**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**FORM 10-Q**

| **ý**                                         |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|----------------------------------------------------|--------|------------------------------------------------------------------------------------------------|
| ** **                                         |   | ** **                                                                                     |
| **For the  Quarterly Period Ended March 31, 2007** |
|                                               |   |                                                                                           |
| **OR**                                             |
|                                               |   |                                                                                           |
| **o**                                              |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**For thetransition period from               to               **

**CommissionFile Number 1-14472**

**CORNELLCOMPANIES, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

Registrant’sTelephone Number, Including Area Code:**(713) 623-0790**

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

Yes  ý  No o

Indicateby a check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):
| Large accelerated Filer o | Accelerated  filer ý | Non-accelerated filer o |
|---------------------------|---------------------------|-------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).

Yes  o No ý

At May 1, 2007, the registrant had 14,171,923shares of common stock outstanding.

 

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**Cornell Companies, Inc.**

**Table of Contents**

**Form 10-Q**
| **Part I**  |   |                                                                                        |   |   |
|-------------|--------|---------------------------------------------------------------------------------------------|--------|--------|
| Item 1.     |   | Financial  Statements (unaudited)                                                           |   |   |
| Item 2.     |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |   |
| Item 3.     |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |   |
| Item 4.     |   | Controls and Procedures                                                                     |   |   |
|        |   |                                                                                        |   |   |
| **Part II** |   |                                                                                        |   |   |
| Item 1.     |   | Legal  Proceedings                                                                          |   |   |
| Item 1A.    |   | Risk  Factors                                                                               |   |   |
| Item 2.     |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   |   |
| Item 3.     |   | Defaults  Upon Senior Securities                                                            |   |   |
| Item 4.     |   | Submission  of Matters to a Vote of Security Holders                                        |   |   |
| Item 5.     |   | Other  Information                                                                          |   |   |
| Item 6.     |   | Exhibits                                                                                    |   |   |

 

2

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**PART I****                   FINANCIALINFORMATION**

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

**CORNELLCOMPANIES, INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**
| ** **                                                                                                                                                             | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                             | ** ** | ** **               | ** ** | ** **                  | ** ** |
| **CURRENT  ASSETS:**                                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash  and cash equivalents                                                                                                                                             |       | $                        | 14,981     |                        | $          | 18,529 |   |
| Investment  securities available for sale                                                                                                                              |       | 10,450                   |       | 11,925                      |       |
| Accounts  receivable – trade (net of allowance for doubtful accounts of $3,832 and  $3,644, respectively)                                                         |       | 68,798                   |       | 72,723                      |       |
| Other  receivables (net of allowance for doubtful accounts of $5,297)                                                                                                  |       | 2,778                    |       | 3,751                       |       |
| Debt  service fund and other restricted assets                                                                                                                         |       | 23,558                   |       | 24,611                      |       |
| Deferred  tax assets                                                                                                                                                   |       | 6,672                    |       | 6,672                       |       |
| Prepaid  expenses and other                                                                                                                                            |       | 7,625                    |       | 7,540                       |       |
| **Total current assets**                                                                                                                                               |       | 134,862                  |       | 145,751                     |       |
| **PROPERTY  AND EQUIPMENT, net**                                                                                                                                       |       | 321,767                  |       | 319,064                     |       |
| **OTHER  ASSETS:**                                                                                                                                                     |       |                     |       |                        |       |
| Debt  service reserve fund                                                                                                                                             |       | 24,372                   |       | 23,801                      |       |
| Goodwill,  net                                                                                                                                                         |       | 12,339                   |       | 12,339                      |       |
| Intangible  assets, net                                                                                                                                                |       | 6,366                    |       | 6,926                       |       |
| Deferred  costs and other                                                                                                                                              |       | 16,835                   |       | 15,652                      |       |
| **Total assets**                                                                                                                                                       |       | $                        | 516,541    |                        | $          | 523,533 |   |
|                                                                                                                                                                   |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                          | ** ** | ** **               | ** ** | ** **                  | ** ** |
|                                                                                                                                                                   |       |                     |       |                        |       |
| **CURRENT  LIABILITIES:**                                                                                                                                              | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Accounts  payable and accrued liabilities                                                                                                                              |       | $                        | 48,593     |                        | $          | 60,163 |   |
| Current  portion of long-term debt                                                                                                                                     |       | 10,520                   |       | 10,510                      |       |
| **Total current liabilities**                                                                                                                                          |       | 59,113                   |       | 70,673                      |       |
| **LONG-TERM  DEBT, net of current portion**                                                                                                                            |       | 256,085                  |       | 255,471                     |       |
| **DEFERRED  TAX LIABILITIES**                                                                                                                                          |       | 11,430                   |       | 11,373                      |       |
| **OTHER  LONG-TERM LIABILITIES**                                                                                                                                       |       | 6,000                    |       | 4,452                       |       |
| **Total liabilities**                                                                                                                                                  |       | 332,628                  |       | 341,969                     |       |
|                                                                                                                                                                   |       |                     |       |                        |       |
| **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, 15,668,887 and  15,603,917 shares issued and 14,128,493 and 14,063,523 shares outstanding,  respectively |       | 16                       |       | 16                          |       |
| Additional  paid-in capital                                                                                                                                            |       | 155,764                  |       | 154,411                     |       |
| Retained  earnings                                                                                                                                                     |       | 39,879                   |       | 38,964                      |       |
| Treasury  stock (1,540,394 shares of common stock, at cost)                                                                                                            |       | (12,308                  | )          | (12,308                     | )          |
| Accumulated  other comprehensive income                                                                                                                                |       | 562                      |       | 481                         |       |
| **Total stockholders’ equity**                                                                                                                                    |       | 183,913                  |       | 181,564                     |       |
| **Total liabilities and stockholders’ equity**                                                                                                                    |       | $                        | 516,541    |                        | $          | 523,533 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

3

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**CORNELLCOMPANIES, INC.****CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME****(Unaudited)(in thousands, except per share data)**
| ** **                                                                                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                                                                                              |       |                                             |       |   |   |
| REVENUES                                                                                                          |       | $                                                | 89,644     |   | $ | 83,847 |   |
| OPERATING EXPENSES                                                                                                |       | 69,610                                           |       | 65,143 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                 |       | —                                           |       | 2,657 |   |
| DEPRECIATION AND AMORTIZATION                                                                                     |       | 3,841                                            |       | 3,726 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                               |       | 8,358                                            |       | 5,112 |   |
|                                                                                                              |       |                                             |       |   |   |
| INCOME FROM OPERATIONS                                                                                            |       | 7,835                                            |       | 7,209 |   |
| INTEREST EXPENSE                                                                                                  |       | 6,781                                            |       | 5,565 |   |
| INTEREST INCOME                                                                                                   |       | (146                                             | )          | (522 | ) |
|                                                                                                              |       |                                             |       |   |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION  FOR INCOME TAXES                                              |       | 1,200                                            |       | 2,166 |   |
| PROVISION FOR INCOME TAXES                                                                                        |       | 536                                              |       | 956 |   |
|                                                                                                              |       |                                             |       |   |   |
| INCOME FROM CONTINUING OPERATIONS                                                                                 |       | 664                                              |       | 1,210 |   |
|                                                                                                              |       |                                             |       |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT OF $283  IN 2006                                                      |       | —                                           |       | (526 | ) |
|                                                                                                              |       |                                             |       |   |   |
| NET INCOME                                                                                                        |       | $                                                | 664        |   | $ | 684 |   |
|                                                                                                              |       |                                             |       |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                        |       |                                             |       |   |   |
| BASIC                                                                                                             |       |                                             |       |   |   |
| Income from continuing operations                                                                                 |       | $                                                | .05        |   | $ | .09 |   |
| Loss from discontinued operations, net of tax                                                                     |       | —                                           |       | (.04 | ) |
| Net income                                                                                                        |       | $                                                | .05        |   | $ | .05 |   |
|                                                                                                              |       |                                             |       |   |   |
| DILUTED                                                                                                           |       |                                             |       |   |   |
| Income from continuing operations                                                                                 |       | $                                                | .05        |   | $ | .09 |   |
| Loss from discontinued operations, net of tax                                                                     |       | —                                           |       | (.04 | ) |
| Net income                                                                                                        |       | $                                                | .05        |   | $ | .05 |   |
|                                                                                                              |       |                                             |       |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                   |       |                                             |       |   |   |
| BASIC                                                                                                             |       | 13,984                                           |       | 13,851 |   |
| DILUTED                                                                                                           |       | 14,246                                           |       | 13,953 |   |
|                                                                                                              |       |                                             |       |   |   |
| COMPREHENSIVE INCOME:                                                                                             |       |                                             |       |   |   |
| Net income                                                                                                        |       | $                                                | 664        |   | $ | 684 |   |
| Unrealized gain (loss) on derivative instruments,  net of tax provision (benefit) of $57 and ($209), respectively |       | 81                                               |       | (301 | ) |
| Comprehensive income                                                                                              |       | $                                                | 745        |   | $ | 383 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

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**CORNELLCOMPANIES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(in thousands)**
| ** **                                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Net income                                                                                              |       | $                                                | 664        |   | $ | 684 |   |
| Adjustments to reconcile net income to net cash used  in operating activities —                    |       |                                             |       |   |   |
| Depreciation                                                                                            |       | 3,280                                            |       | 3,216 |   |
| Amortization of intangibles and other assets                                                            |       | 561                                              |       | 561 |   |
| Amortization of deferred compensation                                                                   |       | —                                           |       | 37 |   |
| Amortization of deferred financing costs                                                                |       | 394                                              |       | 443 |   |
| Amortization of Senior Notes Discount                                                                   |       | 46                                               |       | 46 |   |
| Stock-based compensation                                                                                |       | 448                                              |       | 654 |   |
| Provision for bad debts                                                                                 |       | 510                                              |       | 1,866 |   |
| Loss on sale of property and equipment                                                                  |       | 28                                               |       | 1 |   |
| Deferred income taxes                                                                                   |       | —                                           |       | 599 |   |
| Change in assets and liabilities:                                                                       |       |                                             |       |   |   |
| Accounts receivable                                                                                     |       | 3,191                                            |       | (6,655 | ) |
| Other restricted assets                                                                                 |       | (776                                             | )          | 1,077 |   |
| Other assets                                                                                            |       | (46                                              | )          | 876 |   |
| Accounts payable and accrued liabilities                                                                |       | (12,212                                          | )          | (9,104 | ) |
| Other liabilities                                                                                       |       | (55                                              | )          | 19 |   |
| Net cash used in operating activities                                                                   |       | (3,967                                           | )          | (5,680 | ) |
|                                                                                                    |       |                                             |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Capital expenditures                                                                                    |       | (3,218                                           | )          | (6,980 | ) |
| Purchases of investment securities                                                                      |       | (117,325                                         | )          | (84,125 | ) |
| Sales of investment securities                                                                          |       | 118,800                                          |       | 83,400 |   |
| Payments to restricted debt payment account, net                                                        |       | 1,258                                            |       | 409 |   |
| Net cash used in investing activities                                                                   |       | (485                                             | )          | (7,296 | ) |
|                                                                                                    |       |                                             |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Payments of capital lease obligations                                                                   |       | (2                                               | )          | 3⁄4 |   |
| Tax benefit of stock option exercises                                                                   |       | 214                                              |       | 73 |   |
| Proceeds from exercise of stock options                                                                 |       | 692                                              |       | 901 |   |
| Net cash provided by financing activities                                                               |       | 904                                              |       | 974 |   |
|                                                                                                    |       |                                             |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                               |       | (3,548                                           | )          | (12,002 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                        |       | 18,529                                           |       | 13,723 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                              |       | $                                                | 14,981     |   | $ | 1,721 |   |
|                                                                                                    |       |                                             |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                      |       |                                             |       |   |   |
| Other comprehensive income (loss)                                                                       |       | $                                                | 81         |   | $ | (301 | ) |
| Common stock issued for board of directors fees                                                         |       | —                                           |       | 139 |   |
| Increase in fair value of interest rate swap                                                            |       | 577                                              |       | 1,749 |   |
| Purchases and additions of property and equipment  included in accounts payable and accrued liabilities |       | 2,791                                            |       | — |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

5

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**CORNELLCOMPANIES, INC.****NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

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

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(collectively with its subsidiaries and consolidated special purpose entities,the “Company,” “we,” “us” or “our”) pursuant to the rules and regulations ofthe 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 omittedpursuant to such rules and regulations. In the opinion of management, adjustments and disclosures necessary fora fair presentation 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 the Company’s 2006 AnnualReport on Form 10-K as filed with the Securities and Exchange Commission.

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

See a description of ouraccounting policies in our 2006 Annual Report on Form 10-K.

***Adoption of Financial Accounting Standards Board Interpretation No. 48***

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertaintyin Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN No. 48”).  FIN No. 48 establishes a single model toaddress the accounting for uncertain tax positions.  FIN No. 48 clarifies the accounting forincome taxes by prescribing a minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements.  FIN No. 48 also provides guidance on themeasurement, derecognition, classification and disclosure of tax positions, aswell as the accounting for the related interest and penalties, transition andaccounting in interim periods.  FIN No.48 is effective for fiscal years beginning after December 15, 2006 and requiresthat the impact of the adoption of FIN No. 48 be recorded as an adjustment to beginningretained earnings at January 1, 2007.

