       |                   |       |                   |       |   |   |   |   |
| Adult secure institutional                        |       | $                      | 6,957      |                   | $          | 6,180 |   | $ | 19,376 |   | $ | 18,352 |   |
| Juvenile                                          |       | 3,722                  |       | 3,655                  |       | 11,419 |   | 10,309 |   |
| Adult community-based                             |       | 3,152                  |       | 2,288                  |       | 8,466 |   | 6,485 |   |
| Subtotal                                          |       | 13,831                 |       | 12,123                 |       | 39,261 |   | 35,146 |   |
| General and administrative  expense               |       | (4,760                 | )          | (5,596                 | )          | (15,997 | ) | (15,361 | ) |
| Amortization of intangibles                       |       | (560                   | )          | (413                   | )          | (1,533 | ) | (952 | ) |
| Corporate and other                               |       | (319                   | )          | (446                   | )          | (1,064 | ) | (1,367 | ) |
| Total income from operations                      |       | $                      | 8,192      |                   | $          | 5,668 |   | $ | 20,667 |   | $ | 17,466 |   |
|                                              |       |                   |       |                   |       |   |   |   |   |
| Loss on discontinued operations, net of tax       |       |                   |       |                   |       |   |   |   |   |
| Adult secure institutional                        |       | $                      | —     |                   | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                          |       | (236                   | )          | (1,041                 | )          | (3,323 | ) | (1,833 | ) |
| Adult community-based                             |       | (43                    | )          | 53                     |       | (71 | ) | 112 |   |
| Total loss on discontinued operations, net of tax |       | $                      | (279       | )                      | $          | (988 | ) | $ | (3,394 | ) | $ | (1,721 | ) |

 

| ** **                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| Assets                     |       |                   |       |                  |       |
| Adult secure institutional |       | $                      | 197,643    |                  | $          | 172,793 |   |
| Juvenile                   |       | 108,843                |       | 123,890               |       |
| Adult community-based      |       | 68,346                 |       | 62,984                |       |
| Intangible assets, net     |       | 20,476                 |       | 14,747                |       |
| Corporate and other        |       | 101,098                |       | 133,217               |       |
| Total assets               |       | $                      | 496,406    |                  | $          | 507,631 |   |

 

**12.****      ****Guarantor Disclosures**

 

Wecompleted an offering of $112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofour subsidiaries (Guarantor Subsidiaries). These guarantees are joint and several obligations of the GuarantorSubsidiaries. MCF does not guarantee the Senior Notes (Non-GuarantorSubsidiary). The following condensed consolidating financial informationpresents the financial condition, results of operations and cash flows of theGuarantor Subsidiaries and the Non-Guarantor Subsidiary, together with theconsolidating adjustments necessary to present our results on a consolidatedbasis.

 

15

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**Condensed Consolidating Balance Sheet as ofSeptember 30, 2005 (in thousands) (unaudited)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash equivalents                        |       | $          | 9,185      |             | $          | 906               |       | $                | 37         |             | $          | — |   | $ | 10,128 |   |
| Investment securities                            |       | 20,800     |       | —           |       | —            |       | —           |       | 20,800           |       |
| Accounts receivable, net                         |       | 2,101      |       | 56,305           |       | 189               |       | —           |       | 58,595           |       |
| Debt service fund and other  restricted assets   |       | —     |       | 2,825            |       | 12,958            |       | —           |       | 15,783           |       |
| Prepaids and other                               |       | 12,154     |       | 2,418            |       | —            |       | —           |       | 14,572           |       |
| Total current assets                             |       | 44,240     |       | 62,454           |       | 13,184            |       | —           |       | 119,878          |       |
| Property and equipment, net                      |       | 205        |       | 161,010          |       | 155,697           |       | (5,934           | )          | 310,978          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve fund                        |       | —     |       | —           |       | 23,802            |       | —           |       | 23,802           |       |
| Deferred costs and other, net                    |       | 40,666     |       | 27,524           |       | 8,919             |       | (35,361          | )          | 41,748           |       |
| Investment in subsidiaries                       |       | 16,522     |       | 1,856            |       | —            |       | (18,378          | )          | —           |       |
| Total assets                                     |       | $          | 101,633    |             | $          | 252,844           |       | $                | 201,602    |             | $          | (59,673 | ) | $ | 496,406 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’  Equity**   |       |       |       |             |       |              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable and accrued  liabilities        |       | $          | 39,769     |             | $          | 7,058             |       | $                | 2,347      |             | $          | (2,600 | ) | $ | 46,574 |   |
| Current portion of long-term  debt               |       | —     |       | 1                |       | 9,700             |       | —           |       | 9,701            |       |
| Total current liabilities                        |       | 39,769     |       | 7,059            |       | 12,047            |       | (2,600           | )          | 56,275           |       |
| Long-term debt, net of current portion           |       | 111,305    |       | 111              |       | 156,000           |       | —           |       | 267,416          |       |
| Deferred tax liabilities                         |       | 7,937      |       | (1,763           | )          | —            |       | 621              |       | 6,795            |       |
| Other long-term liabilities                      |       | 5,445      |       | 163              |       | 33,633            |       | (36,564          | )          | 2,677            |       |
| Intercompany                                     |       | (226,066   | )          | 226,066          |       | —            |       | —           |       | —           |       |
| Total liabilities                                |       | (61,610    | )          | 231,636          |       | 201,680           |       | (38,543          | )          | 333,163          |       |
| Stockholders’ equity                        |       | 163,243    |       | 21,208           |       | (78               | )          | (21,130          | )          | 163,243          |       |
| Total liabilities and stockholders’  equity |       | $          | 101,633    |             | $          | 252,844           |       | $                | 201,602    |             | $          | (59,673 | ) | $ | 496,406 |   |

 

16

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

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash equivalents                        |       | $          | 9,559      |             | $          | 296               |       | $                | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment securities                            |       | 51,740     |       | —           |       | —            |       | —           |       | 51,740           |       |
| Accounts receivable, net                         |       | 3,298      |       | 61,189           |       | 378               |       | —           |       | 64,865           |       |
| Debt service fund and other restricted  assets   |       | 121        |       | 2,451            |       | 17,141            |       | —           |       | 19,713           |       |
| Prepaids and other                               |       | 15,664     |       | 1,962            |       | —            |       | —           |       | 17,626           |       |
| Total current assets                             |       | 80,382     |       | 65,898           |       | 17,559            |       | —           |       | 163,839          |       |
| Property and equipment, net                      |       | 672        |       | 128,965          |       | 158,863           |       | (6,245           | )          | 282,255          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve fund                        |       | —     |       | —           |       | 23,801            |       | —           |       | 23,801           |       |
| Deferred costs and other, net                    |       | 39,392     |       | 19,225           |       | 9,362             |       | (30,243          | )          | 37,736           |       |
| Investment in subsidiaries                       |       | 20,613     |       | 1,856            |       | —            |       | (22,469          | )          | —           |       |
| 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               |       | —     |       | 5                |       | 9,000             |       | —           |       | 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           |       | —           |       | 279,528          |       |
| Deferred tax liabilities                         |       | 7,966      |       | —           |       | —            |       | 122              |       | 8,088            |       |
| Other long-term liabilities                      |       | 5,846      |       | 80               |       | 28,546            |       | (32,011          | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083          |       | —            |       | —           |       | —           |       |
| 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 |   |

 

17

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**Condensed Consolidating Statement of Operations for the threemonths ended September 30, 2005****(inthousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,502      |             | $          | 88,766            |       | $                | 4,502      |             | $          | (18,572 | ) | $ | 79,198 |   |
| Operating expenses                                                                    |       | 3,936      |       | 75,070           |       | 32                |       | (18,233          | )          | 60,805           |       |
| Pre-opening and start-up  expenses                                                    |       | —     |       | 1,607            |       | —            |       | —           |       | 1,607            |       |
| Depreciation and amortization                                                         |       | (42        | )          | 2,932            |       | 1,055             |       | (111             | )          | 3,834            |       |
| General and administrative  expenses                                                  |       | 4,742      |       | —           |       | 18                |       | —           |       | 4,760            |       |
| Income (loss) from operations                                                         |       | (4,134     | )          | 9,157            |       | 3,397             |       | (228             | )          | 8,192            |       |
| Overhead allocations                                                                  |       | (6,137     | )          | 6,137            |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | 940        |       | 1,022            |       | 3,422             |       | 11               |       | 5,395            |       |
| Equity income (loss) in  subsidiaries                                                 |       | 1,459      |       | —           |       | —            |       | (1,459           | )          | —           |       |
| Income (loss) from continuing  operations before provision (benefit) for income taxes |       | 2,522      |       | 1,998            |       | (25               | )          | (1,698           | )          | 2,797            |       |
| Provision (benefit) for income  taxes                                                 |       | 1,245      |       | —           |       | —            |       | (4               | )          | 1,241            |       |
| Income (loss) from continuing  operations                                             |       | 1,277      |       | 1,998            |       | (25               | )          | (1,694           | )          | 1,556            |       |
| Discontinued operations, net of  income tax benefit of $150                           |       | —     |       | (279             | )          | —            |       | —           |       | (279             | )          |
| Net income (loss)                                                                     |       | $          | 1,277      |             | $          | 1,719             |       | $                | (25        | )                | $          | (1,694 | ) | $ | 1,277 |   |

 

18

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**Condensed Consolidating Statement of Operations for the threemonths ended September 30, 2004****(inthousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,538      |             | $          | 80,823            |       | $                | 4,502      |             | $          | (18,527 | ) | $ | 71,336 |   |
| Operating expenses                                                                    |       | 6,468      |       | 65,017           |       | 2                 |       | (18,205          | )          | 53,282           |       |
| Pre-opening and start-up  expenses                                                    |       | —     |       | 3,455            |       | —            |       | —           |       | 3,455            |       |
| Depreciation and amortization                                                         |       | —     |       | 2,361            |       | 1,056             |       | (82              | )          | 3,335            |       |
| General and administrative  expenses                                                  |       | 5,571      |       | —           |       | 18                |       | 7                |       | 5,596            |       |
| Income (loss) from operations                                                         |       | (7,501     | )          | 9,990            |       | 3,426             |       | (247             | )          | 5,668            |       |
| Overhead allocations                                                                  |       | (9,687     | )          | 9,687            |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | 590        |       | 1,274            |       | 3,673             |       | 11               |       | 5,548            |       |
| Loss on extinguishment of debt                                                        |       | —     |       | 5                |       | —            |       | —           |       | 5                |       |
| Equity income (loss) in  subsidiaries                                                 |       | (2,634     | )          | —           |       | —            |       | 2,634            |       | —           |       |
| Income (loss) from continuing  operations before provision (benefit) for income taxes |       | (1,038     | )          | (976             | )          | (247              | )          | 2,376            |       | 115              |       |
| Provision (benefit) for income  taxes                                                 |       | (141       | )          | 273              |       | —            |       | (108             | )          | 24               |       |
| Income (loss) from continuing  operations                                             |       | (897       | )          | (1,249           | )          | (247              | )          | 2,484            |       | 91               |       |
| Discontinued operations, net of  income tax benefit of $277                           |       | —     |       | (988             | )          | —            |       | —           |       | (988             | )          |
| Net income (loss)                                                                     |       | $          | (897       | )                | $          | (2,237            | )          | $                | (247       | )                | $          | 2,484 |   | $ | (897 | ) |

