** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

**FORM 10-Q**
| **x**                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                    |
| **For the  Quarterly Period Ended September 30, 2006** |
|                                                   |       |                                                                                          |
| **OR**                                                 |
|                                                   |       |                                                                                          |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from               to               **

**CommissionFile Number 1-14472**

**CORNELLCOMPANIES, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

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

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

Yes  x  No o

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

 

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

Yes  o  No x

At October 31, 2006, the registrant had14,062,898 shares of common stock outstanding.

 

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**Cornell Companies, Inc.**

**Table of Contents**

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

 

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**PART I          FINANCIAL INFORMATION**

**ITEM 1.          Financial Statements**

**CORNELLCOMPANIES, INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**
| ** **                                                                                                                                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **CURRENT ASSETS:**                                                                                                                                                   | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                             |       | $                      | 11,473     |                  | $          | 13,723 |   |
| Investment securities available for sale                                                                                                                              |       | 9,975                  |       | 7,250                 |       |
| Accounts receivable - trade (net of allowance for doubtful  accounts of $3,538 and $3,278, respectively)                                                              |       | 70,396                 |       | 58,701                |       |
| Other receivables (net of allowance for doubtful accounts of  $5,040)                                                                                                 |       | 1,298                  |       | 9,726                 |       |
| Debt service fund and other restricted assets                                                                                                                         |       | 17,177                 |       | 22,219                |       |
| Deferred tax assets                                                                                                                                                   |       | 7,342                  |       | 5,089                 |       |
| Prepaid expenses and other                                                                                                                                            |       | 7,561                  |       | 9,076                 |       |
| Total current assets                                                                                                                                                  |       | 125,222                |       | 125,784               |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 321,055                |       | 323,861               |       |
| **OTHER ASSETS:**                                                                                                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| Debt service reserve fund                                                                                                                                             |       | 23,800                 |       | 23,802                |       |
| Goodwill                                                                                                                                                              |       | 12,339                 |       | 12,577                |       |
| Intangible assets, net                                                                                                                                                |       | 7,487                  |       | 9,089                 |       |
| Deferred costs and other                                                                                                                                              |       | 19,530                 |       | 15,515                |       |
| **Total assets**                                                                                                                                                      |       | $                      | 509,433    |                  | $          | 510,628 |   |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                         | ** ** | ** **             | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **CURRENT LIABILITIES:**                                                                                                                                              | ** ** | ** **             | ** ** | ** **            | ** ** |
| Accounts payable and accrued liabilities                                                                                                                              |       | $                      | 52,847     |                  | $          | 58,797 |   |
| Current portion of long-term debt                                                                                                                                     |       | 10,510                 |       | 9,701                 |       |
| **Total current liabilities**                                                                                                                                         |       | 63,357                 |       | 68,498                |       |
| **LONG-TERM DEBT, net of current portion**                                                                                                                            |       | 255,472                |       | 266,659               |       |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 9,199                  |       | 6,708                 |       |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 4,787                  |       | 3,302                 |       |
| **Total liabilities**                                                                                                                                                 |       | 332,815                |       | 345,167               |       |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                        | ** ** | ** **             | ** ** | ** **            | ** ** |
| Preferred stock, $.001 par value, 10,000,000 shares authorized,  none issued                                                                                          |       | —                 |       | —                |       |
| Common stock, $.001 par value, 30,000,000 shares authorized,  15,603,292 and 15,352,159 shares issued and 14,062,898 and 13,789,172 shares outstanding,  respectively |       | 16                     |       | 15                    |       |
| Additional paid-in capital                                                                                                                                            |       | 154,379                |       | 150,339               |       |
| Retained earnings                                                                                                                                                     |       | 34,243                 |       | 27,091                |       |
| Treasury stock (1,540,394 and 1,562,987 shares of common stock,  at cost, respectively)                                                                               |       | (12,308                | )          | (12,573               | )          |
| Accumulated other comprehensive income                                                                                                                                |       | 288                    |       | 589                   |       |
| **Total stockholders’ equity**                                                                                                                                   |       | 176,618                |       | 165,461               |       |
| **Total liabilities and stockholders’ equity**                                                                                                                   |       | $                      | 509,433    |                  | $          | 510,628 |   |

 

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

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**CORNELL COMPANIES,INC.CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)(Unaudited)(in thousands, except per share data)**
| ** **                                                                                                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                                                  | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| REVENUES                                                                                                                                    |       | $                                | 92,383     |                            | $          | 79,198 |   | $ | 266,728 |   | $ | 231,340 |   |
| OPERATING EXPENSES                                                                                                                          |       | 71,457                           |       | 60,805                          |       | 203,735 |   | 174,844 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                                           |       | ——                     |       | 1,607                           |       | 2,657 |   | 8,453 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                               |       | 4,317                            |       | 3,834                           |       | 12,256 |   | 11,379 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                                         |       | 6,053                            |       | 4,760                           |       | 16,604 |   | 15,997 |   |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM  OPERATIONS                                                                                                                     |       | 10,556                           |       | 8,192                           |       | 31,476 |   | 20,667 |   |
| INTEREST EXPENSE                                                                                                                            |       | 7,119                            |       | 5,918                           |       | 19,903 |   | 18,501 |   |
| INTEREST INCOME                                                                                                                             |       | (619                             | )          | (523                            | )          | (1,766 | ) | (1,782 | ) |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM  CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                        |       | 4,056                            |       | 2,797                           |       | 13,339 |   | 3,948 |   |
| PROVISION FOR INCOME TAXES                                                                                                                  |       | 1,472                            |       | 1,241                           |       | 5,480 |   | 1,861 |   |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM  CONTINUING OPERATIONS                                                                                                          |       | 2,584                            |       | 1,556                           |       | 7,859 |   | 2,087 |   |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT OF $0 AND $381 IN  2006 AND $150 AND $1,827 IN 2005                                             |       | —                           |       | (279                            | )          | (707 | ) | (3,394 | ) |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                                                           |       | $                                | 2,584      |                            | $          | 1,277 |   | $ | 7,152 |   | $ | (1,307 | ) |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| BASIC                                                                                                                                       |       |                             |       |                            |       |   |   |   |   |
| Income from  continuing operations                                                                                                          |       | $                                | .19        |                            | $          | .11 |   | $ | .56 |   | $ | .15 |   |
| Loss from  discontinued operations, net of tax                                                                                              |       | —                           |       | (.02                            | )          | (.05 | ) | (.25 | ) |
| Net income (loss)                                                                                                                           |       | $                                | .19        |                            | $          | .09 |   | $ | .51 |   | $ | (.10 | ) |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| DILUTED                                                                                                                                     |       |                             |       |                            |       |   |   |   |   |
| Income from  continuing operations                                                                                                          |       | $                                | .18        |                            | $          | .11 |   | $ | .56 |   | $ | .15 |   |
| Loss from  discontinued operations, net of tax                                                                                              |       | —                           |       | (.02                            | )          | (.05 | ) | (.25 | ) |
| Net income  (loss)                                                                                                                          |       | $                                | .18        |                            | $          | .09 |   | $ | .51 |   | $ | (.10 | ) |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                                             |       |                             |       |                            |       |   |   |   |   |
| BASIC                                                                                                                                       |       | 13,962                           |       | 13,579                          |       | 13,898 |   | 13,484 |   |
| DILUTED                                                                                                                                     |       | 14,113                           |       | 13,686                          |       | 14,036 |   | 13,608 |   |
|                                                                                                                                        |       |                             |       |                            |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                                                |       |                             |       |                            |       |   |   |   |   |
| Net income  (loss)                                                                                                                          |       | $                                | 2,584      |                            | $          | 1,277 |   | $ | 7,152 |   | $ | (1,307 | ) |
| Unrealized gain  (loss) on derivative instruments, net of tax provision (benefit) of $327 and  ($209) in 2006 and ($168) and ($114) in 2005 |       | 470                              |       | (241                            | )          | (301 | ) | (165 | ) |
| Comprehensive income (loss)                                                                                                                 |       | $                                | 3,054      |                            | $          | 1,036 |   | $ | 6,851 |   | $ | (1,472 | ) |

 

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

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**CORNELL COMPANIES, INC.****CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)(in thousands)**
| ** **                                                                                 | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,**          | ** ** |
| ** **                                                                                 | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                            |       |   |   |
| Net income (loss)                                                                          |       | $                               | 7,152      |   | $ | (1,307 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities - |       |                            |       |   |   |
| Depreciation                                                                               |       | 10,684                          |       | 9,846 |   |
| Amortization of  intangibles and other assets                                              |       | 1,682                           |       | 1,664 |   |
| Amortization of  deferred compensation                                                     |       | 25                              |       | (316 | ) |
| Amortization of  deferred financing costs                                                  |       | 1,329                           |       | 1,198 |   |
| Amortization of  Senior Notes discount                                                     |       | 138                             |       | 138 |   |
| Stock-based  compensation                                                                  |       | 1,574                           |       | — |   |
| Provision for  bad debts                                                                   |       | 1,612                           |       | 3,192 |   |
| Gain on sale of  property and equipment                                                    |       | (155                            | )          | (11 | ) |
| Deferred income  taxes                                                                     |       | 507                             |       | 760 |   |
| Change in  assets and liabilities, net of acquisitions:                                    |       |                            |       |   |   |
| Accounts  receivable                                                                       |       | (9,506                          | )          | 1,169 |   |
| Other restricted  assets                                                                   |       | 1,102                           |       | (254 | ) |
| Other assets                                                                               |       | 1,711                           |       | 3,286 |   |
| Accounts  payable and accrued liabilities                                                  |       | (6,368                          | )          | (1,312 | ) |
| Other  liabilities                                                                         |       | 110                             |       | (81 | ) |
| Net cash  provided by operating activities                                                 |       | 11,597                          |       | 17,972 |   |
|                                                                                       |       |                            |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                            |       |   |   |
| Capital  expenditures                                                                      |       | (10,557                         | )          | (37,331 | ) |
| Purchases of  investment securities                                                        |       | (296,975                        | )          | (905,345 | ) |
| Sales of  investment securities                                                            |       | 294,250                         |       | 936,285 |   |
| Acquisition of  a business, net of cash acquired                                           |       | —                          |       | (9,139 | ) |
| Withdrawals  from restricted debt payment account, net                                     |       | 3,942                           |       | 4,183 |   |
| Proceeds from  sale of property and equipment                                              |       | 2,890                           |       | 624 |   |
| Net cash used  in investing activities                                                     |       | (6,450                          | )          | (10,723 | ) |
|                                                                                       |       |                            |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                            |       |   |   |
| Payments of MCF  bonds                                                                     |       | (9,700                          | )          | (9,000 | ) |
| Payments of  acquired debt                                                                 |       | —                          |       | (1,905 | ) |
| Payments of  capital lease obligations                                                     |       | (8                              | )          | (176 | ) |
| Tax benefit of  stock option exercises                                                     |       | 223                             |       | — |   |
| Proceeds from  exercise of stock options                                                   |       | 2,088                           |       | 4,065 |   |
| Net cash used  in financing activities                                                     |       | (7,397                          | )          | (7,016 | ) |
|                                                                                       |       |                            |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                       |       | (2,250                          | )          | 233 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                           |       | 13,723                          |       | 9,895 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                 |       | $                               | 11,473     |   | $ | 10,128 |   |
|                                                                                       |       |                            |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                         |       |                            |       |   |   |
| Decrease in  fair value of interest rate swap                                              |       | $                               | (864       | ) | $ | (2,660 | ) |
| Other comprehensive  loss, net of tax                                                      |       | (301                            | )          | (165 | ) |
| Common stock  issued for board of directors fees                                           |       | 395                             |       | 266 |   |
| Equipment additions under capital leases                                                   |       | 56                              |       | — |   |

 

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

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**CORNELL COMPANIES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.     Basis ofPresentation**

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(the “Company”) pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles in the United States (“GAAP”)have been condensed or omitted pursuant to such rules and regulations.  In the opinion of management, adjustments anddisclosures necessary for a fair presentation of these financial statementshave been included.  Estimates were usedin the preparation of these financial statements.  Actual results could differ from thoseestimates.  These financial statementsshould be read in conjunction with the financial statements and notes theretoincluded in the Company’s 2005 Annual Report on Form 10-K as filed with theSecurities and Exchange Commission.

**2.     AccountingPolicies**

See a description of ouraccounting policies in our 2005 Annual Report on Form 10-K.

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

Our stock incentive plans provide for thegranting of incentive options and nonqualified options to officers, directorsand key employees of the Company. Grants under these plans vest over periods upto seven years after the date of grant and expire no more than 10 years aftergrant.

Prior to January 1, 2006, we accounted for ourstock option and stock-based compensation plans using the intrinsic-valuemethod outlined by Accounting Principles Board (“APB”) Opinion No. 25.Accordingly, we computed compensation cost for each employee stock optiongranted as the amount by which the quoted market price of our shares on thedate of grant exceeded the amount the employee must pay to acquire the shares.The amount of compensation cost, if any, would be charged to income over thevesting period. No compensation cost had been recognized for the optionsgranted, as the grant price was equal to the market price.

Effective January 1, 2006, we adopted theprovisions of the Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. Under this method,compensation cost recognized for the three and nine months ended September 30,2006, includes the applicable amounts of: (a) compensation cost of allstock-based awards granted prior to, but not yet vested, as of January 1, 2006(based on the grant-date fair value estimated in accordance with the originalprovisions of SFAS No. 123 and previously presented in pro forma footnotedisclosures), and (b) compensation cost for all stock-based awards granted subsequentto January 1, 2006 (based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123(R)). Results for prior periods have notbeen restated.

