** **

**UNITED STATESSECURITIES 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  September 30, 2003**                                                                                                                                                                           |
|                                                                                                                                                                                                                                  |                                                                                               |
| **OR**                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                  |                                                                                               |
| **o**                                                                                                                                                                                                                                 | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                  |                                                                                               |
| **For the transition period                    to                  ** |
|                                                                                                                                                                                                                                  |                                                                                               |
| **Commission File Number 1-14472**                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                  |                                                                                               |
| **CORNELL  COMPANIES, INC.**                                                                                                                                                                                                          |
| (Exact name of  registrant as specified in its charter)                                                                                                                                                                               |

 

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

 

Indicate by a check markwhether Registrant (1) has filed all reports required to be filed by Sections13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months, and (2) has been subject to such filing requirements for the past 90days.

 

Yes  ý  No  o

 

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

 

Yes  ý  No  o

 

At October 31, 2003Registrant had outstanding 13,370,588 shares of its Common Stock.

 

 

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**PART I          FINANCIAL INFORMATION**

 

**ITEM 1.          Financial Statements**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

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

 
|                                                                                                                                 |   | **September 30,  2003** |    | **December 31,  2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|-----------------------------|--------|
| ASSETS                                                                                                                               |   |                         |    |                        |   |
|                                                                                                                                 |   |                         |    |                        |   |
| CURRENT  ASSETS:                                                                                                                     |   |                         |    |                        |   |
| Cash  and cash equivalents                                                                                                           |   | $                            | 40,426  |                        | $      | 52,610 |   |
| Accounts  receivable, net                                                                                                            |   | 60,285                       |    | 60,035                      |   |
| Deferred  tax asset                                                                                                                  |   | 2,751                        |    | 3,300                       |   |
| Prepaids  and other                                                                                                                  |   | 6,534                        |    | 5,528                       |   |
| Other  restricted assets                                                                                                             |   | 11,628                       |    | 14,767                      |   |
| Total  current assets                                                                                                                |   | 121,624                      |    | 136,240                     |   |
| PROPERTY  AND EQUIPMENT, net                                                                                                         |   | 264,021                      |    | 255,450                     |   |
| OTHER  ASSETS:                                                                                                                       |   |                         |    |                        |   |
| Debt  service reserve fund                                                                                                           |   | 23,800                       |    | 24,157                      |   |
| Intangible  assets, net                                                                                                              |   | 12,493                       |    | 13,062                      |   |
| Deferred  costs and other                                                                                                            |   | 23,726                       |    | 12,382                      |   |
| Total  assets                                                                                                                        |   | $                            | 445,664 |                        | $      | 441,291 |   |
|                                                                                                                                 |   |                         |    |                        |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                            |   |                         |    |                        |   |
|                                                                                                                                 |   |                         |    |                        |   |
| CURRENT  LIABILITIES:                                                                                                                |   |                         |    |                        |   |
| Accounts  payable and accrued liabilities                                                                                            |   | $                            | 24,190  |                        | $      | 32,622 |   |
| Current  portion of long-term debt                                                                                                   |   | 8,312                        |    | 7,630                       |   |
| Total  current liabilities                                                                                                           |   | 32,502                       |    | 40,252                      |   |
| LONG-TERM  DEBT, net of current portion                                                                                              |   | 234,594                      |    | 232,258                     |   |
| DEFERRED  TAX LIABILITIES                                                                                                            |   | 8,576                        |    | 4,954                       |   |
| OTHER  LONG-TERM LIABILITIES                                                                                                         |   | 2,641                        |    | 3,875                       |   |
|                                                                                                                                 |   |                         |    |                        |   |
| Total  liabilities                                                                                                                   |   | 278,313                      |    | 281,339                     |   |
|                                                                                                                                 |   |                         |    |                        |   |
| COMMITMENTS  AND CONTINGENCIES                                                                                                       |   |                         |    |                        |   |
|                                                                                                                                 |   |                         |    |                        |   |
| STOCKHOLDERS’  EQUITY:                                                                                                          |   |                         |    |                        |   |
| Preferred  stock, $.001 par value, 10,000,000 shares authorized, none outstanding                                                    |   | —                       |    | —                      |   |
| Common  stock, $.001 par value, 30,000,000 shares authorized, 14,551,313 and  14,201,038 shares issued and outstanding, respectively |   | 15                           |    | 14                          |   |
| Additional  paid-in capital                                                                                                          |   | 143,180                      |    | 140,085                     |   |
| Note  from shareholder                                                                                                               |   | (440                         | )       | (442                        | )      |
| Retained  earnings                                                                                                                   |   | 35,909                       |    | 30,248                      |   |
| Treasury  stock (1,500,938 and 1,429,586 shares of common stock, respectively, at cost)                                              |   | (11,925                      | )       | (11,038                     | )      |
| Deferred  compenstion                                                                                                                |   | (1,018                       | )       | (811                        | )      |
| Other  comprehensive income                                                                                                          |   | 1,630                        |    | 1,896                       |   |
| Total  stockholders’ equity                                                                                                     |   | 167,351                      |    | 159,952                     |   |
| Total  liabilities and stockholders’ equity                                                                                     |   | $                            | 445,664 |                        | $      | 441,291 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**AND COMPREHENSIVE INCOME (LOSS)**

**(Unaudited)**

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

 
|                                                                                                          |   | **Three Months  Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|---------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                          |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| REVENUES                                                                                                      |   | $                                           | 68,642 |                                       | $      | 69,634 |   | $ | 202,253 |   | $ | 207,186 |   |
| OPERATING  EXPENSES                                                                                           |   | 53,495                                      |   | 53,138                                     |   | 156,860 |   | 160,454 |   |
| PRE-OPENING  AND START-UP EXPENSES                                                                            |   | 1,060                                       |   | —                                     |   | 1,453 |   | — |   |
| DEPRECIATION  AND AMORTIZATION                                                                                |   | 2,535                                       |   | 2,672                                      |   | 7,708 |   | 7,252 |   |
| GENERAL  AND ADMINISTRATIVE EXPENSES                                                                          |   | 4,820                                       |   | 5,832                                      |   | 13,440 |   | 17,223 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| INCOME  FROM OPERATIONS                                                                                       |   | 6,732                                       |   | 7,992                                      |   | 22,792 |   | 22,257 |   |
| INTEREST  EXPENSE                                                                                             |   | 4,651                                       |   | 4,985                                      |   | 14,444 |   | 15,780 |   |
| INTEREST  INCOME                                                                                              |   | (423                                        | )      | (645                                       | )      | (1,248 | ) | (1,559 | ) |
| MINORITY  INTEREST IN CONSOLIDATED SPECIAL PURPOSE ENTITIES                                                   |   | —                                      |   | 613                                        |   | — |   | 574 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| INCOME  BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING  PRINCIPLE            |   | 2,504                                       |   | 3,039                                      |   | 9,596 |   | 7,462 |   |
| PROVISION  FOR INCOME TAXES                                                                                   |   | 1,062                                       |   | 1,246                                      |   | 3,935 |   | 3,059 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| INCOME  BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE                                            |   | 1,442                                       |   | 1,793                                      |   | 5,661 |   | 4,403 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| CUMULATIVE  EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF RELATED INCOME TAX  BENEFIT OF $671 IN 2002 |   | —                                      |   | —                                     |   | — |   | (965 | ) |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| NET  INCOME                                                                                                   |   | $                                           | 1,442  |                                       | $      | 1,793 |   | $ | 5,661 |   | $ | 3,438 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| EARNINGS  PER SHARE:                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| BASIC                                                                                                         |   |                                        |   |                                       |   |   |   |   |   |
| Income  before cumulative effect of change in accounting principle                                            |   | $                                           | .11    |                                       | $      | .14 |   | $ | .44 |   | $ | .33 |   |
| Cumulative  effect of change in accounting principle                                                          |   | —                                      |   | —                                     |   | — |   | (.07 | ) |
| Net  income                                                                                                   |   | $                                           | .11    |                                       | $      | .14 |   | $ | .44 |   | $ | .26 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| DILUTED                                                                                                       |   |                                        |   |                                       |   |   |   |   |   |
| Income  before cumulative effect of change in accounting principle                                            |   | $                                           | .11    |                                       | $      | .14 |   | $ | .43 |   | $ | .33 |   |
| Cumulative  effect of change in accounting principle                                                          |   | —                                      |   | —                                     |   | — |   | (.07 | ) |
| Net  income                                                                                                   |   | $                                           | .11    |                                       | $      | .14 |   | $ | .43 |   | $ | .26 |   |
| NUMBER  OF SHARES USED IN PER SHARE COMPUTATION:                                                              |   |                                        |   |                                       |   |   |   |   |   |
| BASIC                                                                                                         |   | 13,044                                      |   | 12,967                                     |   | 12,894 |   | 12,975 |   |
| DILUTED                                                                                                       |   | 13,542                                      |   | 13,197                                     |   | 13,218 |   | 13,337 |   |
|                                                                                                          |   |                                        |   |                                       |   |   |   |   |   |
| Comprehensive  income (loss):                                                                                 |   |                                        |   |                                       |   |   |   |   |   |
| Net  income                                                                                                   |   | $                                           | 1,442  |                                       | $      | 1,793 |   | $ | 5,661 |   | $ | 3,438 |   |
| Unrealized  gain (loss) on derivative instruments                                                             |   | (1,696                                      | )      | 2,309                                      |   | (266 | ) | 2,509 |   |
| Comprehensive  income (loss)                                                                                  |   | $                                           | (254   | )                                          | $      | 4,102 |   | $ | 5,395 |   | $ | 5,947 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

3

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
|                                                                                     |   | **Nine  Months Ended  September 30,** |   |
|------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                     |   | **2003**                                   |   | **2002** |   |
|                                                                                     |   |                                       |   |   |   |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                   |   |                                       |   |   |   |
| Net  income                                                                              |   | $                                          | 5,661  |   | $ | 3,438 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities — |   |                                       |   |   |   |
| Cumulative  effect of change in accounting principle                                     |   | —                                     |   | 965 |   |
| Minority  interest in consolidated special purpose entities                              |   | —                                     |   | (40 | ) |
| Depreciation                                                                             |   | 7,049                                      |   | 6,593 |   |
| Amortization  of intangibles and other assets                                            |   | 659                                        |   | 659 |   |
| Amortization  of deferred compensation                                                   |   | 535                                        |   | 40 |   |
| Amortization  of deferred financing costs                                                |   | 868                                        |   | 824 |   |
| Provision  for bad debts                                                                 |   | 1,706                                      |   | 605 |   |
| Loss  on sale of property and equipment                                                  |   | 50                                         |   | — |   |
| Deferred  income taxes                                                                   |   | 4,171                                      |   | 89 |   |
| Change  in assets and liabilities:                                                       |   |                                       |   |   |   |
| Accounts  receivable                                                                     |   | (1,956                                     | )      | (2,299 | ) |
| Restricted  assets                                                                       |   | 159                                        |   | 1,608 |   |
| Other  assets                                                                            |   | (369                                       | )      | 128 |   |
| Accounts  payable and accrued liabilities                                                |   | (4,220                                     | )      | (7,010 | ) |
| Accrued  interest on MCF bonds                                                           |   | (4,212                                     | )      | (3,696 | ) |
| Deferred  revenues and other liabilities                                                 |   | (1,500                                     | )      | (1,593 | ) |
| Net  cash provided by operating activities                                               |   | 8,601                                      |   | 311 |   |
|                                                                                     |   |                                       |   |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                   |   |                                       |   |   |   |
| Capital  expenditures                                                                    |   | (15,667                                    | )      | (9,300 | ) |
| Escrow  deposit on facility purchase                                                     |   | (12,938                                    | )      | — |   |
| Escrow  deposit on non-compete agreement                                                 |   | (1,000                                     | )      | — |   |
| Withdrawals  from (payments to) restricted debt payment account, net                     |   | 4,192                                      |   | 4,317 |   |
| Return  of restricted assets from deferred bonus plan                                    |   | —                                     |   | 1,000 |   |
| Purchases  of marketable securities, net                                                 |   | —                                     |   | (298 | ) |
| Net  cash used in investing activities                                                   |   | (25,413                                    | )      | (4,281 | ) |
|                                                                                     |   |                                       |   |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                   |   |                                       |   |   |   |
| Proceeds  from long-term debt and line of credit                                         |   | 11,641                                     |   | 542 |   |
| Payments  on line of credit                                                              |   | (1,000                                     | )      | — |   |
| Payments  on MCF bonds                                                                   |   | (7,600                                     | )      | (6,800 | ) |
| Payments  on capital lease obligations                                                   |   | (27                                        | )      | (102 | ) |
| Borrowing  on capital leases                                                             |   | —                                     |   | 65 |   |
| Proceeds  from payments on shareholder notes                                             |   | —                                     |   | 173 |   |
| Proceeds  from exercise of stock options and warrants                                    |   | 2,354                                      |   | 752 |   |
| Purchases  of treasury stock                                                             |   | (740                                       | )      | (1,356 | ) |
| Net  cash provided by (used in) financing activities                                     |   | 4,628                                      |   | (6,726 | ) |
|                                                                                     |   |                                       |   |   |   |
| NET  DECREASE IN CASH AND CASH EQUIVALENTS                                               |   | (12,184                                    | )      | (10,696 | ) |
| CASH  AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                        |   | 52,610                                     |   | 53,244 |   |
| CASH  AND CASH EQUIVALENTS AT END OF PERIOD                                              |   | $                                          | 40,426 |   | $ | 42,548 |   |
|                                                                                     |   |                                       |   |   |   |
| OTHER  NON-CASH INVESTING AND FINANCING ACTIVITIES:                                      |   |                                       |   |   |   |
| Purchases  of treasury stock by deferred bonus plan                                      |   | $                                          | 146    |   | $ | 298 |   |
| Other  comprehensive income (loss)                                                       |   | $                                          | (266   | ) | $ | 2,509 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.****                                      Basisof Presentation**

 

The accompanyingunaudited consolidated financial statements have been prepared by CornellCompanies, Inc. (the “Company”) pursuant to the rules and regulations of theSecurities 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 the financialstatements and notes thereto included in the Company’s 2002 Annual Report onForm 10-K/A as filed with the Securities and Exchange Commission.