 

19

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**Condensed Consolidating Statement of Operations for the ninemonths ended September 30, 2005****(inthousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 13,512     |             | $          | 260,493           |       | $                | 13,506     |             | $          | (56,171 | ) | $ | 231,340 |   |
| Operating expenses                                                                    |       | 12,399     |       | 217,554          |       | 56                |       | (55,165          | )          | 174,844          |       |
| Pre-opening and start-up  expenses                                                    |       | —     |       | 8,453            |       | —            |       | —           |       | 8,453            |       |
| Depreciation and amortization                                                         |       | —     |       | 8,524            |       | 3,166             |       | (311             | )          | 11,379           |       |
| General and administrative  expenses                                                  |       | 15,941     |       | —           |       | 56                |       | —           |       | 15,997           |       |
| Income (loss) from operations                                                         |       | (14,828    | )          | 25,962           |       | 10,228            |       | (695             | )          | 20,667           |       |
| Overhead allocations                                                                  |       | (21,727    | )          | 21,727           |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | 2,418      |       | 3,822            |       | 10,447            |       | 32               |       | 16,719           |       |
| Equity income (loss) in  subsidiaries                                                 |       | (3,847     | )          | —           |       | —            |       | 3,847            |       | —           |       |
| Income (loss) from continuing  operations before provision (benefit) for income taxes |       | 634        |       | 413              |       | (219              | )          | 3,120            |       | 3,948            |       |
| Provision (benefit) for income  taxes                                                 |       | 1,941      |       | —           |       | —            |       | (80              | )          | 1,861            |       |
| Income (loss) from continuing  operations                                             |       | (1,307     | )          | 413              |       | (219              | )          | 3,200            |       | 2,087            |       |
| Discontinued operations, net of  income tax benefit of $1,827                         |       | —     |       | (3,394           | )          | —            |       | —           |       | (3,394           | )          |
| Net income (loss)                                                                     |       | $          | (1,307     | )                | $          | (2,981            | )          | $                | (219       | )                | $          | 3,200 |   | $ | (1,307 | ) |

 

20

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**Condensed Consolidating Statement of Operations for the ninemonths ended September 30, 2004****(inthousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 13,626     |             | $          | 229,749           |       | $                | 13,506     |             | $          | (53,593 | ) | $ | 203,228 |   |
| Operating expenses                                                                    |       | 18,190     |       | 190,971          |       | 25                |       | (52,952          | )          | 156,234          |       |
| Pre-opening and start-up  expenses                                                    |       | —     |       | 4,723            |       | —            |       | —           |       | 4,723            |       |
| Depreciation and amortization                                                         |       | —     |       | 6,566            |       | 3,167             |       | (229             | )          | 9,504            |       |
| General and administrative  expenses                                                  |       | 15,286     |       | —           |       | 56                |       | 19               |       | 15,361           |       |
| Income (loss) from operations                                                         |       | (19,850    | )          | 27,489           |       | 10,258            |       | (431             | )          | 17,466           |       |
| Overhead allocations                                                                  |       | (25,521    | )          | 25,521           |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | (1,380     | )          | 4,701            |       | 11,059            |       | 32               |       | 14,412           |       |
| Loss on extinguishment of debt                                                        |       | —     |       | 2,361            |       | —            |       | —           |       | 2,361            |       |
| Equity income (loss) in  subsidiaries                                                 |       | (7,340     | )          | —           |       | —            |       | 7,340            |       | —           |       |
| Income (loss) from continuing  operations before provision (benefit) for income taxes |       | (289       | )          | (5,094           | )          | (801              | )          | 6,877            |       | 693              |       |
| Provision (benefit) for income  taxes                                                 |       | 999        |       | (380             | )          | —            |       | (359             | )          | 260              |       |
| Income (loss) from continuing  operations                                             |       | (1,288     | )          | (4,714           | )          | (801              | )          | 7,236            |       | 433              |       |
| Discontinued operations, net of  income tax benefit of  $785                          |       | —     |       | (1,721           | )          | —            |       | —           |       | (1,721           | )          |
| Net income (loss)                                                                     |       | $          | (1,288     | )                | $          | (6,435            | )          | $                | (801       | )                | $          | 7,236 |   | $ | (1,288 | ) |

 

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**CondensedConsolidating Statement of Cash Flows for the nine months endedSeptember 30, 2005 (in thousands) (unaudited)**

 
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**                 |       |       |       |             |       |              |       |             |       |             |       |
| Net cash provided by operating  activities                |       | $          | (24,335    | )                | $          | 37,493            |       | $                | 4,814      |             | $          | — |   | $ | 17,972 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**                 |       |       |       |             |       |              |       |             |       |             |       |
| Capital expenditures                                      |       | —     |       | (37,331          | )          | —            |       | —           |       | (37,331          | )          |
| Purchases of investment  securities                       |       | (905,345   | )          | —           |       | —            |       | —           |       | (905,345         | )          |
| Sales of investment securities                            |       | 936,285    |       | —           |       | —            |       | —           |       | 936,285          |       |
| Acquisition of a business                                 |       | (9,139     | )          | —           |       | —            |       | —           |       | (9,139           | )          |
| Withdrawals from restricted debt  payment account, net    |       | —     |       | —           |       | 4,183             |       | —           |       | 4,183            |       |
| Proceeds from sale of fixed  assets                       |       | —     |       | 624              |       | —            |       | —           |       | 624              |       |
| Net cash provided by (used in) investing activities       |       | 21,801     |       | (36,707          | )          | 4,183             |       | —           |       | (10,723          | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from financing activities:**                 |       |       |       |             |       |              |       |             |       |             |       |
| Payments on acquired debt                                 |       | (1,905     | )          | —           |       | —            |       | —           |       | (1,905           | )          |
| Payments of MCF bonds                                     |       | —     |       | —           |       | (9,000            | )          | —           |       | (9,000           | )          |
| Payments of capital lease  obligations                    |       | —     |       | (176             | )          | —            |       | —           |       | (176             | )          |
| Proceeds from exercise of stock  options                  |       | 4,065      |       | —           |       | —            |       | —           |       | 4,065            |       |
| Net cash provided by (used in) financing activities       |       | 2,160      |       | (176             | )          | (9,000            | )          | —           |       | (7,016           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Net increase  (decrease) in cash and cash equivalents** |       | (374       | )          | 610              |       | (3                | )          | —           |       | 233              |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at beginning of period**      |       | 9,559      |       | 296              |       | 40                |       | —           |       | 9,895            |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at end of period**            |       | $          | 9,185      |             | $          | 906               |       | $                | 37         |             | $          | — |   | $ | 10,128 |   |

 

22

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**CondensedConsolidating Statement of Cash Flows for the nine months endedSeptember 30, 2004 (in thousands) (unaudited)**

 
| ** **                                             | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**              |       |       |       |             |       |              |       |             |       |             |       |
| Net cash provided by (used in)  operating activities   |       | $          | (78,091    | )                | $          | 79,959            |       | $                | 4,136      |             | $          | — |   | $ | 6,004 |   |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**              |       |       |       |             |       |              |       |             |       |             |       |
| Capital expenditures, net                              |       | —     |       | (24,863          | )          | —            |       | —           |       | (24,863          | )          |
| Purchases of investment  securities                    |       | (63,165    | )          | —           |       | —            |       | —           |       | (63,165          | )          |
| Sales of investment securities                         |       | 29,750     |       | —           |       | —            |       | —           |       | 29,750           |       |
| Purchase of facility management  contract              |       | —     |       | (2,900           | )          | —            |       | —           |       | (2,900           | )          |
| Refund from restricted escrow  arrangement             |       | 5,000      |       | —           |       | —            |       | —           |       | 5,000            |       |
| Withdrawals from restricted debt  payment account, net |       | —     |       | —           |       | 4,131             |       | —           |       | 4,131            |       |
| Proceeds from sale of fixed  assets                    |       | —     |       | 163              |       | —            |       | —           |       | 163              |       |
| Net cash provided by (used in) investing activities    |       | (28,415    | )          | (27,600          | )          | 4,131             |       | —           |       | (51,884          | )          |
|                                                   |       |       |       |             |       |              |       |             |       |             |       |
| **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 of synthetic lease                            |       | —     |       | (52,499          | )          | —            |       | —           |       | (52,499          | )          |
| Proceeds from Senior Notes, net  of discount           |       | 110,527    |       | —           |       | —            |       | —           |       | 110,527          |       |
| Payments of MCF Bonds                                  |       | —     |       | —           |       | (8,300            | )          | —           |       | (8,300           | )          |
| Payments for debt issuance and  other financing costs  |       | (5,887     | )          | —           |       | —            |       | —           |       | (5,887           | )          |
| Payments of capital lease  obligations                 |       | (7         | )          | —           |       | —            |       | —           |       | (7               | )          |
| Proceeds from exercise of stock  options               |       | 1,454      |       | —           |       | —            |       | —           |       | 1,454            |       |
| Purchases of treasury stock                            |       | (116       | )          | —           |       | —            |       | —           |       | (116             | )          |
| Net cash provided by (used in) financing activities    |       | 103,971    |       | (52,499          | )          | (8,300            | )          | —           |       | 43,172           |       |
|                                                   |       |       |       |             |       |              |       |             |       |             |       |
| **Net decrease in cash and cash equivalents**          |       | (2,535     | )          | (140             | )          | (33               | )          | —           |       | (2,708           | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at beginning of period**   |       | 39,827     |       | 289              |       | 55                |       | —           |       | 40,171           |       |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at end of period**         |       | $          | 37,292     |             | $          | 149               |       | $                | 22         |             | $          | — |   | $ | 37,463 |   |

 

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**ITEM 2.****                            ****Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**Forward Looking Statement Disclaimer**

 

This report contains orincorporates by reference forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These statements are based on current plans and actualfuture activities and results of operations may be materially different fromthose set forth in the forward-looking statements. Important factors that couldcause actual results to differ include, among others, (1) the outcomes ofpending putative class action shareholder and derivative lawsuits, and relatedinsurance coverage, (2) our ability to win new contracts and to executeour growth strategy, (3) risks associated with acquisitions and theintegration thereof (including the ability to achieve administrative andoperating cost savings and anticipated synergies), (4) the timing andcosts of the opening of new programs and facilities or the expansions ofexisting facilities and the related ramp-up of expected occupancy, (5) ourability to negotiate contracts at those facilities for which we currently donot have an operating contract, (6) significant charges to expense ofdeferred costs associated with financing and other projects in development ifwe determine that one or more of such projects is unlikely to be successfullyconcluded, (7) results from alternative deployment or sale of facilitiessuch as the New Morgan Academy and the Campbell Griffin Treatment Center, orthe inability to do so, (8) our ability to complete the construction ofthe Moshannon Valley Correctional Center as anticipated, (9) changes ingovernmental policy and/or funding to discontinue or not renew existing arrangements,to eliminate or discourage the privatization of correctional, detention andpre-release services in the United States, or to eliminate rate increase, (10)the availability of financing on terms that are favorable to us and (11)fluctuations in operating results because of occupancy levels and/or mix,competition (including competition from two competitors that are substantiallylarger than us), increases in cost of operations, fluctuations in interestrates and risks of operations.