Additionally,we have an employee stock purchase plan (“ESPP”) underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yearbegins each January 1st (the “Grant Date”) and ends on December 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15% discount. Prior to January 1, 2006, we were not required torecognize any compensation cost related to our employee-stock purchase Plan.Under SFAS No. 123R our employee-stock purchase plan is considered to be acompensatory ESPP and; therefore, we are required to recognize compensationcost over the requisite service period for grants made under the ESPP.

SFAS No.123R amends SFAS No. 95, “Statement of Cash Flows,” to require reporting of certaintax benefits as a financing cash flow, rather than as a reduction of taxespaid. These tax benefits result from tax deductions in excess of the  compensation expense recognized for optionsexercised. Prior to the adoption of SFAS No. 123R, we presented all taxbenefits resulting from the exercise of stock options as operating cash flowsin our consolidated statement of cash flows.

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

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On November10, 2005, the Financial Accounting Standards Board (the “FASB”) issued FASBStaff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related toAccounting for Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). FSP123R-3 provides for an alternative transition method for establishing thebeginning balance of the additional paid-in capital pool (“APIC pool”) relatedto the tax effects of employee share-based compensation, which is available toabsorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R.We have elected to adopt this alternative transition method, otherwise known asthe “simplified method,” in establishing our beginning APIC pool at January 1,2006.

*Effect of Adopting SFAS No. 123(R)*

The following is the effect of adopting**SFAS No. 123(R) as of January 1, 2006 (in thousands, exceptper share amounts):

|                                                           | ** ** | **Three Months  Ended September 30,  2006** | ** ** | **Nine Months  Ended September 30,  2006** | ** ** |
|-----------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
|                                                      |       |                                                       |       |                                                      |       |
| Stock-based  compensation expense – stock options    |       | $                                                          | 340        |                                                      | $          | 1,339 |   |
| Stock-based  compensation expense – restricted stock |       | 54                                                         |       | 163                                                       |       |
| Employee-stock  purchase plan                             |       | 24                                                         |       | 72                                                        |       |
| Related deferred  income tax benefit                      |       | 171                                                        |       | 648                                                       |       |
|                                                      |       |                                                       |       |                                                      |       |
| Decrease in basic earnings per share                      |       | $                                                          | 0.02       |                                                      | $          | 0.07 |   |
|                                                      |       |                                                       |       |                                                      |       |
| Decrease in diluted  earnings per share                   |       | $                                                          | 0.02       |                                                      | $          | 0.07 |   |

 

At September 30, 2006, 60,000 restricted sharesof our common stock were outstanding subject to performance-based vestingcriteria (30,000 of these are considered market-based restricted stock underSFAS No. 123 (R)). Additionally, 137,200 stock options were outstanding subjectto performance-based vesting criteria (16,100 of these are consideredmarket-based options under SFAS No. 123 (R)).

The 30,000 shares of restricted stock and the16,100 stock options which are considered market-based restricted stock werevalued using a Monte Carlo simulation probability model to estimated futurestock returns. The grant date fair value of these shares was $9.05 per sharefor a total value of $0.5 million. We recognized $0.04 million and $0.11million of expense associated with these shares of restricted stock and optionsduring the three and nine months ended September 30, 2006, respectively.

The amountsabove relate to the impact of recognizing compensation expense related to stockoptions, restricted stock and our employee-stock purchase plan. Compensationexpense related to stock options (121,100 shares) and restricted stock grants(30,000 shares) that vest based upon performance conditions are not includedabove. No compensation expense has been recorded for our performance-basedawards because it has not been deemed probable that the related performancetargets will be met that would allow such options time to vest. We are requiredto periodically re-assess the probability and record expense at the point intime, if ever, it becomes probable these shares of restricted stock and optionswill vest.

We recognize expense for our stock-basedcompensation over the vesting period, which represents the period in which anemployee is required to provide service in exchange for the award. We recognizecompensation expense for stock-based awards immediately if the award hasimmediate vesting.

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*Prior Period Pro Forma Presentation*

Under the modified prospective applicationmethod, results for prior periods have not been restated to reflect the effectsof implementing SFAS No. 123 (R). The following pro forma information, asrequired by SFAS No. 148, “Accounting for Stock-Based Compensation Transitionand Disclosure, an Amendment of FASB Statement No. 123” is presented forcomparative purposes and illustrates the pro forma effect on net income andearnings per share for the period presented as if we had applied the fair valuerecognition provisions of SFAS No. 123 to stock-based employee compensationprior to January 1, 2006 (in thousands, except per-share amounts):
|                                                                                                                                             | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
|                                                                                                                                        |       |                                                       |       |                                                      |       |
| Net income  (loss), as reported                                                                                                             |       | $                                                          | 1,277      |                                                      | $          | (1,307 | ) |
| Add: total  stock-based compensation recorded, net of tax                                                                                   |       | 49                                                         |       | 114                                                       |       |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (640                                                       | )          | (1,473                                                    | )          |
| Pro forma net  income (loss)                                                                                                                |       | $                                                          | 686        |                                                      | $          | (2,666 | ) |
|                                                                                                                                        |       |                                                       |       |                                                      |       |
| Income (loss)  per share:                                                                                                                   |       |                                                       |       |                                                      |       |
| Basic, as reported                                                                                                                          |       | $                                                          | .09        |                                                      | $          | (.10 | ) |
| Basic, pro forma                                                                                                                            |       | $                                                          | .05        |                                                      | $          | (.20 | ) |
| Diluted, as reported                                                                                                                        |       | $                                                          | .09        |                                                      | $          | (.10 | ) |
| Diluted, pro  forma                                                                                                                         |       | $                                                          | .05        |                                                      | $          | (.20 | ) |

 

*Assumptions*

The fair values for the significant stock-based awardsgranted during the nine months ended September 30, 2006 and 2005 were estimatedat the date of grant using a Black-Scholes option pricing model with thefollowing weighted-average assumptions:

|                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
|                              |       |                                                |       |   |   |
| Risk-free rate  of return         |       | 4.31                                                | %          | 4.27 | % |
| Expected life of  award           |       | 5 years                                             |       | 7 years |   |
| Expected  dividend yield of stock |       | 0                                                   | %          | 0 | % |
| Expected  volatility of stock     |       | 45.48                                               | %          | 53.06 | % |
| Weighted-average fair  value      |       | $                                                   | 6.24       |   | $ | 8.02 |   |
|                                   |            |                                                     |            |  |  |  |  |

 

The expected volatility of stock assumption wasderived by referring to changes in the Company’s historical common stock pricesover a timeframe similar to that of the expected life of the award. While wehave no reason to believe that future stock volatility will significantlydiffer from historical stock volatility, we would modify our appliedassumptions in the future if factors warranted. Estimated forfeiture rates arederived from historical forfeiture patterns. We believe the historicalexperience method is the best estimate of forfeitures currently available.

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

8

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Stock-based award activity during the nine monthsended September 30, 2006 was as follows (aggregate intrinsic value inmillions):
|                                                    | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  January 1, 2006                    |       | 697,706                |       | $                                      | 12.21      |                                                | 7.2        |                            | $          | 8.5 |   |
| Granted                                            |       | 45,000                 |       | 13.71                                  |       |                                                |       |                            |       |
| Exercised                                          |       | (164,036               | )          | 11.07                                  |       |                                                |       |                            |       |
| Canceled                                           |       | (60,515                | )          | 13.05                                  |       |                                                |       |                            |       |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  September 30, 2006                 |       | 518,155                |       | $                                      | 12.61      |                                                | 7.5        |                            | $          | 6.5 |   |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and  expected to vest at September 30, 2006 |       | 486,940                |       | $                                      | 12.57      |                                                | 7.4        |                            | $          | 6.1 |   |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at  September 30, 2006                 |       | 310,051                |       | $                                      | 12.20      |                                                | 6.8        |                            | $          | 3.8 |   |

 

The total intrinsic value of stock options exercisedduring the nine months ended September 30, 2006 and 2005 were $0.6 million and$1.9 million, respectively. Net cash proceeds from the exercise of stockoptions were approximately $2.1 million and $4.1 million for the nine monthsended September 30, 2006 and 2005, respectively.

As of September 30, 2006, approximately $1.0 millionof estimated expense with respect to nonvested stock-based awards has yet to berecognized and will be amortized into expense over the employee’s estimatedremaining weighted average service period of approximately 3.33 years.

The following table summarizes information withrespect to stock options outstanding and exercisable at September 30, 2006.
| Range of Exercise Prices         | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                            |       |                    |       |                                                |       |                                   |       |                    |       |                                   |       |
| $3.75  to  $6.50            |       | 23,540                  |       | 4.2                                                 |       | $                                      | 4.12       |                    | 23,540     |                                   | $          | 4.12 |   |
|   6.51  to  10.00 |       | 36,065                  |       | 6.3                                                 |       | 8.40                                   |       | 34,279                  |       | 8.40                                   |       |
| 10.01  to  13.50            |       | 211,750                 |       | 7.5                                                 |       | 12.56                                  |       | 93,732                  |       | 12.25                                  |       |
| 13.51  to  16.00            |       | 246,800                 |       | 7.9                                                 |       | 14.08                                  |       | 158,500                 |       | 14.19                                  |       |
|                                            |       | 518,155                 |       | 7.5                                                 |       | $                                      | 12.61      |                    | 310,051    |                                   | $          | 12.20 |   |

 

Stock-based award activity for nonvested awards duringthe nine months ended September 30, 2006 is as follows:

|                                  | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|----------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  January 1, 2006    |       | 323,469                |       | $                                                           | 13.17      |   |
| Granted                          |       | 45,000                 |       | 13.71                                                       |       |
| Vested                           |       | (153,785               | )          | 13.26                                                       |       |
| Canceled                         |       | (6,580                 | )          | 13.24                                                       |       |
|                             |       |                   |       |                                                        |       |
| Nonvested at September  30, 2006 |       | 208,104                |       | $                                                           | 13.22      |   |

 

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*Restricted Stock*

We have issued restrictedstock under certain employment agreements and a deferred bonus plan which vestsover a specific period of time, generally three to five years.  These shares of restricted common stock aresubject to restrictions on transfer and certain conditions to vesting.

Restricted stock activityfor the nine months ended September 30, 2006 is as follows:

|                                  | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|----------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  January 1, 2006    |       | 51,673                 |       | $                                                           | 16.23      |   |
| Granted                          |       | —                 |       |                                                        |       |
| Vested                           |       | (17,365                | )          | 17.15                                                       |       |
| Canceled                         |       | (9,308                 | )          | 17.15                                                       |       |
|                             |       |                   |       |                                                        |       |
| Nonvested at September  30, 2006 |       | 25,000                 |       | $                                                           | 15.24      |   |

 

As of September 30, 2006,approximately $0.17 million of estimated expense with respect to nonvestedrestricted stock awards has yet to be recognized and will be amortized over aweighted average period of 1.33 years.

***Financial Accounting Standards Board Interpretation No. 48 and OtherTax Matters***

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes” (“FIN 48”),to clarify the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes.”  FIN 48 is effective forfiscal years beginning after December 15, 2006. We are currently reviewing this new guidance to determine the impact onour financial statements.

InMay 2006, Texas enacted a new law that substantially changes the state’s taxsystem, replacing the taxable-capital and earned-surplus components of itsfranchise tax with a new franchise tax that is based on modified gross revenue.The effective tax rate for the third quarter of 2006 reflects an adjustment of approximately$0.2 million for the impact of Texas tax changes which became effective inMay 2006.

***Securities and Exchange Commission (“SEC”)Staff Accounting Bulletin No. 108***

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”)No. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements.” This guidanceindicates that the materiality of a misstatement must be evaluated using boththe rollover and iron curtain approaches. The iron curtain approach quantifiesa misstatement based on the effects of correcting the misstatement existing inthe balance sheet at the end of the current year, while the rollover approachquantifies a misstatement based on the amount of the error originating in thecurrent year income statement. SAB No. 108 will be implemented January 1,2007. We are currently assessing the impact of SAB No. 108; however, we donot believe the adoption of this standard will have a material effect on ourconsolidated financial statements.

***Statement of Financial Accounting Standards No. 157***

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements.” This statementestablishes a framework for measuring fair value within generally acceptedaccounting principles and expands disclosures about fair value measurements. SFASNo. 157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007, and interim periods within those fiscal years. Theprovisions of SFAS No. 157 should be applied prospectively as of the beginningof the fiscal year in which SFAS No. 157 is initially applied, except inlimited circumstances. We expect to adopt SFAS No. 157 beginning January 1,2008. We are currently evaluating the impact that this statement may have onour consolidated financial statements.

**3.     Merger Agreement**

OnOctober 6, 2006, the Company entered into an Agreement and Plan of Merger (the “MergerAgreement”) with The Veritas Capital Fund III, L.P., a Delaware limitedpartnership (“Veritas”), Cornell Holding Corp., a Delaware corporation (“Parent”),and CCI Acquisition Corp., a Delaware corporation and wholly owned subsidiaryof Parent (“Merger Sub”), pursuant to which the Merger Sub will be merged withand into the Company (the “Merger”), with the Company surviving after theMerger as a wholly owned subsidiary of Parent.

Ifthe Merger is consummated, the Company will become a wholly-owned subsidiary ofParent and each stockholder of the Company will receive $18.25 in cash for eachshare of the Company’s common stock they hold.

TheCompany’s Board of Directors has unanimously approved the Merger Agreement andthe transactions contemplated thereby and will recommend that the Company’sstockholders approve the Merger Agreement, the Merger and any othertransactions contemplated thereby. The Merger Agreement, the Merger and anyother transactions contemplated thereby are subject to regulatory andstockholder approvals and other customary closing conditions. The transactionis not subject to a financing contingency.

