**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 March 31, 2004** |
|                                                   |   |                                                                                               |
| **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**                    |

 

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

 

Yes  ý  No  o

 

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

 

Yes  ý  No  o

 

AtApril 30, 2004 Registrant had outstanding 13,299,717 shares of its CommonStock.

 

 

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**PARTI****          FINANCIALINFORMATION**

 

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

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

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

 
|                                                                                                                                 |   | **March 31,  2004** |    | **December 31,  2003** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
| ASSETS                                                                                                                               |   |                     |    |                        |   |
| CURRENT ASSETS:                                                                                                                      |   |                     |    |                        |   |
| Cash and cash equivalents                                                                                                            |   | $                        | 40,132  |                        | $      | 40,171 |   |
| Accounts receivable – trade (net of  allowance for doubtful accounts of $2,066 and $1,929, respectively)                        |   | 52,206                   |    | 52,772                      |   |
| Other receivables (net of allowance for  doubtful accounts of $5,386)                                                                |   | 4,395                    |    | 3,769                       |   |
| Restricted assets                                                                                                                    |   | 20,889                   |    | 22,185                      |   |
| Deferred tax assets                                                                                                                  |   | 3,411                    |    | 3,411                       |   |
| Prepaids and other                                                                                                                   |   | 9,029                    |    | 8,789                       |   |
| Total current assets                                                                                                                 |   | 130,062                  |    | 131,097                     |   |
| PROPERTY AND EQUIPMENT, net                                                                                                          |   | 273,053                  |    | 267,903                     |   |
| OTHER ASSETS:                                                                                                                        |   |                     |    |                        |   |
| Debt service reserve fund                                                                                                            |   | 23,890                   |    | 23,800                      |   |
| Intangible assets, net                                                                                                               |   | 13,047                   |    | 13,287                      |   |
| Deferred costs and other                                                                                                             |   | 13,578                   |    | 12,070                      |   |
| Total assets                                                                                                                         |   | $                        | 453,630 |                        | $      | 448,157 |   |
|                                                                                                                                 |   |                     |    |                        |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                            |   |                     |    |                        |   |
|                                                                                                                                 |   |                     |    |                        |   |
| CURRENT LIABILITIES:                                                                                                                 |   |                     |    |                        |   |
| Accounts payable and accrued liabilities                                                                                             |   | $                        | 28,327  |                        | $      | 36,577 |   |
| Current portion of long-term debt                                                                                                    |   | 8,301                    |    | 8,306                       |   |
| Total current liabilities                                                                                                            |   | 36,628                   |    | 44,883                      |   |
| LONG-TERM DEBT, net of current portion                                                                                               |   | 239,292                  |    | 227,292                     |   |
| DEFERRED TAX LIABILITIES                                                                                                             |   | 7,619                    |    | 7,006                       |   |
| OTHER LONG-TERM LIABILITIES                                                                                                          |   | 1,952                    |    | 2,741                       |   |
| Total liabilities                                                                                                                    |   | 285,491                  |    | 281,922                     |   |
|                                                                                                                                 |   |                     |    |                        |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                        |   |                     |    |                        |   |
|                                                                                                                                 |   |                     |    |                        |   |
| STOCKHOLDERS’ EQUITY:                                                                                                           |   |                     |    |                        |   |
| Preferred stock, $.001 par value,  10,000,000 shares authorized, none issued                                                         |   | ––             |    | ––                |   |
| Common stock, $.001 par value, 30,000,000  shares authorized, 14,683,467 and 14,578,505 shares issued and outstanding,  respectively |   | 15                       |    | 15                          |   |
| Additional paid-in capital                                                                                                           |   | 144,393                  |    | 143,735                     |   |
| Retained earnings                                                                                                                    |   | 34,924                   |    | 34,218                      |   |
| Treasury stock (1,545,356 and 1,537,583  shares of common stock, respectively, at cost)                                              |   | (12,530                  | )       | (12,458                     | )      |
| Deferred compensation                                                                                                                |   | (649                     | )       | (803                        | )      |
| Other comprehensive income                                                                                                           |   | 1,986                    |    | 1,528                       |   |
| Total stockholders’ equity                                                                                                      |   | 168,139                  |    | 166,235                     |   |
| Total liabilities and stockholders’ equity                                                                                      |   | $                        | 453,630 |                        | $      | 448,157 |   |

 

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

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE INCOME**

**(Unaudited)**

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

 
|                                                   |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                   |   | **2004**                                |   | **2003** |   |
|                                                   |   |                                    |   |   |   |
| REVENUES                                               |   | $                                       | 69,324 |   | $ | 66,026 |   |
| PRE-OPENING AND START-UP EXPENSES                      |   | 1,646                                   |   | — |   |
| OPERATING EXPENSES                                     |   | 54,514                                  |   | 51,780 |   |
| DEPRECIATION AND AMORTIZATION                          |   | 3,159                                   |   | 2,569 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                    |   | 4,160                                   |   | 3,898 |   |
|                                                   |   |                                    |   |   |   |
| INCOME FROM OPERATIONS                                 |   | 5,845                                   |   | 7,779 |   |
| INTEREST EXPENSE                                       |   | 5,019                                   |   | 4,847 |   |
| INTEREST INCOME                                        |   | (370                                    | )      | (385 | ) |
|                                                   |   |                                    |   |   |   |
| INCOME BEFORE PROVISION FOR INCOME TAXES               |   | 1,196                                   |   | 3,317 |   |
| PROVISION FOR INCOME TAXES                             |   | 490                                     |   | 1,360 |   |
|                                                   |   |                                    |   |   |   |
| NET INCOME                                             |   | $                                       | 706    |   | $ | 1,957 |   |
|                                                   |   |                                    |   |   |   |
| EARNINGS PER SHARE:                                    |   |                                    |   |   |   |
| BASIC                                                  |   | $                                       | .05    |   | $ | .15 |   |
| DILUTED                                                |   | $                                       | .05    |   | $ | .15 |   |
|                                                   |   |                                    |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE  COMPUTATION:       |   |                                    |   |   |   |
| BASIC                                                  |   | 13,081                                  |   | 12,784 |   |
| DILUTED                                                |   | 13,312                                  |   | 12,940 |   |
|                                                   |   |                                    |   |   |   |
| COMPREHENSIVE INCOME:                                  |   |                                    |   |   |   |
| Net income                                             |   | $                                       | 706    |   | $ | 1,957 |   |
| Unrealized gain on derivative instruments,  net of tax |   | 458                                     |   | 449 |   |
| Comprehensive income                                   |   | $                                       | 1,164  |   | $ | 2,406 |   |

 

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

 

3

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
|                                                                                       |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                       |   | **2004**                                |   | **2003** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |   |                                    |   |   |   |
| Net income                                                                                 |   | $                                       | 706    |   | $ | 1,957 |   |
| Adjustments to reconcile net income to net  cash used in operating activities –– |   |                                    |   |   |   |
| Depreciation                                                                               |   | 2,889                                   |   | 2,349 |   |
| Amortization of intangibles and other  assets                                              |   | 270                                     |   | 220 |   |
| Amortization of deferred compensation                                                      |   | (50                                     | )      | 86 |   |
| Amortization of deferred financing costs                                                   |   | 209                                     |   | 289 |   |
| Provision for bad debts                                                                    |   | 170                                     |   | 1,179 |   |
| Gain on sale of property and equipment                                                     |   | (11                                     | )      | — |   |
| Deferred income taxes                                                                      |   | 295                                     |   | 360 |   |
| Change in assets and liabilities:                                                          |   |                                    |   |   |   |
| Accounts receivable                                                                        |   | (1,931                                  | )      | 839 |   |
| Restricted assets                                                                          |   | 158                                     |   | 5 |   |
| Other assets                                                                               |   | (183                                    | )      | (604 | ) |
| Accounts payable and accrued liabilities                                                   |   | (8,250                                  | )      | (7,856 | ) |
| Deferred revenues and other liabilities                                                    |   | (13                                     | )      | (596 | ) |
| Net cash used in operating activities                                                      |   | (5,741                                  | )      | (1,772 | ) |
|                                                                                       |   |                                    |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |   |                                    |   |   |   |
| Capital expenditures                                                                       |   | (8,192                                  | )      | (1,383 | ) |
| Deposits in (withdrawals from) restricted  debt payment account, net                       |   | 1,048                                   |   | 1,953 |   |
| Proceeds from sale of property and  equipment                                              |   | 163                                     |   | — |   |
| Sale of restricted assets from deferred  bonus plan                                        |   | 86                                      |   | — |   |
| Net cash (used in) provided by investing  activities                                       |   | (6,895                                  | )      | 570 |   |
|                                                                                       |   |                                    |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |   |                                    |   |   |   |
| Proceeds from long-term debt and line of  credit                                           |   | 36,000                                  |   | — |   |
| Payments on line of credit                                                                 |   | (24,000                                 | )      | — |   |
| Payments on capital lease obligations                                                      |   | (6                                      | )      | (9 | ) |
| Payments of debt issuance and other  financing costs                                       |   | (100                                    | )      | — |   |
| Proceeds from exercise of stock options and  warrants                                      |   | 819                                     |   | 382 |   |
| Purchases of treasury stock                                                                |   | (116                                    | )      | (472 | ) |
| Net cash provided by (used in) financing  activities                                       |   | 12,597                                  |   | (99 | ) |
|                                                                                       |   |                                    |   |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                  |   | (39                                     | )      | (1,301 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                          |   | 40,171                                  |   | 52,610 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                 |   | $                                       | 40,132 |   | $ | 51,309 |   |
|                                                                                       |   |                                    |   |   |   |
| OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:                                        |   |                                    |   |   |   |
| Other comprehensive income, net of tax                                                     |   | $                                       | 458    |   | $ | 449 |   |

 

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

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Theaccompanying unaudited consolidated financial statements have been prepared byCornell Companies, Inc. (the “Company”) pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with generally accepted accountingprinciples in the United States (GAAP) have been condensed or omitted pursuantto such rules and regulations.  In theopinion of management, adjustments and disclosures necessary for a fairpresentation of these financial statements have been included.  Estimates were used in the preparation ofthese financial statements.  Actualresults could differ from those estimates. These financial statements should be read in conjunction with thefinancial statements and notes thereto included in the Company’s 2003 AnnualReport on Form 10-K as filed with the Securities and Exchange Commission.

 

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

 

Seea description of the Company’s accounting policies in the Company’s 2003 AnnualReport on Form 10-K.

 

### ***AccountingFor Stock Based Compensation***

 

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

 
|                                                                                                                                        |   | **Three  Months Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                                                                        |   | **2004**                                |   | **2003** |   |
|                                                                                                                                        |   |                                    |   |   |   |
| Net income, as reported                                                                                                                     |   | $                                       | 706    |   | $ | 1,957 |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (157                                    | )      | (583 | ) |
| Pro forma net income                                                                                                                        |   | $                                       | 549    |   | $ | 1,374 |   |
| Earnings per share:                                                                                                                         |   |                                    |   |   |   |
| Basic, as reported                                                                                                                          |   | $                                       | .05    |   | $ | .15 |   |
| Basic, pro forma                                                                                                                            |   | .04                                     |   | .11 |   |
| Diluted, as reported                                                                                                                        |   | .05                                     |   | .15 |   |
| Diluted, pro forma                                                                                                                          |   | .04                                     |   | .11 |   |

 

5

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The Financial Accounting Standards Board (FASB) has proposed to mandateexpense recognition for stock options and other types of equity-basedcompensation based on the fair value of the options at the grant date.  Additionally, the FASB is evaluatingalternatives regarding how to develop a measure of the fair value of anoption.  Based on the final outcome ofthe FASB proposal, the Company may be required to recognize expense related tostock options and other types of equity-based compensation in futureperiods.  Additionally, the Company maybe required to change its current method for determining the fair value ofstock options.  Members of Congress haverecently introduced legislation that would limit the proposed standard.