 

**General**

 

We are a leading provider ofcorrectional, treatment and educational services outsourced by federal, stateand local government agencies.  Weprovide a diversified portfolio of services for adults and juveniles throughour three operating divisions: (1) adult secure institutional services;(2) juvenile justice, educational and treatment services and(3) adult community-based corrections and treatment services.

 

We classify as discontinuedoperations those components of our business that we hold for sale or have beendisposed and have cash flows that are clearly distinguishable operationally andfor financial reporting purposes from the rest of our operations.  For the nine months ended September 30,2005, we classified the operating results of certain facilities and programs asdiscontinued operations.  This was theresult of management’s decision to close at certain facilities.  In the first quarter of 2005, thesefacilities and programs included the Residential School, the Maple Creek Homeand our mental health wrap programs in Pennsylvania.  During the second quarter of 2005, we closed theNorthside Clinic and the Jos-Arz Academy. Notifications were made to the required contracting entities regardingthe termination of the related programs. Accordingly, these facilities and programs have been excluded from suchstatistics and information as to the number of facilities in operation, servicecapacity, contracted beds in operation and average contract occupancypercentages, as well as management’s discussions regarding revenues andexpenses.  Discontinued operations havebeen presented separately in our Consolidated Statements of Operations andComprehensive Income (Loss) for the three and nine months endedSeptember 30, 2005 and 2004.

 

At September 30, 2005,we operated 81 facilities with a total service capacity of 17,992 and had 2facilities under development or construction with an aggregate service capacityof 1,514 upon completion. Our facilities are located in 17 states and theDistrict of Columbia.

 

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The following table setsforth for the periods indicated total residential service capacity andcontracted beds in operation at the end of the periods shown, average contractoccupancy percentages and total non-residential service capacity, excluding inboth periods those facilities and programs that were classified as discontinuedoperations.

 

| ** **                                                                     | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                     | ** ** | **2005**               | ** ** | **2004**               | ** ** |
| **Residential**                                                                | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (1)                                                           |       | 14,324                 |       | 13,656                 |       |
| Contracted beds in operation  (end of period) (2)                              |       | 11,761                 |       | 10,695                 |       |
| Average contract occupancy based  on contracted beds in operation (3) (4) |       | 97.0                   | %          | 99.5                   | %          |
| Average contract occupancy  excluding start-up operations (3) (4)         |       | 103.1                  | %          | 100.6                  | %          |
| **Non-Residential**                                                            | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (5)                                                           |       | 5,182                  |       | 3,852                  |       |

----

(1)          Residentialservice capacity is comprised of the number of beds currently available forservice or available upon the completion of construction or renovation ofresidential facilities.

(2)          At certainresidential facilities, the contracted capacity is lower than the facility’sservice capacity.  We could increase afacility’s contracted capacity by obtaining additional contracts or byrenegotiating existing contracts 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)          Average contractoccupancy percentages reflect less than normalized occupancy during thestart-up phase of any applicable facility, resulting in a lower averagecontract occupancy percentage in periods when we have substantial start-upactivities.

(4)          Averagecontract occupancy percentages are calculated based on actual occupancy for theperiod as a percentage of the contracted capacity for residential facilities inoperation.  These percentages do notreflect the operations of our non-residential community-based programs.  At certain residential facilities, our contractedcapacity is lower than the facility’s service capacity.  Additionally, certain facilities have and arecurrently operating above our current contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded ourcontracted capacity.

(5)          Service capacity for our non-residential programs isbased on either contractual terms or an estimate of the number of clients to beserved.  We update these estimates atleast annually based on the program’s budget and other factors.

 

Wederive substantially all of our revenues from providing adult corrections andtreatment and juvenile justice, educational and treatment services outsourcedby federal, state and local government agencies in the United States.  Revenues for our services are generallyrecognized on a per diem rate based upon the number of occupant days or hoursserved for the period, on a guaranteed take-or-pay basis, on a cost-plusreimbursement basis or on a fee-for-services basis.  For the three months ended September 30,2005, our revenue base consisted of 76.0% for services provided under per diemcontracts, 10.5% for services provided under take-or-pay and managementcontracts, 9.5% for services provided under cost-plus reimbursement contracts,2.9% for services provided under fee-for-service contracts and 1.1% from othermiscellaneous sources.   For the ninemonths ended September 30, 2005, our revenue base consisted of 76.2% forservices provided under per diem contracts, 10.1% for services provided undertake-or-pay and management contracts, 9.4% for services provided undercost-plus reimbursement contracts, 3.0% for services provided underfee-for-service contracts and 1.3% from other miscellaneous sources.  There has been an increase in the percentageof revenues for services provided under per diem contracts and a decrease inthe percentage of revenues provided under fee-for-service contracts between thecomparable periods for 2005 and 2004.  Additionally,the percentages for 2005 reflect the acquisition of CSI in April 2005.  Revenues can fluctuate fromperiod to period due to changes in government funding policies, changes in thenumber of clients referred to our facilities by governmental agencies, theopening of new facilities or the expansion of existing facilities and thetermination of 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 three months ended September 30,2005 and 2004, we realized average per diem rates on our adult secureinstitutional facilities of approximately $49.11 and $47.86, respectively.  For the nine months ended September 30,2005 and 2004, we realized average per diem rates of approximately $48.73 and$48.42, respectively.

 

Revenuesfor our juvenile justice, educational and treatment services division areprimarily generated from per diem, fee-for-service and cost-plus reimbursementcontracts.  For the three months endedSeptember 30, 2005 and 2004, we realized average per diem rates on ourresidential juvenile facilities of approximately $166.76 and $166.20,respectively.  For the nine 

 

25

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monthsended September 30, 2005 and 2004, we realized average per diem rates ofapproximately $165.54 and $164.34, respectively.  For the three months ended September 30,2005 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 $39.37 and $36.04, respectively. For the nine months ended September 30, 2005 and 2004, we realizedaverage fee-for-service rates of approximately $33.24 and $33.02,respectively.  The majority of ourjuvenile services contracts renew annually.

 

Revenuesfor our adult community-based corrections and treatment services division areprimarily generated from per diem and fee-for-service contracts.  For the three months ended September 30,2005 and 2004, we realized average per diem rates on our residential adultcommunity-based facilities of approximately $60.70 and $63.53, respectively.  The decrease in the average per diem in the threemonths ended September 30, 2005 as compared to the same period of 2004 was dueto lower per diem rates at the facilities and programs acquired from CSI inApril 2005.  For the nine months endedSeptember 30, 2005 and 2004, we realized average per diem rates ofapproximately $60.73 and $61.78, respectively. For the three months ended September 30, 2005 and 2004, we realizedaverage fee-for-service rates on our non-residential adult community-basedprograms of approximately $9.59 and $8.15, respectively.  For the nine months ended September 30,2005 and 2004, we realized average fee-for-service rates of approximately $8.90and $8.52, respectively.

 

Factorsconsidered in determining billing rates to charge include: (1) theprograms specified by the contract and the related staffing levels,(2) wage levels customary in the respective geographic areas,(3) whether the proposed facility is to be leased or purchased and(4) the anticipated average occupancy levels that could reasonably be maintained.

 

Wehave historically experienced higher operating margins in our adult secureinstitutional services and adult community-based corrections and treatmentservices divisions as compared to the juvenile justice, educational andtreatment services division.  Additionally,our operating margins within a division can vary from facility to facilitybased on whether a facility is owned or leased, the level of competition forthe contract award, the proposed length of the contract, the occupancy levelsfor a facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract, and our ability to increase a facility’s contract revenue.  A decline in occupancy of certain juvenilejustice, educational and treatment facilities can have a more significantimpact on operating results than the adult secure institutional servicesdivision due to higher per diem rates at certain juvenile facilities.  We have experienced and expectto continue to experience interim period operating margin fluctuations due tothe number of calendar days in the period, higher payroll taxes in the firsthalf of the year, and salary and wage increases and insurance cost increasesthat we incur prior to certain contract rate increases.  Moreover, many of the governmental agencieswith whom we contract continue to experience budget pressures and may approachus to limit 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 correspondingdecrease in operating expenses could also adversely affect our operatingmargin.

 

Weare generally responsible for all facility operating costs, except for certaindebt service and interest or lease payments for facilities where we have amanagement contract only.  At thesefacilities, the facility owner is responsible for all debt service and interestand lease payments related to the facility. We are responsible for all other operating expenses at thesefacilities.  We operated 22 and tenfacilities under management contracts at September 30, 2005 and 2004,respectively.

 

Amajority of our facility operating costs consist of fixed costs.  These fixed costs include lease and rentalexpense, insurance, utilities and depreciation. As a result, when we commence operation of new or expanded facilities,fixed operating costs increase.  Theamount of our variable operating costs, including food, medical services,supplies and clothing, depend on occupancy levels at the facilities weoperate.  Our largest single operatingcost, facility payroll expense and related employment taxes and expenses, hasboth a fixed and a variable component. We can adjust a facility’s staffing levels and the related payrollexpense to a certain extent based on occupancy at a facility, however a minimumfixed number of employees is required to operate and maintain any facilityregardless of occupancy levels. Personnel costs are subject to increases in tightening labor marketsbased 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 vary by contract.  Since pre-opening and start-up costs aregenerally factored into the revenue per diem rate that is charged to acontracting agency, we typically expect to recover these upfront costs over thelife of a contract.  Because occupancyrates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs.  We do notanticipate post-opening start-up costs at adult secure facilities operatedunder any future contracts with the Bureau of Prisons (BOP) because thesecontracts are currently expected to continue to be take-or-pay contracts,meaning that the BOP will pay at least 80.0% of the contractual monthly revenueonce the facility opens, regardless of actual occupancy.

 

26

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Newlyopened facilities are staffed according to applicable regulatory or contractualrequirements 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 juvenileoperations is 12 months from the date we begin recognizing revenue unlessbreak-even occupancy levels are achieved before then.  Our start-up period for new adult operationsis nine months from the date we begin recognizing revenue unless break-evenoccupancy levels are achieved before then. Although we typically recover these upfront costs over the life of thecontract, quarterly results can be substantially affected by the timing of thecommencement of operations as well as the development and construction of newfacilities.

 

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

 

Generaland administrative expenses consist primarily of costs for corporate andadministrative personnel who provide senior management, legal, finance,accounting, human resources, payroll and information systems, costs of businessdevelopment and outside professional and consulting fees.