 

**2.             AccountingPolicies**

 

See a description of theCompany’s accounting policies in the Company’s 2002 Annual Report on Form10-K/A.

 

The Company accounts forits stock-based compensation plans in accordance with Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No.25”).  In accordance with the provisionsof APB No. 25, stock-based employee compensation cost is not reflected in netincome, as all options granted under those plans had an exercise price equal toor in excess of the market value of the underlying common stock on the date ofgrant.  The Financial AccountingStandards Board (“FASB”) has announced that it expects to require companies torecord compensation expense for equity instruments  issued to employees based on their fair value in 2005.  The following table illustrates, inaccordance with Statement of Financial Accounting Standard (“SFAS”) No. 148,the effect of net income and earnings per share as if the Company had appliedthe fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,expect per share amounts):

 
|                                                                                                                                        |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                                                        |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                                                                                                                        |   |                                        |   |                                       |   |   |   |   |   |
| Net  income, as reported                                                                                                                    |   | $                                           | 1,442  |                                       | $      | 1,793 |   | $ | 5,661 |   | $ | 3,438 |   |
| Add:  stock based employee compensation expense, net of related tax effect                                                                  |   | —                                      |   | —                                     |   | — |   | — |   |
| Less:  total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |   | (210                                        | )      | (487                                       | )      | (1,090 | ) | (1,337 | ) |
| Pro  forma net income                                                                                                                       |   | $                                           | 1,232  |                                       | $      | 1,306 |   | $ | 4,571 |   | $ | 2,101 |   |
| Earnings  per share:                                                                                                                        |   |                                        |   |                                       |   |   |   |   |   |
| Basic,  as reported                                                                                                                         |   | $                                           | .11    |                                       | $      | .14 |   | $ | .44 |   | $ | .26 |   |
| Basic,  pro forma                                                                                                                           |   | .09                                         |   | .10                                        |   | .35 |   | .16 |   |
| Diluted,  as reported                                                                                                                       |   | .11                                         |   | .14                                        |   | .43 |   | .26 |   |
| Diluted,  pro forma                                                                                                                         |   | .09                                         |   | .10                                        |   | .35 |   | .16 |   |

 

5

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***New Accounting Pronouncements***

 

The Company implementedSFAS No. 143, SFAS No. 146 and SFAS No. 148 and FIN 45 in the nine months endedSeptember 30, 2003 with no impact on the Company’s reported financialposition or results of operations.

 

In April 2002, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescissionof FASB Statements No. 4, 44, 64, Amendment of FASB Statement No. 13, andTechnical Corrections”, effective for fiscal years beginning after May 15,2002.  SFAS No. 145 rescinds FASBStatement No. 4, 44, 64 and amends SFAS No. 13, “Accounting for Leases,” toeliminate an inconsistency between the required accounting for sale-leasebacktransactions and the required accounting for certain lease modifications thathave economic effects that are similar to sale-leaseback transactions.  Additionally, SFAS No. 145 requires thatgains and losses on the extinguishment of debt be classified as income or lossfrom continuing operations rather than as extraordinary items as previouslyrequired under SFAS No. 4.  The Companyadopted SFAS No. 145 as required on January 1, 2003 and will reclassifyextraordinary losses of $2.9 million, net of related income tax benefit of $2.0million, previously reported in the third and fourth quarters of 2001 to a lossfrom continuing operations in the Company’s 2003 Annual Report on Form 10-K.

 

In January 2003, theFASB issued Interpretation No. 46, “Consolidation of Variable InterestEntities” (“FIN 46”), which addresses the consolidation of variable interestentities as defined in FIN 46.  FIN 46requires an assessment of equity investments to determine if they are variableinterest entities.  FIN 46 is effectiveimmediately for all variable interest entities created after January 31,2003.  For variable interest entitiescreated before February 1, 2003, the provisions of FIN 46 must be appliedno later than the quarter ending December 31, 2003.   In addition, if it is reasonably possiblethat an enterprise will consolidate or disclose information about a variableinterest entity, the enterprise must discuss the following information in allfinancial statements issued after January 31, 2003: (1) the nature,purpose, size or activities of the variable interest entity and (2) theenterprise’s maximum exposure to loss as a result of its involvement with thevariable interest entity.  The Companywill adopt the provisions of FIN 46 in the quarter ending December 31,2003.  Management does not expect thatthe Company’s adoption of FIN 46 will change the Company’s accounting for the2000 synthetic lease transaction and the 2001 Sale and Leaseback Transaction,which are consolidated for reporting purposes. The Company may enter into future arrangements for the development ofnew facilities or to operate facilities which may become subject to theprovisions of FIN 46 and, in some cases, may be required to consolidate therelated activities, facilities and financings. The FASB continues to address various implementation issues that couldpotentially broaden the application of FIN 46 to entities outside itsoriginally interpreted scope and has issued and proposed several FASB StaffPositions.  The Company does not expectthat these FASB Staff Positions will have a material impact on its financialstatements.

 

In April 2003 theFASB issued SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instrumentsand Hedging Activities” (“SFAS No. 149”). SFAS No. 149 amends and clarifies the accounting for derivative instruments,including certain derivative instruments embedded in other contracts, and forhedging activities under SFAS No. 133. SFAS No. 149 is effective for contracts entered into or modified afterJune 30, 2003 and for hedging relationships designated after June 30,2003, and should be applied prospectively. The provisions of SFAS No. 149 that relate to SFAS No. 133implementation issues that have been effective for fiscal quarters that beganprior to June 15, 2003 should continue to be applied in accordance withtheir respective effective dates.  Theadoption of SFAS No. 149 had no material impact on the Company’s financialposition or results of operations.

 

In May 2003 the FASBissued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristicsof Both Liabilities and Equity.”  SFASNo. 150 establishes standards for how an issuer 

 

6

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classifies and measurescertain financial instruments with characteristics of both liabilities and equityin its statements of financial position. SFAS No. 150 is effective for financial instruments entered into ormodified after May 31, 2003, and otherwise is effective at the beginningof the first interim period beginning after June 15, 2003 and must beapplied prospectively by reporting the cumulative effect of a change in anaccounting principle for financial instruments created before the issuance dateof the statement and still existing at the beginning of the interim period ofadoption.  The adoption of SFAS No. 150had no material impact on the Company’s financial position or results ofoperations.

 

In May 2003, theEmerging Issues Task Force (“EITF”) reached a consensus on EITF 01-8“Determining Whether an Arrangement Contains a Lease.” EITF 01-8 providesguidance for determining whether an arrangement contains a lease that is withinthe scope of SFAS No. 13 and is effective for arrangements initiated after thebeginning of the first interim period beginning after May 28, 2003. TheCompany adopted the provisions of EITF 01-8 as of July 1, 2003 with nomaterial impact on the Company’s financial position or results of operations.

 

**3.             Change inAccounting Principle**

 

In June 2001, theFASB issued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwilland Other Intangible Assets,” effective for fiscal years beginning afterDecember 15, 2001. The new rules under these statements require that thepurchase method of accounting be used for all business combinations initiatedafter June 30, 2001 and specifies the criteria for the recognition ofintangible assets separately from goodwill. Under the new rules, goodwill is no longer amortized but is subject toan impairment test  annually.  Other intangible assets that meet the newcriteria under the new rules will continue to be amortized over their remaininguseful lives.  The Company adopted SFASNo. 141 and SFAS No. 142 as of January 1, 2002 and recorded a cumulativeeffect of change in accounting principle charge of $965,000, net of tax,related to the impairment of goodwill for an acquisition made inNovember 1999.

 

**4.             OtherIntangible Assets**

 

Other intangible assetsat September 30, 2003 and December 31, 2002 consisted of thefollowing (in thousands):

 
|                      |   | **September 30,  2003** |   | **December 31,  2002** |   |
|---------------------------|--------|------------------------------|--------|-----------------------------|--------|
| Non-compete  agreements   |   | $                            | 8,390  |                        | $      | 8,300 |   |
| Accumulated  amortization |   | (3,618                       | )      | (2,959                      | )      |
| Other  intangibles, net   |   | $                            | 4,772  |                        | $      | 5,341 |   |

 

Amortization expense fornon-compete agreements was approximately $220,000 and $659,000 for the threeand nine months ended September 30, 2003 and 2002.  Amortization expense for non-competeagreements is expected to be approximately $978,000 for each of the fiscalyears ended December 31 for the next five years.

 

7

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**5.****                                      CreditFacilities**

 

The Company’s long-termdebt consisted of the following (in thousands):

 
|                                                                                                                      |   | **September 30,  2003** |    | **December 31,  2002** |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|---------|-----------------------------|--------|
| **Debt  of Cornell Companies, Inc.:**                                                                                     |   |                         |    |                        |   |
| Revolving  Line of Credit due July 2005 with an interest rate of prime plus 1.0% to  2.0% or LIBOR plus 2.0% to 3.0% |   | $                            | 10,000  |                        | $      | — |   |
| Capital  lease obligations                                                                                                |   | 12                           |    | 37                          |   |
| Subtotal                                                                                                                  |   | 10,012                       |    | 37                          |   |
|                                                                                                                      |   |                         |    |                        |   |
| **Debt  of Consolidated Special Purpose Entities:**                                                                       |   |                         |    |                        |   |
| Synthetic  Lease Investor Note A due July 2005 with an interest rate of LIBOR plus  3.25%                            |   | 41,664                       |    | 41,117                      |   |
| Synthetic  Lease Investor Note B due July 2005 with an interest rate of LIBOR plus  3.50%                            |   | 8,230                        |    | 8,134                       |   |
| MCF  8.47% Bonds due 2016                                                                                                 |   | 183,000                      |    | 190,600                     |   |
| Subtotal                                                                                                                  |   | 232,894                      |    | 239,851                     |   |
|                                                                                                                      |   |                         |    |                        |   |
| Consolidated  total debt                                                                                                  |   | 242,906                      |    | 239,888                     |   |
|                                                                                                                      |   |                         |    |                        |   |
| Less:  current maturities                                                                                                 |   | (8,312                       | )       | (7,630                      | )      |
|                                                                                                                      |   |                         |    |                        |   |
| Consolidated  long-term debt                                                                                              |   | $                            | 234,594 |                        | $      | 232,258 |   |

 

The Company’s 2000 CreditFacility, as amended, has two components - a revolving credit facility and asynthetic lease.  The credit facilityincludes the following characteristics, several of which are discussed in moredetail in the Notes to the table below:

 

(i)                                     providesfor borrowings of up to $37.0 million(1)at September 30, 2003 under arevolving line of credit;

 

(ii)                                  maturesin July 2005;

 

(iii)                               bearsinterest, at the election of the Company, at either the prime rate plus amargin of 2.0%, or a rate which is 3.0% above the applicable LIBOR rate;

 

(iv)                              iscollateralized by substantially all of the Company’s assets, including thestock of all of the Company’s subsidiaries;

 

(v)                                 doesnot permit the payment of cash dividends;

 

(vi)                              requiresthe Company to comply with certain leverage, net worth and debt servicecoverage covenants(2);

 

(vii)                           limitsthe Company’s ability to repurchase its common stock(3); and

 

(viii)                        restrictsthe Company’s ability to use cash that serves as part of the collateral forthe  loan(4).