 

***New Accounting Pronouncements***

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation ofVariable Interest Entities” (FIN 46), which addresses the consolidation ofvariable interest entities as defined in the Interpretation.  The Company’s adoption of FIN 46 did notchange the Company’s accounting for the 2000 synthetic lease transaction andthe 2001 Sale and Leaseback Transaction which are consolidated for reportingpurposes.  The Company has no otherarrangements subject to the provisions of FIN 46.  It is reasonably possible that the Company may enter into futurearrangements for the development of new facilities or to operate facilitiesthat may become subject to the provisions of FIN 46 and, in some cases, may berequired to consolidate the related activities, facilities and financings.

 

**3.****             ****Intangible Assets**

 

Intangibleassets at March 31, 2004 and December 31, 2003 consisted of thefollowing (in thousands):

 
|                     |   | **March 31,  2004** |   | **December 31,  2003** |        |
|--------------------------|--------|--------------------------|--------|-----------------------------|-------------|
|                     |   |                     |   |                        |        |
| Non-compete agreements   |   | $                        | 9,450  |                        | $           | 9,420 |   |
| Accumulated amortization |   | (4,124                   | )      | (3,854                      | )           |
| Other intangibles, net   |   | 5,326                    |   | $                           |  5,566 |   |
| Goodwill                 |   | 7,721                    |   | 7,721                       |        |
|                     |   | $                        | 13,047 |                        | $           | 13,287 |   |

 

Amortizationexpense for non-compete agreements was approximately $270,000 and $220,000 forthe three months ended March 31, 2004 and 2003, respectively.  Amortization expense for the Company’scurrent non-compete agreements is expected to be approximately $1.1 million foreach of the fiscal years ended December 31 for the next five years.

 

6

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**4.****             ****Credit Facilities**

 

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

 
|                                                                                                     |   | **March 31,  2004** |    | **December 31,  2003** |   |
|----------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|-----------------------------|--------|
| **Debt of Cornell  Companies, Inc.:**                                                                    |   |                     |    |                        |   |
| Revolving Line of Credit due July 2005  with an interest rate of prime plus 2.0% or LIBOR plus 3.0% |   | $                        | 14,000  |                        | $      | 2,000 |   |
| Capital lease obligations                                                                                |   | 3                        |    | 8                           |   |
| Subtotal                                                                                                 |   | 14,003                   |    | 2,008                       |   |
|                                                                                                     |   |                     |    |                        |   |
| **Debt of  Consolidated Special Purpose Entities:**                                                      |   |                     |    |                        |   |
| Synthetic Lease Investor Note A due  July 2005 with an interest rate of LIBOR plus 3.25%            |   | 42,255                   |    | 42,255                      |   |
| Synthetic Lease Investor Note B due  July 2005 with an interest rate of LIBOR plus 3.50%            |   | 8,335                    |    | 8,335                       |   |
| MCF 8.47% Bonds due 2016                                                                                 |   | 183,000                  |    | 183,000                     |   |
| Subtotal                                                                                                 |   | 233,590                  |    | 233,590                     |   |
|                                                                                                     |   |                     |    |                        |   |
| Consolidated total debt                                                                                  |   | $                        | 247,593 |                        | $      | 235,598 |   |
|                                                                                                     |   |                     |    |                        |   |
| Less: current maturities                                                                                 |   | (8,301                   | )       | (8,306                      | )      |
|                                                                                                     |   |                     |    |                        |   |
| Consolidated long-term debt                                                                              |   | $                        | 239,292 |                        | $      | 227,292 |   |
|                                                                                                          |        |                          |         |                             |        |  |  |  |  |

 

The Company’s 2000 Credit Facility, as amended, originally provided forborrowings of up to $45.0 million under a revolving line of credit.  The commitment amount is reduced by $1.6million quarterly beginning in July 2002 and by outstanding letters ofcredit.  The available commitment amountunder the amended 2000 Credit Facility was approximately $13.2 million atMarch 31, 2004.  The Company hadoutstanding letters of credit of approximately $6.5 million at March 31,2004.  The amended 2000 Credit Facilitymatures in July 2005 and bears interest, at the election of the Company,at either the prime rate plus a margin of 2.0%, or a rate which is 3.0% abovethe applicable LIBOR rate.  The amended2000 Credit Facility is collateralized by substantially all of the Company’sassets, including the stock of all of the Company’s subsidiaries; does notpermit the payment of cash dividends; and requires the Company to comply withcertain leverage, net worth and debt service coverage covenants.  Additionally, the Company is limited to $2.5million annually for the repurchase of its common stock with an aggregate limitof $7.5 million.  The Company hasobtained an amendment from the lenders under its amended 2000 Credit Facilityextending the scheduled construction completion date for the Moshannon ValleyCorrectional Center. This amendment is effective through June 30,2005.  The Company and its lendersagreed to amend the covenants of the amended 2000 Credit Facility to facilitatecompliance with the terms of the agreement despite the loss of the SouthernPeaks Regional Treatment Center escrowed funds (Note 7).  Included in interest expense for the threemonths ended March 31, 2004 is approximately $145,000 that the Companyexpended in connection with this amendment. Included in the Company’s cash and cash equivalents at March 31,2004 is approximately $39.9 million that is invested in a separate account thatis available to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  This separate account is maintained, inpart, to assure future credit availability.

 

Additionally,the amended 2000 Credit Facility provides the Company with the ability to enterinto synthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $100.0 million, of which approximately $52.4 million had beenutilized as of March 31, 2004.  TheSynthetic Lease Investor’s Note A and Note B have total credit commitments of$81.4 million and $15.1 million, respectively. The

 

7

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Companypays commitment fees at a rate of 0.5% annually for the unused portion of thesynthetic lease financing capacity.  TheSynthetic Lease Investor’s Notes A and B are cross-collateralized with theCompany’s revolving line of credit and contain cross-default provisions.

 

Managementis in the process of negotiating terms for a new senior credit facility torefinance the amended 2000 Credit Facility. If the Company is successful inrefinancing the amended 2000 Credit Facility, the Company will incur chargesrelated to the extinguishment of the synthetic lease obligations and write-offof previously deferred financing costs. As of March 31, 2004, these coststotaled approximately $2.5 million.

 

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

 

In January 2003, the Company executed a five-year lease for theRegional Correctional Center in Albuquerque, New Mexico.  This 970 bed facility consists of two units,the 528 bed South Tower and the 442 bed North Tower.  The Company is currently renovating the South Tower andanticipates opening the 528 bed unit in July 2004.  The Company will then renovate the NorthTower.  Management currently anticipatesthat the facility will reach full capacity of 970 beds byDecember 2004.  As ofMarch 31, 2004, the Company had spent approximately $2.1 million onrenovations.  For the three months endedMarch 31, 2004, the Company incurred pre-opening and start-up expenses ofapproximately $156,000 primarily for personnel and professional costs.

 

Construction of the Southern Peaks Regional Treatment Center is ongoingand is expected to be completed in the third quarter of 2004.  The Company is committed to the project and has reached awritten agreement with the general contractor and the developer to purchase theproperty in the near future (prior to its completion), serve as theconstruction supervisor in lieu of the developer and assume the developer’srights and obligations under the construction contract (except that thedeveloper will remain as contractor for certain of the infrastructure servingthe facility).  In accordance withwritten agreements among the general contractor, the developer and the Company,the Company has advanced approximately $6.3 million to the general contractoras of March 31, 2004, which included $2.3 million from the escrow funds.

 

In September 2003, the Company entered into negotiations with thestate of South Dakota to lease the former State Training School in Plankinton,South Dakota to operate a 40 bed juvenile detention center, the PlankintonRegional Detention Center, and a 82 bed residential juvenile treatment center,the Plankinton Regional Treatment Center.  In March 2004 the Company finalized the lease agreements for thefacilities.  The Company renovated thedetention center and began receiving clients in May 2004.  The Company is currently renovating thetreatment center and anticipates opening the center in August 2004.

 

The Company closed the New Morgan Academy in the fourth quarter of 2002and is currently considering several options ranging from the utilization ofthe facility for another type of program or the sale or lease of the facility.As of March 31, 2004, management is focusing its efforts on reactivatingthe facility.  The primary use currentlyunder consideration is using the facility to house illegal non-criminal adultdetainees or to house non-criminal juvenile aliens. Management is discussingthese opportunities with the Bureau of Immigration and Customs Enforcement(ICE), who has indicated a level of interest but the parties have notprogressed to the contract phase. There can be no assurance that the Companywill be successful in securing a contract with ICE.  Further, before the Company could house adult detainees, theCompany will likely need to obtain a change in the zoning of the Academy, whichis currently zoned only for the housing of juveniles. Management of the Companybelieves that there is a market for the services the Company could provide atper diem rates that will support the recovery of the cost structure of thefacility. However, the Company will continue to evaluate any offers to buy orlease the facility.  The Company is maintaining a small staff tosecure and maintain the facility while the Company considers its options forthe use or sale of the facility.  TheCompany is incurring interest expense of approximately $140,000 per monthrelated to the borrowings for the facility and depreciation expense ofapproximately $46,000 per month for the building.

 

8

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The carrying value of the property and equipment at the New MorganAcademy was approximately $30.2 million at March 31, 2004.  As of March 31, 2004, management believesthat, pursuant to the provisions of Statement of Financial Accounting Standard(SFAS) SFAS No. 144, an impairment allowance is not necessary.  However, management estimates that, were theCompany to sell the facility, it is reasonably possible that the Company wouldnot be able to fully recover the carrying value of its long-lived assets forthis facility.

 

InMarch 2003, the Company reached an agreement with the Commonwealth ofPennsylvania that resolved all outstanding administrative issues relative tothe contract awarded to the Company by the Federal Bureau of Prisons (BOP) tooperate the Moshannon Valley Correctional Center. In October 2003, theCompany received final approval from the BOP of a revised building design forthe facility. Construction plans are being developed for the new design andwork is expected to begin in the second quarter of 2004. InApril 2004, the Company received notice of a draft supplementalenvironmental assessment indicating a population of 1,300 consisting of 1,000adult low-security male offenders and 300 adult minimum-security femaleoffenders.

 

As of March 31, 2004, the Company had incurred approximately $18.4million for design, construction and land development costs and capitalizedinterest related to the Moshannon Valley Correctional Center contract. TheCompany is in the process of submitting a claim to the BOP for reimbursement ofcosts related to the original construction efforts incurred beginning in 1999.Financing of the facility is subject to re-approval of the project by thelenders under the Company’s amended 2000 Credit Facility and agreement by suchlenders to amend certain financial covenants and provisions of the amended 2000Credit Facility. Management is in the process of negotiating terms for a new seniorcredit facility to refinance the amended 2000 Credit Facility which matures inJuly 2005. Additionally, management is pursuing other sources ofadditional debt financing. Management believes that such additional debtfinancing and a new senior credit facility will provide adequate funding forthe construction of the Moshannon Valley Correctional Center.  There can be no assurance that the Companycan obtain the financing it needs.

 

According to the BOP contract, as amended, the Company is required to completethe construction of the facility by July 15, 2004. The Company does notanticipate completing construction by that date and anticipates obtaininganother long-term contract amendment from the BOP extending the constructiondeadline. In the event the Company is not able to negotiate a contractamendment with the BOP, then the BOP may have the right to assert that theCompany has not completed construction of the facility within the time frameprovided in the BOP contract, as amended. Management expects that the contractwill be amended to address cost and construction timing matters resulting fromthe extended delay. In the event that the BOP decides not to continue with theconstruction of the Moshannon Valley Correctional Center and terminates the contract,management believes that the Company has the right to and will recover itsinvested costs. In the event any portion of these costs are determined not tobe recoverable upon contract termination by the BOP, such costs would becharged to expense.