 

#### **RecentDevelopments**

#### ** **

### ***Facility Closures***

 

During the nine months endedSeptember 30, 2005, we elected to close certain facilities and programsbased on an internal analysis of various factors including risk adjusted returnon capital employed, cash flow, operational intensity and personnelrequirements.  These facilities andprograms included the Residential School and the Maple Creek Home facilities,as well as certain mental health wrap programs in Pennsylvania in the firstquarter of 2005.  During the secondquarter of 2005, we closed the Northside Clinic and the Jos-Arz Academy.  For the three months ended September 30,2005 and 2004, these discontinued operations generated net losses ofapproximately $0.3 million and $1.0 million, respectively.  Revenues for these discontinued operationswere approximately $3.4 million for the three months ended September 30,2004 (none for the three months ended September 30, 2005).  For the nine months ended September 30,2005 and 2004, these discontinued operations generated net losses ofapproximately $3.4 million and $1.7 million, respectively.  Revenues for these discontinued operationswere approximately $2.6 million and $10.7 million for the nine months endedSeptember 30, 2005 and 2004, respectively.

 

**NewAccounting Pronouncements**

 

In December 2004, theFASB issued SFAS No. 123R, “Share Based Payment,” which requires companiesto expense the value of employee stock options and other types of equity-basedcompensation based on the fair value of the options at the award’s grant datebased on the estimated number of awards that are expected to vest. Compensationcost for awards that vest would not be reversed if the awards expire withoutbeing exercised. When measuring fair value, companies can choose anoption-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions. Companies will recognize compensation cost per share basedpayment awards as they vest, including the related tax effects.  The effective date of SFAS No. 123R, asamended, applies to annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested share based payment awards at thecompany’s adoption date.  InApril 2005, the Securities and Exchange Commission adopted arule that amends the adoption date of SFAS No. 123R toJanuary 1, 2006.  We are currentlyevaluating the alternative transition methods permitted by SFAS No. 123R.Presently we believe we will utilize the Black-Sholes option pricing model. Wecurrently anticipate that our evaluation process will be completed during thefourth quarter of 2005, with implementation during the first quarter of 2006.

 

UnderSFAS No. 123R, compensatory employee stock purchase plans (ESPP) arerequired to recognize compensation cost over the requisite service period forgrants made under the ESPP.  The criteriathat an ESPP must meet to be considered non-compensatory are more restrictiveunder SFAS No. 123R than they are under APB No. 25.  We are currently evaluating the impact on ourESPP by SFAS No. 123R.

 

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The FASB issued SFASNo. 154, “Accounting Changes and Error Corrections — a replacement of APBOpinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 is effective, and will beadopted, for accounting changes made in fiscal years beginning afterDecember 15, 2005 and is to be applied retrospectively.  SFAS No. 154 requires that retroactiveapplication of a change in accounting principle be limited to the direct effectsof the change.  Our adoption of SFASNo. 154 is not expected to have a material effect on our financialposition, results of operations or cash flows.

 

**Results of Operations**

 

Thefollowing table sets forth for the periods indicated the percentages of revenuerepresented by certain items in our historical consolidated statements ofoperations.

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                           | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Revenues                                                             |       | 100.0                  | %          | 100.0                  | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                   |       | 76.8                   |       | 74.7                   |       | 75.6 |   | 76.9 |   |
| Pre-opening and start-up  expenses                                   |       | 2.0                    |       | 4.8                    |       | 3.7 |   | 2.3 |   |
| Depreciation and amortization                                        |       | 4.8                    |       | 4.7                    |       | 4.9 |   | 4.7 |   |
| General and administrative  expenses                                 |       | 6.0                    |       | 7.8                    |       | 6.9 |   | 7.6 |   |
| Income from operations                                               |       | 10.4                   |       | 8.0                    |       | 8.9 |   | 8.5 |   |
| Interest expense, net                                                |       | 6.8                    |       | 7.8                    |       | 7.2 |   | 7.1 |   |
| Loss on extinguishment of debt                                       |       | —                 |       | —                 |       | — |   | 1.2 |   |
| Income from continuing  operations before provision for income taxes |       | 3.6                    |       | 0.2                    |       | 1.7 |   | 0.2 |   |
| Provision for income taxes                                           |       | 1.6                    |       | —                 |       | 0.8 |   | 0.1 |   |
| Income from continuing  operations                                   |       | 2.0                    |       | 0.2                    |       | 0.9 |   | 0.1 |   |
| Discontinued operations, net of  taxes                               |       | (0.4                   | )          | (1.4                   | )          | (1.5 | ) | (0.8 | ) |
| Net income (loss)                                                    |       | 1.6                    | %          | (1.2                   | )%         | (0.6 | )% | (0.7 | )% |

 

***Three Months Ended September  30, 2005Compared to Three Months Ended September 30, 2004***

 

Certaincomparisons of revenue, expenses and average contract capacity contained hereinhave been made excluding the effect of pre-opening and start-up expenses andrevenues.  Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent non-GAAPmeasures calculated in a manner that is not consistent with U.S. generallyaccepted accounting principles (GAAP). We believe exclusion of the non-recurring effect of pre-opening andstart-up expenses and revenues increases the reader’s understanding of ouroperating trends.

 

***Revenues*****.**  Revenues increased approximately $7.9million, or 11.1%, to $79.2 million for the three months ended September 30,2005 from $71.3 million for the three months ended September 30, 2004.

 

***AdultSecure.***Adult secureinstitutional services division revenues increased approximately $2.8 million,or 9.2%, to $33.3 million for the three months ended September 30, 2005from $30.5 million for the three months ended September 30, 2004 due primarilyto (1) the opening of the two tower Regional Correctional Center inJuly and December 2004 which contributed revenues of approximately$0.8 million, (2) revenues of approximately $1.1 million generated by theeight adult secure facilities acquired from CSI inApril 2005, (3) an increase in revenues of approximately $0.5 millionat the Big Spring Correctional Center due to increased occupancy, (4) anincrease in occupancy at the D. Ray James Prison which increased revenues byapproximately $0.4 million and (5) an increase in revenues ofapproximately $0.6 million at the Walnut Grove Youth Correctional Facility dueto increased occupancy.   The increase inadult secure revenues due to the above was offset, in part, by a decrease inrevenues of approximately $0.8 million due to the non-renewal of the ValenciaCounty Detention Center contract as of December 31, 2004.  The remaining net increase in revenues ofapproximately $0.2 million was due to various insignificant fluctuations inrevenues at our other adult secure facilities.

 

Our adult secureinstitutional services division revenues are primarily generated from contractswith federal and state government agencies. At September 30, 2005, we operated 16 adult secure institutionalfacilities with an aggregate service capacity of 8,114.

 

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Average contract occupancywas 95.7% for the three months ended September 30, 2005 compared to 97.1%for the three months ended September 30, 2004.  The decline in the average contract occupancypercentage in 2005 was due to the two tower Regional Correctional Center whichopened in July and December 2004 and did not operate at full capacityduring the three months ended September 30, 2005.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in2005 and 2004, average contract occupancy was 102.4% and 103.1% forthe three months ended September 30, 2005 and 2004, respectively.  The average per diem rate for our adultsecure facilities was approximately $49.11 and $47.86 for the three monthsended September 30, 2005 and 2004, respectively.  Revenues attributable to start-up operationswere approximately $0.7 million for the three months ended September 30,2005 and 2004  and were attributablesolely to the Regional Correctional Center.

 

***Juvenile.***Juvenile justice, educational andtreatment services division revenues increased approximately $1.3 million, or4.5%, to $30.1 million for the three months ended September 30, 2005 from$28.8 million for the three months ended September 30, 2004 due primarilyto (1) the opening of the Southern Peaks Regional TreatmentCenter in August 2004 which contributed revenues of approximately $1.7million, (2) the commencement of our management contract for the ReadingAlternative Education Program in July 2005 which contributed revenues ofapproximately $0.6 million and (3) the commencement of our management contractat the Oak Hill Youth Center which contributed approximately $0.2 million.  The increase in revenues due to the above wasoffset, in part, by a decrease in revenues of approximately $0.4 million at theAbraxas Center for Adolescent Females (ACAF) and $0.8 million at the CampbellGriffin Treatment Center to due reduced occupancy.

 

At September 30, 2005, weoperated 20 residential juvenile facilities and 15 non-residentialcommunity-based programs with an aggregate service capacity of 4,487.  Our contracts for these facilities andprograms are generally with state and local government agencies and generallyrenew annually.

 

Average contract occupancy for the three months endedSeptember 30, 2005 was 86.8% compared to 88.5% for the three months endedSeptember 30, 2004.  The decline inthe average contract occupancy was principally due to the Campbell GriffinTreatment Center.  Excluding the actualoccupancy and contract capacity for the start-up activities of the PlankintonRegional Detention Center and the Southern Peaks Regional Treatement Center in2004, average contract occupancy was 90.3% for the three months endedSeptember 30, 2004.

 

The average per diem rate for our residential juvenile facilities wasapproximately $166.76 for the three months ended September 30, 2005compared to $166.20 for the three months ended September 30, 2004.  Our average fee-for-service rate for ournon-residential juvenile community-based facilities and programs wasapproximately $39.37 for the three months ended September 30, 2005compared to $36.04 for the three months ended September 30, 2004.  The increase in the average fee-for-servicerate in 2005 as compared to 2004 was due to changes in the mix of servicesprovided by our various non-residential juvenile facilities and programs.

 

There were no revenuesattributable to start-up operations for the three months endedSeptember 30, 2005.  Revenuesattributable to start-up operations were approximately $0.3 million for thethree months ended September 30, 2004 and were attributable to the start-upoperations of the Plankinton Regional Detention Center and Southern PeaksRegional Treatment Center.

 

***AdultCommunity-Based.*****Adultcommunity-based corrections and treatment services division revenues increasedapproximately $3.8 million, or 31.4%, to $15.9 million for the three monthsended September 30, 2005 from $12.1 million for the three months ended September 30,2004 due primarily to (1) revenues of approximately $2.7 million generatedby the eleven adult community-based facilities and programs acquired from CSIin April 2005 and (2) the opening of the Las Vegas Center inDecember 2004 which contributed revenues of approximately $0.4million.  The remaining net increase inrevenues of approximately $0.7 million was due to various insignificantfluctuations in revenues at our other adult community-based corrections andtreatment facilities and programs.

 

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AtSeptember 30, 2005, we operated 21 residential adult community-basedfacilities and 10 non-residential adult community-based programs with an aggregateservice capacity of 5,391.  Average contractoccupancy was 111.7% for the three months ended September 30, 2005compared to 103.0% for the three months ended September 30, 2004.  The average per diem ratefor our residential adult community-based facilities was approximately $60.70for the three months ended September 30, 2005 compared to $63.53 for thethree months ended September 30, 2004. The decrease in the average per diem rate for 2005 as compared to 2004was due to lower per diem rates at the facilities and programs acquired fromCSI in April 2005.  The averagefee-for-service rate for our non-residential adult community-based programs wasapproximately $9.59 for the three months ended September 30, 2005 comparedto $8.15 for the three months ended September 30, 2004.  The increase in the average fee-for-servicerate for 2005 as compared to 2004 was due to changes in the mix of servicesprovided by our various non-residential adult community-based programs andfacilities.  There were no revenuesattributable to start-up operations for the three months ended September 30,2005 and 2004.