 

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(1)           Originally$45.0 million, the maximum loan amount has been reduced quarterly as scheduled

 

8

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and is further reduced by outstanding letters ofcredit ($5.1 million at September 30, 2003). As of September 30,2003, the Company had outstanding borrowings of $10.0 million and $21.9 millionof remaining available commitment under its revolving line of credit.

 

(2)           Due to the consolidation, forfinancial reporting purposes, of MCF as of August 14, 2001, the Companywas not in compliance with certain leverage ratio covenants.  On April 5, 2002, the 2000 CreditFacility was amended to waive such non-compliance and to revise the covenantsto levels that accommodate the Company’s consolidation of special purposeentities in its financial statements. As a result of this waiver and amendment, the Company recognized apre-tax charge to interest expense of approximately $825,000 during the firstquarter of 2002 for lender and other professional fees.

 

Additionally, the Company has obtained a waiver fromthe lenders under the amended 2000 Credit Facility regarding the pendingcontractual default for the Moshannon Valley Correctional Center’s constructiondelay (see Note 7).  This waiver iseffective through October 31, 2004.

 

(3)                 TheCompany is limited to $2.5 million annually for the repurchase of its commonstock with an aggregate limit of $7.5 million.

 

(4)                 Includedin the Company’s cash and cash equivalents at September 30, 2003 isapproximately $39.7 million that is invested in a separate account that isavailable to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  The lenders could limit the Company’sability to use such funds.  Thisseparate account is maintained, in part, to assure future credit availability.

 

Additionally, the amended2000 Credit Facility provides the Company with the ability to enter intosynthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $96.5 million, of which approximately $51.7 million had beenutilized as of September 30, 2003. The Company pays commitment fees at a rate of 0.5% annually for theunused portion of the synthetic lease financing capacity.

 

The synthetic leasefinancing arrangement includes a component of equity capitalization equal to3.5% of the aggregate projects’ costs that is funded by the owner/lessor of theproperties (“Synthetic Lease Investor”). The Synthetic Lease Investor’s equity investment was reported asminority interest in consolidated special purpose entities in the Company’sconsolidated financial statements.  Thecumulative losses of the Synthetic Lease Investor exceeded the recordedminority interest of the Synthetic Lease Investor in 2001, therefore there iscurrently no minority interest balance as of September 30, 2003.  Upon a refinancing or extinguishment of thesynthetic lease obligations the Company will incur a charge to the extent ofthe amount of the Synthetic Lease Investor’s equity investment.  As of September 30, 2003, the amount ofthe Synthetic Lease Investor’s equity investment was approximately $1.8million.

 

**6.             NewMorgan**

 

The Company closed theNew Morgan Academy in the fourth quarter of 2002 and is currently consideringseveral options ranging from the sale or lease of the facility to utilizationof the facility for another type of program. The Company is using a small staff to maintain the facility while theCompany considers its options for the use of the facility.

 

The carrying value of theproperty and equipment at the New Morgan Academy was approximately $30.7million at September 30, 2003. Currently, management of the Company believes that its long-lived assetsat the New Morgan Academy are recoverable either from the cash flows of an alternativeprogram operating at the facility or upon the sale or lease of the facility toa third party, and accordingly, pursuant to the provisions of SFAS No. 144, animpairment provision is not deemed necessary as of September 30, 2003.  However, management estimates that, were theCompany to sell the facility, it is reasonably possible that the 

 

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Company may not be ableto fully recover the carrying value of its long-lived assets for this facility.

 

**7.             NewFacilities and Projects Under Development**

 

In January 2003, theCompany executed a five year lease for the Bernalillo Regional CorrectionalCenter in Albuquerque, New Mexico.  Thefacility, which has been vacated by the County in favor of a new jail, isexpected to be remodeled by the Company and used to provide adult secureconfinement for a wide array of government agencies that have demonstrated aneed for additional bed space.  Thefacility added approximately 1,000 beds to the Company’s current servicecapacity.  The lease was approved by theNew Mexico State Board of Finance in October 2003 and requires monthlyrental payments of approximately $113,000 for the first four years of the leaseand $130,000 for the last year of the lease. The Company expects to begin operating the facility in mid 2004.

 

In May 2003, theCompany acquired a building in San Antonio, Texas for approximately $2.1million in cash.  The Company renovatedthis 121 bed residential juvenile facility called the Texas Adolescent Centerat a cost of approximately $2.0 million and the facility became operational inthe fourth quarter of 2003.

 

In June 2003, theCompany entered into an agreement with a developer to purchase a 160 bedresidential treatment center for juveniles upon completion of construction ofthe facility by the developer.  Thisfacility is named the Southern Peaks Regional Treatment Center and is locatednear Canon City, Colorado.  In August 2003,the Company funded $12.9 million into an escrow account for the purchase priceof the real property, which is recorded in deferred costs and other on theCompany’s consolidated balance sheet.

 

As of November 2003,the Company has not secured commitments to house inmates at the BernalilloRegional Correctional Facility or patients at the Southern Peaks TreatmentCenter.  Although the Company believesthat there will be significant demand for the services at those facilities,there can be no assurance that the Company will develop enough volume at thoselocations to assure their profitable operation.

 

In March 2003, theCompany reached an agreement with the Commonwealth of Pennsylvania thatresolved all outstanding administrative issues relative to the contract awardedto the Company by the Federal Bureau of Prisons (“BOP”) to operate theMoshannon Valley Correctional Center. In October 2003, the Company received final approval from the BOPof a revised building design for the Moshannon Valley Correctional Center.Construction plans are being developed for the new design and work is expectedto begin in early spring 2004.  In theinterim, the Company will negotiate a contract amendment with the BOP that willaccommodate the revised facility design and update the contract for changessince it was originally signed.  If andwhen an amendment to the contract with the BOP is negotiated, this agreementwill allow the Company to move forward with the construction and operation ofthe facility.

 

As of September 30,2003, the Company had incurred approximately $16.8 million for construction andland development costs and capitalized interest related to the Moshannon ValleyCorrectional Center contract.  TheCompany is in the process of submitting a claim to the BOP for reimbursementcosts related to the original construction efforts incurred beginning in1999.  The Company estimates additionalcapital investment of approximately $74 million to complete construction of thefacility, which amount does not include the amount of prior construction coststo be reimbursed by the BOP which are yet to be determined.

 

10

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Financing of the facilityis subject to re-approval of the project by the lenders under the Company’samended 2000 Credit Facility and agreement by such lenders to amend certainfinancial covenants and provisions of the amended 2000 Credit Facility.  In the event the Company’s lenders areunwilling to re-approve the project or to adopt the necessary amendments, or ifthe Company’s cash and current financing arrangements do not provide sufficientfinancing to fund construction costs related to the project, the Companyanticipates needing to obtain additional sources of financing.

 

According to the BOPcontract, as amended, the Company is required to complete the construction ofthe project by January 15, 2004. The Company does not anticipate completing construction by that date andanticipates obtaining another long-term contract amendment from the BOPextending the construction deadline.  Inthe event the Company is not able to negotiate a contract amendment with theBOP, then the BOP may have the right to assert that the Company has notcompleted construction of the facility within the time frame provided in theBOP contract, as amended.  Managementexpects that the contract will be amended to address cost and constructiontiming matters resulting from the extended delay.  In the event that the BOP decides not to continue with theconstruction of the Moshannon Valley Correctional Center and terminates thecontract, management believes that the Company has the right to and willrecover its invested costs.  In theevent any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs would be expensed.

 

At September 30,2003, accounts receivable include costs totaling approximately $1.4 million fordirect costs incurred by the Company since the issuance of the Stop-Work Orderin June 1999 for payroll and other operating costs related to theMoshannon Valley Correctional Center. These costs were incurred with the understanding that such costs wouldbe reimbursed by the BOP.  Although noformal written agreement exists, management believes that these costs will bereimbursed by the BOP in the near term. In the event any portion of these costs are determined not to bereimbursable, such costs will be expensed in the period such determination ismade.

 

**8.****                                      EarningsPer Share**

 

Basic earnings per share(“EPS”) is computed by dividing net income by the weighted average number ofshares of common stock outstanding during the period.  Diluted EPS reflects the potential dilution from common stockequivalents such as stock options and warrants.  For the three months ended September 30, 2003 and 2002,there were 61,186 shares ($8.24 average price) and 745,003 shares ($12.58average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.  For the nine months ended September 30,2003 and 2002 there were 443,026 shares ($12.19 average price) and 419,829shares ($13.86 average price), respectively, of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.

 

**9.             Commitmentsand Contingencies**

 

*Litigation*

 

In March and April 2002,the Company, Steven W. Logan (the Company’s former President and ChiefExecutive Officer), and John L. Hendrix (the Company’s Chief FinancialOfficer), were named as defendants in four federal putative class actionlawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf of Himself and All Others Similarly Situatedv. Cornell Companies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division; (3)*Louis A.Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the United StatesDistrict Court for the Southern District of Texas, Houston Division, and (4) *Anthony J.Scolaro, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1567, in the United StatesDistrict Court for the Southern District of Texas, Houston Division.  The aforementioned lawsuits 

 

11

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were putative classaction lawsuits brought on behalf of all purchasers of the Company’s commonstock between March 6, 2001 and March 5, 2002 and relate to theCompany’s restatement in 2002 of certain financial statements.  The lawsuits involved disclosures madeconcerning two prior transactions executed by the Company: the August 2001sale leaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits were consolidated intothe *GraydonWilliams* action and  FlylinePartners, LP was appointed lead plaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP.  Richard Picard and Anthony Scolarowere also named as plaintiffs.  Sincethen, the court has allowed plaintiff to file an amended consolidated complaint.  The amended consolidated complaint allegesthat the defendants violated Section 10(b) of the Securities Exchange Actof 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b)of the Exchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (“the Securities Act”) and/or Section 15 of theSecurities Act.  The amendedconsolidated complaint seeks, among other things, restitution damages,compensatory damages, rescission or a rescissory measure of damages, costs,expenses, attorneys’ fees and expert fees. A motion to dismiss is currently pending.

 

In March 2002, theCompany, its directors, and its former independent auditor Arthur Andersen LLP,were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas.  The lawsuit relates tothe Company’s restatement in 2002 of certain financial statements.  The lawsuit alleges breaches of fiduciaryduty by all of the individual defendants and asserts breach of contract andprofessional negligence claims only against Arthur Andersen LLP.

 

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

 

The plaintiffs in thesecases have not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, the Company believes it has good defenses and intends tovigorously defend against the claims asserted in these actions.

 

Certain insurancepolicies held by the Company to cover potential director and officer liabilitymay limit the Company’s cash outflows in the event of a decision adverse to theCompany in the matters discussed above. However, if an adverse decision inthese matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, an adverse decision to the Company inthese matters could have a material adverse effect on the Company, itsfinancial condition, its results of operations and its future prospects.

 

Additionally, the Companycurrently and from time to time is 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.  The outcome of suchmatters cannot be predicated with certainty, based on the information known todate, management believes that the ultimate resolution of these matters willnot have a material adverse effect on the Company’s financial position,operating results or cash flow.

 

*Securities and Exchange CommissionInvestigation*

 

Following the restatementof the Company’s 2001 financial statements in 2002, the Securities and ExchangeCommission (the “SEC”) initiated an investigation into the circumstances leading

 

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to this restatement.  Following the SEC’s initial inquiry in 2002,the SEC made no further inquiry with respect to the investigation untilJuly 2003.  Since July 2003,the Company has received additional information requests from the SEC. TheCompany has cooperated, and intends to continue to fully cooperate with theSEC’s investigation.

 

Depending on the scope,timing and result of the SEC investigation, management’s attention and theCompany’s resources could be diverted from operations, which could adverselyaffect the Company’s operating results and contribute to future stock pricevolatility.  The SEC investigation couldalso require that the Company take other actions not currently contemplated.  In addition, the SEC investigation or itsoutcome may increase the costs of defending or resolving current litigation.