 

Separate from a possible recovery in the event that the BOP terminatesthe Moshannon Valley Correctional Center contract, the Company is pursuing aclaim for the reimbursement of a portion of its expenses incurred in connectionwith the issuance of the Stop-Work Order and the delay of the project (includedamong these expenses is approximately $1.4 million in accounts receivable forexpenses incurred by the Company after the June 1999 issuance of the Stop–Work Order).  This reimbursement claimis independent of the amendment to the contract.  If the BOP agrees to an amendment of the contract, the Companywill still pursue this claim.  TheCompany is currently negotiating this claim with the BOP.  The BOP has asserted that it is onlyresponsible for reimbursing that portion of the investment lost due to theissuance of the Stop-Work Order. Although the Company believes that the BOP will reimburse more than the$1.4 million in accounts

 

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receivable at March 31, 2004, it is uncertain how much the BOPwill agree to pay in connection with the Company’s claim forreimbursement.  Any amounts notreimbursed by the BOP will be expensed by the Company if such costs cannot becapitalized with respect to the Company’s remaining real property interest.

 

**6.****    ****Earnings Per Share**

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilution fromcommon stock equivalents such as stock options and warrants.  For the three months ended March 31,2004 and 2003 there were 195,503 shares ($14.72 average price) and 907,403shares ($11.67 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.

 

**7.****    ****Commitments and Contingencies**

 

*Legal Proceedings*

 

**Southern Peaks Regional Treatment Center**

 

OnJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled Cornell Corrections of California, Inc. v. Longboat Global Advisors,LLC, et al., No.2004 CV79761 in the Superior Court of Fulton County, Georgiaunder theories of fraud, conversion, breach of contract and other theories todetermine the location of and to recover approximately $5.4 million previouslydeposited by the Company into what it believed to be an escrow account inconnection with the development of the Southern Peaks Regional TreatmentCenter. The Company has obtained temporary restraining orders freezing any andall financial accounts of the construction lender, one of its principals andcertain other defendants identified during discovery.  The frozen accounts include one of the construction lender’s bankaccounts which contains approximately $250,000.

 

**Shareholder Lawsuits**

 

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

 

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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.

 

InMarch 2002, the Company, its directors, and its former independent auditorArthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas.  The lawsuit related tothe Company’s restatement in 2002 of certain financial statements.  The lawsuit alleged breaches of fiduciaryduty by all of the individual defendants and asserted breach of contract andprofessional negligence claims only against Arthur Andersen LLP.  This lawsuit has been dismissed without prejudiceby agreement.

 

OnJanuary 27, 2004, the  Companyreceived a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that the Company pursue breach of fiduciary duty claims againstvarious officers and directors based on the August 2001 sale leasebacktransaction and the subsequent restatement. The Company has issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision.

 

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

 

The plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty.  However, the Companybelieves it has good defenses and intends to vigorously defend against theclaims asserted in these actions.  TheCompany has not recorded any loss accruals related to these claims.

 

Certain insurance policies held by the Company to cover potentialdirector and officer liability may limit the Company’s cash outflows in theevent of a decision adverse to the Company in the matters discussed above.  However, if an adverse decision in thesematters exceeds the insurance coverage or if the insurance coverage is deemednot to apply to these matters, an adverse decision to the Company in these matterscould have a material adverse effect on the Company, its financial condition,its results of operations and its future prospects.

 

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**Securities and Exchange Commission Investigation**

 

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

 

Depending on the scope, timing and result of the SEC investigation,management’s attention and the Company’s resources could be diverted fromoperations, which could adversely affect the Company’s operating results andcontribute to future stock price volatility. The SEC investigation could also require that the Company take otheractions not currently contemplated.  Inaddition, the SEC investigation or its outcome may increase the costs ofdefending or resolving current litigation.

 

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

 

**Other**

 

Additionally, the Company currently and from time to time is subject toclaims and suits arising in the ordinary course of business, including claimsfor damages for personal injuries or for wrongful restriction of orinterference with offender privileges and employment matters.  The outcome of such matters cannot bepredicated with certainty, based on the information known to date, managementbelieves that the ultimate resolution of these matters will not have a materialadverse effect on the Company’s financial position, operating results or cashflow.

 

**8.****    ****Segment Disclosure**

 

TheCompany’s three operating divisions are its reportable segments.  The adult secure institutional servicessegment consists of the operation of secure adult incarcerationfacilities.  The juvenile segmentconsists of providing residential treatment and educational programs andnon-residential community-based programs to juveniles between the ages of tenand 17 who have either been adjudicated or suffer from behavioralproblems.  The adult community-basedcorrections and treatment services segment consists of providing pre-releaseand halfway house programs for adult offenders who are either on probation orserving the last three to six months of their sentences on parole and preparingfor re-entry into society at large as well as community-based treatment andeducation programs as an alternative to incarceration.  All of the Company’s customers andlong-lived assets are located in the United States of America.  The accounting policies of the Company’sreportable segments are the same as those described in the summary ofaccounting policies in Note 2. Intangible assets are not included in eachsegment’s reportable assets, and the amortization of intangible assets is notincluded in the determination of a segment’s operating income.  The Company evaluates performance based onincome or loss from operations before general and administrative expenses,incentive bonuses, amortization of intangibles, interest and income taxes.  Corporate and other assets are comprisedprimarily of cash, accounts receivable, deposits, property and equipment,deferred taxes, deferred costs and other assets.

 

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The only significant noncash items reported in the respective segments’income from operations is depreciation and amortization (excluding intangibles)(in thousands).

 
|                                    |   | **(in  thousands)  Three Months Ended  March 31,** |   |
|-----------------------------------------|--------|---------------------------------------------------------|--------|
|                                    |   | **2004**                                                |   | **2003** |   |
|                                    |   |                                                    |   |   |   |
| Revenues                                |   |                                                    |   |   |   |
| Adult secure institutional              |   | $                                                       | 25,784 |   | $ | 25,062 |   |
| Juvenile                                |   | 31,138                                                  |   | 28,566 |   |
| Adult community-based                   |   | 12,402                                                  |   | 12,398 |   |
| Total revenues                          |   | $                                                       | 69,324 |   | $ | 66,026 |   |
|                                    |   |                                                    |   |   |   |
| Pre-opening and start-up expenses       |   |                                                    |   |   |   |
| Adult secure institutional              |   | $                                                       | 156    |   | $ | — |   |
| Juvenile                                |   | 1,490                                                   |   | — |   |
| Adult community-based                   |   | —                                                  |   | — |   |
| Total pre-opening and start-up expenses |   | $                                                       | 1,646  |   | $ | — |   |
|                                    |   |                                                    |   |   |   |
| Income from operations                  |   |                                                    |   |   |   |
| Adult secure institutional              |   | $                                                       | 5,873  |   | $ | 6,676 |   |
| Juvenile                                |   | 2,820                                                   |   | 2,844 |   |
| Adult community-based                   |   | 2,139                                                   |   | 2,360 |   |
| Sub-total                               |   | 10,832                                                  |   | 11,880 |   |
| General and administrative expense      |   | (4,160                                                  | )      | (3,898 | ) |
| Incentive bonuses                       |   | —                                                  |   | (245 | ) |
| Amortization of intangibles             |   | (270                                                    | )      | (220 | ) |
| Corporate and other                     |   | (557                                                    | )      | 262 |   |
| Total income from operations            |   | $                                                       | 5,845  |   | $ | 7,779 |   |

 
|                       |   | **March 31,  2004** |    | **December 31,  2003** |   |
|----------------------------|--------|--------------------------|---------|-----------------------------|--------|
| Assets                     |   |                     |    |                        |   |
| Adult secure institutional |   | $                        | 156,492 |                        | $      | 152,229 |   |
| Juvenile                   |   | 116,526                  |    | 110,748                     |   |
| Adult community-based      |   | 60,220                   |    | 57,787                      |   |
| Intangible assets, net     |   | 13,047                   |    | 13,287                      |   |
| Corporate and other        |   | 107,345                  |    | 114,106                     |   |
| Total assets               |   | $                        | 453,630 |                        | $      | 448,157 |   |

 

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

 

**General**

 

TheCompany is a leading provider of correctional, treatment and educationalservices outsourced by federal, state and local governmental agencies.  The Company provides a diversified portfolioof services for adults and juveniles through its three operating divisions: (1)adult secure institutional services; (2) juvenile justice, educational andtreatment services; and (3) adult community-based corrections and treatmentservices. At March 31, 2004, the Company operated 64 facilities with atotal service capacity of 13,878 and had six facilities underdevelopment, construction or renovation with an aggregate service capacity of2,766 upon completion.  The Company’s facilities are located in 15states and the District of Columbia.

 

The following table sets forth for the periods indicated total servicecapacity, the service capacity and contracted beds in operation at the end ofthe periods shown and average occupancy percentages.

 
|                                                                     |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                     |   | **2004**                                |   | **2003** |   |
| Total service capacity (1):                                              |   |                                    |   |   |   |
| Residential                                                              |   | 12,554                                  |   | 11,669 |   |
| Non-residential community-based                                          |   | 4,090                                   |   | 4,276 |   |
| Total                                                                    |   | 16,644                                  |   | 15,945 |   |
| Service capacity in operation (end of  period) (1)                       |   | 13,878                                  |   | 14,515 |   |
| Contracted beds in operation (end of period)  (2)                        |   | 9,394                                   |   | 9,436 |   |
| Average facility occupancy based on beds in  operation (3)(4)            |   | 68.0                                    | %      | 65.3 | % |
| Average contract occupancy based on  contracted beds in operation (4)(5) |   | 100.7                                   | %      | 99.9 | % |
| Average contract occupancy excluding  start-up operations (4)(5)         |   | 101.3                                   | %      | 99.9 | % |

 

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(1)          Our service capacity is comprised of thenumber of beds currently available for service or available upon the completionof construction or renovation of residential facilities and the average programcapacity of non-residential community-based programs.

(2)          At certain residential facilities, ourcontracted capacity is lower than the facility’s service capacity.  We could increase a facility’s contractedcapacity by obtaining additional contracts or by renegotiating existing contractsto increase the number of beds covered. However, there is no guarantee that we will be able to obtain contractsthat provide occupancy levels at a facility’s service capacity or that ourcurrent contracted capacities can be maintained in future periods.

(3)          Average facility occupancy percentages arecalculated based on actual occupancy for the period as a percentage of theservice capacity for residential facilities in operation.  These percentages do not reflect the operationsof non-residential community-based programs.

(4)          Occupancy percentages reflect less thannormalized occupancy during the start-up phase of any applicable facility,resulting in a lower average occupancy in periods when we have substantialstart-up activities.

(5)          Average contract occupancy percentages arecalculated based on actual occupancy for the period as a percentage of thecontracted capacity for residential facilities in operation.  These percentages do not reflect theoperations of non-residential community-based programs.  At certain residential facilities, ourcontracted capacity is lower than the facility’s service capacity.  Additionally, certain facilities have andare currently operating above our contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

 

TheCompany derives substantially all its revenues from providing adult correctionsand treatment and juvenile justice, educational and treatment servicesoutsourced by federal, state and local governmental agencies in the UnitedStates.  Revenues for the Company’sservices are generally recognized on a per diem rate based upon the number ofoccupant days or hours served for the period, on a guaranteed take-or-pay basisor on a cost-plus reimbursement basis.  For the three months ended March 31, 2004, the Company’srevenue base consisted of 71.2% for services provided under per-diem contracts,10.6% for services provided under take-or-pay and management contracts, 9.9%for services provided under cost-plus reimbursement contracts, 6.6% forservices provided under fee-for-service contracts and 1.7% from othermiscellaneous sources. These percentages are generally consistent withcomparable statistics for the three months ended March 31, 2003.   Revenues can fluctuate from period to period due to changes ingovernment funding policies, changes in the

 

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numberof clients referred to the Company’s facilities by governmental agencies, theopening of new facilities or the expansion of existing facilities and thetermination of contracts for a facility or the closure of a facility.