Inconnection with the Merger, the Parent and certain stockholders of the Companyhave entered into a Voting Agreement dated on or about October 6, 2006, wherebysuch stockholders have agreed, among other things, to vote their 

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respective sharesof Company stock in favor of the Merger Agreement, the Merger and thetransactions contemplated thereby.

Thetransaction is expected to be completed by the end of the first quarter of 2007and to be financed with equity from Veritas Capital Fund III, L.P.

**4.     Discontinued Operations**

We classify as discontinued operations those components of our businessthat we hold for sale or that have been disposed and have cash flows that areclearly distinguishable operationally and for financial reporting purposes fromthe rest of our operations. For those components, we have no significantcontinuing involvement after completion of disposal and their operations areeliminated from our ongoing operations. During the year ended December 31,2005, we classified certain components as discontinued operations as the resultof a management decision to close certain facilities. Notifications were madeto the required contracting entities regarding the termination of the relatedprograms. At September 30, 2006, we did not have any significant net propertyand equipment balances pertaining to these operations.  There were no revenues generated by thesediscontinued operations in the three and nine months ended September 30, 2006.These discontinued operations generated revenues of approximately $2.6 millionin the nine months ended September 30, 2005 (none in the three months endedSeptember 30, 2005).

**5.     Intangible Assets**

Intangibleassets at September 30, 2006 and December 31, 2005 consisted of thefollowing (in thousands):
|                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2006**               | ** ** | **2005**              | ** ** |
|                         |       |                   |       |                  |       |
| Non-compete agreements       |       | $                      | 10,040     |                  | $          | 9,960 |   |
| Acquired contract value      |       | 6,442                  |       | 6,442                 |       |
| Accumulated amortization     |       | (8,995                 | )          | (7,313                | )          |
| Identified intangibles,  net |       | 7,487                  |       | 9,089                 |       |
| Goodwill                     |       | 12,339                 |       | 12,577                |       |
| Total intangibles, net       |       | $                      | 19,826     |                  | $          | 21,666 |   |

 

The changes inthe carrying amount of goodwill for the nine months ended September 30, 2006are as follows (in thousands):
|                                   | ** ** | **Adult  Secure** | ** ** | **Juvenile** | ** ** | **Adult  Community-  Based** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|-------------------|------------|--------------|------------|------------------------------|------------|-----------|------------|
|                              |       |              |       |         |       |                         |       |      |       |
| Balance as of  December 31, 2005  |       | $                 | 2,902      |         | $          | 1,060                        |       | $         | 8,615      |   | $ | 12,577 |   |
| Reduction to  goodwill            |       | —            |       | —       |       | (238                         | )          | (238      | )          |
| Balance as of September  30, 2006 |       | $                 | 2,902      |         | $          | 1,060                        |       | $         | 8,377      |   | $ | 12,339 |   |

 

Amortizationexpense for our non-compete agreements was approximately $0.3 million for the threemonths ended September 30, 2006 and 2005 and approximately $0.9 millionfor the nine months ended September 30, 2006 and 2005.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the next fouryears ended December 31 and approximately $0.7 million for the fifth year.

Amortizationexpense for our acquired contract value was approximately $0.3 million for thethree months ended September 30, 2006 and 2005 and approximately $0.8 millionand $0.7 million for the nine months ended September 30, 2006 and 2005,respectively.  Amortization expense forour acquired contract value is expected to be approximately $1.1 million foreach of the next four years ended December 31 and approximately $0.6 millionfor the fifth year.

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**6.     Credit Facilities**

Our long-termdebt at September 30, 2006 and December 31, 2005 consisted of thefollowing (in thousands):
|                                                                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                     | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **Debt of Cornell Companies, Inc.:**                                                                                                                      |       |                   |       |                  |       |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount                                                                 |       | $                      | 110,941    |                  | $          | 110,803 |   |
| Fair-value  adjustment of Senior Notes as a result of interest rate swap                                                                                       |       | (1,009                 | )          | (145                  | )          |
| Revolving Line  of Credit due June 2008 with an interest rate of LIBOR plus 2.25% to  3.5% or prime plus 0.75% to 2.00% (the “Credit Facility”) |       | —                 |       | —                |       |
| Capital lease  obligations                                                                                                                                     |       | 50                     |       | 2                     |       |
| Subtotal                                                                                                                                                       |       | 109,982                |       | 110,660               |       |
| ** **                                                                                                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Debt of Special Purpose Entity:**                                                                                                                            |       |                   |       |                  |       |
| 8.47% Bonds due  2016                                                                                                                                          |       | 156,000                |       | 165,700               |       |
|                                                                                                                                                           |       |                   |       |                  |       |
| Total consolidated debt                                                                                                                                        |       | 265,982                |       | 276,360               |       |
|                                                                                                                                                           |       |                   |       |                  |       |
| Less: current maturities                                                                                                                                       |       | (10,510                | )          | (9,701                | )          |
|                                                                                                                                                           |       |                   |       |                  |       |
| Consolidated long-term debt                                                                                                                                    |       | $                      | 255,472    |                  | $          | 266,659 |   |

 

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $50.4 million at September 30, 2006.  We had no outstanding borrowings on ourCredit Facility at September 30, 2006, but we had outstanding letters of creditof approximately $9.6 million.  Subjectto certain requirements, we have the right to increase the aggregatecommitments under our Credit Facility up to an aggregate amount of $100.0million.  Our Credit Facility matures inJune 2008 and bears interest, at our election, depending on our total leverageratio, at either the prime rate plus a margin ranging from 0.75% to 2.00%, or arate which ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

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

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InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes (the “SeniorNotes”) due July 1, 2012.  The SeniorNotes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of each year,commencing January 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:

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

 

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

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and nine months ended September 30, 2006, we recorded interest expenserelated to this interest rate swap of approximately $0.1 million and $0.2million, respectively, which is reflected as interest expense in theaccompanying financial statements.  Forthe three and nine months ended September 30, 2005, we recorded interestsavings related to this interest rate swap of approximately $0.2 million and$1.0 million, respectively, which is reflected as a reduction to interestexpense in the accompanying financial statements.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either adiscount or premium on the Senior Notes. At September 30, 2006 and December 31, 2005, the fair value of thisderivative instrument was approximately ($1.0) million and ($0.1) million,respectively, and is included in other liabilities.  The carrying value of the Senior Notes as ofthese dates was reduced by the same amount. Because the swap agreement is aneffective fair-value hedge, there is no effect on our results of operationsfrom the mark-to-market adjustment as long as the swap is in effect.

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**7.     Earnings Per Share**

Basic earningsper share (EPS) is computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended September 30,2005, there were 102,643 shares ($15.24 average price) of stock options thatwere not included in the computation of diluted EPS because to do so would havebeen anti-dilutive. There were none for the three months ended September 30,2006. For the nine months ended September 30, 2006 and 2005 there were30,000 shares ($15.68 average price) and 160,637 shares ($14.70 average price),respectively, of stock options that were not included in the computation ofdiluted EPS because to do so would have been anti-dilutive.

The following table summarizes the calculation of net earnings (loss)and weighted average common shares and common equivalent shares outstanding forpurposes of the computation of earnings (loss) per share (in thousands, exceptper share data):
|                                                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                               | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from continuing operations                                        |       | $                                | 2,584      |                            | $          | 1,556 |   | $ | 7,859 |   | $ | 2,087 |   |
| Loss from discontinued operations, net of tax                            |       | —                           |       | (279                            | )          | (707 | ) | (3,394 | ) |
| Net income (loss)                                                        |       | $                                | 2,584      |                            | $          | 1,277 |   | $ | 7,152 |   | $ | (1,307 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares outstanding                               |       | 13,962                           |       | 13,579                          |       | 13,898 |   | 13,484 |   |
| Weighted average common share equivalents outstanding                    |       | 151                              |       | 107                             |       | 138 |   | 124 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares and common share equivalents  outstanding |       | 14,113                           |       | 13,686                          |       | 14,036 |   | 13,608 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic earnings (loss) per share:                                         |       |                             |       |                            |       |   |   |   |   |
| Income from continuing operations                                        |       | $                                | .19        |                            | $          | .11 |   | $ | .56 |   | $ | .15 |   |
| Loss from discontinued operations, net of tax                            |       | —                           |       | (.02                            | )          | (.05 | ) | (.25 | ) |
| Net income (loss)                                                        |       | $                                | .19        |                            | $          | .09 |   | $ | .51 |   | $ | (.10 | ) |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Diluted earnings (loss) per share:                                       |       |                             |       |                            |       |   |   |   |   |
| Income from continuing operations                                        |       | $                                | .18        |                            | $          | .11 |   | $ | .56 |   | $ | .15 |   |
| Loss from discontinued operations, net of tax                            |       | —                           |       | (.02                            | )          | (.05 | ) | (.25 | ) |
| Net income (loss)                                                        |       | $                                | .18        |                            | $          | .09 |   | $ | .51 |   | $ | (.10 | ) |

 

**8.     Commitments and Contingencies**

**Legal Proceedings**

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

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

In the year ended December 31, 2005, we recorded acharge of $0.2 million related to this lawsuit. In addition, we previously have provided insurance reserves for thismatter (as part of our regular review of reported and unreported claims)totaling approximately $0.5 million. During the third quarter of 2006, werecorded an additional settlement charge of approximately $0.9 million and therelated reimbursement of $0.9 million from our general liability andprofessional liability 

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insurance.The charge and reimbursement was recognized in general and administrativeexpenses in our Consolidated Statements of Operations and Comprehensive Income(loss) for the three and nine months ended September 30, 2006. The liability iscarried in accounts payable and accrued liabilities and the reimbursement isincluded in other receivables at September 30, 2006. The funding of thesettlement amount will occur upon the entry by the court of the order grantingpreliminary approval of the stipulation of settlement.

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

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

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas.  The lawsuitalleged that we violated the rights of Lakeisha Shantrail Brown, the deceaseddaughter of Juana Michelle Brown, under the Eighth Amendment of the Constitutionof the United States and the laws of the State of Arkansas by denying Ms. Brownmedical treatment that caused her death and sought unspecified actual andpunitive damages.  In September 2006, theplaintiff filed, and the court granted, an order for voluntary dismissalwithout prejudice. While we believe it likely that this lawsuit may be refiled,we are unable to estimate our financial exposure relating to this lawsuit.  We have insurance coverage and we intend tovigorously defend this matter if sued; however, the ultimate outcome of such alawsuit cannot be determined at this time.

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

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theories offraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atSeptember 30, 2006. In December 2004, the case was tried before a jury andthe jury verdict awarded us approximately $6.5 million in compensatory damagesand approximately $1.4 million in punitive damages, plus attorneys’ fees. Weexpect that the actual damages awarded under the verdict will be adjusteddownward to the $5.4 million actually lost by us and that the punitive damagesaward may be adjusted downward because of a Georgia statute regarding caps onpunitive damages awards. No judgment has yet been entered on this verdict. Theaward for compensatory damages accrues pre-judgment interest at a rate of sevenpercent from the date of loss through the date of judgment. Following the juryverdicts, we collected approximately $0.4 million in January 2005 in fundsthat had been previously frozen under a temporary restraining order issued atthe time that we commenced this litigation. Currently, certain of thedefendants have filed motions for a new trial. No judgment will be entered onthe verdict until after these motions for a new trial have been heard and ruledon by the court. Due to the continued uncertainty surrounding the ultimaterecovery of the funds previously deposited, we will continue to maintain ourexisting reserve of approximately $5.0 million in an allowance for doubtful accountsagainst the corresponding balance as carried in other receivables at September30, 2006.

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

In March and April 2002, the Company, StevenW. Logan (our former President and Chief Executive Officer), and John L.Hendrix (our former Chief Financial Officer), were named as defendants in fourfederal putative class action lawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*,No. H-02-0866, in the United States District Court for the SouthernDistrict of Texas, Houston Division; (2) *RichardPicard, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division;(3) *Louis A. Daly, On Behalf of Himselfand All Others Similarly Situated v. Cornell Companies, Inc., et al.,*No. H-02-1522, in the United States District Court for the SouthernDistrict of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and All Others SimilarlySituated v. Cornell Companies, Inc., et al.,*No. H-02-1567, in the United States District Court for the SouthernDistrict of Texas, Houston Division. The aforementioned lawsuits were putativeclass action lawsuits brought on behalf of all purchasers of our common stockbetween March 6, 2001 and March 5, 2002 and relate to our restatementin 2002 of certain financial statements. The lawsuits involved disclosures madeconcerning two prior transactions executed by us: the August 2001 sale andleaseback transaction and the 2000 synthetic lease transaction. These fourlawsuits were consolidated into the *GraydonWilliams* action and Flyline Partners, LP was appointed leadplaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP. Richard Picard and Anthony Scolaro were also named as plaintiffs. Sincethen, the court allowed 

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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 theExchange Act, Section 11 of the Securities Act of 1933 (the “SecuritiesAct”) and/or Section 15 of the Securities Act. The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees. In February 2006, the court approved the settlement of thismatter. Under the settlement agreement, Cornell has not admitted anywrongdoing. Settlement in the amount of $7.0 million has been funded throughour directors’ and officers’ liability insurance. During the fourth quarter of2005, we recorded the settlement charge of $7.0 million and the relatedreimbursement of $7.0 million from our director’s and officer’s liabilityinsurance. The charge and reimbursement was recognized in general andadministrative expenses in our Consolidated Statements of Operations andComprehensive Income (Loss) for the year ended December 31, 2005. The liabilitywas carried in accounts payable and accrued liabilities and the reimbursementwas included in other receivables at December 31, 2005. The reimbursement wasfunded by the insurance carrier in 2005 into a trust account and funds weredisbursed from the trust account to plaintiffs’ counsel’s escrow account uponcourt approval of the settlement in February 2006.