 

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

 

**10.****                               SegmentDisclosure**

 

The Company’s threeoperating divisions are its reportable segments.  The adult secure institutional segment consists of the operationof secure adult incarceration facilities. The juvenile segment consists of providing residential treatment andeducational programs and non-residential community-based programs to juvenilesbetween the ages of ten and 17 who have either been adjudicated or suffer frombehavioral problems.  The pre-releasesegment consists of providing pre-release and halfway house programs for adultoffenders who are either on probation or serving the last three to six monthsof their sentences on parole and preparing for re-entry into society at largeas well as community-based treatment and education programs as an alternativeto incarceration.  All of the Company’scustomers and long-lived assets are located in the United States ofAmerica.  Intangible assets are notincluded in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome.  The Company evaluatesperformance based on income or loss from operations before general andadministrative expenses, incentive bonuses, amortization of intangibles, interestand income taxes.  Corporate and otherassets are comprised primarily of cash, certain accounts receivable, deposits,property and equipment, deferred taxes, deferred costs and other assets.

 

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The only significantnon-cash item reported in the respective segment’s income or loss fromoperations is depreciation and amortization.

 
|                                |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|-------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                |   |                                        |   |                                       |   |   |   |   |   |
| Revenues                            |   |                                        |   |                                       |   |   |   |   |   |
| Adult  secure institutional         |   | $                                           | 25,805 |                                       | $      | 24,732 |   | $ | 76,461 |   | $ | 73,690 |   |
| Juvenile                            |   | 29,967                                      |   | 32,249                                     |   | 87,995 |   | 95,845 |   |
| Pre-release                         |   | 12,870                                      |   | 12,653                                     |   | 37,797 |   | 37,651 |   |
| Total  revenues                     |   | $                                           | 68,642 |                                       | $      | 69,634 |   | $ | 202,253 |   | $ | 207,186 |   |
|                                |   |                                        |   |                                       |   |   |   |   |   |
| Pre-opening  and start-up expenses  |   |                                        |   |                                       |   |   |   |   |   |
| Adult  secure institutional         |   | $                                           | 43     |                                       | $      | — |   | $ | 192 |   | $ | — |   |
| Juvenile                            |   | 1,017                                       |   | —                                     |   | 1,261 |   | — |   |
| Pre-release                         |   | —                                      |   | —                                     |   | — |   | — |   |
|                                |   | $                                           | 1,060  |                                       | $      | — |   | $ | 1,453 |   | $ | — |   |
|                                |   |                                        |   |                                       |   |   |   |   |   |
| Income  from operations             |   |                                        |   |                                       |   |   |   |   |   |
| Adult  secure institutional         |   | $                                           | 5,998  |                                       | $      | 6,386 |   | $ | 19,448 |   | $ | 18,885 |   |
| Juvenile                            |   | 2,882                                       |   | 5,114                                      |   | 9,982 |   | 13,876 |   |
| Pre-release                         |   | 2,659                                       |   | 2,876                                      |   | 7,814 |   | 8,564 |   |
| Sub-total                           |   | 11,539                                      |   | 14,376                                     |   | 37,244 |   | 41,325 |   |
| General  and administrative expense |   | (4,820                                      | )      | (5,832                                     | )      | (13,440 | ) | (17,223 | ) |
| Incentive  bonuses                  |   | **—**                                  |   | (65                                        | )      | — |   | (300 | ) |
| Amortization  of intangibles        |   | (220                                        | )      | (220                                       | )      | (659 | ) | (659 | ) |
| Corporate  and other                |   | 233                                         |   | (267                                       | )      | (353 | ) | (886 | ) |
| Total  income from operations       |   | $                                           | 6,732  |                                       | $      | 7,992 |   | $ | 22,792 |   | $ | 22,257 |   |

 

 
|                        |   | **September 30,  2003** |    | **December 31,  2002** |   |
|-----------------------------|--------|------------------------------|---------|-----------------------------|--------|
|                        |   |                         |    |                        |   |
| Assets                      |   |                         |    |                        |   |
| Adult  secure institutional |   | $                            | 155,215 |                        | $      | 156,315 |   |
| Juvenile                    |   | 114,262                      |    | 96,239                      |   |
| Pre-release                 |   | 58,509                       |    | 58,071                      |   |
| Intangible  assets, net     |   | 12,493                       |    | 13,062                      |   |
| Corporate  and other        |   | 105,185                      |    | 117,604                     |   |
| Total  assets               |   | $                            | 445,664 |                        | $      | 441,291 |   |

 

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**ITEM 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**General**

 

The Company is a leadingprovider of privatized correctional, treatment and educational servicesoutsourced by federal, state and local government agencies.  The Company provides a diversified portfolioof services for adults and juveniles through its three operating divisions: (1)adult secure institutional services, (2) juvenile treatment, educational anddetention services and (3) pre-release correctional and treatmentservices.  As of September 30,2003, the Company was developing or had contracts to operate 70 facilities witha total service capacity of 16,514.  TheCompany’s facilities are located in 14 states and the District of Columbia.

 

The following table setsforth for the periods indicated total service capacity, the service capacityand contracted beds in operation at the end of the periods shown and theaverage contract occupancy percentages.

 
|                                                                      |   | **September 30,  2003** |   | **September 30,  2002** |   |
|---------------------------------------------------------------------------|--------|------------------------------|--------|------------------------------|--------|
|                                                                      |   |                         |   |                         |   |
| Total  service capacity (1):                                              |   |                         |   |                         |   |
| Residential                                                               |   | 12,378                       |   | 11,267                       |   |
| Non-residential  community-based                                          |   | 4,136                        |   | 4,177                        |   |
| Total                                                                     |   | 16,514                       |   | 15,444                       |   |
| Service  capacity in operation (end of period)                            |   | 13,924                       |   | 14,349                       |   |
| Contracted  beds in operation (end of period)                             |   | 9,445                        |   | 9,503                        |   |
| Average  contract occupancy based on contracted beds in operation (2) (3) |   | 100.1                        | %      | 98.0                         | %      |
| Average  contract occupancy excluding start-up operations (2)             |   | 100.3                        | %      | 98.0                         | %      |

 

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(1)                                  TheCompany’s service capacity is comprised of the number of beds available forservice upon completion of construction of residential facilities and theaverage program capacity of non-residential community-based programs.

 

(2)                                  Occupancypercentages are based on contracted service capacity of residential facilitiesin operation.  Since certain facilitieshave service capacities that exceed contracted capacities, occupancypercentages can exceed 100% of contracted capacity.

 

(3)                                  Occupancypercentages reflect less than normalized occupancy during the start-up phase ofany applicable facility, resulting in a lower average contract occupancy inperiods when the Company has substantial start-up activities.

 

The Company derivessubstantially all its revenues from providing corrections, treatment andeducational services outsourced by federal, state and local government agenciesin the United States.  Revenues for theCompany’s services are generally recognized on a per diem rate based upon thenumber of occupant days or hours served for the period, on a guaranteedtake-or-pay basis or on a cost-plus reimbursement basis.  Revenues may fluctuate from year to year dueto changes in government funding policies, the number of people referred to theCompany’s facilities by governmental agencies or the opening of additionalfacilities.

 

Factors that the Companyconsiders in determining the per diem rate that it will charge include (1) theprograms specified by the contract and the related staffing levels, (2) wagelevels customary in the respective geographic areas, (3) whether the proposedfacility is to be leased or purchased and (4) the anticipated average contractoccupancy levels that the Company believes could reasonably be maintained.

 

The Company hashistorically experienced higher operating margins in its adult secureinstitutional and pre-release divisions as compared to the juveniledivision.  Additionally, the Company’soperating margins within a division can vary from facility to facility based onwhether a facility is owned or leased, the level of competition for thecontract award, the proposed length of the contract, the occupancy levels for afacility, the level of capital commitment required with respect to a facility,the anticipated changes in operating costs 

 

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over the term of thecontract, and the Company’s ability to increase a facility’s contractrevenue.  A decline in occupancy ofcertain juvenile division facilities may have a more significant impact onoperating results than the adult secure division due to higher per diemrevenues of certain juvenile facilities. The Company has experienced, andexpects 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 that are incurred priorto certain contract revenue increases. Additionally, management expects to experience interim marginfluctuations due to fluctuations in employee insurance costs as these costs canvary depending on individual claims under the Company’s self-insured plans.

 

The Company isresponsible for all facility operating costs, except for certain debt serviceand lease payments with respect to facilities for which the Company has only amanagement contract (10 facilities in operation at September 30, 2003 and11 facilities in operation at September 30, 2002).

 

A majority of theCompany’s facility operating costs consists of fixed costs.  These fixed costs include lease and rentalexpense, insurance, utilities and depreciation.  As a result, when the Company commences operation of new orexpanded facilities, fixed operating costs increase.  The amount of the Company’s variable operating costs, includingfood, medical services, supplies and clothing, depend on occupancy levels atthe facilities operated by the Company. The Company’s largest single operating cost, facility payroll expenseand related employment taxes and costs, has both a fixed and a variablecomponent.  The Company can adjust afacility’s staffing levels and the related payroll expense to a certain extentbased on occupancy at a facility, however a minimum fixed number of employeesis required to operate and maintain any facility regardless of occupancylevels.  Personnel costs are subject toincreases in tightening labor markets based on local economic and otherconditions.

 

Following a contractaward, the Company incurs pre-opening and start-up expenses including payroll,benefits, training and other operating costs prior to opening a new or expandedfacility and during the period of operation while occupancy is ramping up.  These costs vary by contract.  Since pre-opening and start-up costs arefactored into the revenue per diem rate that is charged to the contractingagency, the Company typically expects to recover these upfront costs over thelife of the contract.  Because occupancyrates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, the Company may incur additionalpost-opening start-up costs.  TheCompany does not anticipate post-opening start-up costs at facilities operatedunder any future contracts with the BOP because these contracts are, andexpected to continue to be, take-or-pay contracts, meaning that the BOP willpay the Company at least 95.0% of the contractual monthly revenue once thefacility opens, regardless of actual occupancy.

 

Newly opened facilitiesare staffed according to contract requirements when the Company beginsreceiving offenders or clients. Offenders or clients are typically assigned to a newly opened facilityon a phased-in basis over a one- to six-month period, although certain programsrequire a longer time period to reach break-even occupancy levels.  The Company incurs start-up operating lossesat new facilities until break-even occupancy levels are reached.  Although the Company typically recovers theseupfront costs over the life of the contract, quarterly results can be substantiallyaffected by the timing of the commencement of operations as well as developmentand construction of new facilities.

 

Working capitalrequirements generally increase immediately prior to the Company’s commencingmanagement of a new or expanded facility as the Company incurs start-up costsand purchases necessary equipment and supplies before facility managementrevenue is realized.

 

For the three and ninemonths ended September 30, 2003, the Company incurred pre-opening andstart-up costs of approximately $1.1 million and $1.5 million, respectively,related to the combined pre-opening and start-up operations of the BernalilloRegional Correctional Center, the Jos-Arz Residential Treatment Center 

 

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and the Texas AdolescentCenter.  Revenues attributable tostart-up operations were approximately $567,000 and $621,000 for the three andnine months ended September 30, 2003 and were attributable to the Jos-ArzResidential Treatment Center.  Therewere no pre-opening and start-up expenses for the three and nine months endedSeptember 30, 2002.

 

General andadministrative expenses consist primarily of costs for the Company’s corporateand administrative personnel who provide senior management, finance, accounting,human resources, payroll and information systems, business development andrelated costs of business development and outside professional fees.

 

**New Accounting Pronouncements**

 

The Company implementedStatement of Financial Accounting Standard (“SFAS”) No. 143, SFAS No. 146 andSFAS No. 148 and FIN 45 in the nine months ended September 30, 2003 withno impact on the Company’s reported financial position or results ofoperations.

 

In April 2002, theFASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, 64,Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No.145”), effective for fiscal years beginning after May 15, 2002.  SFAS No. 145 rescinds FASB Statement No. 4,44, 64 and amends SFAS No. 13, “Accounting for Leases,” to eliminate aninconsistency between the required accounting for sale-leaseback transactionsand the required accounting for certain lease modifications that have economiceffects that are similar to sale-leaseback transactions.  Additionally, SFAS No. 145 requires thatgains and losses on the extinguishment of debt to be classified as income orloss from continuing operations rather than as extraordinary items aspreviously required under SFAS No. 4. The Company adopted SFAS No. 145 as required on January 1, 2003 andwill reclassify the extraordinary losses previously reported in the third andfourths quarter of 2001 to a loss from continuing operations in the Company’s2003 Annual Report on Form 10-K.