 

Our contracts generally have terms of one to three years, containmultiple renewal options exercisable at the option of the contractinggovernment agency, and contain inflation-based rate adjustment provisions.

 

Revenues for the Company’s adult secure institutional services divisionare primarily generated from perdiem, take-or-pay and managementcontracts.  For the three months endedMarch 31, 2004 and 2003, the Company realized average per diem rates onits adult secure institutional facilities of approximately $48.02 and $48.40,respectively.  The decrease in theaverage per diem rate in 2004 as compared to 2003 is attributable to a 5%reduction in the per diem rate at the D. Ray James Prison facility in thesecond half of 2003 as requested by the contracting agency (the Companymitigated a portion of this rate reduction by negotiating reductions in the levelof service provided).  In the past year,the Company has experienced increasing pressure from contracting governmentalagencies to limit or even reduce per diem rates.  Many of these governmental entities are under severe budgetpressures and it is possible more governmental agencies may approach theCompany about per diem rate concessions. Management anticipates that the 528 bed Regional Correctional Center,which is located in Albuquerque New Mexico, and expected to open inJuly 2004, will add incremental revenue of approximately $5.5 million inthe year ending December 31, 2004. Decreases in, or the lack of anticipated increases in, per diem ratescould adversely effect our current estimate of adult secure institutionalservices division revenues for the year ending December 31, 2004.  Currently, we anticipate obtainingcontractual rate increases such that our average per diem rates will increaseat our adult secure institutional facilities in 2004.

 

Revenues for the Company’s juvenile justice, educational and treatmentservices division are primarily generated from per diem, fee-for-service andcost-plus reimbursement contracts.  Forthe three months ended March 31, 2004 and 2003, the Company realized averageper diem rates on its residential juvenile facilities of approximately $160.83and $160.45, respectively.  For thethree months ended March 31, 2004 and 2003, the Company realized averagefee-for-service rates on its non-residential community-based juvenilefacilities and programs, including rates that are limited by Medicaid and otherprivate insurance providers, of approximately $27.83 and $27.32, respectively. The majority of the Company’s juvenile services contracts renewannually.

 

We anticipate that the Jos-Arz Residential Treatment Center and theTexas Adolescent Center and the opening of the Jos-Arz Therapeutic PublicCharter School, which is currently estimated to begin operating in the secondquarter of 2004, will add incremental revenue of approximately $17.0 millionwhen full capacity is reached. Additionally, we anticipate incremental revenue of approximately $16.0million in annualized revenues due to the Plankinton Regional Detention Center,the Plankinton Regional Treatment Center and the Southern Peaks RegionalTreatment Center, which are currently estimated to begin operating in May 2004,August 2004 and August 2004, respectively.  However, we have not yet entered into definitive operatingcontracts for these facilities . A delay in construction or renovation of thesefacilities or the delay in the execution of operating contracts, or occupancylevels below management’s current estimates could affect the realization of theprojected revenue increase. Additionally, we terminated our contract for the Santa Fe CountyJuverile Development Program effective January 28, 2004.  Revenues for the Santa Fe County JuvenileDevelopment Program were approximately $4.0 million for the year endedDecember 31, 2003.

 

Revenues for the Company’s adult community-based corrections andtreatment services division are primarily generated from per diem contracts andfee-for-service contracts.  For thethree months ended March 31, 2004 and 2003, the Company realized averageper diem rates on its residential adult community-based facilities ofapproximately $61.27 and $59.36, respectively. The increase in the average per diem rate for the 2004 period ascompared to 2003 is due to per diem rate increases received mid-year 2003.  For the three months ended March 31,2004 and 2003, the Company realized average fee-for-service rates on itsnon-residential adult community-based facilities and programs of approximately$8.29 and $10.00, respectively.  Thedecrease****in the average rate forthe 2004 period as compared to 2003 is due to changes in the mix of services providedby the Company’s various non-residential adult community-based programs andfacilities.

 

We anticipate losing approximately $400,000 in revenues from our adultcommunity-based corrections and treatment services in the year endingDecember 31, 2004 due to the termination of the Inglewood Men’s Centercontract in June 2003 and the termination of the Santa Fe ElectronicMonitoring Program in early 2004.  Weexpect to offset this in part by increases in revenues at various other of ouradult community-based facilities and programs.

 

Factorsthe Company considers in determining billing rates to 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 occupancylevels that we believe could reasonably be maintained.

 

TheCompany has historically experienced higher operating margins in its adultsecure institutional services and adult community-based corrections andtreatment services divisions as compared to the juvenile justice, educationaland treatment services division. Additionally, the Company’s operating margins within a division can varyfrom facility to facility based on a number of factors including but notlimited to staffing costs, whether we manage a facility or whether we own orlease it, the level of competition for the contract award, the occupancy levelsfor a facility and the level of capital commitment required with respect to afacility.  In contrast to ourtake-or-pay contracts, our per diem contracts are based on a net rate per dayper occupancy and, as a result, are sensitive to occupancy levels.  Adecline in occupancy of certain juvenile facilities can have a more significantimpact on operating results than the adult secure institutional servicesdivision due to higher per diem rates at certain juvenile facilities.  The

 

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Company has experienced and expects to continue to experience interimperiod operating margin fluctuations due to the number of calendar days in theperiod, higher payroll taxes in the first half of the year, and salary and wageincreases and insurance cost increases that are incurred prior to certaincontract rate increases.  Additionally,a decrease in per diem rates could adversely affect the Company’s operatingmargin.

 

The Company is responsible for all facility operating costs, except forcertain debt service and interest or lease payments for facilities where theCompany has a management contract only. For facilities that the Company has a management contract only, thefacility owner is responsible for all debt service and interest or leasepayments related to the facility. As a result, these types of projects allowthe Company to grow its operations with comparatively lower capitaloutlay.  The Company is responsible forall other operating expenses at these facilities. The Company operated nine andeleven facilities under management contracts at March 31, 2004 and 2003,respectively.

 

Amajority of the Company’s facility operating costs consist of fixed costs.  These fixed costs include lease expense,insurance, utilities and depreciation. As a result, when the Company commences operation of new or expandedfacilities, fixed operating costs increase. The amount of the Company’s variable operating costs, including food,medical services, supplies and clothing, depends on occupancy levels at thefacilities operated by the Company.  TheCompany’s largest single operating cost, facility payroll expense and relatedemployment taxes and costs, has both a fixed and a variable component.  The Company can adjust a facility’s staffinglevels and the related payroll expense to a certain extent based on occupancyat a facility, however a minimum fixed number of employees is required tooperate and maintain any facility, regardless of occupancy levels.  Personnel costs are subject to increases intightening labor markets based on local economic and other conditions.

 

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 aregenerally factored into the revenue per diem rate that is charged to acontracting agency, the Company typically expects to recover these upfrontcosts over the life of a contract.  Becauseoccupancy rates 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 incurring post-opening start-up costs at adultsecure facilities operated under any future contracts with the BOP because theBOP has consistently entered into take-or-pay contracts with private prisonoperations since 1999.  Under these contractsthe BOP pays private operators at least 80.0% of the contracted occupancy oncethe facility opens, regardless of actual occupancy.

 

The Company anticipates incurring pre-opening and start-up costs ofapproximately $5.5 million in the year ending December 31, 2004 for thepre-opening and start-up activities of the Jos-Arz Residential TreatmentCenter, the Southern Peaks Regional Treatment Center, the Regional CorrectionalCenter in New Mexico, the Plankinton Regional Treatment Center, the PlankintonRegional Detention Center and the Moshannon Valley Correctional Center.Unforeseen construction or renovation delays, occupancy levels belowmanagement’s current estimates, or additional development projects not includedwithin current estimates, could affect the Company’s projected pre-opening andstart-up costs.

 

We except to have an additional approximately $0.2 million ofamortization of intangibles in the year ending December 31, 2004 due tothe amortization of two non-compete agreements resulting from the acquisitionof the Jos-Arz Residential Treatment Center management contract inJune 2003.

 

Newly opened facilities are staffed according to applicable regulatoryor contractual requirements when the Company begins receiving offenders orclients.  Offenders or clients aretypically assigned to a newly opened facility on a phased-in basis over a one-to six-month period.  The Company’sstart-up period for new juvenile operations is up to 12 months from the datethe Company begins recognizing revenue unless break-even occupancy levels areachieved before then.  The Company’sstart-up period for new adult operations is up to nine months from the date theCompany begins recognizing revenue unless break-even occupancy levels areachieved before then.  Although theCompany typically recovers these upfront costs over the life of the contract,quarterly results can be substantially affected by the timing of thecommencement of operations as well as the development and construction of newfacilities.

 

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Workingcapital requirements generally increase immediately prior to the Company’scommencing operation of a new facility, or upon the expansion of an existingfacility as the Company incurs start-up costs and purchases necessary equipmentand supplies.

 

Generaland administrative expenses consist primarily of costs for the Company’scorporate and administrative personnel who provide senior management, legal,finance, accounting, human resources, payroll and information systems, costs ofbusiness development and outside professional and consulting fees.

 

# **Management Overview**

 

***Demand*.**  The Company’s business is driven generallyby demand for incarceration or treatment services, and specifically by demandfor private incarceration or treatment services, within its three primarybusiness segments: adult secure institutional services; juvenile justice,educational and treatment services; and adult community-based corrections andtreatment services.  The demand foradult and juvenile corrections and treatment services has generally increasedat a steady rate over the past ten years, largely as a result of increasinglylong sentences and/or mandatory sentences for criminals, increasing demand forincarceration of illegal aliens and a public recognition of the need to provideservices to juveniles that will improve the possibility that they will leadproductive lives.  Growth within ourthree business segments has not, on a capacity basis, increased as rapidly asthe increase in overall demand for correctional services.  Recent suggestions by social commentatorsand various political or governmental representatives suggest thatcommunity-based corrections of adults may be emphasized in the future asalternatives to traditional incarceration. This may decrease demand for higher margin secure services and increasedemand for the Company’s lower margin community corrections services.  Among other things, the Company’s managementmonitors federal, state and industry statistics relative to trends in prisonpopulations, juvenile justice statistics and initiatives, and developments inalternatives to traditional incarceration or detention of adults.

 

The federal government increasingly is turning to private providers forthe incarceration of adults, whether they are serving prison sentences,detained as illegal aliens, detained in anticipation of pending judicialadministration or transitioning from prison to society.  The Bureau of Justice Statistics reportsthat privately operated facilities housed approximately 5.8% of state offendersand 12.4% of federal offenders as of December 31, 2002.  The Bureau of Justice Statistics reportsthat privately operated facilities housed approximately 5.8% of state offendersand 12.4% of federal offenders as of December 31, 2002, an increase from of5.5% and 2.8%, respectively, as of December 31, 1999. The primary federalagencies which use private providers are the Federal Bureau of Prisons (BOP),The Bureau of Immigration, Customs and Enforcement, and the U.S. MarshalsService.  The Company providesadult-secure and adult community-based services to the federal government.  Most of the federal involvement in juvenileadministration in the federal system is handled through Medicare and Medicaidassistance to state governments. Although there are circumstances in which theCompany may contract with a federal agency on a sole source basis, the primarymeans by which the Company secures a contract with a federal agency is via aRequest for Proposal (RFP) bidding process. From time to time, the Company contracts to provide management servicesto a local government, which then bids on a federal contract.

 

States and smaller governmental units are divided on the issue ofprivate prisons and private provision of juvenile and community-based programs,although a majority of states permit private provision of these services.  The Company anticipates that increasingbudget pressure on states and smaller governmental units will cause more statesand smaller governmental units to turn to private providers such as the Companyto provide these services on a more economical basis.  Although it varies from governmental unit to governmental unit,the primary political opposition to privatization of prisons comes from organizedlabor and religious groups.