In March 2002, the Company, its directors, andits former independent auditor Arthur Andersen LLP, were sued in a derivativeaction styled as *William Williams,Derivatively and on Behalf of Nominal Defendant Cornell Companies, Inc. v.Anthony R. Chase, et al.*, No. 2002-15614, in the 127th Judicial District Court of Harris County,Texas. The lawsuit related to our restatement in 2002 of certain financialstatements. The lawsuit alleged breaches of fiduciary duty by all of theindividual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicating thatthe Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows:(1) *Juan Guitierrez, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of Harris County,Texas. These lawsuits relate to our restatement in 2002 of certain financialstatements. These lawsuits all allege breaches of fiduciary duty and waste ofcorporate assets by all of the defendants and seeks unspecified damages. Amotion to dismiss the *Guitierrez*and *Pagano* lawsuits was filed.The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action. The court granted the motion to dismiss the *Guitierrez* action and the plaintiffs have appealed thatruling. The *Menning* action hasbeen dismissed, but with an agreement that the plaintiff’s claims as to theCompany 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 of damages andthe outcome of the matters discussed above cannot be predicted with certainty.However, our management believes that we have good defenses and intends tovigorously defend against the claims asserted in these actions. We have notrecorded any loss accruals related to these claims.

On October 19, 2006, apurported class action complaint was filed in the District Court of HarrisCounty, Texas, 269th Judicial District (No. 2006-67413) by Ted Kinbergy, analleged stockholder of Cornell Companies, Inc., a Delaware corporation (“theCompany”). The complaint names as defendants the Company and each member of itsboard of directors as well as Veritas Capital Fund III, L.P. (“Veritas”). Thecomplaint is a purported class action that alleges, among other things, that(i) the defendants have breached fiduciary duties they assertedly owed to theCompany’s stockholders in connection with the Company entering into theAgreement and Plan of Merger, dated as of October 6, 2006, with Veritas,Cornell Holding Corp., and CCI Acquisition Corp., and (ii) the mergerconsideration is unfair and inadequate. The plaintiffs seek, among otherthings, an injunction against the consummation of the merger. The Companybelieves that the lawsuit is without merit and intends to defend itselfvigorously.

Certain insurance policies held by us to cover potential director andofficer liability may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decisionin these matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, an adverse decision to us in thesematters could have a material adverse effect on us, our financial condition,results of operations and cash flows.

***Other***

Additionally, we currently and from time to time aresubject to claims and suits arising in the ordinary course of business,including claims for damages for personal injuries or for wrongful restrictionof or interference with offender 

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privilegesand employment matters. If an adverse decision in these matters exceeds ourinsurance coverage, or if our coverage is deemed not to apply to these matters,or if the underlying insurance carrier was unable to fulfill its obligationunder the insurance coverage provided, it could have a material adverse effecton our financial condition, results of operations or cash flows.

  During theperiod of August 2000 through May 2003, our general liability andprofessional liability coverage was provided by Specialty Surplus InsuranceCompany, a Kemper Insurance Company (“Kemper”) group member. In June 2004,the Illinois Department of Insurance gave Kemper permission to proceed with arun-off plan it had previously submitted. The three-year plan is designed tohelp Kemper meet its goal of resolving, to the maximum extent possible, allvalid policyholder claims. In view of the risks and uncertainties involved inimplementing the plan, including the need to achieve significant policybuybacks, commutation of reinsurance agreements, and further agreements withregulators, no assurance can be given that the plan will be successfullyimplemented by Kemper. In the year ended December 31, 2004, we accrued aprovision of $0.6 million, and estimated our range of additional exposure to beapproximately $0.5 million with respect to outstanding claims incurred duringthis policy period with Kemper which would become our obligation to resolve ifnot settled through Kemper. During the year ended December 31, 2005, Kemper continuedto implement its run-off plan. As a result, several of our significant claimswere settled by Kemper in the second quarter of 2005. In conjunction with thesesettlements, we recorded a charge against our existing accrual in the amount of$0.3 million. Based on our analysis of the claims activity during the thirdquarter of 2005, we felt it necessary to accrue an additional provision in theamount of approximately $0.2 million during the third quarter of 2005.Additional significant claims were settled by Kemper during the third quarterof 2006. We believe that the uncertainty surrounding the ability of Kemper tosettle our remaining outstanding claims still exists. At September 30, 2006, wedo not believe there is significant exposure above our existing $0.5 millionaccrual for those outstanding claims which could become our obligation toresolve if not settled through Kemper.

While the outcome of these other matters cannot bepredicated with certainty, based on the information known to date, we believe thatthe ultimate resolution of these matters will not have a material adverseeffect on our financial condition, operating results or cash flows.

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

***Big Spring Correctional Center.***  The Federal Bureau of Prisons (“BOP”) issoliciting a Request for Proposals (“RFP”) for services to house approximately7,000 low security non-United States citizen sentenced males in an existingsecure correctional institution procured from private sources or state and localgovernments, with excess capacity, located in Arizona, California, Louisiana,New Mexico, Oklahoma or Texas to replace several existing intergovernmentalagreements (“IGA”) for such services, including the IGA relating to our BigSpring Correctional Center. We submitted a response to the RFP on August 8,2006. Our failure to successfully respond to this RFP would materiallyadversely affect our financial condition, results of operations and liquidity.

***Great Plains CorrectionalFacility.***  Webelieve that our existing contract with the Oklahoma Department of Corrections(“OK DOC”) with respect to our Great Plains Correctional Facility expired inJuly 2006. Despite negotiations with the OK DOC since early 2006, we have beenunable to agree on terms for a new contract. As a result, to preserve ourrights relative to other business opportunities, in October 2006 we notified OKDOC of our intent to terminate the contract. With our Great Plains CorrectionalFacility, as with all our facilities, we seek to maximize the operatingpotential based on an assessment of which potential customer(s) would enable usto realize the highest economic value. To date, we do not have an alternatecustomer for this facility. Our inability to maintain a customer for thisfacility could have an adverse effect on our financial condition, results of operationsand liquidity.

**9.     Derivative Financial Instruments andGuarantees**

***Debt ServiceReserve Fund and Debt Service Fund***

In August 2001, MCF completed a bond offeringto finance the 2001 Sale and Leaseback Transaction.  In connection with this bond offering, tworeserve fund accounts were established by MCF pursuant to the terms of theindenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 millionat September 30, 2006, was established to make payments on MCF’soutstanding bonds in the event we (as lessee) should fail to make the scheduledrental payments to MCF and (2) MCF’s Debt Service Fund, aggregating $15.6million and $19.6 million at September 30, 2006 and December 31, 2005,respectively, used to accumulate the monthly lease payments that MCF receivesfrom us until such funds are used to pay MCF’s semi-annual bond interest andannual bond principal payments.  Bothreserve fund accounts are subject to the agreements with the MCF EquityInvestors whereby guaranteed rates of return of 3.0% and 5.08%, respectively,are provided for in the balance of the Debt Service Reserve Fund and the DebtService Fund.  The guaranteed rates ofreturn are characterized as cash flow hedge derivative instruments.  At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a deferred liability in our Consolidated Balance Sheets.Changes in the fair value of the derivative instruments are recorded as anadjustment to other long-term liabilities and reported as other comprehensiveincome (loss) in our Consolidated Statements of Operations and ComprehensiveIncome (Loss).  At September 30,2006 and December 31, 2005, the fair value of these derivative instrumentswas approximately $3.5 million and $3.0 million, respectively.  As a result, our Consolidated Statements ofOperations and Comprehensive Income (Loss) include other comprehensive netincome (loss) of approximately $0.5 million and ($0.3) million for the threeand nine months ended September 30, 2006, respectively.  For the three and nine months ended September30, 2005, we reported other comprehensive loss of approximately ($0.2) millionrelated to these derivative instruments. The ($0.2) million unrealized loss reported in comprehensive loss forthe nine months ended September 30, 2005 includes an adjustment of $0.6million for the tax effect of changes in fair value during the years endedDecember 31, 2002 and 2003 not previously recorded. 

In connection with MCF’s bond offering, the MCFEquity Investor provided a guarantee of the Debt Service Reserve Fund if abankruptcy of the Company were to occur and a trustee for the estate of theCompany were to include the Debt Service Reserve Fund as an asset of theCompany’s estate.  This guarantee ischaracterized as an insurance contract and is being amortized to expense overthe life of the debt.

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**10.  Segment Disclosure**

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems.  The adult community-based corrections andtreatment services segment consists of providing pre-release and halfway houseprograms for adult offenders who are either on probation or serving the lastthree to six-months of their sentences on parole and preparing for re-entryinto society at large as well as community-based treatment and educationprograms as an alternative to incarceration. All of our customers and long-lived assets are located in the UnitedStates of America.  The accounting policiesof our reportable segments are the same as those described in the summary ofsignificant accounting policies in our 2005 Annual Report on Form 10-K.  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.  We evaluate performance based on income orloss from operations before general and administrative expenses, incentivebonuses, amortization of intangibles, interest and income taxes.  Corporate and other assets are comprisedprimarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferredtaxes, deferred costs and other assets. Corporate and other expense from operations primarily consists ofdepreciation and amortization on the corporate office facilities and equipment,and is presented separately as such charges cannot be readily identified forallocation to a particular segment.

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Thefollowing table excludes the results of discontinued operations for therevenue, pre-opening and start-up expenses and income from operationscategories for all periods presented.  Theonly significant non-cash item reported in the respective segment’s income fromoperations is depreciation and amortization (excluding intangibles) (in thousands).
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                         | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Revenues:                                          |       |                             |       |                            |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 47,243     |                            | $          | 32,190 |   | $ | 130,953 |   | $ | 94,296 |   |
| Juvenile                                           |       | 28,410                           |       | 30,052                          |       | 86,401 |   | 90,506 |   |
| Adult community-based                              |       | 16,730                           |       | 16,956                          |       | 49,374 |   | 46,538 |   |
| Total revenues                                     |       | $                                | 92,383     |                            | $          | 79,198 |   | $ | 266,728 |   | $ | 231,340 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Pre-opening and start-up expenses:                 |       |                             |       |                            |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | —     |                            | $          | 1,607 |   | $ | 2,657 |   | $ | 6,650 |   |
| Juvenile                                           |       | —                           |       | —                          |       | — |   | 1,803 |   |
| Adult community-based                              |       | —                           |       | —                          |       | — |   | — |   |
| Total pre-opening and start-up expenses            |       | $                                | —     |                            | $          | 1,607 |   | $ | 2,657 |   | $ | 8,453 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Income from operations:                            |       |                             |       |                            |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | 11,587     |                            | $          | 6,735 |   | $ | 32,251 |   | $ | 18,940 |   |
| Juvenile                                           |       | 2,629                            |       | 3,722                           |       | 9,258 |   | 11,419 |   |
| Adult community-based                              |       | 3,216                            |       | 3,374                           |       | 9,088 |   | 8,902 |   |
| Subtotal                                           |       | 17,432                           |       | 13,831                          |       | 50,597 |   | 39,261 |   |
| General and administrative expense                 |       | (6,053                           | )          | (4,760                          | )          | (16,604 | ) | (15,997 | ) |
| Amortization of intangibles                        |       | (561                             | )          | (560                            | )          | (1,682 | ) | (1,533 | ) |
| Corporate and other                                |       | (262                             | )          | (319                            | )          | (835 | ) | (1,064 | ) |
| Total income from operations                       |       | $                                | 10,556     |                            | $          | 8,192 |   | $ | 31,476 |   | $ | 20,667 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Loss on discontinued operations, net of tax:       |       |                             |       |                            |       |   |   |   |   |
| Adult secure institutional                         |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | —                           |       | (236                            | )          | (707 | ) | (3,323 | ) |
| Adult community-based                              |       | —                           |       | (43                             | )          | — |   | (71 | ) |
| Total loss on discontinued  operations, net of tax |       | $                                | —     |                            | $          | (279 | ) | $ | (707 | ) | $ | (3,394 | ) |

 
|                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Assets                     |       |                   |       |                  |       |
| Adult secure institutional |       | $                      | 231,485    |                  | $          | 215,147 |   |
| Juvenile                   |       | 103,271                |       | 106,409               |       |
| Adult community-based      |       | 64,154                 |       | 67,871                |       |
| Intangible assets, net     |       | 19,826                 |       | 21,666                |       |
| Corporate and other        |       | 90,697                 |       | 99,535                |       |
| Total assets               |       | $                      | 509,433    |                  | $          | 510,628 |   |

 