 

***OperatingExpenses****.*Operating expenses increasedapproximately $7.5 million, or 14.1%, to $60.8 million for the three monthsended September 30, 2005 from $53.3 million for the three months ended September 30,2004.

 

***AdultSecure.***Adult secureinstitutional services division operating expenses increased approximately $2.3million, or 11.1%, to $23.1 million for the three months ended September 30,2005 from $20.8 million for the three months ended September 30, 2004 due primarilyto (1) operating expenses of approximately $0.9 million attributable tothe eight adult secure facilities acquired from CSI in April 2005,(2) an increase in operating expenses of approximately $0.6 million due toincreased occupancy and higher period costs at the Big Spring CorrectionalCenter and (3) an increase in operating expenses of approximately $1.0 millionat the Regional Correctional Center. Expenses for the Regional CorrectionalCenter were included in pre-opening and start-up expenses in the three monthsended September 30, 2004. Theincrease in operating expenses due to the above was offset, in part, by adecrease in operating expenses of approximately $0.7 million due to the non-renewalof the Valencia County Detention Center contract as of December 31,2004.  The remaining net increase inoperating expenses of approximately $0.5 million was due to variousinsignificant fluctuations in operating expenses at our other adult securefacilities.

 

As a percentage of segmentrevenues, adult secure institutional services division operating expenses were69.5% for the three months ended September 30, 2005 compared to 68.1% forthe three months ended September 30, 2004. Excluding approximately $0.7 million of revenues attributable to thestart-up operations of the Regional Correctional Center in the third quarter of2005 and 2004, adult secure institutional services division operating expenses,as a percentage of segment revenues, were 71.1% and 69.7%, respectively.

 

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses increased approximately $2.5million, or 10.9%, to $25.5 million for the three months ended September 30,2005 from $23.0 million for the three months ended September 30, 2004 dueprimarily to (1) the opening of the Southern Peaks Regional TreatmentCenter in August 2004, which increased operating expenses by approximately$1.8 million, (2) the commencement of our management contract for theLebanon Alternative Education Program in September 2004, which increasedoperating expenses by approximately $0.3 million, (3) the commencement ofour management contract for the Philadelphia Alternative Education Program inAugust 2004, which increased operating expenses by approximately $0.3million, (4) the commencement of our management contract at the Oak Hill YouthCenter which increased operating expenses by approximately $0.1 million and (5)the commencement of our management contract for the Reading Alternative EducationProgram which increased operating expenses by approximately $0.2 million.  The remaining net decrease in operatingexpenses of approximately $0.4 million was due to various insignificantfluctuations in operating expenses at our other juvenile facilities andprograms.

 

Asa percentage of segment revenues, juvenile services division operating expenseswere 84.8% for the three months ended September 30, 2005 compared to 80.0% forthree months ended September 30, 2004. Excluding approximately $0.3 million of revenues attributable to thestart-up operations of the Southern Peaks Regional Treatement Center and thePlankinton Regional Detention Center in the third quarter of 2004, juvenileservices division operating expenses, as a percentage of segment revenues, were80.7% for the three months ended September 30, 2004.

 

***AdultCommunity-Based.*** Adultcommunity-based corrections and treatment services division operating expenses increasedapproximately $2.7 million, or 28.4%, to $12.2 million for the three monthsended September 30, 2005 from $9.5 million for the three months ended September 30,2004 due primarily to (1) operating expenses of approximately $2.3 millionattributable to the eleven adult community-based programs and facilitiesacquired from CSI in April 2005 and (2) the opening of the Las VegasCenter in December 2004 which increased operating expenses byapproximately $0.3 million.  The remainingnet increase in operating expenses of $0.1 million was due to various insignificantfluctuations in operating expenses at our other adult community-basedfacilities and programs.  As a percentage of segment revenues, adult community-basedcorrections and treatment services division operating expenses were 76.7% forthe three months ended September 30, 2005 compared to 78.5% for the threemonths ended September 30, 2004.

 

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***Pre-Openingand Start-up Expenses.***Pre-opening and start-up expenses for the three months ended September 30,2005 were approximately $1.6 million and were attributable to the pre-openingand start-up activities of the Regional Correctional Center and the MoshannonValley Correctional Center.  Pre-openingand start-up expenses for the three months ended September 30, 2004 wereapproximately $3.5 million and were attributable to the pre-opening andstart-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center, the Las Vegas Center and the Plankinton RegionalDetention Center.

 

***Depreciationand Amortization*****.**Depreciationand amortization increased approximately $0.5 million, or 15.2%, to $3.8million for the three months ended September 30, 2005 from $3.3 millionfor the three months ended September 30, 2004.  Depreciation and amortization of property andequipment increased approximately $0.4 million due primarily to depreciation ofthe Southern Peaks Regional Treatment Center and the Regional CorrectionalCenter buildings which were not in operation and were not being depreciated inthe three months ended September 30, 2004. Amortization of intangibles was approximately $0.6 million and $0.3million for the three months ended September 30, 2005 and 2004,respectively.  The increase inamortization expense for intangibles in the three months endedSeptember 30, 2005 as compared to 2004 was due to the amortization of theApril 2005 purchased contract value for the facilities and programsacquired from CSI.

 

***Generaland Administrative Expenses.***General and administrative expenses decreased approximately $0.8 million, or14.3%, to $4.8 million for the three months ended September 30, 2005 from$5.6 million for the three months ended September 30, 2004.  The decrease in general andadministrative expenses was primarily due to a decrease in personnel costs as aresult of management streamlining initiatives implemented in the first quarterof 2005 and a decrease in professional fees.

 

***Interest.*** Interest expense, net of interest income, decreased to approximately$5.4 million for the three months ended September 30, 2005 from $5.5million for the three months ended September 30, 2004.  Capitalized interest for the three monthsended September 30, 2005 was approximately $1.1 million and wasattributable to capitalized interest on development and construction costs forthe Moshannon Valley Correctional Center. Capitalized interest for the three months ended September 30, 2004was approximately $0.6 million and related to development and construction and/orrenovation costs for the Southern Peaks Regional Treatment Center, the RegionalCorrectional Center, the Las Vegas Center and the Moshannon Valley CorrectionalCenter.

 

***IncomeTaxes.*** For the threemonths ended September 30, 2005, we recognized a provision for incometaxes on our income from operations at an estimated effective rate of44.4%.  Additionally, we recognized anincome tax benefit on our loss from discontinued operations at an estimatedeffective rate of 35.0%.  For the threemonths ended September 30, 2004, we recognized an income tax benefit at anestimated effective rate of 21.9%.  Thechange in our estimated effective tax rate in 2005 was related to a reductionin operating income across certain of our business segments and the impact ofcertain non-deductible expenses such as lobbying.

 

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***Nine Months Ended September 30, 2005Compared to Nine Months Ended September 30, 2004***

 

***Revenues*****.**Revenues increased approximately $28.0 million, or 13.8%, to $231.3 million forthe nine months ended September 30, 2005 from $203.3 million for the ninemonths ended September 30, 2004.

 

***AdultSecure.***Adult secureinstitutional services division revenues increased approximately $13.4 million,or 16.1%, to $96.4 million for the nine months ended September 30, 2005from $83.0 million for the nine months ended September 30, 2004 dueprimarily to (1) the acquisition of the Walnut Grove Youth CorrectionalFacility management contract in June 2004 which increased revenues byapproximately $5.8 million, (2) the opening of the two tower RegionalCorrectional Center in July and December 2004 which increasedrevenues by approximately $3.6 million, (3) revenues of approximately $2.1million generated from the eight adult secure facilities acquired from CSI inApril 2005, (4) an increase in revenues of approximately $2.7 millionat the Big Spring Correctional Center due to increased occupancy, (5) anincrease in revenues of approximately $0.9 million at the D. Ray James Prisondue to a per diem rate increase received in the latter half of 2004 and(6) an increase in revenues of approximately $0.6 million at the Donald W.Wyatt Detention Center due to increased occupancy.  The increase in revenues due to the above wasoffset, in part, by a decrease in revenues of approximately $2.5 million due tothe non-renewal of the Valencia County Detention Center contract as ofDecember 31, 2004. The remaining net increase in revenue of approximately$0.2 million was due to various insignificant revenue fluctuations at our otheradult secure institutional facilities.

 

Average contract occupancyfor the nine months ended September 30, 2005 was 94.8% compared to 99.7%for the nine months ended September 30, 2004.  The decline in the average contract occupancypercentage in the nine months ended September 30, 2005 was due to the twotower Regional Correctional Center, which opened in July andDecember 2004, and did not operate at full capacity during the nine monthsended September 30, 2005.  Excluding the actual occupancy and contract capacity for the start-upoperations of the Regional Correctional Center in the nine months endedSeptember 30, 2005 and 2004, average contract occupancy was 103.8% and101.9% for the nine months ended September 30, 2005 and 2004, respectively.

 

 The average per diem rate for our adult securefacilities was approximately $48.73 and $48.42 for the nine months endedSeptember 30, 2005 and 2004, respectively. Revenues attributable to start-up operations for the nine months endedSeptember 30, 2005 and 2004 were approximately $3.3 million and $0.7million, respectively, and were attributable to the start-up operations of theRegional Correctional Center.

 

***Juvenile.***Juvenile justice, educational andtreatment services division revenues increased approximately $6.4 million, or7.6%, to $90.5 million for the nine months ended September 30, 2005 from $84.1million for the nine months ended September 30, 2004 due primarily to (1) theopening of the Southern Peaks Regional Treatment Center in August 2004which contributed revenues of approximately $5.0 million, (2) thecommencement of our management contract for the Lebanon Alternative EducationProgram in September 2004 which contributed revenues of approximately $1.0million, (3) the commencement of our management contract for thePhiladelphia Alternative Education Program in August 2004 whichcontributed revenues of approximately $1.0 million, (4) the commencement of ourmanagement contract for the Reading Alternative Education Program in July 2005which contributed revenues of approximately $0.6 million and (5) an increase inrevenue of approximately $1.0 million for the Philadelphia Family Preservationprogram due increased service hours.  Theincrease in revenues due to the above was offset, in part, by a decrease inrevenues of approximately $2.2 million due to reduced occupancy at ACAF and theCampbell Griffin Treatment Center.

 

Average contract occupancyfor the nine months ended September 30, 2005 was 90.1% compared to 92.9%for the nine months ended September 30, 2004.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Southern Peaks Regional TreatmentCenter in 2005 and 2004 and the start-up activities of the Plankinton RegionalDetention Center in 2004, average contract occupancy was 91.1% for the ninemonths ended September 30, 2005 compared to 94.1% for the nine monthsended September 30, 2004.  Theaverage per diem rate for our residential juvenile facilities was approximately$165.54 and $164.34 for the nine months ended September 30, 2005 and 2004,respectively.  Our averagefee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $33.24 and $33.02 for the nine monthsended September 30, 2005 and 2004, respectively.

 

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Revenuesattributable to start-up operations were approximately $1.5 million for thenine months ended September 30, 2005 and were attributable to the start-upoperations of the Southern Peaks Regional Treatment Center.  Revenues attributable to start-up operationswere approximately $0.3 million for the nine months ended September 30,2004 and were attributable to the start-up operations of the Southern PeaksRegional Treatment Center and the Plankinton Regional Detention Center.