 

Private juvenile and community-based programs are much more widelyaccepted and utilized by states and local governmental units than adult securefacilities.  Many private providers areorganized on a not-for-

 

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profit basis, but there a number of large, for-profit providers, suchas the Company, of juvenile and community-based programs.  The Company’s management monitorsopportunities in these segments via its corporate and regional developmentofficials.  Many of these opportunitiesare not published in any manner and, accordingly, the Company believes thattaking initiative at the state and local level is key.

 

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

 

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

•      occupancy (utilization);

•      per diem reimbursementrates; and

•      operating expenses.

 

The Company’s capacity, commonly expressed in terms of a number of beds,is primarily impacted by the number and size of the facilities owned or leasedby the Company and the facilities which are not owned or leased by the Companybut which are managed by the Company on behalf of a third party owner orlessee.  Management views capacityprimarily as a measure of its development efforts, which may increase capacityby adding new projects or adding to existing projects.  The Company has a number of projects indevelopment which it expects to be placed into service in 2004 and 2005.  As part of measuring its developmentefforts, management assesses (a) whether a given development project wasbrought into service in accordance with management’s expectation as to time andexpense; and (b) the number of projects in development at the relevant point intime.  In addition to the focus on newprojects, capacity will reflect management’s success in renewing andmaintaining existing contracts and facilities. Recently, we have been confronted with the possibility that state orlocal budgetary limitations may cause the contractual commitment at a givenfacility to be reduced or even eliminated, which would require us to secure analternate customer for the facility or close the facility.

 

Management looks at occupancy to assess the efficacy of both itsefforts to market its facilities and its efforts to retain existing customersor contracts.  Because revenue variesdirectly with occupancy, occupancy is a driver of the Company’s revenues.  In the first quarter of 2004, 4.6% of theCompany’s revenues were derived from contracts that were “take-or-pay,” meaningthat the agency making use of the facility is obligated to pay for beds even ifthey are not used.  Historically, theCompany’s occupancy has been very high and management is mindful of the need tomaintain high occupancy levels.  As newdevelopment projects are brought into service, occupancy percentages maydecline until the projects reach full utilization.  Where the Company has commitments for utilization before thecommencement of operations, occupancy reflects the speed at which the Companyachieves full service/implementation. However, the Company often undertakesdevelopment projects without written commitments to make use of a facility. Inthese instances, the Company has performed its own assessment, based onconversations with local government representatives and other factors, of thedemand for services at the facility. There can be no assurance that the Company will recover its investmentin these cases.  The Company plans tomonitor occupancy in order to measure the accuracy of management’s estimationof the demand for the services of these facilities.

 

Per diem reimbursement rates are also a key driver of the Company’sgross revenue and operating margin since revenues from per diem contractsrepresent a majority of our revenues (71.2% during the first quarter of2004).  Per diem rates are a function ofnegotiation between the Company and a governmental unit at the inception of acontract or through the RFP process. Actual per diem rates vary dramatically across the Company’s businesssegments, and within each business segment depending upon the particularservice or program provided. Initial per diem rates often change during theterm of a contract in accordance with a schedule.  The amount of the change can be a fixed amount set forth withinthe contract, an amount determined by formulas set forth within the contract oran amount determined by negotiations between the Company and the governmentalentity. These negotiations are typically similar to the original per diemnegotiation, including a review of the Company’s expenses and approval of anamount to compensate the Company for expenses and assure the Company thepotential of an operating profit.  Inrecent years, as

 

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budgetary pressures on governmental units have increased, the Companyhas granted a few of its customers relief from formulaic increase provisions intheir agreements and some of our customers have not agreed to increase the perdiem rates payable to the Company. Such increases are often necessary for theCompany to offset operating expense increases. Although the Company has mitigated a portion of the impact of these developmentsby reducing services or obtaining commitments for increased volume, it hastaken steps, primarily in the area of legislative and governmental monitoringand lobbying, in an effort to minimize these sorts of adverse developments inthe future.  The Company plans tocontinue to monitor per diem rates as a measure of negotiation skill, customerservice, management and maintenance, political and business astuteness.

 

Management continually monitors its operating expenses.  Foremost among these expenses are employeecompensation and benefits, risk related expenses such as general liability,medical and workers’ compensation, client/inmate costs such as food, clothingand programming costs, financing costs and administrative overhead expenses.Increases or decreases in one or more of these items, such as the Company’srecent experience with rising insurance costs, can have a material effect onthe Company’s performance.  Managementis particularly monitoring the costs of complying with the Sarbanes-Oxley Actof 2002.  The Company spent approximately$165,000 in the first quarter of 2004 for professional expenses for compliancewith the Sarbanes Oxley Act.

 

Management of the Company recognizes that its operating margins aresubject to pressure from a variety of factors, but most notably rising costsand governmental and agency budgetary constraints.  Management also believes that successful development of highermargin and low capital projects is key to mitigating such pressure.  The Company has several development projectscommitted and in various stages of completion. Until those projects arecompleted and brought into service, management will monitor operations andexisting customer relationships to minimize start-up costs.

 

#### **RecentDevelopments**

 

***Southern PeaksRegional Treatment Center***

 

Construction of the Southern Peaks Regional Treatment Center is ongoingand is expected to be completed in the third quarter of 2004.  The Company is committed to the project and has a writtenagreement with the general contractor and the developer to purchase theproperty in the near future (prior to its completion), serve as theconstruction supervisor in lieu of the developer and assume the developer’srights and obligations under the construction contract (except that thedeveloper will remain as contractor for certain of the infrastructure servingthe facility).  In accordance withwritten agreements among the general contractor, the developer and the Company,the Company has advanced approximately $6.3 million to the general contractoras of March 31, 2004, which included $2.3 million from the escrow funds.

 

### ***Las VegasCenter***

### * *

InJune 2003, the BOP issued a RFP for the operation of a 65 bed adultcommunity-based correctional center in Las Vegas, Nevada.  The Company submitted a proposal inSeptember 2003 and received requests for clarifications to its proposal inJanuary and February 2004. The Company purchased a building in January 2004 for approximately$1.3 million in anticipation of winning the contract award.  The Company anticipates renovating thebuilding at a cost of approximately $800,000 and anticipates that theserenovations can be completed within 120 days after receiving the notice toproceed by the BOP.  If the Company isawarded the contract, the facility, which will have a service capacity of 100beds after renovations, should be operational in October 2004.

 

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###### ***CentralCalifornia Treatment Center***

###### *** ***

InJanuary 2004, the Company purchased a building in Los Angeles, Californiafor approximately $2.5 million.  TheCompany anticipates renovation costs of approximately $2.0 million.  This new facility could provide service to220 inmates in a work-furlough type program. Although we do not currently have a contract for this facility, webelieve that due to the growth of the inmate population, severe budget crisisand recent legal settlement requiring additional community services, thisfacility will fill a small part of the overall demand in California.  The potential uses for the facility rangefrom a “halfway back” program to a comprehensive drug and alcohol treatmentprogram.

 

### ***BakerCommunity Correctional Center***

### * *

In April 2004, the Company purchased theBaker Community Correctional Center, which it previously leased, at a purchaseprice of approximately $2.0 million. The Company’s current operating contract for this facility expires inJune 2004.  There is a possibilitythat the CDC, the Company’s current contracting agency, may cut the funding forthe current adult minimum security program at the facility.  However, the Company estimates that there isenough demand for minimum-security services for another inmate population fromthe CDC or through a contract with another agency.  Although the Company is actively pursuing a contract renewal withthe CDC and believes that it will be forthcoming, there can be no assurancethat a renewal will be executed.

 

***PlankintonRegional Detention Center***

 

The Company opened the Plankinton RegionalDetention Center on May 3, 2004. This 40 bed juvenile detention center willgenerate approximately $2.0 million in annualized revenue when full capacity isreached.

 

**New Accounting Pronouncements**

 

InJanuary 2003, the FASB issued Interpretation No. 46, “Consolidation ofVariable Interest Entities” (FIN 46), which addresses the consolidation ofvariable interest entities as defined in the Interpretation.  The Company’s adoption of FIN 46 did notchange the Company’s accounting for the 2000 synthetic lease transaction andthe 2001 Sale and Leaseback Transaction which are consolidated for reportingpurposes.  The Company has no otherarrangements subject to the provisions of FIN 46.  It is reasonably possible that the Company may enter into futurearrangements for the development of new facilities or to operate facilitieswhich may become subject to the provisions of FIN 46 and, in some cases, may berequired to consolidate the related activities, facilities and financings.

 

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**Results of Operations**

 

Thefollowing table sets forth for the periods indicated the percentages ofrevenues represented by certain items in the Company’s historical consolidatedstatements of operations.

 
|                                     |   | **Three  Months  Ended March 31,** |   |
|------------------------------------------|--------|-----------------------------------------|--------|
|                                     |   | **2004**                                |   | **2003** |   |
|                                     |   |                                    |   |   |   |
| Total revenues                           |   | 100.0                                   | %      | 100.0 | % |
| Operating expenses                       |   | 78.6                                    |   | 78.4 |   |
| Pre-opening and start-up expenses        |   | 2.4                                     |   | — |   |
| Depreciation and amortization            |   | 4.6                                     |   | 3.9 |   |
| General and administrative expenses      |   | 6.0                                     |   | 5.9 |   |
| Income from operations                   |   | 8.4                                     |   | 11.8 |   |
| Interest expense, net                    |   | 6.7                                     |   | 6.8 |   |
| Income before provision for income taxes |   | 1.7                                     |   | 5.0 |   |
| Provision for income taxes               |   | 0.7                                     |   | 2.1 |   |
| Net income                               |   | 1.0                                     | %      | 2.9 | % |

 

##### ***Three Months Ended March 31, 2004 Compared to Three Months EndedMarch 31, 2003***

 

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

 

***Revenues***. Revenues increased approximately $3.3 million, or 5.0%, to $69.3 millionfor the three months ended March 31, 2004 from approximately $66.0 millionfor the three months ended March 31, 2003.

 

***Adult Secure***. Adult secure institutional services division revenues increased approximately$722,000, or 2.9%, to $25.8 million for the three months ended March 31,2004 from approximately $25.1 million for the three months ended March 31,2003 due to (1) a 32 bed expansion at the Big Spring Correctional Centercompleted in April 2003, (2) per diem rate increases for the Big SpringCorrectional Center in June 2003 and mid March 2004 thatincreased revenue approximately $607,000 and (3) an increase in revenue ofapproximately $140,000 due to improved occupancy at the Great Plains CorrectionalFacility.  The increase in revenue dueto the above was offset, in part, by a decrease in revenue of approximately$228,000 at the D. Ray James Prison due to a per diem rate reduction in thesecond half of 2003.

 

TheCompany’s adult secure institutional services division revenues are primarilygenerated from contracts with federal and state governmental agencies. AtMarch 31, 2004, the Company operated seven adult secure facilities with anaggregate service capacity of 5,917. The remaining contract terms for thesefacilities range from one to seven years.

 

Average contract occupancy was 101.0% for the three months endedMarch 31, 2004 compared to 98.6% for the three months ended March 31,2003.  The average per diem rate wasapproximately $48.02 and $48.40 for the three months ended March 31, 2004and 2003, respectively.  The decrease inthe average per diem rate was due to the per diem rate reduction at the D. RayJames Prison in the second half of 2003. There were no revenues attributable to start-up operations for the threemonths ended March 31, 2004 and 2003.