 

In January 2003, theFASB issued Interpretation No. 46, “Consolidation of Variable InterestEntities” (“FIN 46”), which addresses the consolidation of variable interestentities as defined in the FIN 46.  FIN46 requires an assessment of equity investments to determine if they arevariable interest entities.  FIN 46 iseffective immediately for all variable interest entities created afterJanuary 31, 2003.  For variableinterest entities created before February 1, 2003, the provisions of FIN46 must be applied no later than the quarter ending December 31,2003.   In addition, if it is reasonablypossible that an enterprise will consolidate or disclose information about avariable interest entity, the enterprise must discuss the following informationin all financial statements issued after January 31, 2003: (1) the nature,purpose, size or activities of the variable interest entity and (2) theenterprise’s maximum exposure to loss as a result of its involvement with thevariable interest entity.  The Companywill adopt the provisions of FIN 46 in the quarter ending December 31,2003.  Management does not expect thatthe Company’s adoption of FIN 46 will change the Company’s accounting for the2000 synthetic lease transaction and the 2001 Sale and Leaseback Transaction,which are consolidated for reporting purposes. The Company may enter into future arrangements for the development ofnew facilities or to operate facilities which may become subject to theprovisions of FIN 46 and, in some cases, may be required to consolidate therelated activities, facilities and financings. The FASB continues to address various implementation issues that couldpotentially broaden the application of FIN 46 to entities outside itsoriginally interpreted scope and has issued and proposed several FASB StaffPositions.  The Company does not expectthat these FASB Staff Positions will have a material impact on its financialstatements.

 

In April 2003 theFASB issued SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instrumentsand Hedging Activities” (“SFAS No. 149”). SFAS No. 149 amends and clarifies the accounting for

 

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derivative instruments,including certain derivative instruments embedded in other contracts, and forhedging activities under SFAS No. 133. SFAS No. 149 is effective for contracts entered into or modified afterJune 30, 2003 and for hedging relationships designated after June 30,2003, and should be applied prospectively. The provisions of SFAS No. 149 that relate to SFAS No. 133implementation issues that have been effective for fiscal quarters that beganprior to June 15, 2003 should continue to be applied in accordance withtheir respective effective dates.  Theadoption of SFAS No. 149 had no material impact on the Company’s financialposition or results of operations.

 

In May 2003 the FASBissued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  SFAS No. 150 establishes standards for how an issuer classifiesand measures certain financial instruments with characteristics of bothliabilities and equity in its statements of financial position.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning afterJune 15, 2003 and must be applied prospectively by reporting thecumulative effect of a change in an accounting principle for financialinstruments created before the issuance date of the statement and still existingat the beginning of the interim period of adoption.  The adoption of SFAS No. 150 had no material impact on theCompany’s financial position or results of operations.

 

In May 2003, theEmerging Issues Task Force (“EITF”) reached a consensus on EITF 01-8 “DeterminingWhether an Arrangement Contains a Lease.” EITF 01-8 provides guidance fordetermining whether an arrangement contains a lease that is within the scope ofSFAS No. 13 and is effective for arrangements initiated after the beginning ofthe first interim period beginning after May 28, 2003. The Company adoptedthe provisions of EITF 01-8 as of July 1, 2003 with no material impact onthe Company's financial position or results of operations.

 

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**Results of Operations**

 

The following table setsforth for the periods indicated the percentages of revenue represented bycertain items in the Company’s historical consolidated statements ofoperations:

 
|                                                                                               |   | **Three  Months  Ended September 30,** |   | **Nine  Months  Ended September 30,** |   |
|----------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                               |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                                                                                               |   |                                        |   |                                       |   |   |   |   |   |
| Revenues                                                                                           |   | 100.0                                       | %      | 100.0                                      | %      | 100.0 | % | 100.0 | % |
| Operating  expenses                                                                                |   | 77.9                                        |   | 76.3                                       |   | 77.6 |   | 77.5 |   |
| Pre-opening  and start-up expenses                                                                 |   | 1.5                                         |   | 0.0                                        |   | 0.7 |   | 0.0 |   |
| Depreciation  and amortization                                                                     |   | 3.7                                         |   | 3.8                                        |   | 3.8 |   | 3.5 |   |
| General  and administrative expenses                                                               |   | 7.0                                         |   | 8.4                                        |   | 6.6 |   | 8.3 |   |
| Income  from operations                                                                            |   | 9.9                                         |   | 11.5                                       |   | 11.3 |   | 10.7 |   |
| Interest  expense, net                                                                             |   | 6.2                                         |   | 6.2                                        |   | 6.5 |   | 6.9 |   |
| Minority  interest in losses of consolidated special purpose entities                              |   | 0.0                                         |   | 0.9                                        |   | 0.0 |   | 0.2 |   |
| Income  before provision for income taxes and cumulative effect of change in  accounting principle |   | 3.7                                         |   | 4.4                                        |   | 4.8 |   | 3.6 |   |
| Provision  for income taxes                                                                        |   | 1.5                                         |   | 1.8                                        |   | 1.9 |   | 1.5 |   |
| Income  before cumulative effect of change in accounting principle                                 |   | 2.2                                         | %      | 2.6                                        | %      | 2.9 | % | 2.1 | % |

 

*Three Months Ended September 30, 2003 Compared to ThreeMonths Ended September 30, 2002*

 

Certain comparisons ofrevenue, expenses and average contract capacity contained herein have been madeexcluding the effect of the Company’s recently closed New Morgan Academy,pre-opening and start-up expenses and revenue and certain general andadministrative expenses, as management believes such comparison increases thereader’s understanding of operating trends.

 

*Revenues*.  Revenues decreased 1.4% to $68.6 million forthe three months ended September 30, 2003 from $69.6 million for the threemonths ended September 30, 2002.

 

Adult secureinstitutional division revenues increased 4.4% to $25.8 million for the threemonths ended September 30, 2003 from $24.7 million for the three monthsended September 30, 2002 due primarily to increased occupancy at the Bakerand Leo Chesney Community Correctional Facilities.  Due to the expected closure of the Baker and  Leo Chesney facilities as of June 30,2002, occupancy decreased significantly in the second quarter of 2002.  Subsequently, the state approved thecontinued use of the facilities and a new contract was obtained for bothfacilities.  Occupancy began ramping upin the third quarter of 2002 but had not reached contract capacity levels untillate in the fourth quarter of 2002.  Forthe three months ended September 30, 2003, both facilities were operatingat contract capacity levels.  Revenuesattributable to the Baker and Leo Chesney facilities were approximately $1.9million for the three months ended September 30, 2003 compared to $980,000for the three months ended September 30, 2002.  The remaining increase in revenue was due to increased occupancyat the Big Spring Complex.  Averagecontract occupancy was 99.6% for the three months ended September 30, 2003compared to 95.2% for the three months ended September 30, 2002. Therewere no revenues attributable to start-up operations for the three months endedSeptember 30, 2003 and 2002.  TheCompany has noted increasing pressure from state and local governments to limitincreases or even reduce per diem rates. Many of these governmental entities are under severe budget pressuresand the Company anticipates that more of these governmental entities willapproach the Company 

 

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about per diemconcessions.

 

Juvenile divisionrevenues decreased 7.1% to $30.0 million for the three months endedSeptember 30, 2003 from $32.2 million for the three months ended September 30,2002 due primarily to the closure of the New Morgan Academy in the fourthquarter of 2002 offset, in part, by an increase in revenue due to theacquisition of the Jos-Arz Residential Treatment Center management contract inJune 2003 as well as increased occupancy and service hours at variousjuvenile facilities and programs.  Theclosure of the New Morgan Academy decreased revenues by approximately $3.6million in the third quarter of 2003 as compared to the same quarter of2002.  This decrease was offset by a netincrease in revenue of approximately $1.3 million as a result of theacquisition of the Jos-Arz Residential Treatment Center management contract inJune 2003 and increased occupancy at various facilities and programsincluding the Alexander Youth Center, Dauphin Mental Health, the LeadershipDevelopment Program (“LDP”) and the Abraxas Center for Adolescent Females(“ACAF”).  Revenues attributable tostart-up operations were approximately $567,000 for the three months endedSeptember 30, 2003 and were attributable solely to the Jos-Arz ResidentialTreatment Center.  Average contractoccupancy for the three months ended September 30, 2003 was 90.6% comparedto 88.1% for the three months ended September 30, 2002.  Excluding the occupancy and contractcapacity for the New Morgan Academy in 2002 and 2003 and the start-upactivities of the Jos-Arz Residential Treatment Center in 2003, averagecontract occupancy for the three months ended September 30, 2003 was 93.8%compared to 92.9% for the three months ended September 30, 2002.

 

Pre-release divisionrevenues increased 1.7% to $12.9 million for the three months endedSeptember 30, 2003 from $12.7 million for the three months endedSeptember 30, 2002 due to overall increased occupancy throughout the divisionoffset, in part, by a decrease in revenue as a result of the termination of theInglewood Men’s Center contract as of June 30, 2003.   Revenues attributable to the InglewoodMen’s Center were approximately $207,000 for the three months ended September 30,2002.  Average contract occupancy was112.0% for the three months ended September 30, 2003 compared to 110.6%for the three months ended September 30, 2002.

 

*Operating Expenses.*  Operating expenses increased 0.7% to $53.5million for the three months ended September 30, 2003 from $53.1 millionfor the three months ended September 30, 2002.

 

Adult secureinstitutional division operating expenses increased 8.6% to $18.8 million forthe three months ended September 30, 2003 from $17.3 million for the threemonths ended September 30, 2002 due primarily to increased staffing andother services as a result of the higher occupancy levels at the BakerCommunity Correctional Facility, Leo Chesney Community Correctional Facilityand the Big Spring Complex in the three months ended September 30, 2003 ascompared to the same period of prior year. Due to the expected closure of the Baker and  Leo Chesney facilities as of June 30, 2002, occupancydecreased significantly in the second quarter of 2002.  Subsequently, the state approved thecontinued use of the facilities and a new contract was obtained for bothfacilities.  Occupancy began ramping upin the third quarter of 2002 but had not reached contract capacity levels untillate in the fourth quarter of 2002.  Forthe three months ended September 30, 2003, both facilities were operatingat contract capacity levels.  Operatingexpenses attributable to the Baker and Leo Chesney facilities wereapproximately $1.6 million for the three months ended September 30, 2003compared to approximately $670,000 for the same period of 2002.  As a percentage of segment revenues, adultsecure institutional division operating expenses were 73.0% for the threemonths ended September 30, 2003 compared to 70.1% for the three months endedSeptember 30, 2002.  The decreasein the 2003 operating margin is due primarily to an increase in employeeinsurance costs incurred under the Company’s self-insured plans and to legalcosts at a certain secure facility. Additionally, the margin was unfavorably impacted by a per diem ratereduction at the Great Plains Correctional Facility.

 

Juvenile divisionoperating expenses decreased 4.3% to $25.3 million for the three months ended 

 

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September 30, 2003from $26.5 million for the three months ended September 30, 2002 due toprimarily to the closure of the New Morgan Academy in the fourth quarter of2002.  Operating expenses for the NewMorgan Academy were approximately $560,000 for the three months endedSeptember 30, 2003 compared to $3.1 million for the three months endedSeptember 30, 2002.  Excluding theNew Morgan Academy’s operating expenses in both periods, juvenile divisionoperating expenses increased 5.7%, or $1.3 million, due to increased staffingand other services as a result of increased occupancy at various facilities andprograms including the Alexander Youth Center, Dauphin Mental Health, LDP andACAF.  Excluding start-up operations in2003 and the operations of the New Morgan Academy in both periods, juveniledivision operating expenses, as a percentage of segment revenues, were 82.9%and 81.3% for the three months ended September 30, 2003 and 2002.  The 2003 operating margin was unfavorablyimpacted by an increase in employee insurance costs as previouslydiscussed.  Additionally, the operatingmargin was unfavorably impacted due to the lack of mid-year rate increases.

 

Pre-release divisionoperating expenses increased 3.5% to $9.7 million for the three months endedSeptember 30, 2003 from $9.4 million for the three months endedSeptember 30, 2002.  As apercentage of revenues, operating expenses were 75.7% for the three monthsended September 30, 2003 compared to 74.4% for the three months endedSeptember 30, 2002.  The decreasein the 2003 operating margin was due to an increase in employee insurance costsas previously discussed, as well as per diem rate reductions at certainpre-release facilities.