We adopted the provisions of FIN No. 48 on January1, 2007.  Our total amount ofunrecognized tax benefits as of the adoption date was approximately $3.0million.  As a result of the adoption ofFIN No. 48, we recorded a cumulative effect adjustment of approximately $0.3million which increased retained earnings at January 1, 2007.  The amount of unrecognized tax benefits didnot materially change in the three months ended March 31, 2007.

Included in the unrecognized tax benefits balanceas of January 1, 2007, are approximately $0.8 million of tax benefits that, ifrecognized in future periods, would impact our effective tax rate.  The difference of approximately $2.2 millionbetween the total amount of unrecognized tax benefits of $3.0 million and theamount that would impact our effective tax rate was offset by an increase indeferred tax assets as of January 1, 2007.

Estimated interest and penalties related to theunderpayment of income taxes are classified as a component of income taxexpense in the Consolidated Statements of Operations and Comprehensive Incomeand totaled approximately $0.02 million in the three months ended March 31,2007.  Accrued interest and penaltieswere approximately $0.3 million at March 31, 2007 and January 1, 2007.

We are subject to income tax in the United Statesand many of the individual states we operate in.  We currently have significant operations inTexas, California and Pennsylvania. State income tax returns are generally subject to examination for aperiod of three to five years after filing. The state impact of any changes made to the federal return remainssubject to examination by various states for a period up to one year afterformal notification to the state.  We areopen to United States Federal Income Tax examinations for the tax years endedDecember 31, 2003 through December 31, 2006.

We do not anticipate a significant change in thebalance of our unrecognized tax benefits within the next 12 months.

### ***Accounting For Stock-Based Compensation***

Ourstock incentive plans provide for the granting of stock options (both incentivestock options and nonqualified stock options), stock appreciation rights,restricted stock units and other stock-based awards to officers, directors andemployees of the Company. Grants of stock options made to date under theseplans vest over periods up to seven years after the date of grant and expire nomore than 10 years after grant.

6

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EffectiveJanuary 1, 2006, we adopted the provisions of the FASB Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. Under this method,compensation cost recognized for the quarter, includes the applicable amountsof: (a) compensation cost of all stock-based awards granted prior to, but notyet vested, as of January 1, 2006 (based on the grant-date fair value estimatedin accordance with the original provisions of SFAS No. 123), and (b)compensation cost for all stock-based awards granted subsequent to January 1,2006 (based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123R).

Additionally,we have an employee stock purchase plan (“ESPP”) underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yeartypically begins each January 1st (the “Grant Date”) and ends on December 31st(the “Exercise Date”). For 2007, however, the plan year will begin April 1,2007.  Purchases of common stock are madeat the end of the year using the lower of the fair market value on either theGrant Date or Exercise Date, less a 15% discount. Under SFAS No. 123Rour employee-stock purchase plan is considered to be a compensatory ESPP and;therefore, we are required to recognize compensation cost over the requisiteservice period for grants made under the ESPP.

SFAS No.123R amends SFAS No. 95, “Statement of Cash Flows,” to require reporting ofexcess tax benefits as a financing cash flow, rather than as a reduction oftaxes paid. These excess tax benefits result from tax deductions in excess ofthe cumulative compensation expense recognized for options exercised. Prior tothe adoption of SFAS No. 123R, we presented all tax benefits resulting from theexercise of stock options as operating cash flows in our Consolidated Statementsof Cash Flows.

On March29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 107 to addresscertain issues related to SFAS No. 123R. SAB 107 provides guidance ontransition methods, valuation methods, income tax effects and other share-basedpayment topics, and we had also applied this guidance in our adoption of SFASNo. 123R.

On November10, 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 123R-3, “TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards” (“FSP123R-3”). FSP 123R-3 provides for an alternative transition method forestablishing the beginning balance of the additional paid-in capital pool (“APICpool”) related to the tax effects of employee share-based compensation, whichis available to absorb tax deficiencies recognized subsequent to the adoptionof SFAS No. 123R. We elected to adopt this alternative transition method,otherwise known as the “simplified method,” in establishing our beginning APICpool at January 1, 2006.

AtMarch 31, 2006, 60,000 shares of restricted stock were outstanding subject toperformance-based vesting criteria (30,000 of these are considered market-basedrestricted stock under SFAS No. 123R). Additionally, 39,200 stock options wereoutstanding subject to performance-based vesting criteria (19,600 of these wereconsidered market-based options under SFAS No. 123R).  The 30,000 shares of restricted stock and the19,600 stock options which were considered market-based restricted stock werevalued using a Monte Carlo simulation probability model to estimate futurestock returns. The grant date fair value of these shares was $9.05 per sharefor a total value of $0.5 million. We recognized $0.04 million of expenseassociated with these shares of restricted stock and options during the firstquarter of 2006.

AtMarch 31, 2007, 107,500 shares of restricted stock were outstanding subject toperformance-based vesting criteria (30,000 of these restricted shares wereconsidered market-based restricted stock under SFAS No. 123R).  There were also 100,100 stock optionsoutstanding subject to performance-based vesting criteria.  We recognized $0.13 million of expenseassociated with these shares of restricted stock and stock options during thethree months ended March 31, 2007.

The amounts above relate to theimpact of recognizing compensation expense related to stock options, restrictedstock and our employee-stock purchase plan. Compensation expense related tostock options (100,100 shares) and restricted stock (77,500 shares) that vestbased upon performance conditions is not recorded for such performance-basedawards until it has been deemed probable that the related performance targetsallowing the vesting of these options and restricted stock  will be met. We are required to periodicallyre-assess the probability and record expense at the point in time, if ever, itbecomes probable these options will vest. During the fourth quarter of 2006 itwas deemed probable that the performance targets pertaining to certainrestricted stock and stock options would be achieved by their vesting date.Accordingly, compensation expense of approximately $0.1 million has beenrecognized for the three months ended March 31, 2007 related to thesestock-based awards.

Werecognize expense for our stock-based compensation over the vesting period,which represents the period in which an employee is required to provide servicein exchange for the award. We recognize compensation expense for stock-basedawards immediately if the award has immediate vesting.

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***Assumptions***

The fair values for the significant stock-based awardsgranted during the three months ended March 31, 2007 and 2006 wereestimated at the date of grant using a Black-Scholes option pricing model withthe following weighted-average assumptions:

|                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                              |       |                                             |       |   |   |
| Risk-free rate  of return         |       | 4.51                                             | %          | 4.31 | % |
| Expected life of  award           |       | 6.25 years                                       |       | 5 years |   |
| Expected  dividend yield of stock |       | 0                                                | %          | 0 | % |
| Expected  volatility of stock     |       | 42.00                                            | %          | 45.48 | % |
| Weighted-average fair  value      |       | $                                                | 9.77       |   | $ | 6.24 |   |
|                                   |            |                                                  |            |  |  |  |  |

 

The expected volatility of stock assumption wasderived by referring to changes in the Company’s historical common stock pricesover a timeframe similar to that of the expected life of the award. Wecurrently have no reason to believe that future stock volatility will differsignificantly from historical stock volatility. Estimated forfeiture rates arederived from historical forfeiture patterns. We believe the historicalexperience method is the best estimate of forfeitures currently available.

In accordance with SAB 107, we used the “simplified”method for “plain vanilla” options to estimate the expected term of optionsgranted during the first quarter of 2006 and 2007.

Stock-based award activity during the three monthsended March 31, 2007 was as follows (aggregate intrinsic value inmillions):

|                                                | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
|                                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  December 31, 2006              |       | 655,260                |       | $                                      | 12.87      |                                                | 7.6        |                            | $          | 8.4 |   |
| Granted                                        |       | 12,500                 |       | 20.12                                  |       |                                                |       |                            |       |
| Exercised                                      |       | (64,970                | )          | 10.65                                  |       |                                                |       |                            |       |
| Canceled                                       |       | (16,100                | )          | 12.60                                  |       |                                                |       |                            |       |
|                                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  March 31, 2007                 |       | 586,690                |       | $                                      | 13.27      |                                                | 7.6        |                            | $          | 7.8 |   |
|                                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and  expected to vest at March 31, 2007 |       | 458,030                |       | $                                      | 13.11      |                                                | 7.4        |                            | $          | 6.0 |   |
|                                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at March 31,  2007                 |       | 296,187                |       | $                                      | 12.77      |                                                | 7.0        |                            | $          | 3.8 |   |

 

The total intrinsic value of stock options exercisedduring the three months ended March 31, 2007 and 2006 was $0.6 million and$0.2 million, respectively. Net cash proceeds from the exercise of stock optionswere approximately $0.7 million and $0.9 million for the three months endedMarch 31, 2007 and 2006, respectively.

As of March 31, 2007, approximately $0.76 millionof estimated expense with respect to time-based nonvested stock option awards hasyet to be recognized and will be amortized into expense over the employee’sremaining requisite service period of approximately 2.75 years. As ofMarch 31, 2007, approximately $0.6 million of estimated expense withrespect to performance based nonvested stock option awards has yet to berecognized and will be recorded if it becomes probable that these options willvest.

8

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The following table summarizes information withrespect to stock options outstanding and exercisable at March 31, 2007.
| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                        |       |                    |       |                                                |       |                                   |       |                    |       |                                   |       |
| $3.75  to  $10.00       |       | 34,250                  |       | 4.7                                                 |       | $                                      | 5.95       |                    | 33,357     |                                   | $          | 5.89 |   |
| $10.01  to  $13.50      |       | 202,140                 |       | 7.4                                                 |       | 12.75                                  |       | 96,330                  |       | 12.77                                  |       |
| $13.51  to $14.50            |       | 305,500                 |       | 8.4                                                 |       | 13.92                                  |       | 136,200                 |       | 13.84                                  |       |
| $14.51  to $22.00            |       | 44,800                  |       | 5.6                                                 |       | 16.82                                  |       | 30,300                  |       | 15.60                                  |       |
|                                        |       | 586,690                 |       | 7.6                                                 |       | $                                      | 13.27      |                    | 296,187    |                                   | $          | 12.77 |   |

 

Stock-basedaward activity for nonvested awards during the three months endedMarch 31, 2007 is as follows:

|                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  December 31, 2006 |       | 322,170                |       | $                                                           | 13.40      |   |
| Granted                         |       | 12,500                 |       | 20.12                                                       |       |
| Vested                          |       | (28,067                | )          | 12.92                                                       |       |
| Canceled                        |       | (16,100                | )          | 12.60                                                       |       |
|                            |       |                   |       |                                                        |       |
| Nonvested at March 31,  2007    |       | 290,503                |       | $                                                           | 13.78      |   |

 

***Restricted Stock***

Wehave previously issued restricted stock under certain employment agreements anda deferred bonus plan which vests over a specific period of time, generallythree to five years.  During the threemonths ended March 31, 2007, we also issued restricted stock under both certainemployment agreements and our 2006 Equity Incentive plan.  These shares of restricted common stock aresubject to restrictions on transfer and certain conditions to vesting.

Restrictedstock activity for the three months ended March 31, 2007 was as follows:

|                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  December 31, 2006 |       | 85,000                 |       | $                                                           | 10.87      |   |
| Granted                         |       | 85,000                 |       | 20.97                                                       |       |
| Vested                          |       | —                 |       |                                                        |       |
| Canceled                        |       | —                 |       |                                                        |       |
|                            |       |                   |       |                                                        |       |
| Nonvested at March 31,  2007    |       | 170,000                |       | $                                                           | 15.92      |   |

 

Asof March 31, 2007, approximately $0.9 million of estimated expense with respectto nonvested time-based restricted stock awards had yet to be recognized andwill be amortized over a weighted average period of 3.55 years. Approximately$1.2 million of estimated expense with respect to nonvested performance-basedrestricted stock option awards had yet to be recognized as of March 31,2007.

***Reclassifications***

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

**3.****                ****Merger Agreement**

On October 6,2006, we entered into an Agreement and Plan of Merger (the “Merger Agreement”)with The Veritas Capital Fund III, L.P., a Delaware limited partnership (“Veritas”),Cornell Holding Corp., a Delaware corporation (“Parent”) and CCI AcquisitionCorp., a Delaware corporation and wholly owned subsidiary of Parent (“MergerSub”), pursuant to which the Merger Sub would be merged with and into us (the “Merger”),with Cornell surviving after the Merger as a wholly owned subsidiary of Parent.

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Our Board ofDirectors unanimously approved the Merger Agreement. In connection with theMerger, the Parent and certain of our stockholders entered into a VotingAgreement dated on or about October 6, 2006, whereby such stockholders agreed,among other things, to vote their respective shares of our stock in favor ofthe Merger Agreement, the Merger and the transactions contemplatedthereby.  At a special meeting of ourstockholders held on January 23, 2007, the proposed Merger Agreement wasrejected.

Under the terms of the Merger Agreement, because theMerger was terminated, we reimbursed $2.5 million of costs incurred by Veritas,Parent and Merger Sub in connection with the proposed merger in February 2007.Such costs for legal and external professional and consulting fees arereflected in general and administrative expenses for the three months endedMarch 31, 2007.

**4.****                ****Discontinued Operations andManagement 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 completion of disposal and their operations areeliminated from our ongoing operations. During 2005, we closed certainfacilities that qualified for discontinued operations and notifications weremade to the required contracting entities regarding the termination of therelated programs. At March 31, 2007, we did not have any significant netproperty and equipment balances pertaining to these operations.  There were no revenues generated by thesediscontinued operations in the three months ended March 31, 2007 and 2006.