 

***AdultCommunity-Based.*** Adultcommunity-based corrections and treatment services division revenues increased approximately$8.3 million, or 23.0%, to $44.4 million for the nine months ended September 30,2005 from $36.1 million for the nine months ended September 30, 2004 dueprimarily to (1) revenues of approximately $5.5 million fromthe eleven adult community-based programs and facilities acquired from CSI inApril 2005,  (2) the opening ofthe Las Vegas Center in December 2004 which contributed revenues ofapproximately $1.2 million, (3) an increase in revenues ofapproximately $0.6 million at the Dallas County Judicial Treatment Center dueto improved occupancy and (4) an increase in revenues of approximately $0.5million at the Taylor Street Center due to improved occupancy.  The remaining net increase in revenue ofapproximately $0.5 million was due to various insignificant fluctuations inrevenues at our other adult community-based facilities and programs.

 

Average contract occupancyfor the nine months ended September 30, 2005 was 109.7% compared to 104.8%for the nine months ended September 30, 2004.  The average per diem rate for our residentialadult community-based facilities was $60.73 and $61.78 for the nine months endedSeptember 30, 2005 and 2004, respectively.   The average fee-for-service rate for ournon-residential adult community-based programs was $8.90 and $8.52 for the ninemonths ended September 30, 2005 and 2004, respectively.   There were no revenues attributable tostart-up operations for the nine months ended September 30, 2005 and 2004.

 

***OperatingExpenses.*** Operatingexpenses increased approximately $18.6 million, or 11.9%, to $174.8 million forthe nine months ended September 30, 2005 from $156.2 million for the ninemonths ended September 30, 2004.

 

***AdultSecure.***Adult secureinstitutional services division operating expenses increased approximately $7.0million, or 11.9%, to $65.7 million for the nine months ended September 30,2005 from $58.7 million for the nine months ended September 30, 2004 dueprimarily to (1) an increase in operating expenses of approximately $4.1million due to the acquisition of the Walnut Grove Youth Correctional Facilitymanagement contract in June 2004, (2) an increase in operatingexpenses of approximately $2.6 million at the Big Spring Correctional Centerdue to increased occupancy, (3) an increase in operating expenses ofapproximately $0.5 million at the Regional Correctional Center and (4) operatingexpenses of $1.7 million from the eight adult secure facilities purchased fromCSI in April 2005.  The increase inoperating expenses due to the above was offset, in part, by a decrease inoperating expenses of approximately $2.1 million due to the non-renewal of theValencia County Detention Center contract as of December 31, 2004.  The remaining net increase in operatingexpenses of approximately $0.2 million was due to various insignificantfluctuations in operating expenses at our other adult secure facilities.

 

Asa percentage of segment revenues, adult secure institutional services division operatingexpenses were 68.1% for the nine months ended September 30, 2005 comparedto 70.6% for the nine months ended September 30, 2004.  Excluding approximately $3.3 million and $0.7million of revenues attributable to the start-up operations of the RegionalCorrectional Center in the nine months ended September 30, 2005 and 2004,respectively, adult secure institutional services division operating expenseswere 70.5% and 71.2%, respectively.  Theimprovement in the 2005 operating margin was due to the positive margin impactof the Walnut Grove Youth Correctional Facility and the eight facilitiesacquired from CSI in April 2005.

 

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses increased approximately $5.5million, or 7.9%, to $74.8 million for the nine months ended September 30,2005 from $69.3 million for the nine months ended September 30, 2004 dueprimarily to (1) the opening of the Southern Peaks Regional TreatmentCenter in August 2004 which increased operating expenses by approximately$3.4 million, (2) the commencement of our management contract for thePhiladelphia Alternative Education Program in August 2004 which increasedoperating expenses by approximately $1.1 million, (3) the commencement ofour management contract for the Lebanon Alternative Education Program inSeptember 2004 which increased operating expenses by approximately $0.8million, (4) the commencement of our management contract for the Oak Hill YouthCenter which increased operating expenses by approximately $0.1 million and (5)the commencement of our management contract for the Reading AlternativeEducation Program which increased operating expenses by approximately $0.2million.  Additionally, in the ninemonths ended September 30, 2005, we recorded a restructuring charge ofapproximately $1.0 million for personnel costs associated with managementstreamlining initiatives implemented in the first quarter of 2005.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of approximately$0.6 million due to the termination of the Santa Fe County Youth DevelopmentProgram in January 2004.  Theremaining net decrease in operating expenses of approximately $0.5 million wasdue to various insignificant fluctuations in operating expenses at our otherjuvenile facilities and programs.

 

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Asa percentage of segment revenues, juvenile services division operating expenseswere 82.7% for the nine months ended September 30, 2005 compared to 82.4%for the nine months ended September 30, 2004.  Excluding approximately $1.5million of revenues attributable to the start-up operations of the SouthernPeaks Regional Treatment Center in the nine months ended September 30,2005 and approximately $0.3 million of revenues attributable to the start-upoperations of the Southern Peaks Regional Treatment Center and the PlankintonRegional Detention Center in 2004, juvenile services division operatingexpenses were 84.1% and 82.7%, respectively .

 

***AdultCommunity-Based.*** Adultcommunity-based corrections and treatment services division operating expenses increasedapproximately $6.1 million, or 21.6%, to $34.4 million for the nine monthsended September 30, 2005 from $28.3 million for the nine months endedSeptember 30, 2004 due to (1) operating expenses of approximately$4.5 million attributable to the eleven adult community-based programs andfacilities acquired from CSI in April 2005, (2) the opening of theLas Vegas Center in December 2004 which increased operating expenses byapproximately $0.8 million and (3) a charge of approximately $0.3 millionfor terminated facility lease option costs. The remaining net increase in operating expenses of approximately $0.5million was due to various insignificant fluctuations in operating expenses atour other adult community-based programs and facilities.

 

As a percentage of segmentrevenues, adult community-based corrections and treatment services divisionoperating expenses were 77.4% for the nine months ended September 30, 2005compared to 78.4% for the nine months ended September 30, 2004.

 

***Pre-Openingand Start-up Expenses.***Pre-opening and start-up expenses for the nine months ended September 30,2005 were approximately $8.5 million and were attributable to the pre-openingand start-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center and the Moshannon Valley Correctional Center.Pre-opening and start-up expenses for the nine months ended September 30,2004 were approximately $4.7 million and were attributable to the pre-openingand start-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center, the Las Vegas Center and the Plankinton RegionalDetention Center.

 

***Depreciationand Amortization*****.** Depreciation and amortization increasedapproximately $1.9 million, or 20.0%, to $11.4 million for the nine monthsended September 30, 2005 compared to $9.5 million for the nine monthsended September 30, 2004.  Depreciationand amortization of property and equipment increased approximately $1.3 milliondue primarily to depreciation of the Southern Peaks Regional Treatment Centerand the Regional Correctional Center buildings that were not in operation andwere not being depreciated in the nine months ended September 30,2004.  Amortization of intangibles wasapproximately $1.5 million and $0.8 million for the nine months endedSeptember 30, 2005 and 2004, respectively. The increase in amortization expense for intangibles in the nine monthsended September 30, 2005 as compared to 2004 was due to amortization ofthe June 2004 purchased contract value for the Walnut Grove YouthCorrectional Facility management contract and the April 2005 purchasedcontract value for the facilities and programs acquired from CSI.

 

***Generaland Administrative Expenses.***General and administrative expenses increased approximately $0.6 million, or3.9%, to $16.0 million for the nine months ended September 30, 2005 from $15.4million for the nine months ended September 30, 2004.  This was due primarily to a restructuringcharge of approximately $1.1 million for personnel costs associated withmanagement streamlining initiatives implemented in the first and second quarterof 2005.  Additionally, professionalfees, principally associated with certain accounting services (includingSarbanes-Oxley compliance), executive recruitment services, and businessdevelopment decreased by approximately $0.5 million.

 

***Interest.*** Interest expense, net of interest income, increased to $16.7million for the nine months ended September 30, 2005 from $14.4 millionfor the nine months ended September 30, 2004.  Interest expense increased approximately $2.7million primarily due to interest on the Senior Notes of approximately $8.0million (net of swap interest income of $1.0 million) in the nine months endedSeptember 30, 2005 compared to $2.6 million (net of swap interest incomeof $0.7 million) in the nine months ended September 30, 2004.  The increase in interest expense attributableto the Senior Notes was offset, in part, by a decrease in interest expense of$1.3 million due to the pay-off of the Synthetic Lease Investor Notes A and Bin June 2004.  Capitalized interestfor the nine months ended September 30, 2005 was approximately $2.2million and related to development and construction costs for the MoshannonValley Correctional Center.  Capitalizedinterest for the nine months ended September 30, 2004 was approximately$1.3 million and related to development and construction costs for theMoshannon Valley Correctional Center, the Southern Peaks Regional TreatmentCenter, the Regional Correctional Center and the Las Vegas Center.  Additionally, interest income increasedapproximately $0.4 million for the nine months ended September 30, 2005 ascompared to the same period in 2004 due to higher fund balances and higherinterest rates in the 2005 period.

 

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***Loss on Extinguishment ofDebt.***In June 2004, we recognized a loss on theextinguishment of debt of approximately $2.4 million related to the earlyretirement of the Synthetic Lease Investor Notes A and B and our revolving lineof credit under the Amended 2000 Credit Facility.

 

***IncomeTaxes.*** For the ninemonths ended September 30, 2005, we recognized a provision for incometaxes on our income from continuing operations at an estimated effective rateof 47.1%.  Additionally, we recorded anincome tax benefit on our loss from discontinued operations at an estimatedeffective rate of 35.0%.  For the ninemonths ended September 30, 2004, we recognized an income tax benefit at anestimated effective rate of 29.0%.  Thechange in our estimated effective rate in 2005 was related to a reduction inoperating income across certain of our business segments and the impact ofcertain non-deductible expenses such as lobbying.

 

**Liquidity and Capital Resources**

 

***General*****.**Ourprimary capital requirements are for (1) purchases, construction orrenovation of new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operatingcontracts, (5) acquisitions, (6) information systems hardware andsoftware, and (7) furniture, fixtures and equipment.  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.

 

***CashFlows From Operating Activities.***  Cash provided by operations wasapproximately $18.0 million for the nine months ended September 30, 2005compared to $6.0 million for the nine months ended September 30, 2004.  The increase was principally due to anincrease in accounts payable and accrued liabilities due to higher accruedinterest (pertaining to the Senior Notes issued in June 2004) and a decrease inaccounts receivable due to increased collections during 2005.