 

*Pre-Opening and Start-up Expenses.*  Pre-opening and start-up expenses for thethree months ended September 30, 2003 were approximately $1.1 million andrelated to the pre-opening and start-up operations of the Bernalillo RegionalCorrectional Center, the Texas Adolescent Center and the Jos-Arz ResidentialTreatment Center.

 

*Depreciation and Amortization*.  Depreciation and amortization was $2.5million for the three months ended September 30, 2003 compared to $2.7million for the three months ended September 30, 2002.  The decrease in depreciation andamortization expense was primarily due to certain fully depreciated assets  offset, in part, by current year propertyand equipment purchases.  Amortizationof intangibles was approximately $220,000 for the three months endedSeptember 30, 2003 and 2002.

 

*General and Administrative Expenses.*  General and administrative expensesdecreased 17.4% to $4.8 million for the three months ended September 30,2003 from $5.8 million for the three months ended September 30, 2002.  Included in general and administrativeexpenses for the three months ended September 30, 2002 was a charge ofapproximately $1.3 million for the settlement of a management contract with theCompany’s former president who resigned his position inSeptember 2002.  Excluding the abovecharge from the 2002 period, general and administrative expenses increased 7.1%from the same period of the prior year. The increase was primarily due to professional fees associated withincreased business development.

 

*Interest.*  Interest expense, net of interest income,decreased to $4.2 million for the three months ended September 30, 2003from $4.3 million for the three months ended September 30, 2002.  The decrease was primarily due to areduction in MCF’s bonds payable as a result of an annual principal payment of$7.6 million on July 31, 2003.  Capitalizedinterest for the three months ended September 30, 2003 and 2002 wasapproximately $183,000 and $210,000, respectively, and related to the MoshannonValley Correctional Center.

 

*Minority Interest in ConsolidatedSpecial Purpose Entities*. The cumulative losses of MCF exceeded the recorded minority interest ofMCF during the first quarter of 2002. The cumulative losses of the Synthetic Lease Investor exceeded therecorded minority interest of the Synthetic Lease Investor during the thirdquarter of 2001.  Since the cumulativelosses of MCF and the Synthetic Lease Investor exceed the equity 

 

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which was recorded asminority interest by the Company, the excess losses can no longer be allocatedto minority interest in 2002 in the Company’s Consolidated Statements ofOperations in 2002.  As a result, futureexcess losses related to MCF and the Synthetic Lease Investor’s Interests willbe reflected in the Company’s Consolidated Statements of Operations.  For the three months endedSeptember 30, 2002, the Company recorded a charge of approximately $0.6million as a result of a distribution made by MCF to its equity investors.

 

*Income Taxes.*  For the three months endedSeptember 30, 2003 and 2002, the Company recognized a provision for incometaxes at an estimated effective rate of 41.0%.

 

*Nine Months Ended September 30, 2003 Compared to NineMonths Ended September 30, 2002*

 

Certain comparisons ofrevenue, expenses and average contract capacity contained herein have been madeexcluding the effect of the Company’s recently closed New Morgan Academy,pre-opening and start-up expenses and revenue, an accounts receivable allowancecharge in the pre-release segment and certain general and administrativeexpenses, as management believes such comparison increases the reader’sunderstanding of operating trends.

 

*Revenues*.  Revenues decreased 2.4% to $202.3 millionfor the nine months ended September 30, 2003 from $207.2 million for thenine months ended September 30, 2002.

 

Adult secureinstitutional division revenues increased 3.8% to $76.5 million for the ninemonths ended September 30, 2003 from $73.7 million for the nine monthsended September 30, 2002 due primarily to increased occupancy at the BakerCommunity Correctional Facility, Leo Chesney Community Correctional Facilityand the Big Spring Complex.  In the ninemonths ended September 30, 2002, the Baker and Leo Chesney facilities hada significant reduction in occupancy as these facilities were preparing for potentialclosure in June 2002.  Thesecontracts were subsequently renewed and the facilities began ramping upoccupancy in the third quarter of 2002 but had not reached contract capacitylevels until late in the fourth quarter of 2002.  For the nine months ended September 30, 2003 occupancy atthese two facilities was at contract capacity levels.  Revenues attributable to the Baker and Leo Chesney CommunityCorrectional Centers were approximately $5.6 million in the nine months endedSeptember 30, 2003 compared to $4.0 million in the nine months endedSeptember 30, 2002.  There were norevenues attributable to start-up operations for the nine months endedSeptember 30, 2003 and 2002. Average contract occupancy was 99.1% for the nine months endedSeptember 30, 2003 compared to 96.8% for the nine months endedSeptember 30, 2002. The Company has noted increasing pressure from stateand local governments to limit increases or even reduce per diem rates.  Many of these governmental entities areunder severe budget pressures and the Company anticipates that more of thesegovernmental entities will approach the Company about per diem concessions.

 

Juvenile divisionrevenues decreased 8.2% to $88.0 million for the nine months endedSeptember 30, 2003 from $95.8 million for the nine months endedSeptember 30, 2002 due primarily to the closure of the New Morgan Academyin the fourth quarter of 2002 offset, in part, by an increase in revenue due tothe acquisition of the Jos-Arz Residential Treatment Center management contractin June 2003 and increased occupancy and service hours at various juvenilefacilities and programs.  Revenuesattributable to the New Morgan Academy were $26,000 in the nine months endedSeptember 30, 2003 as compared to $12.9 million in the nine months endedSeptember 30, 2002. This decrease was offset by a net increase in revenueof approximately $5.1 million as a result of the acquisition of the Jos-ArzResidential Treatment Center management contract in June 2003 and improvedoccupancy and service hours at various facilities including the Alexander YouthCenter, Cornell Abraxas 1 (“A-1”), ACAF, Dauphin Mental Health and the GriffinJuvenile Facility.  Revenuesattributable to start-up operations were approximately $621,000 for the nine

 

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months endedSeptember 30, 2003 and were attributable to the start-up operations of theJos-Arz Residential Treatment Center. Average contract occupancy for the nine months ended September 30,2003 was 91.3% compared to 90.1% for the nine months ended September 30,2002.  Excluding the occupancy andcontract capacity for the New Morgan Academy in 2002 and 2003 and the start-upactivities of the Jos-Arz Residential Treatment Center in 2003, averagecontract occupancy for the nine months ended September 30, 2003 was 92.7%compared to 92.5% for the nine months ended September 30, 2002.

 

Pre-release divisionrevenues increased 0.4% to $37.8 million for the nine months endedSeptember 30, 2003 from $37.7 million for the nine months endedSeptember 30, 2002 due to overall improved occupancy throughout thedivision offset, in part, by the termination of the Santa Barbara Centercontract in March 2003 and the Inglewood Men’s Center contract inJune 2003.  Revenues attributableto these two facilities were approximately $366,000 and $910,000 for the ninemonths ended September 30, 2003 and 2002. There were no revenues attributable to start-up operations for the ninemonths ended September 30, 2003 and 2002. Average contract occupancy was 110.6% for the nine months endedSeptember 30, 2003 compared to 109.1% for the nine months endedSeptember 30, 2002.

 

*Operating Expenses.*  Operating expenses decreased 2.2% to $156.9million for the nine months ended September 30, 2003 from $160.5 millionfor the nine months ended September 30, 2002.

 

Adult secureinstitutional division operating expenses increased 3.9% to $54.2 million forthe nine months ended September 30, 2003 from $52.2 million for the ninemonths ended September 30, 2002 due primarily to increased staffing andother services due to increased occupancy at the Baker Community CorrectionalFacility, Leo Chesney Community Correctional Facility and the Big SpringComplex.  As a percentage of segmentrevenues, adult secure institutional division operating expenses were 70.9% forthe nine months ended September 30, 2003 compared to 70.8% for the ninemonths ended September 30, 2002.

 

Juvenile divisionoperating expenses decreased 6.6% to $74.8 million for the nine months ended September 30,2003 from $80.1 million for the nine months ended September 30, 2002 dueprimarily to the closure of the New Morgan Academy in the fourth quarter of2002 offset, in part, by increased occupancy and service hours at variousjuvenile facilities.  Operating expensesfor the New Morgan Academy were approximately $1.4 million in the nine monthsended September 30, 2003 compared to $10.9 million in the nine monthsended September 30, 2002. Excluding the New Morgan Academy’s operating expenses in both periods,juvenile division operating expenses increased 6.2%, or $4.3 million, due toincreased staffing and other services as a result of increased occupancy andservice hours at various facilities and programs including the Alexander YouthCenter, A-1, ACAF, Dauphin Mental Health, and the Griffin JuvenileFacility.  Excluding start-up operationsin 2003 and the operations of the New Morgan Academy in 2003 and 2002, juveniledivision operating expenses, as a percentage of segment revenues, were 83.6% and83.5%, respectively.

 

Pre-release divisionoperating expenses increased 3.0% to $28.9 million for the nine months endedSeptember 30, 2003 from $28.1 million for the nine months endedSeptember 30, 2002 due primarily to increased staffing and other services due to increased occupancythroughout the division offset, in part, by a decrease in expenses as a resultof the termination of the Santa Barbara contract in March 2003 and theInglewood Men’s Center contract in June 2003.  Operating expenses for these two facilities were approximately$522,000 for the nine months ended September 30, 2003 compared to $900,000for the same period of 2002.  As apercentage of segment revenues, operating expenses were 76.5% for the ninemonths ended September 30, 2003 compared to 74.6% for the nine monthsended September 30, 2002.  Thedecline in the 2003 operating margin was due primarily to increased employeeinsurance costs under the Company’s self-insured plan, increased legal andprofessional expenses at certain facilities and a charge to bad debt expense ofapproximately $230,000 to provide allowance for certain insurance and medicaidreceivables in 

 

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the nine months endedSeptember 30, 2003.

 

*Pre-Opening and Start-up Expenses.*  Pre-opening and start-up expenses for thenine months ended September 30, 2003 were approximately $1.5 million andwere attributable to the pre-opening and start-up operations of the BernalilloRegional Correctional Center, the Texas Adolescent Center and the Jos-ArzResidential Treatment Center.  Therewere no pre-opening and start-up expenses for the nine months endedSeptember 30, 2002.

 

*Depreciation and Amortization*.  Depreciation and amortization was $7.7million for the nine months ended September 30, 2003 compared to $7.3million for the nine months ended September 30, 2002.  The increase in depreciation andamortization expense was due to depreciation and amortization related tocurrent year property and equipment purchases. Amortization of intangibles was approximately $659,000 for the ninemonths ended September 30, 2003 and 2002.

 

*General and Administrative Expenses.*  General and administrative expensesdecreased 22.0% to $13.4 million for the nine months ended September 30,2003 from $17.2 million for the nine months ended September 30, 2002.  Included in the general and administrativeexpenses for the nine months ended September 30, 2003 were costs ofapproximately $580,000 for site acquisition costs and legal expenses primarilyassociated with the Company’s increased development activity and a chargerelated to the deferred compensation plan. General and administrative expenses for the nine months endedSeptember 30, 2002 included (1) a charge of approximately $1.9 million forlegal and professional fees related to the special committee review andrestatement of the Company’s financial statements and for defense of theCompany’s shareholder litigation, (2) a charge of approximately $1.0 millionfor the write-off of deferred project financing costs associated with the BOPSoutheast project and (3) a charge of approximately $1.3 million for thesettlement of a management contract with the Company’s former president whoresigned his position in September 2002. Excluding the above charges from the applicable 2003 and 2002 periods,general and administrative expenses decreased 1.3% from the same period of theprior year due primarily to cost management strategies implemented bymanagement in late 2002.  The majorityof these savings were realized from a reduction in personnel and relatedcosts.  Management expects general andadministrative expenses to increase over the remaining quarter of 2003 ascertain open positions are filled and professional and other costs are incurredrelated to compliance with the Sarbanes-Oxley Act of 2002.

 

*Interest.*  Interest expense, net of interest income,decreased to $13.2 million for the nine months ended September 30, 2003from $14.2 million for the nine months ended September 30, 2002.  For the nine months ended September 30,2002, interest expense includes approximately $825,000 for lenders’ fees andrelated professional fees incurred to obtain certain waivers and amendments tothe Company’s credit agreement obtained in conjunction with the restatement ofthe Company’s financial statements. Additionally, interest expense decreased as a result of a reduction inthe MCF bond payable due to an annual principal payment of $7.6 million onJuly 31, 2003.  Capitalizedinterest for the nine months ended September 30, 2003 and 2002 wasapproximately $567,000 and $619,000, respectively, and related to the MoshannonValley Correctional Center.