**5.****                ****Intangible Assets**

Intangible assets at March31, 2007 and December 31, 2006 consisted of the following (in thousands):

|                                                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                    |       |                     |       |                        |       |
| Non-compete  agreements                                 |       | $                        | 10,040     |                        | $          | 10,040 |   |
| Accumulated  amortization – non-compete agreements |       | (7,524                   | )          | (7,240                      | )          |
| Acquired  contract value                                |       | 6,442                    |       | 6,442                       |       |
| Accumulated  amortization – contract value         |       | (2,592                   | )          | (2,316                      | )          |
| Identified intangibles, net                             |       | 6,366                    |       | 6,926                       |       |
| Goodwill, net                                           |       | 12,339                   |       | 12,339                      |       |
| Total  intangibles, net                                 |       | $                        | 18,705     |                        | $          | 19,265 |   |

 

There were nochanges in the carrying amount of our goodwill in the three months ended March31, 2007.

Amortization expense for our non-compete agreements was approximately$0.3 million for the three months ended March 31, 2007 and 2006.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the next twoyears ended December 31 and approximately $0.7 million for the third year.

Amortization expense for our acquired contract value was approximately$0.3 million for the three months ended March 31, 2007 and 2006.  Amortization expense for our acquiredcontract value is expected to be approximately $1.1 million for each of thenext three years ended December 31 and approximately $0.6 million for thefourth year.

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

At March 31, 2007 and December 31, 2006, our long-term debt consistedof the following (in thousands):
|                                                                                                                                                           | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                                                                                                                      |       |                     |       |                        |       |
| **Debt of  Cornell Companies, Inc.:**                                                                                                                     | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Senior Notes, unsecured, due July 2012 with an  interest rate of 10.75%, net of discount of $966 and $1,013, respectively                                 |       | $                        | 111,034    |                        | $          | 110,987 |   |
| Fair-value adjustment of Senior Notes as a result of  interest rate swap                                                                                  |       | (476                     | )          | (1,053                      | )          |
| 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  “Credit Facility”) |       | —                   |       | —                      |       |
| Capital lease obligations                                                                                                                                 |       | 47                       |       | 47                          |       |
| Subtotal                                                                                                                                                  |       | 110,605                  |       | 109,981                     |       |
|                                                                                                                                                      |       |                     |       |                        |       |
| **Debt of  Special Purpose Entity:**                                                                                                                      | ** ** | ** **               | ** ** | ** **                  | ** ** |
| 8.47% Bonds due 2016                                                                                                                                      |       | 156,000                  |       | 156,000                     |       |
|                                                                                                                                                      |       |                     |       |                        |       |
| Total  consolidated debt                                                                                                                                  |       | 266,605                  |       | 265,981                     |       |
|                                                                                                                                                      |       |                     |       |                        |       |
| Less: current  maturities                                                                                                                                 |       | (10,520                  | )          | (10,510                     | )          |
|                                                                                                                                                      |       |                     |       |                        |       |
| Consolidated long-term  debt                                                                                                                              |       | $                        | 256,085    |                        | $          | 255,471 |   |

 

***Long-Term Credit Facilities.***  OurCredit 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 our CreditFacility was approximately $49.7 million at March 31, 2007.  We had no outstanding borrowings on ourCredit Facility at March 31, 2007, but we had outstanding letters of credit ofapproximately $10.3 million.  Subject tocertain requirements, we have the right to increase the commitments under ourCredit Facility up to an aggregate amount of $100.0 million.  Our Credit Facility matures in June 2008 andbears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our 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 bear interest ata rate of 8.47% per annum and are payable in semi-annual installments ofinterest and annual installments of principal. All unpaid principal and accrued interest on the bonds is due on theearlier of August 1, 2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by the Company.

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes (the “SeniorNotes”) due July 1, 2012.  The SeniorNotes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future 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 each year,commencing January 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:

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

 

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

In conjunctionwith the issuance of the Senior Notes, we entered into an interest rate swaptransaction with a financial institution to hedge our exposure to changes inthe fair value on $84.0 million of our Senior Notes.  The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a variablerate.  The terms of the interest rateswap 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 floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree months ended March 31, 2007, we recorded interest expense related to thisinterest rate swap of approximately $0.01 million, which is reflected asinterest expense in the accompanying financial statements. For the three monthsended March 31, 2006, we recorded interest savings related to this interestrate swap of approximately $0.1 million which is reflected as a reduction tointerest expense in the accompanying financial statements.  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 March 31, 2007 and December 31, 2006, the fair value of thisderivative instrument was approximately ($0.5) million and ($1.1) million,respectively, and is included in other long-term liabilities in theaccompanying financial statements.  Thecarrying value of the Senior Notes as of these dates was adjusted accordinglyby the same amount. Because the swap agreement is an effective fair-valuehedge, there will be no effect on our results of operations from themark-to-market adjustment as long as the swap is in effect.

**7.****                ****Projects Under Development,Construction or Renovation**

During 2006, the Federal Bureau of Prisons (“BOP”)solicited a Request for Proposals (“RFP”) for services to house approximately7,000 low security, non-United States citizens, sentenced males in an existingsecure correctional institution procured from private sources or state andlocal governments, with excess capacity, located in Arizona, California,Louisiana, New Mexico, Oklahoma or Texas to replace several existingintergovernmental agreements (“IGA”) for such services, including the IGArelating to our Big Spring Correctional Center in Texas. In January 2007, wewere awarded a contract from the BOP for our Big Spring Correctional Center. Inconjunction with this contract, we will undertake certain facility expansionactivities during the year ending December 31, 2007. As of March 31, 2007, wehad incurred and capitalized costs of approximately $2.6 million related tothese expansion activities.  We believethat our existing cash and our available balance under our Credit Facility willprovide adequate funding to complete these expansion activities.

We are also expanding the D. Ray James Prison inGeorgia during the year ending December 31, 2007 to increase its servicecapacity by 300 beds. As of March 31, 2007, we had incurred and capitalizedcosts of approximately $2.0 million related to this expansion. We believe thatour existing cash and our available balance under our Credit Facility willprovide adequate funding to complete this expansion.

**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 March 31, 2007 and2006, there were 12,500 shares ($20.12 average price) and 114,600 shares ($15.13average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

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The following table summarizes thecalculation of net earnings and weighted average common shares and commonequivalent shares outstanding for purposes of the computation of earnings pershare (in thousands, except per share data):

|                                                                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                               | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                                                     |       |                                             |       |   |   |
| Income from continuing operations                                        |       | $                                                | 664        |   | $ | 1,210 |   |
| Loss from discontinued operations, net of tax                            |       | —                                           |       | (526 | ) |
| Net income                                                               |       | $                                                | 664        |   | $ | 684 |   |
|                                                                     |       |                                             |       |   |   |
|                                                                     |       |                                             |       |   |   |
|                                                                     |       |                                             |       |   |   |
| Weighted average common share outstanding                                |       | 13,984                                           |       | 13,851 |   |
| Weighted average common share equivalents outstanding                    |       | 262                                              |       | 102 |   |
| Weighted average common shares and common share equivalents  outstanding |       | 14,246                                           |       | 13,953 |   |
|                                                                     |       |                                             |       |   |   |
| Basic income (loss) per share:                                           |       |                                             |       |   |   |
| Income from continuing operations                                        |       | $                                                | .05        |   | $ | .09 |   |
| Loss from discontinued operations, net of tax                            |       | —                                           |       | (.04 | ) |
| Net income                                                               |       | $                                                | .05        |   | $ | .05 |   |
|                                                                     |       |                                             |       |   |   |
| Diluted income (loss) per share:                                         |       |                                             |       |   |   |
| Income from continuing operations                                        |       | $                                                | .05        |   | $ | .09 |   |
| Loss from discontinued operations, net of tax                            |       | —                                           |       | (.04 | ) |
| Net income                                                               |       | $                                                | .05        |   | $ | .05 |   |

 

**9.     Commitments and Contingencies**

**Legal Proceedings**

***Valencia CountyDetention Center***

InApril 2007, a lawsuit was filed against the Company in Federal District courtin Albuquerque, New Mexico, by Joe Torres and Eufrasio Armijo, who each allegedthat he was stripped searched at the Valencia County Detention Center (“VCDC”)in New Mexico in violation of his federal rights under the Fourth, Fourteenthand Eighth amendments to the U.S. constitution.  The claimants also allegeviolation of their rights under state law and seek to bring the case as a classaction on behalf of themselves and all detainees at VCDC during the applicablestatues of limitation.  The plaintiffs seek damages and declaratory andinjunctive relief.  The 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 vigorously defend this lawsuit.  We havenot recorded any loss accruals related to this lawsuit.

##### ***Lincoln County Detention Center***

In August 2005, a lawsuit was filed by a detainee atthe Lincoln County Detention Center (“LCDC”) in the U.S. District Court of NewMexico (Santa Fe) seeking unspecified damages. The lawsuit relates to theformer LCDC policy that required strip and visual body cavity searches for alldetainees and inmates and alleges that such policy violates a detainee’s Fourthand Fourteenth Amendment rights under the U.S. Constitution.  The lawsuit was filed as a putative classaction lawsuit brought on behalf of all inmates who were searched at the LCDCfrom May 2002 to July 2005. In September 2006, we agreed to a proposedstipulation of settlement which, subject to the approval of the court, willresolve this action.  The settlementamount under the terms of the agreement is $1.6 million, and will be fundedprincipally through our general liability and professional liability coverage.

In the year ended December 31, 2005, we recorded acharge of $0.2 million related to this lawsuit. In addition, we previously haveprovided insurance reserves for this matter (as part of our regular review ofreported and unreported claims) totaling approximately $0.5 million.  During the third quarter of 2006, we recordedan additional settlement charge of approximately $0.9 million and the relatedreimbursement from our general liability and professional liabilityinsurance.  The charge and reimbursementwas recognized in general and administrative expenses for the year ended December31, 2006. The reimbursement was funded by the 

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insurancecarrier in the first quarter of 2007 into a settlement account.  The matter is pending entry by the court forthe order granting preliminary approval of the stipulation of settlement, whichis currently anticipated to occur during the second quarter of 2007.

In addition, in connection with our acquisition of theLCDC facility, certain amounts were placed in escrow to offset any undisclosedliability relating to such acquisition. We have given notice to the prior owner of LCDC that we will seek torecover from the escrow any losses we may incur as a result of such litigation.

##### ***Alexander Youth Service Center***

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas.  The lawsuitalleges that we violated the rights of Lakeisha Shantrail Brown, the deceaseddaughter of Juana Michelle Brown, under the U.S. Constitution and the laws ofthe State of Arkansas by denying Ms. Brown medical treatment that caused herdeath and sought unspecified actual and punitive damages.  In September 2006, the plaintiff filed, andthe court granted, an order for voluntary dismissal without prejudice.  The lawsuit was refiled in December 2006 as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV17808*,*in the United States District Court  for the Eastern District of Arkansas.   We are unable at this time to estimate ourfinancial exposure relating to this lawsuit. We believe our insurance coverage is adequate to cover any potentialdamages relating to this action.  Weintend to vigorously defend this matter; however, the ultimate outcome of thislawsuit cannot be determined at this time.

##### ***Southern Peaks Regional Treatment Center***

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atMarch 31, 2007. In December 2004, the jury awarded us approximately $6.5million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorneys’ fees. The actual damages portion of the award underthe final Judgment and Decree (“Judgment”) entered on December 20, 2006 wasadjusted downward to the $5.4 million actually lost by us.  The award for compensatory damages accruespre-judgment interest at a rate of 7 percent from the date of loss through thedate of judgment. Following the jury verdicts, we collected approximately $0.4million in January 2005 in funds that had been previously frozen under atemporary restraining order issued at the time that we commenced thislitigation. Currently, one of the defendants has filed an appeal of theJudgment.  Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we recorded an additional reserve in the amount of approximately$0.3 million in the quarter ended December 31, 2006.  We will continue to maintain our existingreserve of approximately $5.3 million in an allowance for doubtful accountsagainst the corresponding balance as carried in other receivables at March 31,2007 and December 31, 2006.

###### ***Shareholder Lawsuits***

On October 19, 2006, a purported class action complaint was filed inthe District Court of Harris County, Texas, 269th Judicial District (No.2006-67413) by Ted Kinbergy, an alleged stockholder of Cornell. The complaintnames as defendants Cornell and each member of our board of directors as wellas Veritas Capital Fund III, L.P. (“Veritas”). The complaint alleges, amongother things, that (i) the defendants have breached fiduciary duties theyassertedly owed to our stockholders in connection with our entering into theAgreement and Plan of Merger, dated as of October 6, 2006, with Veritas,Cornell Holding Corp., and CCI Acquisition Corp., and (ii) the mergerconsideration is unfair and inadequate. The plaintiffs sought, among otherthings, an injunction against the consummation of the merger. The proposedmerger was rejected at a special meeting of our stockholders held on January23, 2007. We believe that the lawsuit is without merit and intend to defendourselves vigorously.

We hold insurance policies to cover potential directorand officer liability, some of which may limit our cash outflows in the eventof a decision adverse to us in the matters discussed above. However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance coverage is deemed not to apply to these matters, it could have amaterial adverse effect on us, our financial condition, results of operationsand future cash flows.

***Other***

Additionally, wecurrently and from time to time are subject to claims and suits arising in theordinary course of business, including claims for damages for personal injuriesor for wrongful restriction of or interference with offender privileges andemployment 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 condition, results of operations or cash flows.