 

***CashFlows From Investing Activities*****.**  Cash used in investing activities wasapproximately $10.7 million for the nine months ended September 30, 2005due to net sales of investment securities of $30.9 million offset by capitalexpenditures of $46.4 million comprised of approximately $37.3 million for thedevelopment and construction of the Moshannon Valley Correctional Center andapproximately $9.1 million (net) for the acquisition of CSI.  Additionally, there were net withdrawals fromthe restricted debt payment account of approximately $4.2 million and proceedsof $0.6 million from the sale of fixed assets. Cash used in investing activities was approximately $51.9 million forthe nine months ended September 30, 2004 due primarily to net purchases ofinvestment securities of  $33.4 millionand capital expenditures of $30.4 million for the purchase and development ofthe Southern Peaks Regional Treatment Center, the Las Vegas Center and theCentral California Treatment Center buildings, renovation of the RegionalCorrectional Center, renovations to the Plankinton Regional Detention Center,capitalized interest on the Moshannon Valley Correctional Center, the RegionalCorrectional Center, the Las Vegas Center and the Southern Peaks RegionalTreatment Center and various other facility improvements and/or expansions andinformation technology and software development costs.  Additionally, we spent approximately $2.9million for the purchase of the Walnut Grove Youth Correctional Facility managementcontract.  We received approximately $5.6million from the BOP for reimbursement of costs incurred subsequent to theStop-Work Order for the Moshannon Valley Correctional Center.  Additionally, there were withdrawals, net ofdeposits, to the restricted debt payment account of approximately $4.1million.  Additionally, we received $5.0million from our restricted escrow arrangement related to the Southern PeaksRegional Treatment Center.

 

***CashFlows From Financing Activities*****.**  Cash used by financing activities wasapproximately $7.0 million for the nine months ended September 30, 2005due primarily to a $9.0 million semi-annual principal payment on MCF’s bondsand repayments of approximately $1.9 million in debt acquired from CSI offsetby stock option proceeds received of $4.1 million.  Cash provided by financingactivities was approximately $43.2 million for the nine months ended September30, 2004 due primarily to cash proceeds of $110.5 million from the issuance ofthe Senior Notes in June 2004 offset by net repayments on our revolving line ofcredit of $2.0 million and the repayment of the Synthetic Lease Investor NotesA and B of $50.6 million.  Additionally,we made cash payments of approximately $1.9 million related to the earlyretirement of the Synthetic Lease Investor Notes A and B, an $8.3 millionsemi-annual principal payment on MCF’s bonds and approximately $5.9 millionrelated to the issuance of the Senior Notes and our new revolving line ofcredit.  Additionally, proceeds fromstock options were approximately $1.5 million.

 

***TreasuryStock/Repurchases.***   There were no purchases of our common stockin the nine months ended September 30, 2005.  The number of treasury shares reported atSeptember 30, 2005 has increased by 15,404 shares to reflect shares which hadbeen repurchased in prior periods (which had been inadvertently excluded fromthe share count presented, but which had been properly reflected in the costpresented).  We repurchased inthe open market 10,000 shares of our common stock for approximately $0.1million in the nine months ended September 30, 2004.

 

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***Long-Term Credit Facilities.*** The 2004Credit 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 $50.6 million at September 30,2005.  We had no outstanding borrowingson the 2004 Credit Facility at September 30, 2005, but we had outstandingletters of credit of approximately $9.4 million.  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, 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. The2004 Credit Facility is collateralized by substantially all of our assets,including the assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured bythe assets of MCF.  The 2004 CreditFacility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

MCFis obligated for the outstanding balance of its 8.47% Taxable Revenue Bonds,Series 2001.  The bonds bearinterest at a rate of 8.47% per annum and are payable in semi-annualinstallments of interest and annual installments of principal.  All unpaid principal and accrued interest onthe bonds is due on the earlier of August 1, 2016 (maturity) or as notedunder the bond documents.  The bonds arelimited, nonrecourse obligations of MCF and secured by the property andequipment, bond reserves, assignment of subleases and substantially all assetsrelated to the facilities included in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by us.

In June 2004, we issued $112.0million in principal of 10.75% Senior Notes (the “Senior Notes”) dueJuly 1, 2012.  The Senior Notes areunsecured 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 redeemed duringthe 12-month period commencing on July 1 of 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 mayredeem up to 35% of the original aggregate principal amount of the Senior Notesat a redemption price of 110.75% of the principal amount thereof with the netcash of public offerings of equity, provided that at least 65% of the originalaggregate principal amount of the Senior Notes remains outstanding after theredemption 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,each holder will have the right to require us to repurchase all or a portion ofsuch holder’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 abilityof our Guarantors to, among other things, incur additional indebtedness, paydividends or make other distributions, make other restricted payments andinvestments, create liens, incur restrictions on the ability of the Guarantorsto pay dividends or other payments to us, enter into transactions withaffiliates, and engage in mergers, consolidations and certain sales of assets.

In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap transaction with afinancial institution to hedge our exposure to changes in the fair value on$84.0 million of our Senior Notes.  Thepurpose of this transaction was to convert future interest due on $84.0 millionof the Senior Notes to a variable rate. The terms of the interest rate swap contract and the underlying debtinstrument are identical.  We have designatedthe swap agreement as a fair value hedge. The swap has a notional amount of $84.0 million and matures inJuly 2012 to mirror the maturity of the Senior Notes.  Under the agreement, we pay on a semi-annualbasis (each January 1 and July 1) a floating rate based on a six-monthU.S. dollar LIBOR rate, plus a spread, and receive a fixed-rate interest of10.75%.  For the three and nine monthsended September 30, 2005, we recorded interest savings related to thisinterest rate swap of approximately $0.2 million and $1.0 million, respectively,which is reflected as a reduction to interest expense in our accompanyingfinancial statements.  For the three andnine months ended September 30, 2004, we recorded interest savings related tothis interest rate swap of approximately $0.6 million and $0.7 million,respectively.  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 September 30, 2005 andDecember 31, 2004, the fair value of this derivative instrument wasapproximately $0.5 million and $3.2 million, respectively, and is included inother assets in our Consolidated Balance Sheets as of these dates.  The carrying value of the Senior Notes as ofthese dates was adjusted accordingly by the same amount. Because the swapagreement is considered an effective fair-value hedge, there will be no effecton our results of operations from the mark-to-market adjustment as long as theswap is in effect.

 

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***Contractual Uncertainties Related to Certain Facilities***

 

***Regional Correctional Center.***  In January 2003, we executed a five-yearlease for the Regional Correctional Center in Albuquerque, New Mexico. This 970bed facility consists of two units, the 528 South Tower and the 442 bed NorthTower. We renovated the South Tower and opened the unit in July 2004.  We renovated the North Tower and opened theunit in December 2004.  As ofSeptember 30, 2005, we had invested approximately $9.7 million onrenovations and furniture and equipment for both towers.  For the three and nine months endedSeptember 30, 2005, we incurred pre-opening and start-up expenses ofapproximately $1.5 million and $6.4 million, respectively, and recognizedrevenue of approximately $1.5 million and $4.3 million, respectively, relatedto this facility.  We currentlyanticipate that there will be periods that the facility will reach substantialcapacity during the fourth quarter of 2005. However, there can be no assurance that we will develop enough volume atthe facility to assure its profitability. The lease for the facility requires monthly rental payments ofapproximately $113,000 for the first two years and $130,000 for the last threeyears of the lease.

 

***New Morgan Academy.***We closed theNew Morgan Academy in the fourth quarter of 2002 and are currently consideringseveral options including the utilization of the facility for another type ofprogram or the sale or lease of the facility. As of September 30, 2005, we are principally focusing our effortson the potential insertion of a program in 2006.  We are maintaining a small staff to secureand maintain the facility.  We recognizedpre-tax costs of $0.9 million and $2.6 million in our Consolidated Statementsof Operations and Comprehensive Income (Loss) for the three and nine monthsended September 30, 2005, respectively, and pre-tax costs of $1.2 millionand $2.8 million for the three and nine months ended September 30, 2004,respectively, for related holding costs (depreciation, interest, property,taxes and other maintenance costs).

 

The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of Statement of FinancialAccounting Standards (SFAS) No. 144, at December 31, 2004.  As of September 30, 2005, we believethat, pursuant to the provisions of SFAS No. 144, no additional impairmentallowance is necessary.  The carryingvalue of the property and equipment for the New Morgan Academy, after theimpairment charge, was approximately $20.0 million and $20.4 million atSeptember 30,  2005 andDecember 31, 2004, respectively.

 

***Central California Treatment Center***.  In January 2004, we purchased a building inLos Angeles, California for which our carrying value was approximately $2.7million at September 30, 2005.   Thisfacility could provide service to 220 inmates in a work-furlough typeprogram.  Although we do not currentlyhave a contract for this facility, the facility has been submitted and is underconsideration in several proposals.  Webelieve that due to the growth of the inmate population, severe budget crisisand recent legal settlements requiring additional community services, thisfacility would fill 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.

 

In addition, during the third quarter of 2005 we received notice from alocal governmental agency of a possible intent to acquire the facility.  The amount of the preliminary offer slightlyexceeds our carrying value.  It isexpected that a final decision from the agency regarding their intent toacquire the facility from us will be rendered within the next six months.

 

***Campbell Griffin Treatment Center.***  In October 2005 we initiated the temporaryclosure of this leased facility in San Antonio, Texas, and transferred theresidents to our Texas Adolescent Treatment Center ( also located in SanAntonio).  It is our intent to reactivatethis facility during the first quarter of 2006. Accordingly, it has not beenincluded in discontinued operations.

 

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***FutureLiquidity*****.  **Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under the 2004 Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future development contracts,including the construction of the Moshannon Valley Correctional Center. To theextent our cash and current financing arrangements do not provide sufficientfinancing to fund construction costs related to future adult secureinstitutional contract awards or significant facility expansions, we anticipateobtaining additional sources of financing to fund such activities.  However, there can be no assurance that suchfinancing will be available or will be available on terms favorable to us.

 

***ContractualObligations and Commercial Commitments*****.** We haveassumed various financial obligations and commitments in the ordinary course ofconducting our business.  We havecontractual obligations requiring future cash payments under our existingcontractual arrangements, such as management, consultative and non-competitionagreements.

 

Wemaintain operating leases in the ordinary course of our businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, andthe terms of these agreements range from 2005 until 2075.  As of September 30, 2005, our totalcommitment under these operating leases was approximately $35.7 million.

 

Thefollowing table details our known future cash payments (on an undiscountedbasis) related to various contractual obligations as of September 30, 2005(in thousands):

 
| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | ** **                 | ** ** | ** ** | ** ** | **2006 -** | ** ** | **2008 -** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Total**                  | ** ** | **2005** | ** ** | **2007** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
|                                         |       |                       |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                     |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                   |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.         |       | $                          | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| • Special  Purpose Entities             |       | 165,700                    |       | — |   | 20,200 |   | 23,800 |   | 121,700 |   |
| Long-term debt - interest (1)                |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.         |       | 76,741                     |       | 2,858 |   | 22,730 |   | 22,753 |   | 28,400 |   |
| • Special  Purpose Entities             |       | 95,508                     |       | — |   | 27,248 |   | 23,682 |   | 44,578 |   |
| Construction commitments                     |       | 15,523                     |       | 11,985 |   | 3,538 |   | — |   | — |   |
| Capital lease obligations                    |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.         |       | 112                        |       | 1 |   | 88 |   | 22 |   | 1 |   |
| Operating leases                             |       | 35,702                     |       | 1,750 |   | 12,634 |   | 6,996 |   | 14,322 |   |
| Consultative and  non-competition agreements |       | 2,265                      |       | 461 |   | 1,554 |   | 250 |   | — |   |
| Total contractual cash  obligations          |       | $                          | 503,551    |   | $ | 17,055 |   | $ | 87,992 |   | $ | 77,503 |   | $ | 321,001 |   |

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(1)          We have an interest rateswap agreement under which we receive a fixed interest rate and pay a floatinginterest rate. The future cash payments on the Cornell Companies, Inc.long-term debt — interest assume an effective rate of 9.81% on the relatedinterest rate swap contract.