 

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***Juvenile*****.** Juvenile justice, educational and treatment services division revenuesincreased approximately $2.6 million, or 9.0%, to $31.1 million for the threemonths ended March 31, 2004 from $28.6 million for the three months endedMarch 31, 2003 due to (1) the opening of the Texas Adolescent Center inOctober 2003 which produced revenue of approximately $1.2 million, (2) anincrease in revenue of approximately $2.8 million as a result of increasedoccupancy at the Cornell Abraxas I (A-I) facility, the Cornell AbraxasParenting Academy, the Leadership Development Program (LDP), the CornellAbraxas Youth Center, the Danville Center for Adolescent Females and theCornell Abraxas Center for Adolescent Females (ACAF) and increased servicehours for the Harrisburg, PA and Washington, DC community-based programs and(3) the acquisition of the Jos-Arz Residential Treatment Center managementcontract in June 2003 which contributed revenue of approximately$593,000.  This increase in revenue wasoffset, in part, by a decrease in revenue of approximately $770,000 due to theCompany’s termination of the Santa Fe County Youth Development Program contracteffective January 28, 2004. Additionally, the Company did not receivecustomary mid-year per diem rate increases at its juvenile facilities andprograms in Pennsylvania in 2003. The Company currently expects to receive perdiem rate increases at these facilities and programs in July 2004.

 

At March 31, 2004 the Company operated 22 residential juvenilefacilities and 15 non-residential community-based programs with an aggregateservice capacity of 4,217.  TheCompany’s contracts for these facilities and programs are generally with stateand local government agencies and generally renew annually.

 

Average contract occupancy for the three months ended March 31,2004 was 91.9% compared to 92.3% for the three months ended March 31,2003.  Excluding the occupancy andcontract capacity for the start-up operations of the Jos-Arz ResidentialTreatment Center in 2004, average contract occupancy was 95.0% for the threemonths ended March 31, 2004. Although the exclusion of actual occupancy and contract capacity for start-upoperations is a non-GAAP measure, the Company believes it is important toprovide average contract occupancy rates excluding start-up operations so as toprovide more comparable information with other periods.  The average per diem rate for the Company’sresidential juvenile facilities was approximately $160.83 for the three monthsended March 31, 2004 compared to approximately $160.45 for the threemonths ended March 31, 2003. The Company’s average fee-for-service ratefor its non-residential juvenile community-based facilities and programs wasapproximately $27.83 for the three months ended March 31, 2004 compared toapproximately $27.32 for the three months ended March 31, 2003.

 

Revenues attributable to start-up operations were approximately $593,000for the three months ended March 31, 2004 and were attributable solely tothe operations of the Jos-Arz Residential Treatment Center.  There were no revenues attributable tostart-up operations for the three months ended March 31, 2003.

 

***Adult Community-Based*****.** Adult community-based corrections and treatment services divisionrevenues were approximately $12.4 million for the three months endedMarch 31, 2004 and 2003.  AtMarch 31, 2004, the Company operated 15 residential adult community-basedfacilities and five non-residential community-based programs with an aggregateservice capacity of 3,744.  Average contract occupancy for the threemonths ended March 31, 2004 was 108.2% compared to 110.3% for the threemonths ended March 31, 2003. The average per diem rate for theCompany’s residential adult community-based facilities was $61.27 for the threemonths ended March 31, 2004 compared to $59.36 for the three months endedMarch 31, 2003.  The increase in theaverage per diem rate was due to rate increases obtained mid-year 2003.  The average fee-for-service rate for theCompany’s non-residential adult community-based programs was $8.29 for thethree months ended March 31, 2004 compared to $10.00 for the three monthsended March 31, 2003.  The decreasein the average fee-for-service rate is due to changes in the mix of servicesprovided by the Company.  There were norevenues attributable to start-up operations for the three months endedMarch 31, 2004 and 2003.

 

***Operating Expenses.*** Operating expenses increased approximately $2.7 million, or 3.8%, to$54.5 million for the three months ended March 31, 2004 from $51.8 millionfor the three months ended March 31, 2003.

 

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***Adult Secure*****.** Adult secure institutional services division operating expensesincreased approximately $1.3 million, or 7.2%, to $18.7 million for the threemonths ended March 31, 2004 from $17.4 million for the three months endedMarch 31, 2003.  Theincrease in operating expenses was due to increased occupancy at the Big SpringCorrectional Center as a result of a 32 bed expansion completed inApril 2003 and increased occupancy at the Great Plains CorrectionalCenter.  Additionally, the Company incurredhigher employee insurance and legal costs in the three months endedMarch 31, 2004 as compared to the three months ended March 31, 2003.This increase was offset, in part, by a decrease in operating expenses at theD. Ray James Prison due to a reduction in the services provided by the Companyas a result of the per diem rate reduction in the second half of 2003.

 

As a percentage of segment revenues, adult secure institutionalservices operating expenses were 72.5% for the three months endedMarch 31, 2004 compared to 69.6% for the three months ended March 31,2003.  The decline in the 2004 operatingmargin was due to increased employee insurance and legal costs in the 2004period as compared to the same period of 2003. The 2004 margin was favorably impacted by a reduction in rent expensedue to the September 2003 repurchase of furniture and equipment formerlyleased under a sale and leaseback transaction in 1999.

 

***Juvenile*****. **Juvenilejustice, educational and treatment services operating expenses increasedapproximately $1.0 million, or 4.2%, to $26.0 million for the three monthsended March 31, 2004 from $25.0 million for the three months endedMarch 31, 2003 due to the opening of the Texas Adolescent Center inOctober 2003 and increased occupancy at A-1, the Cornell Abraxas ParentingAcademy, LDP, the Cornell Abraxas Youth Center, the Danville Center forAdolescent Females and the Cornell Abraxas Center for Adolescent Females andincreased service hours at the Harrisburg, PA and Washington, DCcommunity-based programs.  Additionally,the Company incurred higher employee insurance and legal costs in the threemonths ended March 31, 2004 as compared to the three months endedMarch 31, 2003.  For the threemonths ended March 31, 2003, juvenile division operating expenses includeda charge to bad debt expense of approximately $0.5 million to provide anallowance for certain insurance and Medicaid receivable accounts.

 

As a percentage of segment revenues, juvenile services operatingexpenses were 83.5% for the three months ended March 31, 2004 compared to87.4% for the three months ended March 31, 2003. Excluding $593,000 ofrevenue attributable to the start-up operations of the Jos-Arz ResidentialTreatment Center in 2004, juvenile services division operating expenses were85.1% for the three months ended March 31, 2004.  The 2003 operating margin was unfavorably impacted by the chargeto bad debt expense of approximately $0.5 million.  The 2004 operating margin was unfavorably impacted due to higheremployee insurance costs and legal costs. The 2004 margin was favorablyimpacted from the operations of the Texas Adolescent Center and a reduction inrent expense due to the September 2003 repurchase of furniture andequipment that was formerly leased under a sale and leaseback transaction in1999.

 

***Adult Community-Based*****.** Adult community-based corrections and treatment services operatingexpenses increased approximately $0.1 million, or 1.0%, to $9.8 million for thethree months ended March 31, 2004 from $9.7 million for the three monthsended March 31, 2003. Operating expenses for the three months endedMarch 31, 2003 included a charge to bad debt expense of approximately $0.2million to provide an allowance for certain insurance and Medicaid receivableaccounts.  As a percentage of segmentrevenues, adult community-based corrections and treatment services operatingexpenses were 78.6% for the three months ended March 31, 2004 compared to77.9% for the three months ended March 31, 2003.   The decline in the 2004 operating margin is due to higheremployee insurance and legal costs in the three months ended March 31,2004 as compared to the same period in 2003 offset, in part, by a reduction inrent expense due to the September 2003 repurchase of furniture andequipment formerly leased under a sale and leaseback transaction in 1999.

 

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***Pre-opening and start-up expenses.***  Pre-openingand start-up expenses for the three months ended March 31, 2004 wereapproximately $1.6 million and were attributable to the pre-opening andstart-up activities of the Jos-Arz Residential Treatment Center, the SouthernPeaks Regional Treatment Center and the Regional Correctional Center in NewMexico.  These expenses consistedprimarily of personnel and related expenses, facility rent, professional andrecruiting expenses.  There were nopre-opening and start-up expenses for the three months ended March 31,2003.

 

***Depreciation and Amortization*****.** Depreciation and amortization expense was approximately $3.2 million forthe three months ended March 31, 2004 compared to approximately $2.7million for the three months ended March 31, 2003.  The increase was primarily due todepreciation resulting from the September 2003 repurchase of furniture andequipment formerly leased under a 1999 sale and leaseback transaction anddepreciation expense on current year property and equipment purchases.  Amortization of intangibles wasapproximately $270,000 and $220,000 for the three months ended March 31,2004 and 2003, respectively.

 

***General and Administrative Expenses.*** General and administrative expenses increased approximately $262,000, or6.7%, to $4.2 million for the three months ended March 31, 2004 fromapproximately $3.9 million for the three months ended March 31, 2003 dueto legal costs of approximately $221,000 related to the Southern Peaks RegionalTreatment Center litigation and professional expenses of approximately $165,000for Sarbanes-Oxley compliance.  Theincrease was offset, in part, by a decrease in rent expense due to theSeptember 2003 repurchase of furniture and equipment formerly leased undera sale and leaseback transaction in 1999.

 

***Interest.*** Interest expense, net of interest income, increased to approximately$4.6 million for the three months ended March 31, 2004 from approximately$4.5 million for the three months ended March 31, 2003 due primarily toincreased borrowings under the Company’s revolving line of credit.  Additionally, interest expense for the threemonths ended March 31, 2004 includes fees of approximately $145,000 incurredto amend the Company’s amended 2000 Credit Facility.  Capitalized interest for the three months ended March 31,2004 and 2003 was approximately $208,000 and $186,000, respectively, and isattributable to interest on the Company’s Synthetic Lease Facility for thedevelopment and construction of the Moshannon Valley Correctional Center.

 

***Minority Interest in Losses ofConsolidated Special Purpose Entities*****.** Minority interest in consolidated special purpose entities representsthird party equity contributed to the special purpose entities consolidated bythe Company for financial reporting purposes. Minority interest is adjusted for income and losses of the specialpurpose entities.  The cumulative lossesof MCF exceeded the recorded minority interest of MCF during the first quarterof 2002.  The cumulative losses of thesynthetic lease investor exceeded the recorded minority interest of thesynthetic lease investor during the third quarter of 2001.  Since the cumulative losses of MCF and thesynthetic lease investor exceed the equity which is recorded as minorityinterest by the Company, the excess losses are being recorded in the Company’sConsolidated Statement of Operations.

 

***Income Taxes.***  Forthe three months ended March 31, 2004 and 2003, the Company recognized aprovision for income taxes at an estimated effective rate of 41.0%.

 

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**Liquidity and Capital Resources**

 

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

 

***Cash Flows Used In OperatingActivities.***  Cash flows used in operations wasapproximately $5.7 million for the three months ended March 31, 2004compared to approximately $1.8 million for the three months endedMarch 31, 2003.  The increase incash used in operations is primarily attributable to a reduction in net incomeand an increase in accounts receivable in 2004.

 

***Cash Flows Used in InvestingActivities*****.**  Cash used in investing activities wasapproximately $6.9 million for the three months ended March 31, 2004 dueprimarily to capital expenditures of $8.2 million for the purchase of the LasVegas Center and the Central California Treatment Center buildings, developmentand construction of the Southern Peaks Regional Treatment Center, renovation ofthe Regional Correctional Center in New Mexico and capitalized interest on theMoshannon Valley Correctional Center and various other facility improvementsand/or expansions and information technology and software development costs.  This use of cash was offset, in part, bywithdrawals from the restricted debt payment account, net of deposits, ofapproximately $1.0 million.  Cashprovided by investing activities was approximately $0.6 million for the threemonths ended March 31, 2003 due to capital expenditures of approximately$1.4 million offset by withdrawals from the restricted debt payment account,net of deposits, of approximately $2.0 million.