During the period fromAugust 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 IllinoisDepartment of Insurance gave Kemper permission to proceed with a run-off planit had previously submitted. The three-year plan is 

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designed to help Kemper meet its goal of resolving, tothe maximum extent possible, all valid policyholder claims. In view of therisks and uncertainties involved in implementing the plan, including the needto achieve significant policy buybacks, commutation of reinsurance agreements,and further agreements with regulators, the plan may not be successfullyimplemented by Kemper. In the year ended December 31, 2004, we accrued aprovision of $0.6 million, and estimated our range of additional exposure to beapproximately $0.5 million with respect to outstanding claims incurred duringthis policy period with Kemper which would become our obligation to resolve ifnot settled through Kemper. During the year ended December 31, 2005,Kemper continued to implement its run-off plan. As a result, several of oursignificant claims were settled by Kemper during 2005. In conjunction withthese settlements, we recorded a charge against our existing accrual in theamount of $0.3 million. Based on our analysis of the claims activity during thethird quarter of 2005, we felt it necessary to accrue an additional provisionin the amount of approximately $0.2 million during the third quarter of 2005.Additional significant claims continued to be settled by Kemper during thesecond half of 2006. As a result, we released reserves of approximately $0.4million during the quarter ended December 31, 2006. At March 31, 2007, we donot believe there is significant exposure above our existing $0.1 millionaccrual for those outstanding claims which could become our obligation toresolve if not settled through Kemper.

While the outcome of suchmatters cannot be predicated with certainty, based on the information known todate, we believe that the ultimate resolution of these matters will not have amaterial adverse effect on our financial condition, operating results or cashflows.

**Facility Acquisition**

We announced on April 16, 2007 that we had enteredinto an agreement with GRW Corporation (“GRW”) to acquire GRW’s CorrectionalFacility in Brush, Colorado. The Correctional Facility currently has thecapacity to house approximately 270 medium-security female inmates under anIntergovernmental Agreement with the City of Brush and the Colorado Departmentof Corrections.  The transaction wasclosed effective May 1, 2007 at a purchase price of $8.9 million.

***10.   Derivative Financial Instruments andGuarantees***

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

In August 2001, MCFcompleted a bond offering to finance the 2001 Sale and LeasebackTransaction.  In connection with thisbond offering, two reserve fund accounts were established by MCF pursuant tothe terms of the indenture: (1) MCF’s Debt Service Reserve Fund, aggregatingapproximately $24.4 million at March 31, 2007, was established to make paymentson MCF’s outstanding bonds in the event we (as lessee) should fail to make thescheduled rental payments to MCF and (2) MCF’s Debt Service Fund, aggregatingapproximately $21.7 million at March 31, 2007, used to accumulate the monthlylease payments that MCF receives from us until such funds are used to pay MCF’ssemi-annual bond interest and annual bond principal payments.  Both reserve fund accounts are subject to theagreements with the MCF Equity Investors whereby guaranteed rates of return of3.0% and 5.08%, respectively, are provided for in the balance of the DebtService Reserve Fund and the Debt Service Fund. The guaranteed rates of return are characterized as cash flow hedgederivative instruments.  At inception,the derivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income.  AtMarch 31, 2007 and December 31, 2006, the fair value of these derivativeinstruments was approximately $3.0 million and $3.2 million, respectively.  Our Consolidated Statements of Operations andComprehensive Income include comprehensive income (loss) of approximately $0.1million and ($0.3) million in the three months ended March 31, 2007 and 2006,respectively.

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 is being amortized to expenseover the life of the debt.

**11.   Segment Disclosure**

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 last threeto six-months of their sentences on parole and preparing for re-entry intosociety at large as well as community-based treatment and 

15

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education programs as an alternative toincarceration.  All of our customers andlong-lived assets are located in the United States of America.  The accounting policies of our reportablesegments are the same as those described in the summary of significantaccounting policies in our 2006 Annual Report on Form 10-K.  Intangible assets are not included in eachsegment’s reportable assets, and the related amortization of intangible assetsis not included in the determination of a segment’s income fromoperations.  We evaluate performancebased on income or loss from operations before general and administrativeexpenses, incentive bonuses, amortization of intangibles, interest and incometaxes.  Corporate and other assets arecomprised primarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferredtaxes, deferred costs and other assets. Corporate and other expense from operations primarily consists ofdepreciation on the corporate office facilities and equipment, and is presentedseparately as such charges cannot be readily identified for allocation to aparticular segment.

The only significantnon-cash items reported in the respective segments’ income from operations isdepreciation and amortization (excluding intangibles) (in thousands).
| ** **                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                               |       |                                             |       |   |   |
| Revenues:                                          |       |                                             |       |   |   |
| Adult secure  institutional                        |       | $                                                | 46,509     |   | $ | 37,882 |   |
| Juvenile                                           |       | 26,798                                           |       | 29,292 |   |
| Adult  community-based                             |       | 16,337                                           |       | 16,673 |   |
| Total revenues                                     |       | $                                                | 89,644     |   | $ | 83,847 |   |
|                                               |       |                                             |       |   |   |
| Pre-opening and  start-up expenses:                |       |                                             |       |   |   |
| Adult secure  institutional                        |       | $                                                | —     |   | $ | 2,657 |   |
| Juvenile                                           |       | —                                           |       | — |   |
| Adult  community-based                             |       | —                                           |       | — |   |
| Total pre-opening and  start-up expenses           |       | $                                                | —     |   | $ | 2,657 |   |
|                                               |       |                                             |       |   |   |
| Income from operations:                            |       |                                             |       |   |   |
| Adult secure  institutional                        |       | $                                                | 11,871     |   | $ | 7,538 |   |
| Juvenile                                           |       | 2,410                                            |       | 2,694 |   |
| Adult  community-based                             |       | 2,652                                            |       | 2,960 |   |
| Sub-total                                          |       | 16,933                                           |       | 13,192 |   |
| General and administrative  expenses               |       | (8,358                                           | )          | (5,112 | ) |
| Amortization of  intangibles                       |       | (561                                             | )          | (561 | ) |
| Corporate and  other                               |       | (179                                             | )          | (310 | ) |
| Total income from  operations                      |       | $                                                | 7,835      |   | $ | 7,209 |   |
|                                               |       |                                             |       |   |   |
| Loss on discontinued  operations, net of tax:      |       |                                             |       |   |   |
| Adult secure  institutional                        |       | $                                                | —     |   | $ | — |   |
| Juvenile                                           |       | —                                           |       | (524 | ) |
| Adult  community-based                             |       | —                                           |       | (2 | ) |
| Total loss on  discontinued operations, net of tax |       | $                                                | —     |   | $ | (526 | ) |

 
| ** **                  | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------|------------|---------------------|------------|------------------------|------------|
| Assets:                     |       |                |       |                   |       |
| Adult secure  institutional |       | $                   | 234,531    |                   | $          | 233,670 |   |
| Juvenile                    |       | 97,261              |       | 100,366                |       |
| Adult  community-based      |       | 64,281              |       | 63,105                 |       |
| Intangible  assets, net     |       | 18,705              |       | 19,265                 |       |
| Corporate and  other        |       | 101,763             |       | 107,127                |       |
| Total assets                |       | $                   | 516,541    |                   | $          | 523,533 |   |

 

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**12.   GuarantorDisclosures**

Wecompleted an offering of $112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofour subsidiaries (Guarantor Subsidiaries). MCF does not guarantee the Senior Notes (“Non-Guarantor Subsidiary”).These guarantees are joint and several obligations of the GuarantorSubsidiaries.  The following condensedconsolidating financial information presents the financial condition, resultsof operations and cash flows for the parent company, the Guarantor Subsidiariesand the Non-Guarantor Subsidiary, together with the consolidating adjustmentsnecessary to present our results on a consolidated basis.

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# **Condensed Consolidating BalanceSheet as of March 31, 2007 (in thousands) (unaudited)**

| ** **                                      | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| **Assets**                                      | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                 |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash equivalents                       |       | $          | 14,495     |                        | $          | 419                             |       | $                | 67         |             | $          | — |   | $ | 14,981 |   |
| Investment securities available for sale        |       | 10,450     |       | —                      |       | —                          |       | —           |       | 10,450           |       |
| Accounts receivable                             |       | 2,494      |       | 68,719                      |       | 363                             |       | —           |       | 71,576           |       |
| Debt service fund and other restricted assets   |       | —     |       | 1,863                       |       | 22,287                          |       | (592             | )          | 23,558           |       |
| Prepaid expenses and other                      |       | 12,008     |       | 2,289                       |       | —                          |       | —           |       | 14,297           |       |
| Total current assets                            |       | 39,447     |       | 73,290                      |       | 22,717                          |       | (592             | )          | 134,862          |       |
| Property and equipment, net                     |       | 98         |       | 177,527                     |       | 149,364                         |       | (5,222           | )          | 321,767          |       |
| Other assets:                                   |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service reserve fund                       |       | —     |       | —                      |       | 24,372                          |       | —           |       | 24,372           |       |
| Deferred costs and other                        |       | 51,002     |       | 21,696                      |       | 6,575                           |       | (43,733          | )          | 35,540           |       |
| Investment in subsidiaries                      |       | 26,750     |       | 1,856                       |       | —                          |       | (28,606          | )          | —           |       |
| Total assets                                    |       | $          | 117,297    |                        | $          | 274,369                         |       | $                | 203,028    |             | $          | (78,153 | ) | $ | 516,541 |   |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**   | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Current liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $          | 36,777     |                        | $          | 11,132                          |       | $                | 2,293      |             | $          | (1,609 | ) | $ | 48,593 |   |
| Current portion of long-term debt               |       | —     |       | 20                          |       | 10,500                          |       | —           |       | 10,520           |       |
| Total current liabilities                       |       | 36,777     |       | 11,152                      |       | 12,793                          |       | (1,609           | )          | 59,113           |       |
| Long-term debt, net of current portion          |       | 110,558    |       | 27                          |       | 145,500                         |       | —           |       | 256,085          |       |
| Deferred tax liabilities                        |       | 10,959     |       | 94                          |       | —                          |       | 377              |       | 11,430           |       |
| Other long-term liabilities                     |       | 7,668      |       | 155                         |       | 44,255                          |       | (46,078          | )          | 6,000            |       |
| Intercompany                                    |       | (232,578   | )          | 232,578                     |       | —                          |       | —           |       | —           |       |
| Total liabilities                               |       | (66,616    | )          | 244,006                     |       | 202,548                         |       | (47,310          | )          | 332,628          |       |
| Stockholders’ equity                       |       | 183,913    |       | 30,363                      |       | 480                             |       | (30,843          | )          | 183,913          |       |
| Total liabilities and stockholders’ equity |       | $          | 117,297    |                        | $          | 274,369                         |       | $                | 203,028    |             | $          | (78,153 | ) | $ | 516,541 |   |

 

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**Condensed Consolidating Balance Sheetas of December 31, 2006 (in thousands)**
| ** **                                      | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| **Assets**                                      | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                 |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash equivalents                       |       | $          | 18,083     |                        | $          | 371                             |       | $                | 75         |             | $          | — |   | $ | 18,529 |   |
| Investment securities available for sale        |       | 11,925     |       | 3⁄4                      |       | 3⁄4                          |       | 3⁄4           |       | 11,925           |       |
| Accounts receivable                             |       | 2,661      |       | 73,448                      |       | 365                             |       | 3⁄4           |       | 76,474           |       |
| Debt service fund and other restricted assets   |       | 3⁄4     |       | 1,658                       |       | 22,953                          |       | 3⁄4           |       | 24,611           |       |
| Prepaid expenses and other                      |       | 11,909     |       | 2,303                       |       | 3⁄4                          |       | 3⁄4           |       | 14,212           |       |
| Total current assets                            |       | 44,578     |       | 77,780                      |       | 23,393                          |       | 3⁄4           |       | 145,751          |       |
| Property and equipment, net                     |       | 108        |       | 173,916                     |       | 150,419                         |       | (5,379           | )          | 319,064          |       |
| Other assets:                                   |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service reserve fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,801                          |       | 3⁄4           |       | 23,801           |       |
| Deferred costs and other                        |       | 48,448     |       | 21,943                      |       | 6,754                           |       | (42,228          | )          | 34,917           |       |
| Investment in subsidiaries                      |       | 27,427     |       | 2,237                       |       | 3⁄4                          |       | (29,664          | )          | 3⁄4           |       |
| Total assets                                    |       | $          | 120,561    |                        | $          | 275,876                         |       | $                | 204,367    |             | $          | (77,271 | ) | $ | 523,533 |   |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**   | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Current liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $          | 46,791     |                        | $          | 9,371                           |       | $                | 5,577      |             | $          | (1,576 | ) | $ | 60,163 |   |
| Current portion of long-term debt               |       | 3⁄4     |       | 10                          |       | 10,500                          |       | 3⁄4           |       | 10,510           |       |
| Total current liabilities                       |       | 46,791     |       | 9,381                       |       | 16,077                          |       | (1,576           | )          | 70,673           |       |
| Long-term debt, net of current portion          |       | 109,934    |       | 37                          |       | 145,500                         |       | 3⁄4           |       | 255,471          |       |
| Deferred tax liabilities                        |       | 10,959     |       | 94                          |       | 3⁄4                          |       | 320              |       | 11,373           |       |
| Other long-term liabilities                     |       | 6,011      |       | 211                         |       | 42,680                          |       | (44,450          | )          | 4,452            |       |
| Intercompany                                    |       | (234,698   | )          | 234,698                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total liabilities                               |       | (61,003    | )          | 244,421                     |       | 204,257                         |       | (45,706          | )          | 341,969          |       |
| Stockholders’ equity                       |       | 181,564    |       | 31,455                      |       | 110                             |       | (31,565          | )          | 181,564          |       |
| Total liabilities and stockholders’ equity |       | $          | 120,561    |                        | $          | 275,876                         |       | $                | 204,367    |             | $          | (77,271 | ) | $ | 523,533 |   |