**11.  GuarantorDisclosures**

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

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**CondensedConsolidating Balance Sheet as of September 30, 2006 (in thousands)(unaudited)**
| ** **                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                      |       |       |       |             |       |                |       |             |       |             |       |
|                                            |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                 |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash equivalents                       |       | $          | 11,105     |             | $          | 308                 |       | $                | 60         |             | $          | — |   | $ | 11,473 |   |
| Investment securities                           |       | 9,975      |       | —           |       | —              |       | —           |       | 9,975            |       |
| Accounts receivable                             |       | 2,466      |       | 69,039           |       | 189                 |       | —           |       | 71,694           |       |
| Debt service fund and other restricted assets   |       | 11         |       | 1,522            |       | 15,644              |       | —           |       | 17,177           |       |
| Prepaids and other                              |       | 12,504     |       | 2,399            |       | —              |       | —           |       | 14,903           |       |
| Total current assets                            |       | 36,061     |       | 73,268           |       | 15,893              |       | —           |       | 125,222          |       |
| Property and equipment, net                     |       | 119        |       | 174,873          |       | 151,475             |       | (5,412           | )          | 321,055          |       |
| Other assets:                                   |       |       |       |             |       |                |       |             |       |             |       |
| Debt service reserve fund                       |       | —     |       | —           |       | 23,800              |       | —           |       | 23,800           |       |
| Deferred costs and other                        |       | 46,597     |       | 26,878           |       | 8,329               |       | (42,448          | )          | 39,356           |       |
| Investment in subsidiaries                      |       | 22,156     |       | 1,959            |       | —              |       | (24,115          | )          | —           |       |
| Total assets                                    |       | $          | 104,933    |             | $          | 276,978             |       | $                | 199,497    |             | $          | (71,975 | ) | $ | 509,433 |   |
| ** **                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’ Equity**   |       |       |       |             |       |                |       |             |       |             |       |
|                                            |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                            |       |       |       |             |       |                |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $          | 44,739     |             | $          | 8,153               |       | $                | 2,220      |             | $          | (2,265 | ) | $ | 52,847 |   |
| Current portion of long-term debt               |       | —     |       | 10               |       | 10,500              |       | —           |       | 10,510           |       |
| Total current liabilities                       |       | 44,739     |       | 8,163            |       | 12,720              |       | (2,265           | )          | 63,357           |       |
| Long-term debt, net of current portion          |       | 109,932    |       | 40               |       | 145,500             |       | —           |       | 255,472          |       |
| Deferred tax liabilities                        |       | 10,836     |       | (1,822           | )          | —              |       | 185              |       | 9,199            |       |
| Other long-term liabilities                     |       | 6,116      |       | 199              |       | 40,678              |       | (42,206          | )          | 4,787            |       |
| Intercompany                                    |       | (243,308   | )          | 243,308          |       | —              |       | —           |       | —           |       |
| Total liabilities                               |       | (71,685    | )          | 249,888          |       | 198,898             |       | (44,286          | )          | 332,815          |       |
| Stockholders’ equity                       |       | 176,618    |       | 27,090           |       | 599                 |       | (27,689          | )          | 176,618          |       |
| Total liabilities and stockholders’ equity |       | $          | 104,933    |             | $          | 276,978             |       | $                | 199,497    |             | $          | (71,975 | ) | $ | 509,433 |   |

 

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**Condensed Consolidating Balance Sheet as ofDecember 31, 2005 (in thousands)**
| ** **                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                      |       |       |       |             |       |                |       |             |       |             |       |
|                                            |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                 |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash equivalents                       |       | $          | 12,579     |             | $          | 1,114               |       | $                | 30         |             | $          | — |   | $ | 13,723 |   |
| Investment securities                           |       | 7,250      |       | 3⁄4           |       | 3⁄4              |       | 3⁄4           |       | 7,250            |       |
| Accounts receivable                             |       | 7,718      |       | 60,337           |       | 372                 |       | 3⁄4           |       | 68,427           |       |
| Restricted assets                               |       | 3⁄4     |       | 2,633            |       | 19,586              |       | 3⁄4           |       | 22,219           |       |
| Prepaids and other                              |       | 11,828     |       | 2,337            |       | 3⁄4              |       | 3⁄4           |       | 14,165           |       |
| Total current assets                            |       | 39,375     |       | 66,421           |       | 19,988              |       | 3⁄4           |       | 125,784          |       |
| Property and equipment, net                     |       | 148        |       | 174,886          |       | 154,641             |       | (5,814           | )          | 323,861          |       |
| Other assets:                                   |       |       |       |             |       |                |       |             |       |             |       |
| Debt service reserve fund                       |       | 3⁄4     |       | 3⁄4           |       | 23,802              |       | 3⁄4           |       | 23,802           |       |
| Deferred costs and other                        |       | 41,926     |       | 23,861           |       | 8,772               |       | (37,378          | )          | 37,181           |       |
| Investment in subsidiaries                      |       | 14,602     |       | 3,806            |       | 3⁄4              |       | (18,408          | )          | 3⁄4           |       |
| Total assets                                    |       | $          | 96,051     |             | $          | 268,974             |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |
| ** **                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’ Equity**   |       |       |       |             |       |                |       |             |       |             |       |
|                                            |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                            |       |       |       |             |       |                |       |             |       |             |       |
| Accounts payable and accrued liabilities        |       | $          | 43,561     |             | $          | 11,920              |       | $                | 5,879      |             | $          | (2,563 | ) | $ | 58,797 |   |
| Current portion of long-term debt               |       | 3⁄4     |       | 1                |       | 9,700               |       | 3⁄4           |       | 9,701            |       |
| Total current liabilities                       |       | 43,561     |       | 11,921           |       | 15,579              |       | (2,563           | )          | 68,498           |       |
| Long-term debt, net of current portion          |       | 110,659    |       | —           |       | 156,000             |       | 3⁄4           |       | 266,659          |       |
| Deferred tax liabilities                        |       | 8,076      |       | (1,763           | )          | 3⁄4              |       | 395              |       | 6,708            |       |
| Other long-term liabilities                     |       | 5,490      |       | 108              |       | 35,640              |       | (37,936          | )          | 3,302            |       |
| Intercompany                                    |       | (237,196   | )          | 237,196          |       | 3⁄4              |       | 3⁄4           |       | 3⁄4           |       |
| Total liabilities                               |       | (69,410    | )          | 247,462          |       | 207,219             |       | (40,104          | )          | 345,167          |       |
| Stockholders’ equity                       |       | 165,461    |       | 21,512           |       | (16                 | )          | (21,496          | )          | 165,461          |       |
| Total liabilities and stockholders’ equity |       | $          | 96,051     |             | $          | 268,974             |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |

 

21

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**Condensed Consolidating Statement ofOperations for the three months ended September 30, 2006****(in thousands)**
| ** **                                                                  | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                    |       | $          | 4,502      |             | $          | 105,376             |       | $                | 4,502      |             | $          | (21,997 | ) | $ | 92,383 |   |
| Operating expenses                                                          |       | 7,223      |       | 86,144           |       | —              |       | (21,910          | )          | 71,457           |       |
| Depreciation and amortization                                               |       | —     |       | 3,402            |       | 1,055               |       | (140             | )          | 4,317            |       |
| General and administrative expenses                                         |       | 6,007      |       | —           |       | 46                  |       | —           |       | 6,053            |       |
| Income (loss) from operations                                               |       | (8,728     | )          | 15,830           |       | 3,401               |       | 53               |       | 10,556           |       |
| Overhead allocations                                                        |       | (12,631    | )          | 12,631           |       | —              |       | —           |       | —           |       |
| Interest, net                                                               |       | 2,088      |       | 1,272            |       | 3,129               |       | 11               |       | 6,500            |       |
| Equity earnings in subsidiaries                                             |       | 2,112      |       | —           |       | —              |       | (2,112           | )          | —           |       |
| Income (loss) from continuing operations before provision for  income taxes |       | 3,927      |       | 1,927            |       | 272                 |       | (2,070           | )          | 4,056            |       |
| Provision for income taxes                                                  |       | 1,343      |       | —           |       | —              |       | 129              |       | 1,472            |       |
| Income (loss) from continuing operations                                    |       | 2,584      |       | 1,927            |       | 272                 |       | (2,199           | )          | 2,584            |       |
| Discontinued operations                                                     |       | —     |       | —           |       | —              |       | —           |       | —           |       |
| Net income (loss)                                                           |       | $          | 2,584      |             | $          | 1,927               |       | $                | 272        |             | $          | (2,199 | ) | $ | 2,584 |   |

 

22

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**Condensed Consolidating Statement ofOperations for the three months ended September 30, 2005****(in thousands)**
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,502      |             | $          | 88,766              |       | $                | 4,502      |             | $          | (18,572 | ) | $ | 79,198 |   |
| Operating expenses                                                                    |       | 3,936      |       | 75,070           |       | 32                  |       | (18,233          | )          | 60,805           |       |
| Pre-opening and start-up expenses                                                     |       | —     |       | 1,607            |       | —              |       | —           |       | 1,607            |       |
| Depreciation and amortization                                                         |       | (42        | )          | 2,932            |       | 1,055               |       | (111             | )          | 3,834            |       |
| General and administrative expenses                                                   |       | 4,742      |       | —           |       | 18                  |       | —           |       | 4,760            |       |
| Income (loss) from operations                                                         |       | (4,134     | )          | 9,157            |       | 3,397               |       | (228             | )          | 8,192            |       |
| Overhead allocations                                                                  |       | (6,137     | )          | 6,137            |       | —              |       | —           |       | —           |       |
| Interest, net                                                                         |       | 940        |       | 1,022            |       | 3,422               |       | 11               |       | 5,395            |       |
| Equity earnings in subsidiaries                                                       |       | 1,459      |       | —           |       | —              |       | (1,459           | )          | —           |       |
| Income (loss) from continuing operations before provision  (benefit) for income taxes |       | 2,522      |       | 1,998            |       | (25                 | )          | (1,698           | )          | 2,797            |       |
| Provision (benefit) for income taxes                                                  |       | 1,245      |       | —           |       | —              |       | (4               | )          | 1,241            |       |
| Income (loss) from continuing operations                                              |       | 1,277      |       | 1,998            |       | (25                 | )          | (1,694           | )          | 1,556            |       |
| Discontinued operations, net of income tax benefit of $150                            |       | —     |       | (279             | )          | —              |       | —           |       | (279             | )          |
| Net income (loss)                                                                     |       | $          | 1,277      |             | $          | 1,719               |       | $                | (25        | )                | $          | (1,694 | ) | $ | 1,277 |   |

 

23

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**Condensed Consolidating Statement ofOperations for the nine months ended September 30, 2006****(in thousands)**
| ** **                                                                  | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                    |       | $          | 13,506     |             | $          | 303,067             |       | $                | 13,506     |             | $          | (63,351 | ) | $ | 266,728 |   |
| Operating expenses                                                          |       | 17,295     |       | 249,503          |       | 33                  |       | (63,096          | )          | 203,735          |       |
| Pre-opening and start-up expenses                                           |       | —     |       | 2,657            |       | —              |       | —           |       | 2,657            |       |
| Depreciation and amortization                                               |       | —     |       | 9,492            |       | 3,166               |       | (402             | )          | 12,256           |       |
| General and administrative expenses                                         |       | 16,520     |       | —           |       | 84                  |       | —           |       | 16,604           |       |
| Income (loss) from operations                                               |       | (20,309    | )          | 41,415           |       | 10,223              |       | 147              |       | 31,476           |       |
| Overhead allocations                                                        |       | (30,034    | )          | 30,034           |       | —              |       | —           |       | —           |       |
| Interest, net                                                               |       | 4,685      |       | 3,812            |       | 9,608               |       | 32               |       | 18,137           |       |
| Equity earnings in subsidiaries                                             |       | 7,293      |       | —           |       | —              |       | (7,293           | )          | —           |       |
| Income (loss) from continuing operations before provision for  income taxes |       | 12,333     |       | 7,569            |       | 615                 |       | (7,178           | )          | 13,339           |       |
| Provision for income taxes                                                  |       | 5,181      |       | —           |       | —              |       | 299              |       | 5,480            |       |
| Income (loss) from continuing operations                                    |       | 7,152      |       | 7,569            |       | 615                 |       | (7,477           | )          | 7,859            |       |
| Discontinued operations, net of income tax benefit  of $381                 |       | —     |       | (707             | )          | —              |       | —           |       | (707             | )          |
| Net income (loss)                                                           |       | $          | 7,152      |             | $          | 6,862               |       | $                | 615        |             | $          | (7,477 | ) | $ | 7,152 |   |

** **

24

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**Condensed Consolidating Statement ofOperations for the nine months ended September 30, 2005****(in thousands)**
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 13,512     |             | $          | 260,493             |       | $                | 13,506     |             | $          | (56,171 | ) | $ | 231,340 |   |
| Operating expenses                                                                    |       | 12,399     |       | 217,554          |       | 56                  |       | (55,165          | )          | 174,844          |       |
| Pre-opening and start-up expenses                                                     |       | —     |       | 8,453            |       | —              |       | —           |       | 8,453            |       |
| Depreciation and amortization                                                         |       | —     |       | 8,524            |       | 3,166               |       | (311             | )          | 11,379           |       |
| General and administrative expenses                                                   |       | 15,941     |       | —           |       | 56                  |       | —           |       | 15,997           |       |
| Income (loss) from operations                                                         |       | (14,828    | )          | 25,962           |       | 10,228              |       | (695             | )          | 20,667           |       |
| Overhead allocations                                                                  |       | (21,727    | )          | 21,727           |       | —              |       | —           |       | —           |       |
| Interest, net                                                                         |       | 2,418      |       | 3,822            |       | 10,447              |       | 32               |       | 16,719           |       |
| Equity earnings in subsidiaries                                                       |       | (3,847     | )          | —           |       | —              |       | 3,847            |       | —           |       |
| Income (loss) from continuing operations before provision  (benefit) for income taxes |       | 634        |       | 413              |       | (219                | )          | 3,120            |       | 3,948            |       |
| Provision (benefit) for income taxes                                                  |       | 1,941      |       | —           |       | —              |       | (80              | )          | 1,861            |       |
| Income (loss) from continuing operations                                              |       | (1,307     | )          | 413              |       | (219                | )          | 3,200            |       | 2,087            |       |
| Discontinued operations, net of income tax benefit of $1,827                          |       | —     |       | (3,394           | )          | —              |       | —           |       | (3,394           | )          |
| Net income (loss)                                                                     |       | $          | (1,307     | )                | $          | (2,981              | )          | $                | (219       | )                | $          | 3,200 |   | $ | (1,307 | ) |