 

***Cash Flows From Financing Activities*****.**  Cashprovided by financing activities was approximately $12.6 million for the threemonths ended March 31, 2004 due primarily to net borrowings under theCompany’s revolving line of credit of $12.0 million and proceeds from theexercise of stock options of $0.8 million. Cash used in financing activities for the three months endedMarch 31, 2003 was approximately $0.1 million due primarily to purchasesof treasury stock of approximately $0.5 million offset by proceeds from stockoption exercises of approximately $0.4 million.

 

***Treasury Stock/Repurchases.***  TheCompany repurchased in the open market 10,000 shares of its common stock forapproximately $0.1 million in the three months ended March 31, 2004.  For the remainder of 2004, the Company canrepurchase approximately $0.7 million of shares under the terms of the amended2000 Credit Facility.

 

***Long-Term Credit Facilities.*** The Company’s amended 2000 Credit Facilityoriginally provided for borrowings of up to $45.0 million under a revolvingline of credit.  The commitment amountis reduced by $1.6 million quarterly beginning July 2002 and byoutstanding letters of credit. The Company had outstanding letters of credit ofapproximately $6.5 million at March 31, 2004. Accordingly, the availableundrawn commitment amount under the amended 2000 Credit Facility was $13.2million as of March 31, 2004.   The amended 2000 Credit Facility matures in July 2005 and 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.  The amended 2000 Credit Facility iscollateralized by substantially all of the Company’s assets, including thestock of all of the Company’s subsidiaries; does not permit the payment of cashdividends; and requires the Company to comply with certain leverage, net worthand debt service coverage covenants. Additionally, the Company is limited to $2.5 million annually for therepurchase of its common stock with an aggregate limit of $7.5 million. TheCompany has obtained an amendment from the lenders under the amended 2000Credit Facility extending the scheduled construction termination date for theMoshannon Valley Correctional Center. The amendment is effective throughJune 30, 2005.  Included in theCompany’s cash and cash equivalents at

 

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March 31,2004 is approximately $39.9 million that is invested in a separate account thatis available to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  This separate account is maintained, inpart, to assure future credit availability.

 

Additionally,the amended 2000 Credit Facility provides the Company with the ability to enterinto synthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the leases of upto $100.0 million, of which approximately $52.4 million had been utilized as ofMarch 31, 2004.  The Company payscommitment fees at a rate of 0.5% annually for the unused portion of the leasefinancing capacity.

 

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

 

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

 

Managementis in process of negotiating terms for a new senior credit facility torefinance the amended 2000 Credit Facility. If the Company is successful inrefinancing the amended 2000 Credit Facility, the Company will incur chargesrelated to the extinguishment of the synthetic lease obligations and thewrite-off of previously deferred financing costs. At March 31, 2004, thesecosts totaled approximately $2.5 million.

 

***Contractual Uncertainties Related toCertain Facilities.******* In January 2003, the Company executed afive year lease for the Regional Correctional Center in Albuquerque, NewMexico.  The facility consists oftwo units – the South Tower, which has a service capacity of 528 beds, and theNorth Tower, which has a service capacity of 442 beds.  The Company is currently renovating theSouth Tower and anticipates opening the 528 bed unit in July 2004. TheCompany will then renovate the North Tower. Management estimates that the facility will reach full capacity of 970beds by December 2004. As of March 31, 2004, the Company had spentapproximately $2.1 million on renovations to the 528 bed South Tower unit andexpects to spend an additional $5.1 million to complete renovations of bothunits.   For the three months endedMarch 31, 2004, the Company recognized pre-opening and start-up costs ofapproximately $156,000 primarily for personnel and professional expenses.  Based on the Company’s discussions withpotential contracting governmental agencies and the demand for services to beprovided, management of the Company anticipates that there is adequate demandto fill the initial 528 bed South Tower unit in the near future. However, therecan be no assurance that the Company will develop enough volume at the facilityto assure its profitability.  The leasefor the facility requires monthly rental payments of approximately $113,000 forthe first two years and $130,000 for the last three years of the lease.  Depending on the ultimate services toprovided and the timing of occupancy ramp-up, management expects this facilitywill incur additional pre-opening and start-up costs of approximately $1.4million in the year ending December 31, 2004.

 

Construction of the Southern Peaks Regional Treatment Center is ongoingand is expected to be completed in the third quarter of 2004.  The Company is committed to the project and has a writtenagreement with the general contractor and the developer to purchase theproperty in the near future (prior to its completion), serve as theconstruction supervisor in lieu of the developer and assume the developer’srights and obligations under the construction contract (except that thedeveloper will remain as contractor for certain of the infrastructure servingthe facility).  In accordance withwritten agreements among the general contractor, the developer and the Company,the Company has advanced approximately $6.3 million to the general contractoras of March 31, 2004, which included $2.3 million from the escrow funds.

 

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In September 2003, the Company entered into negotiations with thestate of South Dakota to lease the former State Training School in Plankinton,South Dakota to operate a 40 bed juvenile justice center, the PlankintonRegional Detention Center, and a 82 bed residential juvenile treatment center,the Plankinton Regional Treatment Center.  In January 2004 the Company finalized the lease agreements for thefacilities.  The Company renovated thedetention center and began receiving clients in May 2004.  The Company is currently renovating thetreatment center and anticipates opening the center in August 2004.

 

The Company closed the New Morgan Academy in the fourth quarter of 2002and is currently considering several options ranging from the utilization ofthe facility for another type of program or the sale or lease of thefacility.  As of March 31, 2004, managementof the Company was focusing its efforts on reactivating the facility.  The primary use currently underconsideration is using the facility to house illegal non-criminal adultdetainees or to house non-criminal juvenile aliens. Management is discussing theseopportunities with the Bureau of Immigration and Customs Enforcement (ICE), whohas indicated a level of interest but the parties have not progressed to thecontract phase. There can be no assurance that the Company will be successfulin securing a contract with ICE. Further, before the Company could house adult detainees, the Companywill likely need to obtain a change in zoning of the Academy, which iscurrently zoned only for the housing of juveniles. There can be no assurancesthat the Company will be able to secure the contemplated zoning change or to doso on terms favorable to the Company. Management of the Company believes that there is a market for theservices the Company could provide at per diem rates that will support therecovery of the cost structure of the facility. However, the Company willcontinue to evaluate any offers to buy or lease the facility.  The Company is maintaining a small staff to secure and maintain thefacility while the Company considers its options for the use or sale of thefacility.  The Company expects to incuroperating expenses of approximately $150,000 per month for payroll, propertytaxes and other operating costs until the facility is utilized for analternative program or until the facility is sold.  Additionally, the Company is incurring interest expense ofapproximately $140,000 per month related to the borrowings for the facility anddepreciation expense of approximately $46,000 per month for the building.

 

The carrying value of the property and equipment at the New MorganAcademy was approximately $30.2 million at March 31, 2004.  Management believes, pursuant to theprovisions of SFAS No. 144, that an impairment allowance is not deemednecessary as of March 31, 2004. However, management estimates that, were the Company to sell thefacility, it is reasonably possible that the Company would not be able to fullyrecover the carrying value of its long-lived assets for this facility.

 

InMarch 2003, the Company reached an agreement with the Commonwealth ofPennsylvania that resolved all outstanding administrative issues relative tothe contract awarded to the Company by the BOP to operate the Moshannon ValleyCorrectional Center. In October 2003, the Company received final approvalfrom the BOP for a revised building design for the facility. Construction plansare being developed for the new design and work is expected to begin in thesecond quarter of 2004.  InApril 2004, the Company received notice of a draft supplementalenvironmental assessment indicating a population of 1,300 consisting of 1,000 adultlow-security male offenders and 300 adult minimum-security female offenders.  Inthe interim, the Company is negotiating a contract amendment with the BOP toaccommodate the revised facility design and update the contract for changessince it was originally signed. If and when an amendment to the contract withthe BOP is successfully negotiated, this agreement would allow the Company tomove forward with the construction and operation of the facility.

 

As of March 31, 2004, the Company had incurred approximately $18.4million for design, construction and land development costs and capitalizedinterest related to the Moshannon Valley Correctional Center contract. TheCompany is in the process of submitting a claim to the BOP for reimbursement ofcosts related

 

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to the original construction efforts incurred beginning in 1999. TheCompany estimates an additional capital investment of approximately $74.0million to complete construction of the facility.  As the Company’s cash and current financing arrangements do notprovide sufficient financing to fund construction costs related to the project,the Company anticipates needing to obtain additional sources of financing.  Management is in the process of negotiatingterms for a new senior credit facility to refinance the amended 2000 CreditFacility which matures in July 2005. Additionally, management is pursuingother sources of additional debt financing. Management believes that suchadditional debt financing and a new senior credit facility will provideadequate funding for the construction of Moshannon Valley Correctional Center.

 

According to the BOP contract, as amended, the Company is required tocomplete the construction of the facility by July 15, 2004. The Companydoes not anticipate completing construction by that date and anticipatesobtaining another long-term contract amendment from the BOP extending theconstruction deadline. In the event the Company is not able to negotiate acontract amendment with the BOP, then the BOP may have the right to assert thatthe Company has not completed construction of the facility within the timeframe provided in the BOP contract, as amended. Management expects that thecontract will be amended to address cost and construction timing mattersresulting from the extended delay.  Inthe event that the BOP decides not to continue with the construction of theMoshannon Valley Correctional Center and terminates the contract, managementbelieves that the Company has the right to and will recover its invested costs.In the event any portion of these costs are determined not to be recoverableupon contract termination by the BOP, such costs would be charged to expense.

 

Separate from a possible recovery in the event that the BOP terminatesthe Moshannon Valley Correctional Center contract, the Company is pursuing aclaim for reimbursement of a portion of its expenses incurred in connectionwith the issuance of the Stop-Work Order and the delay of the project (includedamong these expenses is approximately $1.4 million in accounts receivable forexpenses incurred by the Company after the June 1999 issuance of the Stop–Work Order).  This reimbursement claimis independent of the amendment to the contract.  If the BOP agrees to an amendment of the contract, the Companywill still pursue this claim. The Company is currently negotiating this claimwith the BOP.  The BOP has asserted thatit is only responsible for reimbursing a portion of these costs – that portionof the investment lost due to the issuance of the Stop-Work Order.  Although the Company believes that the BOPwill reimburse more than the $1.4 million in accounts receivable, it isuncertain how much the BOP will agree to pay in connection with the Company’sclaim for reimbursement.  Any amountsnot reimbursed by the BOP will be expensed by the Company if such costs cannotbe capitalized with respect to the Company’s remaining real property interest.

 

***Future Liquidity*****.** Management believes that the Company’s existing cash and cashequivalents and the cash flows generated from operations, together with therevolving credit available under the amended 2000 Credit Facility, and thesynthetic lease financing capacity thereunder, will provide only such liquidityas would permit the Company to meet the Company’s operating needs and thecapital and working capital requirements for a limited number of developmentprojects.    As discussed above, theCompany must obtain additional sources of financing to fund the construction ofthe Moshannon Valley Correctional Center. Management is in the process of negotiating terms for a new seniorcredit facility to refinance the amended 2000 Credit Facility which matures inJuly 2005. Additionally, management is pursuing other sources of additionaldebt financing.  There can be noassurance that such financing will be available, or will be available on termsfavorable to the Company. The Company’s inability to obtain a new senior creditfacility and additional debt financing could result in the Company having toabandon or surrender projects previously committed to and announced as awardedor contemplated, including the Moshannon Valley Correctional Center. If theCompany is to fund construction costs and working capital requirements relatedto future adult secure institutional contract awards or significant facilityexpansions, the Company must obtain additional sources of financing to fundsuch activities.

 

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*Contractual Obligations and Commercial Commitments*.  TheCompany has assumed various financial obligations and commitments in theordinary course of conducting its business. The Company has contractual obligations requiring future cash paymentsunder its existing contractual arrangements, such as management, consultativeand non-competition agreements.