 

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# **Condensed Consolidating Statement of Operationsfor the three months ended March 31, 2007****(in thousands) (unaudited)**

| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                      |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                  |       | $          | 4,502      |                        | $          | 101,422                         |       | $                | 4,502      |             | $          | (20,782 | ) | $ | 89,644 |   |
| Operating expenses                                        |       | 3,314      |       | 86,981                      |       | 13                              |       | (20,698          | )          | 69,610           |       |
| Pre-opening and start-up expenses                         |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Depreciation and amortization                             |       | —     |       | 2,942                       |       | 1,056                           |       | (157             | )          | 3,841            |       |
| General and administrative expenses                       |       | 8,339      |       | —                      |       | 19                              |       | —           |       | 8,358            |       |
| Income (loss) from operations                             |       | (7,151     | )          | 11,499                      |       | 3,414                           |       | 73               |       | 7,835            |       |
| Overhead allocations                                      |       | (10,987    | )          | 10,987                      |       | —                          |       | —           |       | —           |       |
| Interest, net                                             |       | 1,793      |       | 1,274                       |       | 3,047                           |       | 521              |       | 6,635            |       |
| Equity loss in subsidiaries                               |       | (810       | )          | —                      |       | —                          |       | 810              |       | —           |       |
| Income (loss) before provision (benefit) for income taxes |       | 1,233      |       | (762                        | )          | 367                             |       | 362              |       | 1,200            |       |
| Provision (benefit) for income taxes                      |       | 569        |       | —                      |       | —                          |       | (33              | )          | 536              |       |
| Net income (loss)                                         |       | $          | 664        |                        | $          | (762                            | )          | $                | 367        |             | $          | 395 |   | $ | 664 |   |

 

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# **Condensed Consolidating Statement of Operationsfor the three months ended March 31, 2006****(in thousands) (unaudited)**

| ** **                                                                   | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                         |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                     |       | $          | 4,502      |                        | $          | 94,189                          |       | $                | 4,502      |             | $          | (19,346 | ) | $ | 83,847 |   |
| Operating expenses                                                           |       | 5,182      |       | 79,196                      |       | 26                              |       | (19,261          | )          | 65,143           |       |
| Pre-opening and start-up expenses                                            |       | —     |       | 2,657                       |       | —                          |       | —           |       | 2,657            |       |
| Depreciation and amortization                                                |       | —     |       | 2,799                       |       | 1,056                           |       | (129             | )          | 3,726            |       |
| General and administrative expenses                                          |       | 5,093      |       | —                      |       | 19                              |       | —           |       | 5,112            |       |
| Income (loss) from operations                                                |       | (5,773     | )          | 9,537                       |       | 3,401                           |       | 44               |       | 7,209            |       |
| Overhead allocations                                                         |       | (8,386     | )          | 8,386                       |       | —                          |       | —           |       | —           |       |
| Interest, net                                                                |       | 478        |       | 1,270                       |       | 3,284                           |       | 11               |       | 5,043            |       |
| Equity loss in subsidiaries                                                  |       | (557       | )          | —                      |       | —                          |       | 557              |       | —           |       |
| Income (loss) before provision for income taxes and  discontinued operations |       | 1,578      |       | (119                        | )          | 117                             |       | 590              |       | 2,166            |       |
| Provision for income taxes                                                   |       | 894        |       | —                      |       | —                          |       | 62               |       | 956              |       |
| Income (loss) before discontinued operations                                 |       | 684        |       | (119                        | )          | 117                             |       | 528              |       | 1,210            |       |
| Loss on discontinued operations, net of income tax benefit of  $283          |       | —     |       | (526                        | )          | —                          |       | —           |       | (526             | )          |
| Net income (loss)                                                            |       | $          | 684        |                        | $          | (645                            | )          | $                | 117        |             | $          | 528 |   | $ | 684 |   |

 

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**Condensed Consolidating Statement of Cash Flowsfor the three months ended March 31, 2007 (in thousands) (unaudited)**
| ** **                                            | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash (used in) provided by  operating activities  |       | $          | (5,969     | )                           | $          | 3,268                           |       | $                | (1,266     | ) | $ | (3,967 | ) |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital expenditures                                  |       | —     |       | (3,218                      | )          | —                          |       | (3,218           | )          |
| Purchases of investment securities                    |       | (117,325   | )          | —                      |       | —                          |       | (117,325         | )          |
| Sales of investment securities                        |       | 118,800    |       | —                      |       | —                          |       | 118,800          |       |
| Payments to restricted debt payment  account, net     |       | —     |       | —                      |       | 1,258                           |       | 1,258            |       |
| Net cash (used in) provided by investing activities   |       | 1,475      |       | (3,218                      | )          | 1,258                           |       | (485             | )          |
|                                                  |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from financing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Payments of capital lease obligations                 |       | —     |       | (2                          | )          | —                          |       | (2               | )          |
| Tax benefit of stock option exercises                 |       | 214        |       | —                      |       | —                          |       | 214              |       |
| Proceeds from exercise of stock options               |       | 692        |       | —                      |       | —                          |       | 692              |       |
| Net cash (used in) provided by financing activities   |       | 906        |       | (2                          | )          | —                          |       | 904              |       |
|                                                  |       |       |       |                        |       |                            |       |             |       |
| Net increase (decrease)  in cash and cash equivalents |       | (3,588     | )          | 48                          |       | (8                              | )          | (3,548           | )          |
| Cash and cash  equivalents at beginning of period     |       | 18,083     |       | 371                         |       | 75                              |       | 18,529           |       |
| Cash and cash  equivalents at end of period           |       | $          | 14,495     |                        | $          | 419                             |       | $                | 67         |   | $ | 14,981 |   |

 

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# **Condensed Consolidating Statement of Cash Flowsfor the three months ended March 31, 2006 (in thousands) (unaudited)**

| ** **                                          | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from operating activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash (used in) provided by operating activities |       | $          | (11,997    | )                           | $          | 6,727                           |       | $                | (410       | ) | $ | (5,680 | ) |
| ** **                                          | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital expenditures                                |       | —     |       | (6,980                      | )          | —                          |       | (6,980           | )          |
| Payments to restricted debt payment  account, net   |       | —     |       | —                      |       | 409                             |       | 409              |       |
| Purchases of investment securities                  |       | (84,125    | )          | —                      |       | —                          |       | (84,125          | )          |
| Sales of investment securities                      |       | 83,400     |       | —                      |       | —                          |       | 83,400           |       |
| Net cash (used in) provided by investing activities |       | (725       | )          | (6,980                      | )          | 409                             |       | (7,296           | )          |
|                                                |       |       |       |                        |       |                            |       |             |       |
| **Cash flows from financing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Tax benefit of stock option exercises               |       | 73         |       | —                      |       | —                          |       | 73               |       |
| Proceeds from exercise of stock options             |       | 901        |       | —                      |       | —                          |       | 901              |       |
| Net cash provided by financing activities           |       | 974        |       | —                      |       | —                          |       | 974              |       |
|                                                |       |       |       |                        |       |                            |       |             |       |
| Net decrease in cash  and cash equivalents          |       | (11,748    | )          | (253                        | )          | (1                              | )          | (12,002          | )          |
| Cash and cash  equivalents at beginning of period   |       | 12,579     |       | 1,114                       |       | 30                              |       | 13,723           |       |
| Cash and cash  equivalents at end of period         |       | $          | 831        |                        | $          | 861                             |       | $                | 29         |   | $ | 1,721 |   |

** **

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

**General**

We are a leading provider ofcorrectional, detention, educational, rehabilitation and treatment servicesoutsourced by federal, state and local government agencies. We provide adiversified portfolio of services for adults and juveniles through our threeoperating divisions: (1) adult secure institution and detention services;(2) juvenile justice, educational and treatment services and(3) adult community-based corrections and treatment services. AtMarch 31, 2007, we operated 76 facilities with a total service capacity of18,253.   We also had three facilitiesthat were vacant with an aggregate service capacity of 224. Our facilities arelocated in 16 states and the District of Columbia.

The following table (which excludes data related to discontinuedfacilities in 2006) sets forth for the periods indicated total residentialservice capacity and contracted beds in operation at the end of the periodsshown, average contract occupancy percentages and total non-residential servicecapacity.
|                                                                                              | ** ** | **March 31,  2007** | ** ** | **March 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
|                                                                                         |       |                     |       |                     |       |
| **Residential**                                                                              |       |                     |       |                     |       |
| Service  capacity (1) (2)                                                               |       | 14,556                   |       | 13,008                   |       |
| Contracted beds  in operation (end of period) (1) (3)                                   |       | 13,352                   |       | 12,284                   |       |
| Average  contract occupancy based on contracted beds in operation (1) (4) (5) |       | 100.3                    | %          | 97.9                     | %          |
| Average  contract occupancy excluding start-up operations (1) (4) (5)              |       | 100.3                    | %          | 97.9                     | %          |
| **Non-Residential**                                                                          |       |                     |       |                     |       |
| Service capacity (1) (6)                                                                |       | 3,921                    |       | 4,792                    |       |

 

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(1)          Datapresented excludes discontinued facilities.

(2)          Residentialservice capacity is comprised of the number of beds currently available forservice or available upon the completion of construction, expansion orrenovation of residential facilities.

(3)          At certain residentialfacilities, the contracted capacity is lower than the facility’s servicecapacity. We could increase a facility’s contracted capacity by obtainingadditional contracts or by renegotiating existing contracts to increase thenumber of beds covered. However, there is no guarantee that we will be able toobtain contracts that provide occupancy levels at a facility’s service capacityor that current contracted capacities can be maintained in future periods.

(4)          Occupancy percentagesreflect less than normalized occupancy during the start-up phase of any applicablefacility, resulting in a lower average occupancy in periods when we havesubstantial start-up activities.

(5)          Average contractoccupancy percentages are calculated based on actual occupancy for the periodas a percentage of the contracted capacity for residential facilities inoperation. These percentages do not reflect the operations of non-residentialcommunity-based programs. At certain residential facilities, our contractedcapacity is lower than the facility’s service capacity. Additionally, certainfacilities have and are currently operating above the contracted capacity. As aresult, average contract occupancy percentages can exceed 100% if the averageactual occupancy exceeded contracted capacity.

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

We derive substantially all of our revenues from providing adult correctionsand treatment and juvenile justice, educational and treatment servicesoutsourced by federal, state and local government agencies in the UnitedStates. Revenues for our services are generally recognized on a per diem ratebased upon the number of occupant days or hours served for the period, on aguaranteed take-or-pay basis or on a cost-plus reimbursement basis. For thethree months ended March 31, 2007, our revenue base consisted of 72.4% forservices provided under per diem contracts, 20.0% for services provided undertake-or-pay and management contracts, 4.7% for services provided undercost-plus reimbursement contracts, 2.3% for services provided underfee-for-service contracts and 0.6% from other miscellaneous sources. Whilethese percentages are generally consistent with comparable statistics for thethree months ended March 31, 2006, there has been a decrease in thepercentage of revenues for services provided under per diem contracts and anincrease in the percentage of revenues provided under take-or-pay andmanagement contracts between the comparable periods for 2007 and 2006 dueprimarily to the Moshannon Valley Correctional Center which opened in April2006 and is a significant take-or-pay contract. Additionally, the decrease in the percentages of revenues from per diemcontracts between the comparable periods for 2007 and 2006 was offset, in part,by an increase in revenues at the Regional Correctional Center.

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Revenues can fluctuate from period to period due tochanges in government funding policies, changes in the number or types ofclients referred to our facilities by governmental agencies, the opening of newfacilities or the expansion of existing facilities and the termination ofcontracts for a facility or the closure of a facility.

Factors considered in determining billing rates to charge include: (1)the programs specified by the contract and the related staffing levels; (2)wage levels customary in the respective geographic areas; (3) whether theproposed facility is to be leased or purchased and (4) the anticipated averageoccupancy levels that could reasonably be expected to be maintained.

Revenues for our adult secure institutional services division areprimarily generated from per diem, take-or-pay and management contracts.  We believe that these types of contracts willcontinue to be offered to the private sector, as federal, state and localgovernment agencies face challenges posed by increasing inmate populations.  In addition, heightened focus on borderpatrol and immigration enforcement is expected to generate increased need fordetention services from the federal sector. We intend to work with existing and potential customers to service theseneeds as such opportunities arise.

For the three months ended March 31, 2007 and 2006, we realizedaverage per diem rates on our adult secure institutional facilities ofapproximately $54.99 and $53.80, respectively. The increase in the average perdiem rate is principally due to increased operations at the RegionalCorrectional Center in 2007.

Revenues for our juvenile justice, educational andtreatment services division are primarily generated from per diem,fee-for-service and cost-plus reimbursement contracts. We believe that ourability to work with highly-troubled youth offers our customers a solution toaddressing the unique needs of specialized juvenile populations. Through ourAbraxas Youth and Family Services division, we expect to look for opportunitieswhere our expertise at servicing these populations are of value to counties,school districts and other contracting agencies. In addition, we intend toleverage our national footprint and scale to compete in an increasinglyregulated marketplace.