** **

25

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**CondensedConsolidating Statement of Cash Flows for the nine months endedSeptember 30, 2006 (in thousands)**
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**                 | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net cash  provided by (used in) operating activities      |       | $          | (1,060     | )                | $          | 6,869               |       | $                | 5,788      |             | $          | — |   | $ | 11,597 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**                 | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Capital  expenditures                                     |       | —     |       | (10,557          | )          | —              |       | —           |       | (10,557          | )          |
| Purchase of  investment securities                        |       | (296,975   | )          | —           |       | —              |       | —           |       | (296,975         | )          |
| Sales of  investment securities                           |       | 294,250    |       | —           |       | —              |       | —           |       | 294,250          |       |
| Withdrawals  from restricted debt payment account, net    |       | —     |       | —           |       | 3,942               |       | —           |       | 3,942            |       |
| Proceeds from  the sale of property and equipment         |       | —     |       | 2,890            |       | —              |       | —           |       | 2,890            |       |
| Net cash used in investing activities                     |       | (2,725     | )          | (7,667           | )          | 3,942               |       | —           |       | (6,450           | )          |
|                                                      |       |       |       |             |       |                |       |             |       |             |       |
| **Cash flows from financing activities:**                 | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Payments of MCF  Bonds                                    |       | —     |       | —           |       | (9,700              | )          | —           |       | (9,700           | )          |
| Payments of  capital lease obligations                    |       | —     |       | (8               | )          | —              |       | —           |       | (8               | )          |
| Tax benefit of  stock option exercises                    |       | 223        |       | —           |       | —              |       | —           |       | 223              |       |
| Proceeds from  exercise of stock options                  |       | 2,088      |       | —           |       | —              |       | —           |       | 2,088            |       |
| Net cash provided by (used in) financing activities       |       | 2,311      |       | (8               | )          | (9,700              | )          | —           |       | (7,397           | )          |
|                                                      |       |       |       |             |       |                |       |             |       |             |       |
| **Net (decrease) increase in cash and cash  equivalents** |       | (1,474     | )          | (806             | )          | 30                  |       | —           |       | (2,250           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at beginning of  period**     |       | 12,579     |       | 1,114            |       | 30                  |       | —           |       | 13,723           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at end of period**            |       | $          | 11,105     |             | $          | 308                 |       | $                | 60         |             | $          | — |   | $ | 11,473 |   |

 

26

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**Condensed Consolidating Statement ofCash Flows for the nine months ended September 30, 2005 (in thousands)**
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**                 |       |       |       |             |       |                |       |             |       |             |       |
| Net cash  provided by (used in) operating activities      |       | $          | (24,335    | )                | $          | 37,493              |       | $                | 4,814      |             | $          | — |   | $ | 17,972 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**                 |       |       |       |             |       |                |       |             |       |             |       |
| Capital  expenditures                                     |       | —     |       | (37,331          | )          | —              |       | —           |       | (37,331          | )          |
| Purchases of  investment securities                       |       | (905,345   | )          | —           |       | —              |       | —           |       | (905,345         | )          |
| Sales of  investment securities                           |       | 936,285    |       | —           |       | —              |       | —           |       | 936,285          |       |
| Acquisition of  a business                                |       | (9,139     | )          | —           |       | —              |       | —           |       | (9,139           | )          |
| Withdrawals  from restricted debt payment account, net    |       | —     |       | —           |       | 4,183               |       | —           |       | 4,183            |       |
| Proceeds from  the sale of property and equipment         |       | —     |       | 624              |       | —              |       | —           |       | 624              |       |
| Net cash provided by (used in) investing activities       |       | 21,801     |       | (36,707          | )          | 4,183               |       | —           |       | (10,723          | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from financing activities:**                 |       |       |       |             |       |                |       |             |       |             |       |
| Payments on  acquired debt                                |       | (1,905     | )          | —           |       | —              |       | —           |       | (1,905           | )          |
| Payments of MCF  bonds                                    |       | —     |       | —           |       | (9,000              | )          | —           |       | (9,000           | )          |
| Payments of  capital lease obligations                    |       | —     |       | (176             | )          | —              |       | —           |       | (176             | )          |
| Proceeds from  exercise of stock options                  |       | 4,065      |       | —           |       | —              |       | —           |       | 4,065            |       |
| Net cash provided by (used in) financing activities       |       | 2,160      |       | (176             | )          | (9,000              | )          | —           |       | (7,016           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Net increase (decrease) in cash and cash  equivalents** |       | (374       | )          | 610              |       | (3                  | )          | —           |       | 233              |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at beginning of  period**     |       | 9,559      |       | 296              |       | 40                  |       | —           |       | 9,895            |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at end of period**            |       | $          | 9,185      |             | $          | 906                 |       | $                | 37         |             | $          | — |   | $ | 10,128 |   |

 

27

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**ITEM 2.          Management’s Discussion and Analysisof Financial Condition and Results of Operations**

**General**

We are a leading provider ofcorrectional, detention, educational, rehabilitation and treatment servicesoutsourced by federal, state and local government agencies. We provide adiversified portfolio of services for adults and juveniles through our threeoperating divisions: (1) adult secure institution and detention services;(2) juvenile justice, educational and treatment services and(3) adult community-based corrections and treatment services. AtSeptember 30, 2006, we operated 76 facilities with a total servicecapacity of 18,820. We also had three facilities that were substantially vacantwith an aggregate service capacity of 406. Our facilities are located in 17states and the District of Columbia.

The following table (whichexcludes data related to discontinued operating facilities) sets forth for theperiods indicated total residential service capacity and contracted beds inoperation at the end of the periods shown, average contract occupancypercentages and total non-residential service capacity.
|                                                                                    | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **2006**               | ** ** | **2005**               | ** ** |
| **Residential**                                                                    | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service  capacity (1) (2)                                                          |       | 14,634                 |       | 14,324                 |       |
| Contracted beds  in operation (end of period) (1) (3)                              |       | 13,508                 |       | 11,997                 |       |
| Average contract  occupancy based on contracted beds in operation (1) (4) (5) |       | 96.4                   | %          | 95.7                   | %          |
| Average  contract occupancy excluding start-up operations (1) (4) (5)         |       | 96.4                   | %          | 101.6                  | %          |
| **Non-Residential**                                                                | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (1) (6)                                                           |       | 4,592                  |       | 5,182                  |       |

 

----

(1)   Data presented excludes discontinued operating facilities.

(2)   Residential service capacity iscomprised of the number of beds currently available for service or availableupon the completion of construction or renovation of residential facilities.

(3)   Atcertain residential facilities, the contracted capacity is lower than thefacility’s service capacity.  We couldincrease a facility’s contracted capacity by obtaining additional contracts orby renegotiating existing contracts to increase the number of bedscovered.  However, we may not be able toobtain contracts that provide occupancy levels at a facility’s service capacityor that current contracted capacities can be maintained in future periods.

(4)   Occupancypercentages reflect less than normalized occupancy during the start-up phase ofany applicable facility, resulting in a lower average occupancy in periods whenwe have substantial start-up activities.

(5)   Averagecontract occupancy percentages are calculated based on actual occupancy for thenine month period as a percentage of the contracted capacity for residentialfacilities in operation.  Thesepercentages do not reflect the operations of non-residential community-basedprograms.  At certain residentialfacilities, our contracted capacity is lower than the facility’s servicecapacity.  Additionally, certainfacilities have and are currently operating above the contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

(6)   Servicecapacity for non-residential programs is based on either contractual terms oran estimate of the number of clients to be served.  We update these estimates at least annuallybased on the program’s budget and other factors.

We derive substantially all ofour revenues from providing adult corrections and treatment and juvenilejustice, educational and treatment services outsourced by federal, state andlocal government agencies in the United States. Revenues for our services are generally recognized on a per diem ratebased upon the number of occupant days or hours served for the period, on aguaranteed take-or-pay basis or on a cost-plus reimbursement basis. Forthe three months ended September 30, 2006, our revenue base consisted of72.1% for services provided under per diem contracts, 17.8% for servicesprovided under take-or-pay and management contracts, 6.6% for services providedunder cost-plus reimbursement contracts, 2.1% for services provided underfee-for-service contracts and 1.4% from other miscellaneous sources. For thenine months ended September 30, 2006, our revenue base consisted of 73.2%for services provided under per diem contracts, 15.5% for services providedunder take-or-pay and management contracts, 7.5% for services provided under cost-plusreimbursement contracts, 2.4% for services provided under fee-for-servicecontracts and 1.4% from other miscellaneous sources.  While these percentages are generallyconsistent with comparable statistics for the three and nine months endedSeptember 30, 2005, there has been a decrease in the percentage of revenues forservices provided under per diem contracts and in the percentage of revenuesprovided under fee-for-service and cost-plus reimbursement contracts, and anincrease in the percentage of revenues provided under take-or-pay contractsbetween the comparable periods.  Theincrease in the percentage of revenues 

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providedunder take-or-pay contracts is primarily due to the start of operations at theMoshannon Valley Correctional Center in April 2006.  Revenues can fluctuate from period to period due to changes ingovernment funding policies, changes in the number of people referred to ourfacilities by governmental agencies, the opening of new facilities or theexpansion of existing facilities and the termination of contracts for afacility or the closure of a facility.

Revenues for our adultsecure institutional services division are primarily generated from per diem,take-or-pay and management contracts. For the three months ended September 30, 2006 and 2005, we realizedaverage per diem rates on our adult secure institutional facilities ofapproximately $56.49 and $48.35, respectively. For the nine months endedSeptember 30, 2006 and 2005, we realized average per diem rates of approximately$56.40 and $48.21, respectively. The increase in the average per diem rates in2006 is due primarily to the opening of the Moshannon Valley CorrectionalCenter in April 2006.

Revenues for our juvenile justice, educational andtreatment services division are primarily generated from per diem,fee-for-service and cost-plus reimbursement contracts.  For the three months ended September 30,2006 and 2005, we realized average per diem rates on our residential juvenilefacilities of approximately $172.08 and $168.80, respectively.  For the nine months ended September 30,2006 and 2005, we realized average per diem rates of approximately $169.26 and$167.35, respectively.  For the threemonths ended September 30, 2006 and 2005, we realized averagefee-for-service rates for our non-residential community-based juvenilefacilities and programs, including rates that are limited by Medicaid and otherprivate insurance providers, of approximately $38.13 and $40.38,respectively.  For the nine months endedSeptember 30, 2006 and 2005, we realized average fee-for-service rates ofapproximately $36.41 and $33.30, respectively. The increase in the average fee-for-service rates for 2006 is due tochanges in the mix of services provided at our non-residential juvenilefacilities and programs, as well as the addition of several new alternativeeducation programs in 2005. The majority of our juvenile services contractsrenew annually.

Revenues for our adult community-based corrections andtreatment services division are primarily generated from per diem andfee-for-service contracts.  For the threemonths ended September 30, 2006 and 2005, we realized average per diem rates onour residential adult community-based facilities of approximately $61.81 and$61.89, respectively.  For the ninemonths ended September 30, 2006 and 2005, we realized average per diemrates of $61.38 and $61.44, respectively. For the three months ended September 30, 2006 and 2005, we realizedaverage fee-for-service rates on our non-residential adult community-basedprograms of approximately $10.23 and $10.09, respectively.  For the nine months ended September 30,2006 and 2005, we realized average fee-for-service rates of approximately$10.10 and $9.48, respectively.  

Factors considered indetermining billing rates to charge include: (1) the programs specified bythe contract and the related staffing levels, (2) wage levels customary inthe respective geographic areas, (3) whether the proposed facility is tobe leased or purchased and (4) the anticipated average occupancy levelsthat could reasonably be maintained.

We have historicallyexperienced higher operating margins in our adult secure institutional servicesand adult community-based corrections and treatment services as compared to thejuvenile justice, educational and treatment services division. Additionally,our operating margins within a division can vary from facility to facilitybased on whether a facility is owned or leased, the level of competition forthe contract award, the proposed length of the contract, the occupancy levelsfor a facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract, and our ability to increase a facility’s contract revenue. Undertake-or-pay contracts, such as the Moshannon Valley Correctional Center,operating margins are typically higher during the early stages of the contractas the facility’s population ramps up (as revenues are received at contractpercentages regardless of actual occupancy). As the variable costs (primarily resident related and certain facilitycosts) increase as the population grows, operating margins will generallydecline to a stabilized level. As we experienced in the third quarter of 2006,we would expect such margin impact pertaining to our Moshannon ValleyCorrectional Center to also occur in the fourth quarter of 2006. A decline inoccupancy of certain juvenile justice, educational and treatment facilities canhave a more significant impact on operating results than the adult secureinstitutional services division due to higher per diem rates at certainjuvenile facilities.

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

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We are responsible for allfacility operating costs, except for certain debt service and interest or leasepayments for facilities where we have a management contract only. At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all otheroperating expenses at these facilities. We operated 18 and 22 facilities undermanagement contracts at September 30, 2006 and 2005, respectively. 