 

*Minority Interest in ConsolidatedSpecial Purpose Entities*. The cumulative losses of MCF exceeded the recorded minority interest ofMCF during the first quarter of 2002. The cumulative losses of the Synthetic Lease Investor exceeded therecorded minority interest of the Synthetic Lease Investor during the thirdquarter of 2001.  Since the cumulativelosses of MCF and the Synthetic Lease Investor exceed the equity that wasrecorded as minority interest by the Company, the excess losses can no longerbe allocated to the minority interest in the Company’s Consolidated Statementsof Operations in 2002.  In the ninemonths ended September 30, 2002, the Company recorded a charge ofapproximately $0.6 million as a result of a distribution made by MCF to itsequity investors.

 

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*Income Taxes.*  For the nine months ended September 30,2003 and 2002, the Company recognized a provision for income taxes at anestimated effective rate of 41.0%.

 

*Cumulative Effect of Change inAccounting Principle.* The Company recorded a cumulative effect of a change in accountingprinciple charge of $965,000, net of tax, in the nine months endedSeptember 30, 2002 related to the impairment of certain goodwill thatarose from an acquisition made in November 1999.

 

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**Liquidity and Capital Resources**

 

*General*.  The Company’s primary capital requirementshave generally been and are expected to be for (1) construction or purchase ofnew facilities, (2) expansions of existing facilities, (3) working capital, (4)pre-opening and start-up costs related to new operating contracts, (5)acquisitions, and (6) information systems hardware and software.  Working capital requirements generallyincrease immediately prior to the Company commencing management of a newfacility as the Company incurs start-up costs and purchases necessary equipmentand supplies before facility management revenue is realized.

 

*Contractual Obligations andCommercial Commitments*. The Company has assumed various financial obligations and commitments inthe ordinary course of conducting its business.  The Company has contractual obligations requiring future cashpayments under its existing contractual arrangements, such as management,consultative and non-competition agreements.

 

The Company maintainsoperating leases in the ordinary course of its business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthe agreements vary from 2003 until 2075. As of September 30, 2003, the Company’s total commitment underthese operating leases was approximately $40.8 million.

 

The following table details the Company’s known futurecash payments (on an undiscounted basis) related to various contractualobligations as of September 30, 2003 (in thousands):

 
|                                                  |   | **Payments  Due by Period** |    |
|-------------------------------------------------------|--------|-----------------------------|---------|
|                                                  |   | **Total**                   |    | **Remainder  of  2003** | ** ** | **2004 -  2005** | ** ** | **2006 -  2007** | ** ** | **Thereafter** | ** ** |
|                                                  |   |                        |    |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                             |   |                        |    |   |   |   |   |   |   |   |   |
| Long-term  debt                                       |   |                        |    |   |   |   |   |   |   |   |   |
| -  MCF Bonds                                          |   | $                           | 183,000 |   | $ | — |   | $ | 17,300 |   | $ | 20,200 |   | $ | 145,500 |   |
| -  Synthetic Lease Investor  Notes A and B            |   | 49,894                      |    | — |   | 49,894 |   | — |   | — |   |
| -  Cornell Companies, Inc.  Revolving Line of Credit  |   | 10,000                      |    | — |   | 10,000 |   | — |   | — |   |
| Capital  lease obligations  - Cornell Companies, Inc. |   | 12                          |    | 12 |   | — |   | — |   | — |   |
|                                                  |   |                        |    |   |   |   |   |   |   |   |   |
| Operating  leases                                     |   | 40,755                      |    | 1,578 |   | 8,635 |   | 6,524 |   | 24,018 |   |
| Consultative  and non-competition agreements          |   | 1,100                       |    | 105 |   | 720 |   | 275 |   | — |   |
| Total  contractual cash obligations                   |   | $                           | 284,761 |   | $ | 1,695 |   | $ | 86,549 |   | $ | 26,999 |   | $ | 169,518 |   |

 

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The Company enters into letters of credit in theordinary course of its operating and financing activities.  As of September 30, 2003, the Companyhad outstanding letters of credit of $5.1 million related to insurance andother operating activities.  Thefollowing table details the Company’s letter of credit commitments as ofSeptember 30, 2003 (in thousands):

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

 

*Long-Term Credit Facilities.*The Company’s 2000 Credit Facility, as amended, has two components - arevolving credit facility and a synthetic lease.  The credit facility includes the following characteristics,several of which are discussed in more detail in the Notes to the table below:

 

(i)                                     providesfor borrowings of up to $37.0 million(1) at September 30, 2003 under arevolving line of credit;

 

(ii)                                  maturesin July 2005;

 

(iii)                               bearsinterest, at the election of the Company, at either the prime rate plus amargin of 2.0%, or a rate which is 3.0% above the applicable LIBOR rate;

 

(iv)                              iscollateralized by substantially all of the Company’s assets, including the stockof all of the Company’s subsidiaries;

 

(v)                                 doesnot permit the payment of cash dividends;

 

(vi)                              requiresthe Company to comply with certain leverage, net worth and debt servicecoverage covenants(2);

 

(vii)                           limitsthe Company’s ability to repurchase its common stock(3); and

 

(viii)                        restrictsthe Company’s ability to use cash that serves as part of the collateral forthe  loan(4).

 

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(1)           Originally $45.0million, the maximum loan amount has been reduced quarterly as scheduled and isfurther reduced by outstanding letters of credit ($5.1 million atSeptember 30, 2003). As of September 30, 2003, the Company hadoutstanding borrowings of $10 .0 million and $21.9 million of remainingavailable commitment under its revolving line of credit.

 

(2)           Due to the consolidation, forfinancial reporting purposes, of MCF as of August 14, 2001, the Companywas not in compliance with certain leverage ratio covenants.  On April 5, 2002, the 2000 CreditFacility was amended to waive such non-compliance and to revise the covenantsto levels that accommodate the Company’s consolidation of special purposeentities in its financial statements. As a result of this waiver and amendment, the Company recognized apre-tax charge to interest expense of approximately $825,000 during the firstquarter of 2002 for lender and other professional fees.

 

Additionally, the Company has obtained a waiver from the lenders underthe amended 2000 Credit Facility regarding the pending contractual default forthe Moshannon Valley Correctional Center’s construction delay (see Note7).  This waiver is effective throughOctober 31, 2004.

 

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(3)                 TheCompany is limited to $2.5 million annually for the repurchase of its commonstock with an aggregate limit of $7.5 million.

 

(4)                 Includedin the Company’s cash and cash equivalents at September 30, 2003 isapproximately $39.7 million that is invested in a separate account that isavailable to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  The lenders could limit the Company’sability to use such funds.  Thisseparate account is maintained, in part, to assure future credit availability.

 

Additionally, the amended2000 Credit Facility provides the Company with the ability to enter intosynthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $96.5 million, of which approximately $51.7 million had beenutilized as of September 30, 2003. The Company pays commitment fees at a rate of 0.5% annually for theunused portion of the synthetic lease financing capacity.

 

The synthetic leasefinancing arrangement includes a component of equity capitalization equal to3.5% of the aggregate projects’ costs that is funded by the owner/lessor of theproperties (“Synthetic Lease Investor”). The Synthetic Lease Investor’s equity investment was reported as minorityinterest in consolidated special purpose entities in the Company’s consolidatedfinancial statements.  The cumulativelosses of the Synthetic Lease Investor exceeded the recorded minority interestof the Synthetic Lease Investor in 2001, therefore there is currently nominority interest balance as of September 30, 2003.  Upon a refinancing or extinguishment of the synthetic leaseobligations the Company will incur a charge to the extent of the amount of theSynthetic Lease Investor’s equity investment.  As of September 30, 2003, the amount of the Synthetic LeaseInvestor’s equity investment was approximately $1.8 million.

 

*Cash Flows From OperatingActivities.*  Cashflows provided by operating activities were approximately $8.6 million for thenine months ended September 30, 2003 compared to approximately $0.3million for the nine months ended September 30, 2002.  The increase is primarily attributable toincreased earnings and working capital changes.

 

*Cash Flows From Investing Activities*.  Cash used in investing activities wasapproximately $25.4 million for the nine months ended September 30, 2003and included capital expenditures of approximately $15.6 million that includedthe repurchase of furniture, fixtures and equipment under the 1999 Sale and LeasebackTransaction, the purchase and renovation of the Texas Adolescent Center,various facility improvements and/or expansions, information technology andsoftware development costs. Additionally, the Company funded $12.9 million into an escrow account forthe purchase price of the real property for the Southern Peaks RegionalTreatment Center and made a deposit of $1.0 million into an escrow account fora non-compete agreement related to the Jos-Arz Residential Treatment Centermanagement contract.  There were cashinflows of $4.2 million for amounts withdrawn from the restricted debt paymentaccount for debt service payments on the MCF Bonds, net of deposit payments tothe restricted debt payment account. Cash used in investing activities was approximately $4.3 million for thenine months ended September 30, 2002 primarily due to capital expendituresof approximately $9.3 million offset, in part, by amounts withdrawn from therestricted debt payment account for debt service payments on the MCF Bonds, netof borrowings under the revolving line of credit net of deposit payments to therestricted debt payment account.

 

*Cash Flows From Financing Activities*.  Cash provided by financing activities wasapproximately $4.6 million for the nine months ended September 30, 2003due primarily to net proceeds from borrowings under the revolving line ofcredit of approximately $10.0 million and proceeds from stock option exercisesof  approximately $2.4 million offset,in part, by repayment of $7.6 million of MCF Bond principal and purchases ofapproximately $0.7 million of treasury shares. Cash used in the financing activities for the nine months endedSeptember 30, 2002 was approximately $6.7 million due primarily to repaymentof $6.8

 

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million of MCF Bondprincipal and proceeds from stock option exercises of approximately $0.8million offset, in part, by cash used for treasury stock purchases of $1.4million.

 

*Treasury Stock/Repurchases.*  As of January 1, 2003, the Companycould purchase approximately $2.1 million of its common stock as permittedunder the terms of the amended 2000 Credit Facility.  The Company purchased in the open market 67,500 shares of itscommon stock for approximately $0.7 million during the nine months endedSeptember 30, 2003.  Accordingly,the Company can purchase approximately $1.4 million of shares during theremaining term of the amended 2000 Credit Facility.

 

*New Morgan Academy.*  The Company closed the New Morgan Academy inthe fourth quarter of 2002 and is currently considering several options rangingfrom the sale or lease of the facility to utilization of the facility foranother type of program.  The Company isusing a small staff to maintain the facility while the Company considers its optionsfor the use of the facility.

 

The carrying value of theproperty and equipment at the New Morgan Academy was approximately $30.7million at September 30, 2003. Currently, management of the Company believes that its long-lived assetsat the New Morgan Academy are recoverable either from the cash flows of analternative program operating at the facility or upon the sale or lease of thefacility to a third party, and accordingly, pursuant to the provisions of SFASNo. 144, an impairment provision is not deemed necessary as ofSeptember 30, 2003.  However,management estimates that, were the Company to sell the facility, it isreasonably possible that the Company may not be able to fully recover thecarrying value of its long-lived assets for this facility.

 

*New Facilities and Project UnderDevelopment.*  InJanuary 2003, the Company executed a five year lease for the BernalilloRegional Correctional Center in Albuquerque, New Mexico.  The facility, which has been vacated by theCounty in favor of a new jail, is expected to be remodeled by the Company andused to provide adult secure confinement for a wide array of governmentagencies that have demonstrated a need for additional bed space.  The facility added approximately 1,000 bedsto the Company’s current service capacity. The lease was approved by the New Mexico State Board of Finance inOctober 2003 and requires monthly rental payments of approximately$113,000 for the first four years of the lease and $130,000 for the last yearof the lease.

 

In May 2003, theCompany acquired a building in San Antonio, Texas for approximately $2.1million in cash.  The Company renovatedthis 121 bed residential juvenile facility called the Texas Adolescent Centerat a cost of approximately $2.0 million and the facility became operational inthe fourth quarter of 2003.

 

In June 2003, theCompany entered into an agreement with a developer to purchase a 160 bedresidential treatment center for juveniles upon completion of construction ofthe facility by the developer.  Thisfacility is named the Southern Peaks Regional Treatment Center and is locatednear Canon City, Colorado.  InAugust 2003, the Company funded $12.9 million into an escrow account forthe purchase price of the real property.