For the three months ended March 31, 2007 and2006, we realized average per diem rates on our residential juvenile justice,educational and treatment facilities of approximately $171.50 and  $172.85, respectively. For the three monthsended March 31, 2007 and 2006, we realized average fee-for-service ratesfor our non-residential community-based juvenile facilities and programs,including rates that are limited by Medicaid and other private insuranceproviders, of approximately $44.11 and $34.93, respectively.  The increase in the average fee-for-servicerate in the three months ended March 31, 2007 is due to changes in the mix ofthe services provided by our various juvenile justice, educational andtreatment programs and facilities.   Themajority of our juvenile services contracts renew annually.

Revenues for our adult community-based corrections andtreatment services division are primarily generated from per diem contracts andfee-for-service contracts. We believe that these contracts, when coupled withour adult secure institutional offerings, position us to service the full spectrum of adult corrections needs.Increasing numbers of probationers and parolees, along with an emphasis onproviding re-entry services for these populations, suggest that marketconditions will continue to favor programs like those operated by us. We expectthat our national presence and demonstrated experience in this sector willallow us to effectively compete for new contracts.

For the three months ended March 31, 2007 and2006, we realized average per diem rates on our residential adultcommunity-based corrections and treatment facilities of approximately $62.11and $63.12, respectively. For the three months ended March 31, 2007 and2006, we realized average fee-for-service rates on our non-residential adultcommunity-based corrections and treatment facilities and programs ofapproximately $15.94 and $9.11, respectively. Our average fee-for-service ratesfluctuates from year to year due to changes in the mix of services provided byour various adult community-based corrections and treatment programs and facilities.

We have historicallyexperienced higher operating margins in our adult secure institutional servicesand adult community-based corrections and treatment services as compared to thejuvenile justice, educational and treatment 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. Undertake-or-pay contracts, such as the Moshannon Valley Correctional Centercontract, operating margins are typically higher during the early stages of thecontract as the facility’s population ramps up (as revenues are received atcontract percentages regardless of actual occupancy).  As the variable costs (primarilyresident-related and certain facility costs) increase with the growth inpopulation, operating margins will generally decline to a stabilizedlevel.  Following its activation in April2006, we experienced such margin impact pertaining to the Moshannon ValleyCorrectional Center in the third and fourth quarters of 2006.  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.

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We have experienced andexpect to continue to experience interim period operating margin fluctuationsdue to the number of calendar days in the period, higher payroll taxes in thefirst half of the year and salary and wage increases and insurance costincreases that are incurred prior to certain contract rate increases.Periodically, many of the governmental agencies with whom we contract mayexperience budgetary pressures and may approach us to limit or reduce perdiem rates. Decreases in, or the lack of anticipated increases in, per diemrates could adversely impact our operating margin. Additionally, a decrease inper diem rates without a corresponding decrease in operating expenses couldalso adversely affect our operating margin.

We are responsible for allfacility operating costs, except for certain debt service and interest or leasepayments for facilities where we have a management contract only. At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all otheroperating expenses at these facilities. We operated 17 facilities undermanagement contracts at March 31, 2007 and 21 facilities at March 31,2006.

A majority of our facilityoperating costs consists of fixed costs. These fixed costs include lease andrental expense, insurance, utilities and depreciation. As a result, when wecommence operation of new or expanded facilities, fixed operating costsincrease. The amount of our variable operating costs, including food, medicalservices, supplies and clothing, depend on occupancy levels at the facilitieswe operate. Our largest single operating cost, facility payroll expense andrelated employment taxes and expenses, has both a fixed and a variablecomponent. 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 intightening labor markets based on local economic and other conditions.

We incur pre-opening and start-up expenses including payroll, benefits,training and other operating costs prior to opening a new or expanded facilityand during the period of operation while occupancy is ramping up. These costsvary by contract. Since pre-opening and start-up costs are generally factoredinto the revenue per diem rate that is charged to the contracting agency, wetypically expect to recover these upfront costs over the life of the contract.Because occupancy rates during a facility’s start-up phase typically result incapacity under-utilization for at least 90 to 180 days, we may incuradditional post-opening start-up costs. We do not anticipate post-openingstart-up costs at any adult secure facilities operated under any futurecontracts with the BOP because these contracts are currently expected tocontinue to be take-or-pay contracts, meaning that the BOP will pay at least80.0% of the contractual monthly revenue once the facility opens, regardless ofactual occupancy.

Newly opened facilities are staffed according to applicable regulatoryor contractual requirements when we begin receiving offenders or clients.Offenders or clients are typically assigned to a newly opened facility on aphased-in basis over a one- to six-month period. Our start-up period for newjuvenile operations is 12 months from the date we begin recognizing revenueunless break-even occupancy levels are achieved before then. Our start-upperiod for new adult operations is nine months from the date we beginrecognizing revenue unless break-even occupancy levels are achieved beforethen. 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.

Working capital requirements generally increase immediately prior tocommencing management of a new or expanded facility as we incur start-up costsand purchase necessary equipment and supplies before facility managementrevenue is realized.

General and administrativeexpenses consist primarily of costs for corporate and administrative personnelwho provide senior management, legal, finance, accounting, human resources,payroll and information systems, costs of business development and outsideprofessional and consulting fees.  Asdiscussed in Note 3 to the accompanying consolidated financial statements, weincurred additional legal and outside professional and consulting fees relatedto the Merger Agreement.

#### **Recent Developments**

***Big Spring Correctional Center***

During2006, the BOP solicited a RFP for services to house approximately 7,000 lowsecurity, non-United States citizen, sentenced males in an existing securecorrectional institution procured from private sources or state and localgovernments with excess capacity located in Arizona, California, Louisiana, NewMexico, Oklahoma or Texas to replace several existing intergovernmentalagreements (“IGA”) for such services, including the IGA relating to our BigSpring Correctional Center.  In January2007, we were awarded a contract from the BOP to operate the Big SpringCorrectional Center. The take-or-pay contract, which is effective April 1,2007, provides for an initial contract term of four years with three two-yearrenewal option periods. In conjunction with this contract, we will undertakecertain facility expansion activities in 2007. As of March 31, 2007, we hadincurred and capitalized costs of approximately $2.6 million related to theseexpansion activities.

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***FacilityAcquisition***

We announced on April 16, 2007 that we had enteredinto an agreement with GRW Corporation (“GRW”) to acquire GRW’s  Correctional Facility in Brush, Colorado. TheCorrectional Facility currently has the capacity to house approximately 270medium-security female inmates under an Intergovernmental Agreement with theCity of Brush and the Colorado Department of Corrections.  The transaction was closed effective May 1,2007 at a purchase price of $8.9 million.

***GreatPlains Correctional Facility***

#### In May 2007, we were awardeda contract by the Arizona Department of Corrections for our Great PlainsCorrectional Facility in Hinton, Oklahoma. The contract calls for a total of 2,000 medium-security inmates to behoused at the facility.  We expect tohouse approximately 916 inmates at the existing facility and the remainderwould be housed through an expansion of the existing facility.  We have not finalized the scheduling with thecustomer; although we currently expect to begin receiving inmates late in thethird quarter of this year and complete the expansion by the fourth quarter of2008.

#### **New Accounting Pronouncements**

***Statement of Financial AccountingStandards No. 157***

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.” This statement establishes a framework for measuring fairvalue within generally accepted accounting principles and expands the requireddisclosures concerning fair value measurements. SFAS No. 157 is effective forfinancial statements issued for fiscal years beginning after November 15, 2007,and interim periods within those fiscal years. The provisions of SFAS No. 157must be applied prospectively as of the beginning of the fiscal year in whichSFAS No. 157 is adopted, except in limited circumstances. We plan to adopt theprovisions of SFAS No. 157 January 1, 2008. We are currently evaluating theimpact that the adoption of this standard may have on our consolidatedfinancial statements.

***Statement ofFinancial Accounting Standards No. 159***

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115.” This statement, for which adoption isoptional, permits entities to choose to measure many financial instruments andcertain other items at fair value that are not currently required to bemeasured at fair value and establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities. SFAS No.159 is effective as of the beginning of an entity’s first fiscal year thatbegins after November 15, 2007. Early adoption is permitted as of the beginningof a fiscal year that begins on or before November 15, 2007, provided the entityalso elects to apply the provisions of SFAS No. 157, “Fair Value Measurements.”  We are currently evaluating the impact theadoption of this standard may have on our consolidated financial statements.

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**Results of Operations**

The following table sets forthfor the periods indicated the percentages of revenues represented by certainitems in our consolidated statements of operations.

|                                                                      | ** ** | **Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                           | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
|                                                                 |       |                                             |       |   |   |
| Revenues                                                             |       | 100.0                                            | %          | 100.0 | % |
| Operating expenses                                                   |       | 77.7                                             |       | 77.7 |   |
| Pre-opening and  start-up expenses                                   |       | —                                           |       | 3.2 |   |
| Depreciation and  amortization                                       |       | 4.3                                              |       | 4.4 |   |
| General and  administrative expenses                                 |       | 9.3                                              |       | 6.1 |   |
| Income from  operations                                              |       | 8.7                                              |       | 8.6 |   |
| Interest  expense, net                                               |       | 7.4                                              |       | 6.0 |   |
| Income from  continuing operations before provision for income taxes |       | 1.3                                              |       | 2.6 |   |
| Provision for  income taxes                                          |       | 0.6                                              |       | 1.2 |   |
| Income from  continuing operations                                   |       | 0.7                                              |       | 1.4 |   |
| Loss on  discontinued operations, net of tax                         |       | —                                           |       | (0.6 | ) |
| Net income                                                           |       | 0.7                                              | %          | 0.8 | % |

 

##### ***Three Months EndedMarch 31, 2007 Compared to Three Months Ended March 31, 2006***

Certain comparisons ofrevenue, expenses and average contract occupancy contained in this report havebeen made excluding the effect of pre-opening and start-up expenses andrevenues, and related occupancy and contract capacity. Pre-opening and start-upexpenses are charged to operations as incurred. They include payroll, benefits,training and other operating costs during periods prior to opening a new orexpanded facility and during the period of operation while occupancy is rampingup. We believe supplemental disclosures concerning pre-opening and start-upexpenses and revenues increases the reader’s understanding of our operatingtrends.

***Revenues***.Revenues increased approximately $5.8 million, or 6.9%, to $89.6 million forthe three months ended March 31, 2007 from approximately $83.8 million forthe three months ended March 31, 2006.

***Adult Secure***.Adult secure institutional services division revenues increased approximately$8.6 million, or 22.7%, to $46.5 million for the three months endedMarch 31, 2007 from approximately $37.9 million for the three months endedMarch 31, 2006 due primarily to revenues of approximately $8.9 million atthe Moshannon Valley Correctional Center which opened in April 2006 offset, inpart, by a decrease in revenues of approximately $1.3 million at the GreatPlains Correctional Facility due to reduced occupancy as the OklahomaDepartment of Corrections (“OKDOC”) withdrew their inmates (refer to “Management’sDiscussion and Analysis of Financial Condition and Results of Operations — ContractualUncertainties Related to Certain Facilities — Great Plains CorrectionalFacility” included in Item 2 of this report). The remaining net increase inrevenues of approximately $1.0 million was due to various fluctuations inrevenues at our other adult secure facilities.

Our adult secure institutional services divisionrevenues are primarily generated from contracts with federal and stategovernmental agencies. AtMarch 31, 2007, we operated 10 adult secure institutional facilities withan aggregate service capacity of 9,442.

Average contract occupancy was 102.0% for the three months endedMarch 31, 2007 compared to 98.9% for the three months ended March 31,2006. The increase in the 2007 occupancy percentage was due to an increase in occupancyat the Moshannon Valley Correctional Center and the D. Ray James Prison.  The average per diem rate was approximately$54.99 and $53.80 for the three months ended March 31, 2007 and 2006,respectively. There were no revenues attributable to start-up operations forthe three months ended March 31, 2007 and 2006.

***Juvenile***.Juvenile justice, educational and treatment services division revenuesdecreased approximately $2.5 million, or 8.5%, to $26.8 million for the threemonths ended March 31, 2007 from $29.3 million for the three months endedMarch 31, 2006 due primarily to (1) a decrease in revenues ofapproximately $1.7 million due to the termination and subsequent transition of ourmanagement contract at the Alexander Youth Services Center effective January31, 2007, (2) a decrease in revenues of approximately $0.9 million at theDanville Center for Adolescent Females (“DCAF”) due to the expiration of ourmanagement contract in March 2006

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and (3) a decrease in revenues of approximately $0.9million at the South Mountain Secure Treatment Unit (“SMSTU”) due to theexpiration of our management contract in June 2006.  The decrease in revenues due to the above wasoffset, in part, by (1) an increase in revenues of approximately $0.4 millionat the Cornell Abraxas Academy (formerly the New Morgan Academy) which reopenedin October 2006 and (2) an increase in revenues of approximately $0.6 millionat the Leadership Development Program (“LDP”) due to increased occupancy.