 

Weenter into letters of credit in the ordinary course of our operating andfinancing activities.  As of September 30,2005, we had outstanding letters of credit of approximately $9.4 millionrelated to insurance and other operating activities.  The following table details our letter ofcredit commitments as of September 30, 2005 (in thousands):

 
| ** **                | ** ** | **Total**     | ** ** | **Amount of  Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------------------------------|------------|
| ** **                | ** ** | **Amounts**   | ** ** | **Less than**                                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Over** | ** ** |
| ** **                | ** ** | **Committed** | ** ** | **1 Year**                                      | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
|                      |       |          |       |                                            |       |   |   |   |   |   |   |
| Commercial Commitments:   |       |          |       |                                            |       |   |   |   |   |   |   |
| Standby letters of credit |       | $             | 9,378      |                                            | $          | 8,628 |   | $ | — |   | $ | 500 |   | $ | 250 |   |
|                           |            |               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 3.****                            ****Quantitative and Qualitative Disclosures aboutMarket Risk**

 

In the normal course of business, we are exposed to market risk,primarily from changes in interest rates. We continually monitor exposure to market risk and develop appropriatestrategies to manage this risk.  We arenot exposed to any other significant market risks, including commodity pricerisk or, foreign currency exchange risk or interest rate risks from the use ofderivative financial instruments.  Inconjunction with the issuance of the Senior Notes, we entered into an interestrate swap of $84.0 million related to the interest obligations under the SeniorNotes in effect converting them to a floating rate based on six-month LIBOR.

 

**Interest Rate Exposure**

 

Ourexposure to changes in interest rates primarily results from our long-term debtwith both fixed and floating interest rates. The debt on our consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction and approximately $28.0million of the Senior Notes not hedged by the interest rate swap entered intoby the Company.  At September 30,2005, 30.3% ($84.0 million of debt outstanding on the Senior Notes issued inJune 2004) of our consolidated long-term debt was subject to variableinterest rates.  The detrimental effectof a hypothetical 100 basis point increase in interest rates would be to reduceincome before provision for income taxes by approximately $0.2 million and $0.6million for the three and nine months ended September 30, 2005.  At September 30, 2005, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

 

**ITEM 4.****                            ****Controls and Procedures**

 

We maintain disclosurecontrols and procedures designed to ensure that information disclosed in ourannual and periodic reports is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’srules and forms. In addition, we designed these disclosure controls andprocedures to ensure that this information is accumulated and communicated tomanagement, including the chief executive officer (CEO) and chief financialofficer (CFO), to allow timely decisions regarding required disclosures. SECrules require that we disclose the conclusions of our CEO and CFO about theeffectiveness of our disclosure controls and procedures.

 

We do not expect that our disclosure controls and procedures willprevent all errors or fraud. The design of disclosure controls and proceduresmust reflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitation in a cost-effective control system, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, if any,within the Company have been detected.

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we have evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Actof 1934, as amended (the Exchange Act) as of the end of the period required bythis report. Based on that evaluation, our principal executive officer andprincipal financial officer have concluded that these controls and proceduresare effective as of that date.

 

In connection with the evaluation described above, there have been nochanges in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under Exchange Act)during our fiscal quarter ended September 30, 2005 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II****                          ****OTHER INFORMATION**

 

**ITEM 1.****                            ****Legal Proceedings**

 

##### ***LincolnCounty Detention Center***

##### * *

On August 22, 2005, alawsuit was filed by a detainee at the Lincoln County Detention Center (“LCDC”)in the U.S. District Court of New Mexico (Santa Fe).  The lawsuit relates to the former LCDC policythat required strip searches for all detainees and inmates and alleges thatsuch policy violates a detainee’s Fourth Amendment right.  The lawsuit was filed as aputative class action lawsuit brought on behalf of all inmates who weresearched at the facility from May 2002 to July 2005.  This lawsuit is in its early stages and no discoveryhas been conducted. The ultimate outcome of the lawsuit cannot be determined atthis time. However, we intend to aggressively defend this lawsuit. We have notrecorded any loss accrual related to this lawsuit.

 

***Southern Peaks Regional Treatment Center***

 

On January 5, 2004,we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v. Longboat GlobalAdvisors, LLC, et al*., No.2004 CV79761 in the Superior Court ofFulton County, Georgia under theories of fraud, conversion, breach of contractand other theories to determine the location of and to recover funds previouslydeposited by us into what we believed to be an escrow account in connectionwith the development and construction of the Southern Peaks Regional TreatmentCenter.  Of the funds previouslydeposited, approximately $5.3 million remains to be recovered at September 30,2005.  In December 2004, thecase was tried before a jury and the jury verdict awarded approximately $6.5million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorneys’ fees.  We expectthat the actual damages awarded under the verdict will be adjusted downward tothe $5.4 million actually lost by us and that the punitive damages award may beadjusted downward because of a Georgia statute regarding caps on punitivedamages awards.  No judgment has yet beenentered on this verdict.  The award forcompensatory damages accrues pre-judgment interest at a rate of 7 percent fromthe date of loss through the date of judgment.  Following thejury verdicts, we collected approximately $0.4 million in January 2005 infunds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Currently, certain of the defendants havefiled motions for a new trial. No judgment will be entered on the verdict untilafter these motions for a new trial have been heard and ruled on by thecourt.  Due to the continued uncertaintysurrounding the ultimate recovery of the funds previously deposited, we willcontinue to maintain our existing reserve of approximately $5.0 million in anallowance for doubtful accounts.

 

**ShareholderLawsuits**

 

In March andApril 2002, the Company, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe 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 SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits were putative class action lawsuits broughton behalf of all purchasers of our common stock between March 6, 2001 andMarch 5, 2002 and relate to our restatement in 2002 of certain financialstatements.  The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic leasetransaction.  These four lawsuits wereconsolidated into the *Graydon Williams*action and Flyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs tofile an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of theExchange 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.  The Company filed a motion todismiss the lawsuit.  In an order enteredApril 1, 2005, the court granted the motion to dismiss with respect to theplaintiffs’ securities fraud claims pursuant to Sections 10(b) and20(a) of the Exchange Act and Rule 10b-5.  The court denied the motion to dismiss as tothe remaining claims covering the Company’s secondary offering in 2001.  Subject to court approval and documentation,the parties have agreed to settle this matter. Under the 

 

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proposed settlement agreement, the Companyhas not admitted any wrongdoing. Settlement in the amount of $7 million will be funded through theCompany’s directors’ and officers’ liability insurance.  The Company has not reached settlement in thepending derivative litigation discussed below.

 

In March 2002, theCompany, our directors, and our former independent auditor Arthur Andersen LLP,were sued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant CornellCompanies, 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.

 

On January 27, 2004, wereceived a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that we pursue breach of fiduciary duty claims against variousofficers and directors based on the August 2001 sale leaseback transactionand the subsequent restatement.  We haveissued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision.

 

In May andSeptember 2002, the Company and our then directors were sued in threeother 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 the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.*, No. H-02-1896, in the United Stated District Court forthe Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, 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 court granted the motion todismiss the *Guitierrez* action andthe plantiffs have appealed that ruling. The *Menning* action hasbeen dismissed, but with an agreement that the plaintiff’s claims as to Cornellare tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

The plaintiffs in these caseshave not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, we believe we have good defenses andintend to vigorously defend against the claims asserted in these actions.  We have not recorded any loss accruals relatedto these claims.

 

Certain insurance policies held by us to cover potential director andofficer liability may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations 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 offender privilegesand employment matters. If an adverse decision in these matters exceeds ourinsurance coverage, or if our coverage is deemed not to apply to these matters,or if the underlying insurance carrier was unable to fulfill its obligationunder the insurance coverage provided, it could have a material adverse effecton our financial position, results of operations or cash flows.

 

During the period ofAugust 2000 through May 2003, our general liability and professionalliability coverage was provided by Specialty Surplus Insurance Company, aKemper 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 regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  In the year ended December 31, 2004, werecorded a reserve of $0.6 million, and estimated our range of additional exposureto be approximately $0.5 million with respect to outstanding claims incurredduring this policy period with Kemper which would become our obligation toresolve if not settled through Kemper.

 

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Duringthe nine months ended September 30, 2005, Kemper continued to implementits run-off plan.  As a result, severalof our significant claims were settled by Kemper in the second quarter of 2005.In conjunction with these settlements, we recorded a charge against ourexisting reserve in the amount of $0.3 million. We believe that the uncertainty surrounding the ability of Kemper tosettle our remaining outstanding claims still exists. Based on our analysis ofthe claims activity during the third quarter, we felt it necessary to record anadditional reserve in the amount of approximately $0.2 million at September 30,2005.  We believe our estimated range ofexposure, above our existing $0.5 million reserve, to be approximately $0.1million related to the outstanding claims which could become our obligation toresolve if not settled through Kemper.

 

Whilethe outcome of such matters cannot be predicated with certainty, based on theinformation known to date, we believe that the ultimate resolution of these matterswill not have a material adverse effect on our financial position, operatingresults or cash flow.

 

**ITEM 2.****                            ****Unrestricted Sales of Equity Securities and Useof Proceeds**

 

None

 

**ITEM 3.****                            ****DefaultsUpon Senior Securities**

 

None

 

**ITEM 4.****                            ****Submission of Matters to a Vote of SecurityHolders**

 

None

 

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**ITEM 5.****                            ****Other Information**

 

None

 

**ITEM 6.****                            ****Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                            |
|----------------------|------------|------------------------------------------------------------|
| 11.1                 |       | Computation  of Per Share Earnings                         |
| 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 |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                                           |   | **CORNELL COMPANIES, INC.**           |   |
|------------------------------------------------|--------|---------------------------------------|--------|
|                                           |   |                                  |   |
|                                           |   |                                  |   |
| Date:    November  9, 2005 | By:    | /s/ James E. Hyman                    |   |
|                                           |   | JAMES E. HYMAN                        |   |
|                                           |   | Chief Executive Officer  and          |   |
|                                           |   | Chairman of the Board                 |   |
|                                           |   | (Principal Executive  Officer)        |   |
|                                           |   |                                  |   |
|                                           |   |                                  |   |
| Date:    November 9, 2005  | By:    | /s/ John R. Nieser                    |   |
|                                           |   | JOHN R. NIESER                        |   |
|                                           |   | Chief Financial Officer and Treasurer |   |
|                                           |   | (Principal Financial Officer)         |   |

 

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