 

In March 2003, theCompany reached an agreement with the Commonwealth of Pennsylvania thatresolved all outstanding administrative issues relative to the contract awardedto the Company by the Federal Bureau of Prisons (“BOP”) to operate theMoshannon Valley Correctional Center. In October 2003, the Company received final approval from the BOPof a revised building design for the Moshannon Valley Correctional Center.  Construction plans are being developed forthe new design

 

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and work is expected tobegin in early spring 2004.  In theinterim, the Company will negotiate a contract amendment with the BOP that willaccommodate the revised facility design, and update the contract for changessince it was orignially signed.  If andwhen an amendment to the contract with the BOP is negotiated, this agreementwill allow the Company to move forward with the construction and operation ofthe facility.

 

As of September 30,2003, the Company had incurred approximately $16.8 million for construction andland development costs and capitalized interest related to the Moshannon ValleyCorrectional Center contract.  TheCompany is in the process of submitting a claim to the BOP for reimbursementcosts related to the original construction efforts incurred beginning in1999.  The Company estimates additionalcapital investment of approximately $74 million to complete construction of thefacility, which amount does not include the amount of prior construction coststo be reimbursed by the BOP which are yet to be determined.  Financing of the facility is subject tore-approval of the project by the lenders under the Company’s amended 2000Credit Facility and agreement by such lenders to amend certain financial covenantsand provisions of the amended 2000 Credit Facility.  In the event the Company’s lenders are unwilling to re-approvethe project or to adopt the necessary amendments, or if the Company’s cash andcurrent financing arrangements do not provide sufficient financing to fundconstruction costs related to the project, the Company anticipates needing toobtain additional sources of financing.

 

According to the BOPcontract, as amended, the Company is required to complete the construction ofthe project by January 15, 2004. The Company does not anticipate completing construction by that date andanticipates obtaining another long-term contract amendment from the BOPextending the construction deadline.  Inthe event the Company is not able to negotiate a contract amendment with theBOP, then the BOP may have the right to assert that the Company has notcompleted construction of the facility within the time frame provided in theBOP contract, as amended.  Managementexpects that the contract will be amended to address cost and constructiontiming matters resulting from the extended delay.  In the event that the BOP decides not to continue with theconstruction of the Moshannon Valley Correctional Center and terminates thecontract, management believes that the Company has the right to and willrecover its invested costs.  In theevent any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs would be expensed.

 

At September 30,2003, accounts receivable include costs totaling approximately $1.4 million fordirect costs incurred by the Company since the issuance of the Stop-Work Orderin June 1999 for payroll and other operating costs related to theMoshannon Valley Correctional Center. These costs were incurred with the understanding that such costs wouldbe reimbursed by the BOP.  Although noformal written agreement exists, management believes that these costs will bereimbursed by the BOP in the near term. In the event any portion of these costs are not reimbursed, such costswill be expensed in the period such determination is made.

 

*Future Liquidity*.  Management believes that the Company’s cashand the cash flows generated from operations, together with the creditavailable under the amended 2000 Credit Facility and the operating leasecapacity thereunder, will provide sufficient liquidity to meet the Company’scapital and working capital requirements for its committed development projectsand currently awarded contracts.  To theextent the Company’s cash and current financing arrangements do not providesufficient financing to fund costs related to future contract awards,acquisitions or significant facility expansions, the Company anticipatesobtaining additional sources of financing to fund such activities.  However, there can be no assurance that suchfinancing will be available or will be available on terms favorable to theCompany.

 

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**ITEM 3.****                   Quantitativeand Qualitative Disclosures about Market Risk**

 

In the normal course ofbusiness, the Company is exposed to market risk, primarily from changes ininterest rates.  The Company continuallymonitors exposure to market risk and develops appropriate strategies to managethis risk.  The Company is not exposedto any other significant market risks, including commodity price risk, foreigncurrency exchange risk or interest rate risks from the use of derivativefinancial instruments.  Management doesnot use derivative financial instruments for trading or to speculate on changesin interest rates or commodity prices.

 

**Interest Rate Exposure**

 

The Company’s exposure tochanges in interest rates primarily results from its long-term debt with bothfixed and floating interest rates.  Thedebt on the Company’s consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction.  At September 30, 2003, approximately24.7% ($59.9 million of debt outstanding to the Synthetic Lease Investor andthe amended 2000 Credit Facility) of the Company’s consolidated long-term debtwas subject to variable interest rates. The detrimental effect of a hypothetical 100 basis point increase ininterest rates would be to reduce income before provision for income taxes byapproximately $150,000 and $450,000 for the three and nine months endedSeptember 30, 2003.  AtSeptember 30, 2003, the fair value of the Company’s consolidated fixedrate debt approximated carrying value based upon discounted future cash flowsusing current market prices.

 

**Forward Looking Statement Disclaimer**

 

This quarterly report onForm 10-Q contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements are based on currentplans and actual future activities and results of operations may be materiallydifferent from those set forth in the forward-looking statements. Importantfactors that could cause actual results to differ include, among others, (1)the outcomes of pending putative class action shareholder and derivativelawsuits, and related insurance coverage, (2) the outcome of the pending SECinvestigation, (3) risks associated with acquisitions and the integrationthereof (including the ability to achieve administrative and operating costsavings and anticipated synergies), (4) the timing and costs of the opening ofnew programs and facilities or the expansions of existing facilities, (5)changes in governmental policy and/or funding to discontinue or not renewexisting arrangements or to eliminate or discourage the privatization ofcorrectional, detention and pre-release services in the United States, (6) theavailability of debt and equity financing on terms that are favorable to theCompany, (7) fluctuations in operating results because of occupancy,competition (including competition from two competitors that are substantiallylarger than the Company), increases in cost of operations, fluctuations ininterest rates and risks of operations, (8) significant charges to expense ofdeferred costs associated with financing and other projects in development ifmanagement determines that one or more of such projects is unlikely to besuccessfully concluded, (9) results from alternative deployment or sale offacilities such as the New Morgan Academy and (10) the Company’s ability tonegotiate a contract amendment with the BOP related to the Moshannon ValleyCorrectional Center.

 

**ITEM 4.****                   Controlsand Procedures**

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we have evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”) and as required by paragraph (b) of Rules 13a-15and 15d-15(e) of the Exchange Act, as of the end of our third fiscal quarter of2003.  Based on that evaluation, our

 

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principal executiveofficer and principal financial officer have concluded that these controls andprocedures are effective as of that date.

 

Disclosure controls andprocedures are our controls and other procedures that are designed to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reported,within the time periods specified under the Exchange Act.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in the reports that we file under the ExchangeAct is accumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

 

**PART II****                             OTHERINFORMATION**

 

**ITEM 1.****                               LegalProceedings**

 

In March andApril 2002, the Company, Steven W. Logan (the Company’s former Presidentand Chief Executive Officer), and John L. Hendrix (the Company’s ChiefFinancial Officer), were named as defendants in four federal putative classaction lawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf of Himself and All Others Similarly Situatedv. Cornell Companies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division; (3)*Louis A.Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the United StatesDistrict Court for the Southern District of Texas, Houston Division, and (4) *Anthony J.Scolaro, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1567, in the United StatesDistrict Court for the Southern District of Texas, Houston Division.  The aforementioned lawsuits were putativeclass action lawsuits brought on behalf of all purchasers of the Company’scommon stock between March 6, 2001 and March 5, 2002 and relate tothe Company’s restatement in 2002 of certain financial statements.  The lawsuits involved disclosures madeconcerning two prior transactions executed by the Company: the August 2001sale leaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits were consolidated intothe *GraydonWilliams* action and  FlylinePartners, LP was appointed lead plaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP.  *Richard Picard* and *Anthony Scolaro* were alsonamed as plaintiffs.  Since then, thecourt has allowed plaintiff to file an amended consolidated complaint.  The amended consolidated complaint allegesthat the defendants violated Section 10(b) of the Securities Exchange Actof 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b)of the Exchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (“the Securities Act”) and/or Section 15 of theSecurities Act.  The amendedconsolidated complaint seeks, among other things, restitution damages, compensatorydamages, rescission or a rescissory measure of damages, costs, expenses,attorneys’ fees and expert fees.  Amotion to dismiss is currently pending.

 

In March 2002, theCompany, its directors, and its former independent auditor Arthur Andersen LLP,were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas.  The lawsuit relates tothe Company’s restatement in 2002 of certain financial statements.  The lawsuit alleges breaches of fiduciaryduty by all of the individual defendants and asserts breach of contract andprofessional negligence claims only against Arthur Andersen LLP.

 

In May andJune 2002, the Company and its directors were sued in three otherderivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. H-02-1812, in theUnited Stated District Court for the Southern District of Texas, HoustonDivision;

 

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(2) *Thomas Pagano, Derivatively on Behalfof Cornell Companies, Inc. v. Steven W. Logan, et. al.*, No.H-02-1896, in the United Stated District Court for the Southern District of Texas,Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. 2002-28924, in the164th Judicial District Court of Harris County, Texas.  The lawsuit relates to the Company’srestatement in 2002 of certain financial statements.  These lawsuits all allege breaches of fiduciary duty and waste ofcorporate assets by all of the defendants. A motion to dismiss the *Guitierrez* and *Pagano* lawsuits wasfiled.  The court dismissed the *Pagano*action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez*action is still pending.  The *Menning*action has been dismissed, but with an agreement that the plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the  Guitierrez case, including any appeals.

 

The plaintiffs in thesecases have not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, the Company believes it has good defenses and intends tovigorously defend against the claims asserted in these actions.

 

Certain insurancepolicies held by the Company to cover potential director and officer liabilitymay limit the Company’s cash outflows in the event of a decision adverse to theCompany in the matters discussed above. However, if an adverse decision inthese matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, an adverse decision to the Company inthese matters could have a material adverse effect on the Company, itsfinancial condition, its results of operations and its future prospects.

 

Additionally, the Companycurrently and from time to time is 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.  The outcome of suchmatters cannot be predicated with certainty, based on the information known todate, management believes that the ultimate resolution of these matters willnot have a material adverse effect on the Company’s financial position,operating results or cash flow.

 

***SEC Investigation***

 

Following the restatementof the Company's 2001 financial statements in 2002, the SEC initiated aninvestigation into the circumstances leading to this restatement.  Following the SEC’s initial inquiry in 2002the SEC made no further inquiry with respect to the investigation untilJuly 2003.  Since July 2003,the Company has received additional information requests from the SEC.  The Company has cooperated, and intends tocontinue to fully cooperate with the SEC’s investigation.

 

Depending on the scope,timing and result of the SEC investigation, management’s attention and theCompany’s resources could be diverted from operations, which could adverselyaffect the Company’s operating results and contribute to future stock pricevolatility.  The SEC investigation couldalso require that we take other actions not currently contemplated.  In addition, the SEC investigation or itsoutcome may increase the costs of defending or resolving current litigation.

 

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

 

**ITEM 6.****                               Exhibitsand Reports on Form 8-K**

 

a.    Exhibits

 

11.1         Computation of Per Share Earnings

31.1         Section 302 Certification of ChiefExecutive Officer

31.2         Section 302 Certification of ChiefFinancial Officer

32.1         Section 906 Certification of ChiefExecutive Officer

32.2         Section 906 Certification of ChiefFinancial Officer

 

b.    Reports on Form 8-K

 

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The Company furnished aCurrent Report on From 8-K dated July 31, 2003 with a press releaseannouncing its financial results for the second quarter ended June 30,2003.

 

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 
|   |                   |   | **CORNELL COMPANIES, INC.**                                                           |
|--------|------------------------|--------|---------------------------------------------------------------------------------------|
|   |                   |   |                                                                                  |
| Date:  | November 14, 2003 | By:    | /s/ Harry J. Phillips,  Jr.                                                           |
|   |                   |   | HARRY J. PHILLIPS, JR.                                                                |
|   |                   |   | Chief Executive Officer  and  Chairman of the Board  (Principal Executive Officer)    |
|   |                   |   |                                                                                  |
|   |                   |   |                                                                                  |
| Date:  | November 14, 2003 | By:    | /s/ John L. Hendrix                                                                   |
|   |                   |   | JOHN L. HENDRIX                                                                       |
|   |                   |   | Executive Vice  President and  Chief Financial Officer  (Principal Financial Officer) |

 

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