A majority of our facilityoperating costs consists of fixed costs. These fixed costs include lease andrental expense, insurance, utilities and depreciation. As a result, when wecommence operation of new or expanded facilities, fixed operating costsincrease. The amount of our variable operating costs, including food, medicalservices, supplies and clothing, depend on occupancy levels at the facilitieswe operate. Our largest single operating cost, facility payroll expense andrelated employment taxes and expenses, has both a fixed and a variablecomponent. We can adjust a facility’s staffing levels and the related payrollexpense to a certain extent based on occupancy at a facility, however a minimumfixed number of employees is required to operate and maintain any facilityregardless of occupancy levels. Personnel costs are subject to increases intightening labor markets based on local economic and other conditions.

We incur pre-opening andstart-up expenses including payroll, benefits, training and other operatingcosts prior to opening a new or expanded facility and during the period ofoperation while occupancy is ramping up. These costs vary by contract. Sincepre-opening and start-up costs are generally factored into the revenue per diemrate that is charged to the contracting agency, we typically expect to recoverthese upfront costs over the life of the contract. Because occupancy ratesduring a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs. We do not anticipate post-opening start-up costsat any adult secure facilities operated under any future contracts with the BOPbecause these contracts are currently expected to continue to be take-or-paycontracts, meaning that the BOP will pay at least 80.0% of the contractualmonthly revenue once the facility opens, regardless of actual occupancy.

Newly opened facilities arestaffed according to applicable regulatory or contractual requirements when webegin receiving offenders or clients. Offenders or clients are typicallyassigned to a newly opened facility on a phased-in basis over a one- tosix-month period. Our start-up period for new juvenile operations is 12 monthsfrom the date we begin recognizing revenue unless break-even occupancy levelsare achieved before then. Our start-up period for new adult operations is ninemonths from the date we begin recognizing revenue unless break-even occupancylevels are achieved before then. Although we typically recover these upfrontcosts over the life of the contract, quarterly results can be substantiallyaffected by the timing of the commencement of operations as well as thedevelopment and construction of new facilities.

Working capital requirements generallyincrease immediately prior to commencing management of a new or expandedfacility as we incur start-up costs and purchase necessary equipment andsupplies before facility management revenue is realized.

General and administrativeexpenses consist primarily of costs for corporate and administrative personnelwho provide senior management, legal, finance, accounting, human resources,payroll and information systems, costs of business development and outsideprofessional and consulting fees.  Wewould expect to continue to incur additional legal and outside professional andconsulting fees related to the Merger Agreement with Veritas, described in “RecentDevelopments” below, during the fourth quarter of 2006 and first quarter of2007.

#### **Recent Developments**

**Merger Agreement**

OnOctober 6, 2006, the Company entered into an Agreement and Plan of Merger (the “MergerAgreement”) with The Veritas Capital Fund III, L.P., a Delaware limitedpartnership (“Veritas”), Cornell Holding Corp., a Delaware corporation (“Parent”),and CCI Acquisition Corp., a Delaware corporation and wholly owned subsidiaryof Parent (“Merger Sub”), pursuant to which the Merger Sub will be merged withand into the Company (the “Merger”), with the Company surviving after theMerger as a wholly owned subsidiary of Parent.

Ifthe Merger is consummated, the Company will become a wholly-owned subsidiary ofParent and each stockholder of the Company will receive $18.25 in cash for eachshare of the Company’s common stock they hold.

TheCompany’s Board of Directors has unanimously approved the Merger Agreement andthe transactions contemplated thereby and will recommend that the Company’sstockholders approve the Merger Agreement, the Merger and any othertransactions contemplated thereby. The Merger Agreement, the Merger and anyother transactions contemplated thereby are 

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subject toregulatory and stockholder approvals and other customary closing conditions.The transaction is not subject to a financing contingency.

Inconnection with the Merger, the Parent and certain stockholders of the Companyhave entered into a Voting Agreement dated on or about October 6, 2006, wherebysuch stockholders have agreed, among other things, to vote their respectiveshares of Company stock in favor of the Merger Agreement, the Merger and thetransactions contemplated thereby.

Thetransaction is expected to be completed by the end of the first quarter of 2007and to be financed with equity from Veritas Capital Fund III, L.P.

***ShareholderLitigation***

On October 19, 2006, apurported class action complaint was filed in the District Court of HarrisCounty, Texas, 269th Judicial District (No. 2006-67413) by Ted Kinbergy, analleged stockholder of Cornell Companies, Inc., a Delaware corporation (“Cornell”).The complaint names as defendants Cornell and each member of its board ofdirectors as well as Veritas Capital Fund III, L.P. (“Veritas”). The complaintis a purported class action that alleges, among other things, that (i) thedefendants have breached fiduciary duties they assertedly owed to Cornell’sstockholders in connection with Cornell entering into the Agreement and Plan ofMerger, dated as of October 6, 2006, with Veritas, Cornell Holding Corp., andCCI Acquisition Corp., and (ii) the merger consideration is unfair andinadequate. The plaintiffs seek, among other things, an injunction against theconsummation of the merger. Cornell believes that the lawsuit is without merit andintends to defend itself vigorously.

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

On January 1, 2006, we adopted theprovisions of the Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. The modifiedprospective transition method requires that compensation cost be recognized inthe financial statements for all awards granted after the date of adoption aswell as for existing awards for which the requisite service has not beenrendered as of the date of adoption and requires that prior periods not berestated. Our stock incentive plans provide for the granting of incentiveoptions and nonqualified options to officers, directors and key employees ofthe Company. Outstanding options vest over periods up to seven years after thedate of grant and expire no more than 10 years after grant. Prior to theadoption of SFAS No. 123R, we used the intrinsic-value based method to accountfor stock options and recorded no charges against earnings with respect tooptions granted. We have elected to use the “short-cut method” to calculate thehistorical pool of windfall tax benefits upon adoption of SFAS 123R. Theelection to use the “short-cut method” had no effect on our consolidatedfinancial statements.

The adoption of SFAS No. 123R reducedincome from continuing operations before income taxes for the three and ninemonths ended September 30, 2006 by approximately $0.4 million and $1.6 million,respectively, and reduced net income for the three and nine months endedSeptember 30, 2006 by approximately $0.2 million ($0.02 per basic anddiluted share) and $0.9 million ($0.07 per basic and diluted share),respectively. The adoption of SFAS No. 123R had an immaterial effect onour Consolidated Statement of Cash Flows for the nine months endedSeptember 30, 2006. Refer to Part I, Item 1, Note 2 to the consolidatedfinancial statements for further information concerning the adoption of SFASNo. 123R.

***Employee-Stock Purchase Plan***

We have an employee stockpurchase plan under which employees can make contributions to purchase ourcommon stock. Participation in the plan is elected annually by employees. Theplan year begins each January 1st (the “Grant Date”) and ends onDecember 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15% discount. Under SFAS No. 123R, compensatory employee stock purchaseplans (“ESPP”) are required to recognize compensation cost over the requisiteservice period for grants made under the ESPP. We recognized approximately$0.02 million and $0.07 million of expense related to this plan in the three andnine months ended September 30, 2006.

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

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes” (“FIN 48”),to clarify the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes.”  FIN 48 is effective forfiscal years 

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beginning afterDecember 15, 2006.  We are currentlyreviewing this new guidance to determine the impact on our financialstatements.

***Statement Financial Accounting Standards No. 157***

InSeptember 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” Thisstatement establishes a framework for measuring fair value within generallyaccepted accounting principles and expands disclosures about fair valuemeasurements. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. The provisions of SFAS No. 157 should be appliedprospectively as of the beginning of the fiscal year in which SFAS No. 157 isinitially applied, except in limited circumstances. We expect to adopt SFAS No.157 beginning January 1, 2008. We are currently evaluating the impact that thisinterpretation may have on our consolidated financial statements.

***Securities and Exchange Commission (“SEC”)Staff Accounting Bulletin No. 108***

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”)No. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements.” This guidanceindicates that the materiality of a misstatement must be evaluated using boththe rollover and iron curtain approaches. The iron curtain approach quantifiesa misstatement based on the effects of correcting the misstatement existing inthe balance sheet at the end of the current year, while the rollover approachquantifies a misstatement based on the amount of the error originating in thecurrent year income statement. SAB No. 108 will be implemented January 1,2007. We are currently assessing the impact of SAB No. 108; however, we donot believe the adoption of this standard will have a material effect on ourconsolidated financial statements.

**Results of Operations**

The followingtable sets forth for the periods indicated the percentages of revenuerepresented by certain items in our historical consolidated statements ofoperations.
|                                                                     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                          | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                            |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                  |       | 77.3                             |       | 76.8                            |       | 76.4 |   | 75.6 |   |
| Pre-opening and start-up expenses                                   |       | —                           |       | 2.0                             |       | 1.0 |   | 3.7 |   |
| Depreciation and amortization                                       |       | 4.7                              |       | 4.8                             |       | 4.6 |   | 4.9 |   |
| General and administrative expenses                                 |       | 6.6                              |       | 6.0                             |       | 6.2 |   | 6.9 |   |
| Income from operations                                              |       | 11.4                             |       | 10.4                            |       | 11.8 |   | 8.9 |   |
| Interest expense, net                                               |       | 7.0                              |       | 6.8                             |       | 6.8 |   | 7.2 |   |
| Income from continuing operations before provision for income taxes |       | 4.4                              |       | 3.6                             |       | 5.0 |   | 1.7 |   |
| Provision for income taxes                                          |       | 1.6                              |       | 1.6                             |       | 2.1 |   | 0.8 |   |
| Income from continuing operations                                   |       | 2.8                              |       | 2.0                             |       | 2.9 |   | 0.9 |   |
| Discontinued operations, net of tax                                 |       | —                           |       | (0.4                            | )          | (0.3 | ) | (1.5 | ) |
| Net income (loss)                                                   |       | 2.8                              | %          | 1.6                             | %          | 2.6 | % | (0.6 | )% |

 

***ThreeMonths Ended September 30, 2006 Compared to Three Months Ended September 30,2005***

Certain comparisons ofrevenues, expenses and average contract capacity contained herein have beenmade excluding the effect of pre-opening and start-up expenses andrevenues.  Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent measurescalculated in a manner that is not consistent with U.S. generally acceptedaccounting principles (GAAP).  We believethe exclusion of the non-recurring effect of pre-opening and start-up expensesand revenues increases the reader’s understanding of our operating trends.

***Revenues*****.** Revenues increased approximately $13.2 million, or 16.7%, to $92.4million for the three months ended September 30, 2006 from $79.2 million forthe three months ended September 30, 2005.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $15.0million, or 46.6%, to $47.2 million for the three months ended September 30,2006 from $32.2 million for the three months ended September 30, 2005 due primarilyto (1) revenues of approximately $8.8 million at the MoshannonValley Correctional Center which opened in April 2006, (2) an increase inrevenues of approximately $2.6 million at the Regional Correctional Center dueto increased occupancy, (3) revenues of approximately $1.8 million at the MesaVerde Community Correctional Center and (4) an increase in revenues ofapproximately $0.9 million at the D. Ray James Prison due to increasedoccupancy and a per diem rate increase in mid-year 2005. The remaining netincrease in revenues of approximately $0.9 million was due to variousinsignificant fluctuations in revenues at our other adult secure facilities.

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Ouradult secure institutional services division revenues are primarily generatedfrom contracts with federal and state government agencies.  At September 30, 2006 we operated 10adult secure institutional facilities with an aggregate service capacity of9,442.

Averagecontract occupancy was 98.7% for the three months ended September 30, 2006compared to 95.8% for the three months ended September 30, 2005.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in2005, average contract occupancy was 102.6% for the three months endedSeptember 30, 2005. The average contract occupancy statistics for 2006reflect the activation and continued ramp-up in population at the MoshannonValley Correctional Center.  The averageper diem rate for our adult secure facilities was approximately $56.49 and$48.35 for the three months ended September 30, 2006 and 2005,respectively.  The increase in the perdiem rate for 2006 was due to the opening of the Moshannon Valley CorrectionalCenter in April 2006. There were no revenues attributable to start-upoperations in the three months ended September 30, 2006.  Revenues attributable to start-up operationswere approximately $0.7 million in the three months ended September 30,2005 and were attributable to the Regional Correctional Center in New Mexico.

***Juvenile.***Juvenile justice, educational andtreatment services division revenues decreased approximately $1.7 million, or5.6%, to $28.4 million for the three months ended September 30, 2006 from$30.1 million for the three months ended September 30, 2005 due primarilyto (1) a decrease in revenues of approximately $0.8 million due to thetemporary closure of the Campbell Griffin Treatment Center in October 2005, (2)a decrease in revenues of approximately $0.9 million at the Danville Center forAdolescent Females due to reduced occupancy preceding the conclusion of ourmanagement contract in March 2006, (3) a decrease in revenues of approximately$0.8 million due to the termination of our operating contract at the SouthMountain Secure Treatment Unit effective June 30, 2006 and (4) a decrease inrevenues of approximately $0.3 million due to the termination of our operatingcontract for the Washington, DC community-based programs in August 2006.  The remaining net increase in revenues ofapproximately $1.1 million was due to various insignificant fluctuation inrevenues at our other juvenile facilities and programs. We currently plan toreactivate the Campbell Griffin Treatment Center in the first quarter of 2007.

AtSeptember 30, 2006, we operated 16 residential juvenile facilities and 13non-residential juvenile community-based programs with an aggregate servicecapacity of 3,845.  Our contracts forthese facilities and programs are generally with state and local governmentagencies and generally renew annually.

Average contractoccupancy for the three months ended September 30, 2006 was 93.5% comparedto 86.8% for the three months ended September 30, 2005.  The increase was due to higher populations atvarious facilities including the Southern Peaks Regional Treatment Center.