***At March 31, 2007, weoperated 16 residential juvenile facilities and 13 non-residentialcommunity-based programs with an aggregate service capacity of 3,916. Ourcontracts for these facilities and programs are primarily with state and localgovernment agencies and generally renew annually.***

***Average contract occupancy for thethree months ended March 31, 2007 was 91.8% compared to 92.1% for thethree months ended March 31, 2006.***

***The average per diem rate for ourresidential juvenile facilities was approximately $171.50 for the three monthsended March 31, 2007 compared to $172.85 for the three months endedMarch 31, 2006. Our average fee-for-service rate for our non-residentialjuvenile community-based facilities and programs was approximately $44.11 forthe three months ended March 31, 2007 compared to approximately $34.93 forthe three months ended March 31, 2006. The increase in the averagefee-for-service rates is due to changes in the mix of services provided. Therewere no revenues attributable to start-up operations for the three months endedMarch 31, 2007 and 2006.***

***Adult Community-Based***. Adult community-based corrections and treatment services divisionrevenues decreased approximately $0.4 million, or 2.4%, to $16.3 million forthe three months ended March 31, 2007 from $16.7 million for the threemonths ended March 31, 2006 primarily due to (1) a decrease in revenues ofapproximately $0.3 million at the Cordova Center due to reduced occupancy and(2) a decrease in revenues of approximately $0.2 million due to the terminationof the SWICC program in October 2006. The remaining net increase in revenues of approximately $0.1 million wasdue to various insignificant fluctuations in revenues at our other adultcommunity-based facilities and programs.

At March 31, 2007, we operated 28 residentialadult community-based facilities and 9 non-residential community-based programswith an aggregate service capacity of 4,895. Average contract occupancy for the threemonths ended March 31, 2007 was 99.0% compared to 98.3% for the threemonths ended March 31, 2006. The average per diem rate for ourresidential adult community-based facilities was $62.11 for the three monthsended March 31, 2007 compared to $63.12 for the three months endedMarch 31, 2006. The average fee-for-service rate for our non-residentialadult community-based programs was $15.94 for the three months endedMarch 31, 2007 compared to $9.11 for the three months ended March 31,2006. The increase in the average fee-for-service rates is due to a change inmix of services provided. There were no revenues attributable to start-upoperations for the three months ended March 31, 2007 and 2006.

***Operating Expenses****.*Operatingexpenses increased approximately $4.5 million, or 6.9%, to $69.6 million forthe three months ended March 31, 2007 from $65.1 million for the threemonths ended March 31, 2006.

***Adult Secure***.Adult secure institutional services division operating expenses increasedapproximately $6.5 million, or 24.9%, to $32.6 million for the three monthsended March 31, 2007 from $26.1 million for the three months endedMarch 31, 2006. The increase in operating expenses was primarilydue to (1) operating expenses of approximately $5.4 million at the MoshannonValley Correctional Center which opened in April 2006 and (2) an increasein operating expenses of approximately $0.8 million at the RegionalCorrectional Center due to increased occupancy. The remaining net increase inoperating expenses of approximately $0.3 million was due to variousinsignificant fluctuations in operating expenses at our other adult securefacilities.

As a percentage of segment revenues, adult secureinstitutional services division operating expenses were 70.1% for the threemonths ended March 31, 2007 compared to 69.0% for the three months endedMarch 31, 2006..

***Juvenile***.****Juvenile justice, educational andtreatment services division operating expenses decreased approximately $2.1million, or 8.1%, to $23.7 million for the three months ended March 31,2007 from $25.8 million for the three months ended March 31, 2006 dueprimarily to (1) a decrease in operating expenses of approximately $1.4 millionat the Alexander Youth Services Center due to the termination and subsequenttransition of our management contract for this facility effective January 31,2007, (2) a decrease in operating expenses of approximately $0.8 million atDCAF due to the expiration of our management contract in March 2006 and (3) adecrease in operating expenses of approximately $0.8 million at SMSTU due tothe expiration of our management contract in June 2006.  The decrease in operating expenses due to theabove was offset, in part, by (1) an increase in operating expenses ofapproximately $0.5 million at the Cornell Abraxas Academy (formerly the NewMorgan Academy) which reopened in October 2006 and (2) an increase in operatingexpenses of approximately $0.3 million at LDP due to increased occupancy.  The remaining net increase in operating expensesof approximately $0.1 million was due to various insignificant fluctuations inoperating expenses at our other juvenile facilities and programs.

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As a percentage of segment revenues, juvenile servicesdivision operating expenses were 88.5% for the three months endedMarch 31, 2007 compared to 88.0% for the three months ended March 31,2006.

***Adult Community-Based***. Adult community-based corrections and treatment services divisionoperating expenses increased approximately $0.1 million, or 0.8%, to $13.3million for the three months ended March 31, 2007 from $13.2million for the three months ended March 31, 2006 due to variousinsignificant fluctuations in operating expenses at our adult community-basedfacilities and programs. As a percentage of segment revenues, adultcommunity-based corrections and treatment services division operating expenseswere 81.4% for the three months ended March 31, 2007 compared to 79.4% forthe three months ended March 31, 2006.

***Pre-opening and start-up expenses.***** **There were no pre-opening and start-up expenses for the three monthsended March 31, 2007**. **Pre-opening and start-up expenses for thethree months ended March 31, 2006 were approximately $2.7 million and wereattributable to the pre-opening activities of the Moshannon Valley CorrectionalCenter.

***Depreciation and Amortization*****. **Depreciation and amortization was approximately $3.8 million and $3.7million for the three months ended March 31, 2007 and 2006, respectively.Amortization of intangibles was approximately $0.6 million for the three monthsended March 31, 2007 and 2006.

***General and Administrative Expenses. ***Generaland administrative expenses increased approximately $3.3 million, or 64.7%, toapproximately $8.4 million for the three months ended March 31, 2007 from approximately$5.1 million for the three months ended March 31, 2006 due primarily tothe reimbursement to Veritas of  $2.5million of costs related to the Merger Agreement coupled with an increase inlegal and professional fees related to the Merger Agreement.

***Interest. ***Interest expense, net of interest income,increased to approximately $6.6 million for the three months endedMarch 31, 2007 from approximately $5.0 million for the three months endedMarch 31, 2006 due primarily to a decrease in capitalized interest  of approximately $1.5 million. Capitalizedinterest was approximately $0.02 million for the three months ended March 31,2007 and was attributable to the expansion projects at the Big SpringCorrectional Center and the D. Ray James Prison.  Capitalized interest was approximately $1.5million for the three months ended March 31, 2006 and was attributable to constructionof the Moshannon Valley Correctional Center.

***Income Taxes. ***Forthe three months ended March 31, 2007, we recognized a provision forincome taxes on our income from continuing operations at an estimated effectiverate of 44.7%. For the three months ended March 31, 2006, we recognized aprovision for income taxes on our income from continuing operations at anestimated effective rate of 44.1%. Additionally, we recognized an income taxbenefit on our loss from discontinued operations for the three months endedMarch 31, 2006 at an estimated effective rate of 35.0%. The change in our estimated effective tax rate in 2007 is related to anincrease in operating income across certain of our business segments relativeto the same period of 2006, apportionment of income to higher tax ratejurisdictions and the net impact of certain non-deductible expenses such aslobbying and interest on tax-exempt investment securities.

## **Liquidity and Capital Resources**

***General*****.**Ourprimary capital requirements are for (1) purchases, construction orrenovation of new facilities, (2) expansions of existing facilities,(3) working capital, (4) pre-opening and start-up costs related tonew operating contracts, (5) acquisitions, (6) information systemshardware and software and (7) furniture, fixtures and equipment purchases.Working capital requirements generally increase immediately prior to commencingmanagement of a new facility as we incur start-up costs and purchase necessaryequipment and supplies before facility management revenue is realized.

***Cash Flows From Operating Activities.*** Cash usedin operating activities was approximately $4.0 million for the three months endedMarch 31, 2007 compared to approximately $5.7 million for the three monthsended March 31, 2006. The decrease is principally due to an increase incertain working capital accounts in 2007.

***Cash Flows From Investing Activities*****.** Cashused in investing activities was approximately $0.5 million for the threemonths ended March 31, 2007 due primarily to capital expenditures ofapproximately $3.2 million related to the expansion projects at the Big SpringCorrectional Center and the D. Ray James Prison, offset by net sales ofinvestment securities of approximately $1.5 million and payments to therestricted debt payment account, net, of approximately $1.3 million. Cash usedin investing activities was approximately $7.3 million for the three monthsended March 31, 2006 due primarily to net purchases of investmentsecurities of $0.7 million and capital expenditures of approximately $7.0million, related primarily to construction and equipment costs for theMoshannon Valley Correctional Center. Additionally, there were net payments tothe restricted debt payment account of approximately $0.4 million.

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***Cash Flows From Financing Activities*****. **Cash provided by financing activities was approximately $0.9 million and $1.0million for the three months ended March 31, 2007 and 2006, respectively,due primarily to proceeds from the exercise of stock options in each period.

***Treasury Stock Repurchases.*** Wedid not purchase any of our common stock in the three months endedMarch 31, 2007 and 2006.

***Long-Term Credit Facilities.*** OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit. Theavailable commitment under our Credit Facility was approximately $49.7 millionat March 31, 2007. We had no outstanding borrowings on our Credit Facilityat March 31, 2007, but we had outstanding letters of credit ofapproximately $10.3 million. Subject to certain requirements, we have the rightto increase the aggregate commitments under our Credit Facility up to anaggregate amount of $100.0 million. Our Credit Facility matures inJune 2008 and bears interest, at our election, depending on our totalleverage ratio, at either the prime rate plus a margin ranging from 0.75% to2.00%, or a rate which ranges from 2.25% to 3.50% above the applicable LIBORrate. Our Credit Facility is collateralized by substantially all of ourassets, including the assets and stock of all of our subsidiaries. Our CreditFacility is not secured by the assets of MCF. Our Credit Facility containsstandard covenants including compliance with laws, limitations on capitalexpenditures, restrictions on dividend payments, limitations on mergers andcompliance with financial covenants.

MCFis obligated for the outstanding balance of its 8.47% Taxable Revenue Bonds,Series 2001. The bonds bear interest at a rate of 8.47% per annum and arepayable in semi-annual installments of interest and annual installments ofprincipal. All unpaid principal and accrued interest on the bonds is due on theearlier of August 1, 2016 (maturity) or as noted under the bond documents.The bonds are limited, nonrecourse obligations of MCF and secured by theproperty and equipment, bond reserves, assignment of subleases andsubstantially all assets related to the facilities included in the 2001 Saleand Leaseback Transaction. The bonds are not guaranteed by us.

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes(the “Senior Notes”) due July 1, 2012. The Senior Notes are unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (collectively, the “Guarantors”). The Senior Notes are notguaranteed by MCF (the “Non-Guarantor”). Interest on the Senior Notes is payable semi-annually on January 1and July 1 of each year, commencing January 1, 2005. On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes atthe redemption prices (expressed as a percentage of the principal amount)listed below, plus accrued and unpaid interest, if any, on the Senior Notesredeemed, to the applicable date of redemption, if redeemed during the 12-monthperiod 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 toJuly 1, 2007, we may redeem up to 35% of the original aggregateprincipal amount of the Senior Notes at a redemption price of 110.75% of theprincipal amount thereof with the net cash of public offerings of equity,provided that at least 65% of the original aggregate principal amount of theNotes remains outstanding after the redemption and other conditions are met.Upon the occurrence of specified change of control events, unless we haveexercised our option to redeem all the Senior Notes as described above, eachholder will have the right to require us to repurchase all or a portion of suchholder’s Senior Notes at a purchase price in cash equal to 101% of theaggregate principal amount of the notes repurchased plus accrued and unpaidinterest, if any, on the Senior Notes repurchased, to the applicable date ofpurchase. The Senior Notes were issued under an indenture (the “Indenture”)which limits our ability and the ability of our Guarantors to, among otherthings, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

In conjunctionwith the issuance of the Senior Notes, we entered into an interest rate swaptransaction with a financial institution to hedge our exposure to changes inthe fair value on $84.0 million of our Senior Notes. The purpose of thistransaction was to convert future interest due on $84.0 million of the SeniorNotes to a variable rate. The terms of the interest rate swap contract and theunderlying debt instrument are identical. We have designated the swap agreementas a fair value hedge. The swap has a notional amount of $84.0 million andmatures in July 2012 to mirror the maturity 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 months ended March 31,2007 we recorded interest expense related to this interest rate swap ofapproximately $0.01 million which is reflected as interest expense in theaccompanying financial statements.  Forthe three months ended March 31, 2006, we recorded interest savings related tothis interest rate swap of approximately $0.1 million which is

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reflected as areduction to interest expense in the accompanying financial statements. Theswap agreements are marked to market each quarter with a correspondingmark-to-market adjustment reflected as either a discount or premium on theSenior Notes. At March 31, 2007 and December 31, 2006 the fair valueof this derivative instrument was approximately ($0.5) million and ($1.1)million, respectively, and is included in other liabilities in the accompanyingfinancial statements. The carrying value of the Senior Notes as of these dateswas reduced by the same amount. Because the swap agreement is considered aneffective fair-value hedge, there will be no effect on our results ofoperations from the mark-to-market adjustment as long as the swap is in effect.

**Contractual Uncertainties Related to Certain Facilities**

***Cornell Abraxas Academy (formerly the New Morgan Academy).***  We closed the Cornell Abraxas Academy(formerly the New Morgan Academy) in the fourth quarter of 2002. The facility,which reopened in October 2006, operates as a residential treatment facilityfor youth sex offenders.

The carrying value of theproperty and equipment for the Cornell Abraxas Academy was approximately $19.4million and $19.5 million at March 31, 2007 and December 31, 2006,respectively. We believe that, pursuant to the provisions of SFAS No. 144, noimpairment has occurred.