 

TheCompany maintains operating leases in the ordinary course of its businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, andthe terms of these agreements range from 2004 until 2075.  As of March 31, 2004, the Company’stotal commitment under these operating leases was approximately $40.1 million.

 

Thefollowing table details the Company’s known future cash payments (on anundiscounted basis) related to various contractual obligations as ofMarch 31, 2004 (in thousands):

 
|                                        |   |      |    | **Payments  Due by Period** |   |             |   |
|---------------------------------------------|--------|-----------|---------|-----------------------------|--------|------------------|--------|
|                                        |   | **Total** |    | **2004**                    |   | **2005 -  2006** |   | **2007 -  2008** |   | **Thereafter** |   |
|                                        |   |      |    |                        |   |             |   |   |   |   |   |
| Contractual Obligations:                    |   |      |    |                        |   |             |   |   |   |   |   |
| Long-term debt                              |   |      |    |                        |   |             |   |   |   |   |   |
| - Cornell Companies, Inc.                   |   | $         | 14,000  |                        | $      | —           |   | $ | 14,000 |   | $ | — |   | $ | — |   |
| - Special Purpose Entities                  |   | 233,590   |    | 8,300                       |   | 69,290           |   | 21,900 |   | 134,100 |   |
| Capital lease obligations                   |   |      |    |                        |   |             |   |   |   |   |   |
| - Cornell Companies, Inc.                   |   | 3         |    | 1                           |   | 2                |   | — |   | — |   |
| Operating leases                            |   | 40,677    |    | 3,934                       |   | 8,498            |   | 6,563 |   | 21,682 |   |
| Consultative and non-competition agreements |   | 1,005     |    | 285                         |   | 720              |   | — |   | — |   |
| Total contractual cash obligations          |   | $         | 289,275 |                        | $      | 12,520           |   | $ | 92,509 |   | $ | 28,463 |   | $ | 155,782 |   |

 

TheCompany enters into letters of credit in the ordinary course of operating andfinancing activities.  As ofMarch 31, 2004, the Company had outstanding letters of credit ofapproximately $6.5 million related to insurance and other operatingactivities.  The following table detailsthe Company’s letter of credit commitments as of March 31, 2004 (inthousands):

 
|                      |   | **Total  Amounts  Committed** |                  | **Amount of  Commitment Expiration Per Period** |          |   |          |
|---------------------------|--------|-------------------------------|-----------------------|-------------------------------------------------|---------------|--------|---------------|
|                      |   |                          | **Less than  1 Year** |                                            | **1-3 Years** |   | **4-5 Years** |   | **Over  5 Years** |   |
|                      |   |                          |                  |                                            |          |   |          |   |   |   |   |
| Commercial Commitments:   |   |                          |                  |                                            |          |   |          |   |   |   |   |
| Standby letters of credit |   | $                             | 6,546                 |                                            | $             | 6,546  |          | $ | — |   | $ | –– |   | $ | –– |   |
|                           |        |                               |                       |                                                 |               |        |               |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

**Interest Rate Exposure**

 

TheCompany’s exposure to changes in interest rates primarily results from itslong-term debt with both fixed and floating interest rates.  The debt on the Company’s consolidatedfinancial statements with fixed interest rates consists of the 8.47% Bondsissued by MCF in August 2001 in connection with the 2001 Sale andLeaseback Transaction.  AtMarch 31, 2004, approximately 26.1% (approximately $50.6 million of debtoutstanding on the Synthetic Lease Investor Notes A and B and $14.0 million outstanding on the Company’s revolving line of credit) of the Company’sconsolidated long-term debt was subject to variable interest rates.  The detrimental effect of a hypothetical 100basis point increase in interest rates would be to reduce income beforeprovision for income taxes by approximately $161,000 for the three months endedMarch 31, 2004.  At March 31,2004, the fair value of the Company’s consolidated fixed rate debt approximatedthe carrying value based upon discounted future cash flows using current marketprices.

 

**Forward Looking Statement Disclaimer**

 

Thisquarterly report on Form 10-Q contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995. This reportcontains or incorporates by reference forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995.  These statements are based on current plansand expectations of management and involve risks and uncertainties that couldcause actual future activities and results of operations to be materiallydifferent from those set forth in the forward-looking statements.  Important factors that could cause actualresults to differ include, among others, (1) the outcomes of pending putativeclass action shareholder and derivative lawsuits, and related insurancecoverage, (2) the outcome of the pending SEC investigation, (3) risksassociated with acquisitions and the integration thereof (including the abilityto achieve administrative and operating cost savings and anticipatedsynergies), (4) the timing and costs of the opening of new facilities or theexpansions of existing facilities, (5) changes in governmental policy and/orfunding to discontinue or not renew existing arrangements or to eliminate ordiscourage the privatization of correctional, detention and adultcommunity-based services in the United States, or to eliminate rate increases,(6) the availability of debt and equity financing on terms that are favorableto the Company, (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 of facilitiessuch as the New Morgan Academy or the inability to do so, (10) the Company’sability to negotiate a contract amendment with the BOP related to the MoshannonValley Correctional Center and (11) the Company’s ability to negotiatecontracts at those facilities that the Company currently does not have anoperating contract.

 

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

 

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

 

The Company does not expect that its disclosure controls and procedureswill prevent all errors or fraud. The design of disclosure controls andprocedures must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitation in a cost-effective control system, no evaluation ofcontrols can provide absolute assurance that all control issues and instancesof fraud, if any, within the Company have been detected.

 

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

 

In connection with the evaluation described above, there have been nochanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under Exchange Act) during itsfiscal quarter ended March 31, 2004 that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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

 

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

 

**Southern Peaks Regional Treatment Center**

 

OnJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled Cornell Corrections of California, Inc. v. Longboat Global Advisors,LLC, et al., No.2004 CV79761 in the Superior Court of Fulton County, Georgiaunder theories of fraud, conversion, breach of contract and other theories todetermine the location of and to recover approximately $5.4 million previouslydeposited by the Company into what it believed to be an escrow account inconnection with the development of the Southern Peaks Regional TreatmentCenter. The Company has obtained temporary restraining orders freezing any andall financial accounts of the construction lender, one of its principals andcertain other defendants identified during discovery.  The frozen accounts include one of the construction lender’s bankaccounts which contains approximately $250,000.

 

**Shareholder Lawsuits**

 

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

 

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

 

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January 27,2004, the Company received a letter from William Williams, the plaintiff in the*William Williams* action discussedabove, demanding that the Company pursue breach of fiduciary duty claims againstvarious officers and directors based on the August 2001 sale leasebacktransaction and the subsequent restatement of the Company’s financialstatements.  The Company has issued apreliminary response to the letter indicating that the Board will consider therequest and inform Mr. Williams of its decision.

 

InMay and June 2002, the Company and its directors were sued in three otherderivative lawsuits styled as follows: (1) *JuanGuitierrez, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.,* No. H-02-1812, in the United Stated District Court for theSouthern District of Texas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of Cornell Companies, Inc. v.Steven W. Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,* No. 2002-28924, in the164th Judicial District Court of Harris County, Texas.  These lawsuits relate 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 was filed.  The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

The plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty.  However, the Companybelieves it has good defenses and intends to vigorously defend against theclaims asserted in these actions.  TheCompany has not recorded any loss accruals related to these claims as ofMarch 31, 2004.

 

Certain insurance policies held by the Company to cover potentialdirector and officer liability may limit the Company’s cash outflows in theevent of a decision adverse to the Company in the matters discussed above.  However, if an adverse decision in thesematters exceeds the insurance coverage or if the insurance coverage is deemednot to apply to these matters, an adverse decision to the Company in thesematters could have a material adverse effect on the Company, its financialcondition, its results of operations and its future prospects.

 

**Securities and Exchange Commission Investigation**

 

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

 

Depending on the scope, timing and result of the SEC investigation,management’s attention and the Company’s resources could be diverted fromoperations, which could adversely affect the Company’s operating results andcontribute to future stock price volatility. The SEC investigation could also require that the Company take otheractions not currently contemplated.  Inaddition, the SEC investigation or its outcome may increase the costs ofdefending or resolving current litigation.

 

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

 

**Other**

 

Additionally, the Company currently and from time to time is subject toclaims and suits arising in the ordinary course of business, including claimsfor damages for personal injuries or for wrongful restriction of orinterference with offender privileges and employment matters.  The outcome of such matters cannot bepredicated with certainty, based on the information known to date, managementbelieves that the ultimate resolution of these matters will not have a materialadverse effect on the Company’s financial position, operating results or cash flow.

 

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**ITEM 2. Changes in Securities and Use of Proceeds.**

 

Thefollowing table provides information about purchases by the company during thequarter ended March 31, 2004 of equity securities that are registered bythe company pursuant to Section 12 of the Exchange Act;

 
| **Period**               |   | **Total Number of  Shares (or Units)  Purchased (1)** |   | **Average Price  Paid per Share  (or Unit)** |   | **Total Number of  Shares (or Units)  Purchased as  Part of Publicly  Announced Plans  or Programs (2)** |   | **Maximum  Number of  Shares that May  Yet Be Purchased  Under the Plans  or Programs** |    |
|--------------------------|--------|-------------------------------------------------------|--------|----------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|---------|
| 01/01/04  –01/31/04 |   | —                                                |   | —                                       |   | —                                                                                                   |   | 223,500                                                                                 |    |
| 02/01/04  –02/29/04 |   | —                                                |   | —                                       |   | —                                                                                                   |   | 223,500                                                                                 |    |
| 03/01/04  –03/31/04 |   | 10,000                                                |   | $                                            | 11.58  |                                                                                                     | 10,000 |                                                                                    | 213,500 |   |
|                     |   |                                                  |   |                                         |   |                                                                                                     |   |                                                                                    |    |
| Total                    |   | 10,000                                                |   | $                                            | 11.58  |                                                                                                     | 10,000 |                                                                                    | 213,500 |   |

 

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(1)   The Companyrepurchased an aggregate 10,000shares of common stock pursuant to the repurchase to a previously announcedboard authorization.

(2)   TheCompany’s board of directors approved the repurchase by the Company of commonstock having an aggregate value of $10.0 million.  Under the Company’s amended 2000 Credit Facility, the Company islimited to an aggregate value of $7.5 million, limited to $2.5 millionannually.

 

**ITEM5.****        OtherInformation**

 

None

 

**ITEM6.****        Exhibitsand Reports on Form 8-K**

 

a.     Exhibits

 

11.1         Computationof Per Share Earnings

31.1         Section 302Certification of Chief Executive Officer

31.2         Section 302Certification of Chief Financial Officer

32.1         Section 906Certification of Chief Executive Officer

32.2         Section 906Certification of Chief Financial Officer

 

b.     Reports on Form 8-K

 

TheCompany furnished a Current Report on Form 8-K dated March 11, 2004 with apress release announcing its financial results for the quarter endedDecember 31, 2003.

 

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**SIGNATURES**

 

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

 

 
|   |          | **CORNELL COMPANIES, INC.** |
|--------|---------------|-----------------------------|
|   |          |                        |
|   |          |                        |   |
| Date:  | May  10, 2004 | By:                         | /s/  Harry J. Phillips, Jr. |   |
|   |          |                        | HARRY  J. PHILLIPS, JR. |
|   |          |                        | Chief  Executive Officer and |
|   |          |                        | Chairman  of the Board |
|   |          |                        | (Principal  Executive Officer) |
|   |          |                        |   |
|   |          |                        |   |
| Date:  | May  10, 2004 | By:                         | /s/  John L. Hendrix |   |
|   |          |                        | JOHN  L. HENDRIX |
|   |          |                        | Executive  Vice President and |
|   |          |                        | Chief  Financial Officer |
|   |          |                        | (Principal  Financial Officer) |
|        |               |                             |  |  |  |

 

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