***Great Plains Correctional Facility.*** We believe that our existing contract with theOklahoma Department of Corrections (“OKDOC”) with respect to our leased GreatPlains Correctional Facility expired in July 2006. Despite negotiations withOKDOC since early 2006, we have been unable to agree on terms for a newcontract.  As a result, to preserve our rightsrelative to other business opportunities, in October 2006 the Hinton EconomicDevelopment Authority notified OKDOC of our intent to terminate thecontract.  Effective April 1, 2007, thefacility was vacant. At our Great Plains Correctional Facility, as with all ourfacilities, we seek to maximize the operating potential based on an assessmentof which potential customer(s) would enable us to realize the highest economicvalue. This facility generated revenues of approximately $1.9 million and $3.2million in the three months ended March 31, 2007 and 2006, respectively.  The net carrying value of this facility wasapproximately $35.8 million and $36.1 million at March 31, 2007 and December31, 2006, respectively. As it is our intent to reactivate this facility, theoperations of this facility has not been reported as discontinued operations.In May 2007, we were awarded a contract by the Arizona Department ofCorrections to house 2,000 medium-security inmates at this facility. Theanticipated start date of the contract is expected to occur in the thirdquarter of 2007. We believe that no impairment has occurred.

***Hector Garza Residential Treatment Center(formerly the Campbell Griffin Treatment Center).***  In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas.  It is our intent to reactivate this facilityduring the year ending December 31, 2007. Accordingly, it has not been reportedas discontinued operations.  Our netcarrying value for this facility at March 31, 2007 and December 31, 2006 wasapproximately $4.3 million and $4.2 million, respectively. We believe that noimpairment has occurred. Our inability to obtain a new customer for thisfacility could have an adverse effect on our financial condition, results ofoperations and liquidity.

***Future Liquidity*****.**We believe that the existing cash and thecash flows generated from operations, together with the credit available underour Credit Facility, will provide sufficient liquidity to meet our committedcapital and working capital requirements for currently awarded and certainpotential future development contracts. To the extent our cash and currentfinancing arrangements do not provide sufficient financing to fund constructioncosts related to future contract awards, acquisitions or significant facilityexpansions, we anticipate obtaining additional sources of financing to fundsuch activities. However, there can be no assurance that such financing will beavailable or will be available on terms favorable to us.

***Contractual Obligations and CommercialCommitments*****.**We haveassumed various financial obligations and commitments in the ordinary course ofconducting our business. We have contractual obligations requiring future cashpayments under our existing contractual arrangements, such as management,consultative and non-competition agreements.

Wemaintain operating leases in the ordinary course of our business activities.These leases include those for operating facilities, office space and officeand operating equipment, and the terms of the agreements vary from 2007 until2075. As of March 31, 2007, our total commitment under these operatingleases was approximately $28.0 million.

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Thefollowing table details known future cash payments (on an undiscounted basis)related to various contractual obligations as of March 31, 2007 (inthousands):
| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008 -  2009** | ** ** | **2010 -  2011** | ** ** | **Thereafter** | ** ** |
|                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt – principal              |       |                                      |       |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.          |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| - Special Purpose Entities              |       | 156,000                                   |       | 10,500 |   | 23,800 |   | 28,000 |   | 93,700 |   |
| Long-term debt - interest (1)                |       |                                      |       |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.          |       | 64,606                                    |       | 9,255 |   | 24,620 |   | 24,595 |   | 6,136 |   |
| - Special Purpose Entities              |       | 74,867                                    |       | 6,607 |   | 23,682 |   | 19,482 |   | 25,096 |   |
| Construction  commitments                    |       | 28,356                                    |       | 28,356 |   | — |   | — |   | — |   |
| Capital lease  obligations                   |       |                                      |       |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.          |       | 47                                        |       | 10 |   | 23 |   | 14 |   | — |   |
| Operating leases                             |       | 28,048                                    |       | 4,593 |   | 9,615 |   | 4,791 |   | 9,049 |   |
| Consultative and  non-competition agreements |       | 585                                       |       | 335 |   | 250 |   | — |   | — |   |
| Total contractual cash  obligations          |       | $                                         | 464,509    |   | $ | 59,656 |   | $ | 81,990 |   | $ | 76,882 |   | $ | 245,981 |   |

 

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(1)             We have an interest rate swap agreement under whichwe receive a fixed interest rate and pay a floating interest rate. The futurecash payments on the Cornell Companies, Inc. long-term debt — interestassume an effective rate of 10.91% on the related interest rate swap contract.

We enter into letters ofcredit in the ordinary course of operating and financing activities. As ofMarch 31, 2007, we had outstanding letters of credit of approximately $10.3million related to insurance and other operating activities. The followingtable details our letter of credit commitments as of March 31, 2007 (inthousands):
| ** **                 | ** ** | **Total**              | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|----------------------------|------------|------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Amounts  Committed** | ** ** | **Less than  1 Year**                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **Over  5 Years** | ** ** |
| ** **                 | ** ** | ** **             | ** ** | ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Commercial  Commitments:   | ** ** | ** **             | ** ** | ** **                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Standby letters  of credit |       | $                      | 10,251     |                                                                    | $          | 9,501 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                            |            |                        |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Forward-Looking Statements**

 

Thestatements included in this quarterly report regarding future financialperformance, expected future actions and activities, results of operations andother statements that are not historical facts are forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. Statements to the effect that we or management “anticipates,”“believes,” “budgets,” “estimates,” “expects,” “forecasts,” “intends,” “plans,”“predicts,” or “projects” a particular result or course of events, or that suchresult or course of events “could,” “might,” “may,” “scheduled” or “should”occur, and similar expressions, are also intended to identify forward-lookingstatements. Forward-looking statements in this quarterly report include, butare not limited to, revenues, revenue mix, expenses, personnel costs, operatingmargins, financial results, liquidity, working capital requirements, pricing,per diem rates, utilization, increasing number of parolees and inmates,effectiveness of our strategy, capital requirements, capital expenditures, ourcontract from the Arizona Department of Corrections for our Great PlainsCorrectional Facility, planned projects, expansions, the timing and cost ofcompletion of capital projects, performance of acquired facilities andbusinesses, demand, supply, customer programs, contract commencements, futureactivity and market outlook in our various market sectors, debt levels andother uses of excess cash, our effective tax rate, changes in laws andregulations, results and effects of legal proceedings and governmental auditsand assessments, adequacy of insurance, adequacy of cash flow for ourobligations, effects of accounting changes and adoption of accounting policies.Such statements are subject to numerous risks, uncertainties and assumptions,including, but not limited to, those described in “Item 1A. Risk Factors”included in our Annual Report on Form 10-K for the year ended December 31, 2006and other factors discussed in this quarterly report and in our other filingswith the SEC, which are available free of charge on the SEC's website atwww.sec.gov. Should one or more of these risks or uncertainties materialize, orshould underlying assumptions prove incorrect, actual results may varymaterially from those indicated. All subsequent written and oralforward-looking statements attributable to us or to persons acting on ourbehalf are expressly qualified in their entirety by reference to these risks anduncertainties. You should not place undue reliance on forward-lookingstatements. Each forward-looking statement speaks only as of the date of theparticular statement, and we undertake no obligation to publicly update orrevise any forward-looking statements. 

**ITEM 3.****                ****Quantitative and QualitativeDisclosures about Market Risk.**

Inthe normal course of business, we are exposed to market risk, primarily fromchanges in interest rates. We continually monitor exposure to market risk anddevelop appropriate strategies to manage this risk. We are not exposed to anyother significant market risks, including commodity price risk, foreigncurrency exchange risk or interest rate risks from the use of derivativefinancial instruments. In connection with the issuance of the Senior Notes, weentered into an interest rate swap of $84.0 million related to the interestobligations under the Senior Notes in effect converting them to a floating ratebased 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 consolidatedfinancial statements with fixed interest rates consists of the 8.47% Bondsissued by MCF in August 2001 in connection with the 2001 Sale andLeaseback Transaction and approximately $28.0 million of the Senior Notes (nothedged by the interest rate swap). At March 31, 2007, approximately 31.5%($84.0 million of debt outstanding on the Senior notes issued in June 2004)of our consolidated long-term debt was subject to variable interest rates. Thedetrimental effect of a hypothetical 100 basis point increase in interest rateswould be to reduce income before provision for income taxes by approximately$0.2 million for the three months ended March 31, 2007. At March 31,2007, the fair value of our consolidated fixed rate debt approximated carryingvalue based upon discounted future cash flows using current market prices.

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

**Evaluation of Disclosure Controls and Procedures**

Wemaintain disclosure controls and procedures designed to provide reasonableassurance that information disclosed in our annual and periodic reports isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. In addition,we designed these disclosure controls and procedures to ensure that thisinformation is accumulated and communicated to management, including the chiefexecutive officer (“CEO”) and chief financial officer (“CFO”), to allow timelydecisions regarding required disclosures. SEC rules require that wedisclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

We do not expect that our disclosure controlsand procedures will prevent all errors or fraud. A control system, no matterhow well conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met.  In addition, the design of disclosurecontrols and procedures must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitation in a cost-effective control system,misstatements due to error or fraud could occur and not be detected.

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, and as required by paragraph (b) ofRules 13a-15 and 15d-15 of the Securities Exchange Act of 1934, as amended (the“Exchange Act”), we have evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the endof the period required by this report. Based on that evaluation, our principalexecutive officer and principal financial officer have concluded that thesecontrols and procedures are effective as of that date.

**Changesin Internal Control over Financial Reporting**

In connection with the evaluation as required byparagraph (d) of Rules 13a-15 and 15d-15 of the Exchange Act, we have notidentified any change in our internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under ExchangeAct) that occurred during our fiscal quarter ended March 31, 2007 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II****              ****OTHER INFORMATION**
| **ITEM 1.**  | ** ** | **Legal  Proceedings.**                                                                                                                                                                                                                                                                                             |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
|         |       | See Part I,  Item 1. Financial Statements, Note 9.                                                                                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                                                                                                                                |
| **ITEM 1A.** | ** ** | **Risk  Factors.**                                                                                                                                                                                                                                                                                                  |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
|         |       | The risk factors as previously discussed in our  Form 10-K for the fiscal year ended December 31, 2006 are  incorporated herein by this reference. There are no material changes to such  risk factors.                                                                                                   |
|         |       |                                                                                                                                                                                                                                                                                                                |
| **ITEM 2.**  | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds.**                                                                                                                                                                                                                                                   |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
|         |       | None.                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                |
| **ITEM 3.**  | ** ** | **Defaults  Upon Senior Securities.**                                                                                                                                                                                                                                                                               |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
|         |       | None.                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                |
| **ITEM 4.**  | ** ** | **Submission of Matters to a Vote of Security  Holders.**                                                                                                                                                                                                                                                           |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
|         |       | The submission  of matters to a vote of security holders as previously discussed in our Form  10K for the fiscal year ended December 31, 2006 are incorporated herein by  this reference. There have been no other matters submitted to a vote of the  securities holders in the three months ended March 31, 2007. |
|         |       |                                                                                                                                                                                                                                                                                                                |
| **ITEM 5.**  | ** ** | **Other  Information.**                                                                                                                                                                                                                                                                                             |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                          |
| ** **   | ** ** | None.                                                                                                                                                                                                                                                                                                               |
| ** **   | ** ** |                                                                                                                                                                                                                                                                                                                |
| **ITEM 6.**  | ** ** | **Exhibits.**                                                                                                                                                                                                                                                                                                       | ** ** | ** ** |
|         |       | 3.1                                                                                                                                                                                                                                                                                                                 | Restated Certificate of Incorporation of Cornell  Companies, Inc. (incorporated by reference to Exhibit 3.1 to our Annual  Report on Form 10-K for the year ended December 31, 1996) |   |   |
|         |       | 3.2                                                                                                                                                                                                                                                                                                                 | Amended and Restated Bylaws of Cornell Companies,  Inc. (incorporated by reference to Exhibit 3.1 to our Quarterly Report on  Form 10-Q for the quarter ended March 31, 2001) |   |   |
|         |       | 3.3                                                                                                                                                                                                                                                                                                                 | Certificate of Amendment of Restated Certificate of  Incorporation of Cornell Companies, Inc. (incorporated by reference to  Exhibit 4.2 to Registration Statement on Form S-8 (Registration No.  333-42444)) |   |   |
|         |       | 10.1                                                                                                                                                                                                                                                                                                                | Agreement dated March 9, 2007, between Cornell  Companies, Inc., North Star Group and Wynnefield Group (incorporated by  reference to Exhibit 99.1 to our Current Report on Form 8-K filed on March  12, 2007) |   |   |
|         |       | 10.2                                                                                                                                                                                                                                                                                                                | Employment Agreement, dated as of March 19, 2007,  between Cornell Companies, Inc. and William E. Turcotte |   |   |
|         |       | 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**

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.
|                                     |   | **CORNELL COMPANIES, INC.**            |
|-------------------------------------|--------|---------------------------------------------|
|                                |   |                                        |
|                                |   |                                        |
| Date:  May 10,  2007 | By:    | /s/ James E. Hyman                          |
|                                |   | JAMES E. HYMAN                              |
|                                |   | Chief Executive Officer and Chairman of the |
|                                |   | Board (Principal Executive Officer)         |
|                                |   |                                        |
|                                |   |                                        |
| Date:  May 10,  2007 | By:    | /s/ John R. Nieser                          |
|                                |   | JOHN R. NIESER                              |
|                                |   | Chief Financial Officer and Treasurer       |
|                                |   | (Principal Financial Officer and Principal  |
|                                |   | Accounting Officer)                         |

 

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