Theaverage per diem rate for our residential juvenile facilities was approximately$172.08 for the three months ended September 30, 2006 compared to $168.80for the three months ended September 30, 2005.  Our average fee-for-service rate for ournon-residential juvenile community-based facilities and programs wasapproximately $38.13 for the three months ended September 30, 2006compared to $40.38 for the three months ended September 30, 2005. Thedecrease in average fee-for-service rate in 2006 is due to changes in the mixof services provided at our non-residential juvenile facilities and programs,as well as the addition of several new alternative education programs in 2005.There were no revenues attributable to start-up operations for the three monthsended September 30, 2006 and 2005.

***Adult Community-Based.*****Adult community-based corrections andtreatment services division revenues decreased approximately $0.3 million, or1.8%, to $16.7 million for the three months ended September 30, 2006 from $17.0million for the three months ended September 30, 2005 due primarily to adecrease in combined revenues of approximately $0.4 million at the CordovaCenter and the Midtown Center due to reduced occupancy. The remaining netincrease in revenues of $0.1 million was due to various fluctuations inrevenues at our other adult community-based facilities and programs.

AtSeptember 30, 2006, we operated 27 residential adult community-basedfacilities and 10 non-residential adult community-based programs with anaggregate service capacity of 5,533.  Averagecontract occupancy was 96.6% for the three months ended September 30, 2006compared to 100.9% for the three months ended September 30, 2005.  The average per diem rate for ourresidential adult community-based facilities was approximately $61.81 for thethree months ended September 30, 2006 compared to $61.89 for the threemonths ended September 30, 2005. The average fee-for-service rate for our non-residential adultcommunity-based programs was approximately $10.23 for the three months endedSeptember 30, 2006 compared to $10.09 for the three months endedSeptember 30, 2005.  There were norevenues attributable to start-up operations for the three months endedSeptember 30, 2006 and 2005.

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***Operating Expenses****.*Operating expenses increasedapproximately $10.7 million, or 17.6%, to $71.5 million for the three monthsended September 30, 2006 from $60.8 million for the three months endedSeptember 30, 2005.

***Adult Secure.***Adultsecure institutional services division operating expenses increased approximately$11.2 million, or 50.2%, to $33.5 million for the three months ended September 30,2006 from $22.3 million for the three months ended September 30, 2005 due primarilyto (1) operating expenses of approximately $4.5 million at the MoshannonValley Correctional Center which opened in April 2006, (2) an increase inoperating expenses of approximately $2.6 million at the Regional CorrectionalCenter as a portion of the operating expenses for the three months endedSeptember 30, 2005 were reported as pre-opening and start-up expenses and (3)operating expenses of approximately $1.4 million at the Mesa Verde CommunityCorrectional Center which we began managing in January 2006.  The remaining net increase in operatingexpenses of approximately $2.7 million was due to various fluctuations inoperating expenses at our other adult secure facilities.

As a percentage of segment revenues, adult secureinstitutional services division operating expenses were 70.8% for the threemonths ended September 30, 2006 compared to 69.2% for the three monthsended September 30, 2005.  AsMoshannon Valley Correctional Center continues to ramp-up its population duringthe fourth quarter 2006, we anticipate some margin decreases as certainvariable costs increase.  Excludingapproximately $0.7 million of revenues attributable to the start-up operationsof the Regional Correctional Center in the three months ended September 30,2005, adult secure institutional services division operating expenses, as apercentage of segment revenues, were 70.8%.

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses decreased approximately $0.5million, or 2.0%, to $25.0 million for the three months ended September 30,2006 from $25.5 million for the three months ended September 30, 2005 dueprimarily to (1) a decrease in operating expenses of approximately $0.8million due to the temporary closure of the Campbell Griffin Treatment Centerin October 2005, (2) a decrease in operating expenses of approximately $0.8million at the Danville Center for Adolescent Females (due to reduced occupancyas noted above), (3) a decrease in operating expenses of approximately $0.7million at the South Mountain Secure Treatment Unit due to the expiration ofour management contract effective June 30, 2006 and (4) a decrease in operatingexpenses of approximately $0.1 million due to the expiration of our managementcontract for the Washington, DC community-based programs in August 2006. Theabove decreases in operating expenses were offset, in part, by (1) an increasein operating expenses of approximately $0.4 million at the Alexander YouthCenter due to increased occupancy, (2) an increase in operating expenses ofapproximately $0.3 million at the Southern Peaks Regional Treatment Center dueto increased occupancy, (3) an increase in operating expenses of approximately$0.2 million at the Reading Alternative School which we began managing in July2005 and (4) an increase in operating expenses of approximately $0.4 million atthe New Morgan Academy as we are preparing to re-open the facility in October2006. The remaining net increase in operating expenses of approximately $0.6million was due to various insignificant fluctuations in operating expenses atour other juvenile facilities and programs.

As a percentageof segment revenues, juvenile services division operating expenses were 87.9%for the three months ended September 30, 2006 compared to 84.8% for threemonths ended September 30, 2005.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses wereapproximately $13.0 million for the three months ended September 30, 2006and 2005. As a percentage of segment revenues, adult community-baseddivision operating expenses were 77.7% for the three months ended September 30,2006 compared to 76.9% for the three months ended September 30, 2005.

***Pre-Opening and Start-up Expenses.*** Therewere no pre-opening and start-up expenses for the three months ended September 30,2006.  Pre-opening and start-up expensesfor the three months ended September 30, 2005 were approximately $1.6million and were attributable to the pre-opening and start-up activities of theRegional Correctional Center and the Moshannon Valley Correctional Center.

***Depreciation and Amortization*****. **Depreciationand amortization increased approximately $0.5 million, or 13.2%, to $4.3million for the three months ended September 30, 2006 from $3.8 millionfor the three months ended September 30, 2005 due primarily todepreciation of the building and related furniture and equipment at theMoshannon Valley Correctional Center which opened in April 2006.  Amortization of intangibles was approximately$0.6 million for the three months ended September 30, 2006 and 2005.  

***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $1.3 million, or 27.1%, to$6.1 million for the three months ended September 30, 2006 from $4.8million for the three months ended September 30, 2005 due primarilyto professional and consulting expenses of approximately $1.2 million incurredin conjunction with our review of strategic alternatives and subsequentdecision to enter into the Merger Agreement with 

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Veritas, which wasexecuted in October 2006.  In addition,compensation expense of approximately $0.4 million was recognized under theprovisions of FAS 123R which we adopted effective January 1, 2006. See Part I,Item 1, Note 2 to the accompanying financial statements for further discussionconcerning our adoption of FAS 123R. These increases were partiallyoffset by higher professional and consulting expenses of approximately $0.3million incurred in conjunction with the 2005 proxy process.

***Interest.*** Interest expense, net of interestincome, increased to approximately $6.5 million for the three months endedSeptember 30, 2006 from $5.4 million for the three months ended September 30,2005.  In the three months endedSeptember 30, 2006 we recognized interest expense related to the interest rateswap of $0.1 million compared to interest income of $0.2 million in the threemonths ended September 30, 2005.  Atcurrent interest rate levels, we would expect to continue to incur additionalinterest expense under our interest rate swap. Any additional rise in interest rates would increase our interestexpense.  Moreover, we did not capitalizeinterest in the three months ended September 30, 2006.  Capitalized interest for the three monthsended September 30, 2005 was approximately $1.1 million and related todevelopment and construction costs for the Moshannon Valley CorrectionalCenter.  Additionally, MCF made anannual principal payment of $9.7 million on their outstanding bonds, whichreduced interest expense in the three months ended September 30, 2006 byapproximately $0.2 million as compared to the three months ended September 30,2005.

***Income Taxes.*** For thethree months ended September 30, 2006, we recognized a provision forincome taxes on our income from operations at an estimated effective rate of 36.3%.  For the three months ended September 30,2005, we recognized a provision for income taxes on income from operations atan estimated effective rate of 44.4%. The change in our estimated effective tax rate in 2006 was related to anincrease in operating income across certain of our business segments (relativeto prior periods) which reduces the net impact of certain non-deductibleexpenses such as lobbying and tax-exempt income. The effective tax rate for thethird quarter of 2006 also reflects an adjustment of approximately $0.2 millionfor the cumulative impact of certain statuatory tax changes which wereeffective as of June 30, 2006.

***NineMonths Ended September 30, 2006 Compared to Nine Months Ended September 30,2005***

***Revenues*****.** Revenues increased approximately $35.4million, or 15.3%, to $266.7 million for the nine months ended September 30,2006 from $231.3 million for the nine months ended September 30, 2005.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $36.7million, or 38.9%, to $131.0 million for the nine months ended September 30,2006 from $94.3 million for the nine months ended September 30, 2005 dueprimarily to (1) revenues of approximately $17.7 million at theMoshannon Valley Correctional Center which opened in April 2006, (2) anincrease in revenues of approximately $8.6 million at the Regional CorrectionalCenter due to increased occupancy, (3) revenues of approximately $5.2 millionat the Mesa Verde Community Correctional Facility which we began managing inJanuary 2006, (4) an increase in revenues of approximately $2.5 million at theD. Ray James Prison due to increased occupancy coupled with a per diem rateincrease in 2005 and (5) an increase in revenues of approximately $1.4 millionat our two secure facilities in California. The remaining net increase in revenues of approximately $1.3 million wasdue to various fluctuations in revenues at our other adult secure facilities.

 Average contract occupancy for the ninemonths ended September 30, 2006 was 96.8% compared to 94.9% for the ninemonths ended September 30, 2005. Excluding the actual occupancy and contract capacity for the start-upoperations of the Regional Correctional Center in the nine months endedSeptember 30, 2005, average contract occupancy was 104.0% for the ninemonths ended September 30, 2005. The average contract occupancy statistics for 2006 reflect the activationand continued ramp-up in population at the Moshannon Valley CorrectionalCenter.

 The averageper diem rate for our adult secure facilities was approximately $56.40 and$48.21 for the nine months ended September 30, 2006 and 2005,respectively.  The increase in the perdiem rate in 2006 is due to the opening of the Moshannon Valley CorrectionalCenter in April 2006.  There were norevenues attributable to start-up operations for the nine months endedSeptember 30, 2006.  Revenuesattributable to start-up operations for the nine months ended September 30,2005 were approximately $3.3 million and were attributable to the start-upoperations of the Regional Correctional Center in New Mexico.  

***Juvenile.***Juvenile justice, educational andtreatment services division revenues decreased approximately $4.1 million, or4.5%, to $86.4 million for the nine months ended September 30, 2006 from $90.5million for the nine months ended September 30, 2005 due primarily to (1) adecrease in revenues of approximately $3.5 million as a result of the temporaryclosure of the Campbell Griffin Treatment Center in October 2005, (2) adecrease in revenues of approximately $2.0 million at the Danville Center forAdolescent Females (“DCAF”) due to reduced occupancy preceding the conclusionof our management contract in March 2006, (3) a decrease in revenues ofapproximately $1.1 million at the Harrisburg Alternative School due to acontract renewal change in July 2005, (4) a decrease in revenues ofapproximately $0.9 million due to the expiration of our management contract forthe South Mountain Secure Treatment Unit (“SMSTU”) effective June 30, 2006 

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and (5) a decreasein revenues of approximately $0.6 million due to the expiration of ourmanagement contract for the Washington, DC (“DC”) community-based programseffective August 31, 2006.  The decreasein revenues due to the above was offset, in part, by (1) an increase inrevenues at the Alexander Youth Center of approximately $0.5 million due toincreased occupancy, (2) an increase in revenues of approximately $1.2 millionat the Southern Peaks Regional Treatment Center due to improved occupancy asthe facility was ramping-up in 2005 and (3) an increase in revenues ofapproximately $1.2 million at the Reading Alternative School which we beganoperating in July 2005.  The remaining netincrease in revenues of approximately $1.1 million was due to variousfluctuations in revenues at our other juvenile facilities and programs.  The concluded/terminated contracts at DCAF,SMSTU and DC generated total revenues of $3.2 million and $6.7 million,respectively, for the nine months ended September 30, 2006 and 2005.

Average contract occupancy was 92.7% for the ninemonths ended September 30, 2006 compared to 90.1% for the nine monthsended September 30, 2005. Excluding the actual occupancy and contract capacityfor the start-up activities of the Southern Peaks Regional Treatment Center in2005, average contract occupancy was 91.1% for the nine months endedSeptember 30, 2005.  The increase inaverage contract occupancy during the nine months ended September 30, 2006 isdue to higher populations at various programs including the Southern PeaksRegional Treatment Center.  The averageper diem rate for our residential juvenile facilities was approximately $169.26and $167.35 for the nine months ended September 30, 2006 and 2005,respectively.  Our averagefee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $36.41 and $33.30 for the nine monthsended September 30, 2006 and 2005, respectively.  The increase in average fee-for-service ratein 2006 is due to changes in the mix of services provided, as well as theaddition of several new alternative education programs in 2005.

There were norevenues attributable to start-up operations for the nine months endedSeptember 30, 2006.  Revenuesattributable to start-up operations were approximately $1.5 million for thenine months ended September 30, 2005 and were attributable to the start-upoperations of the Southern Peaks Regional Treatment Center.  

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division revenues increased approximately$2.9 million, or 6.2%, to $49.4 million for the nine months ended September 30,2006 from $46.5 million for the nine months ended September 30, 2005 dueprimarily to revenues ofapproximately $3.2 million generated from the facilities and programs acquiredfrom Correctional Systems, Inc. (“CSI”) in April 2005.  The remaining net decrease in revenues ofapproximately $0.3 million was due to various insignificant fluctuations inrevenues at our other adult community-based facilities and programs.

Average contract occupancy for the nine months endedSeptember 30, 2006 was 97.0% compared to 102.0% for the nine months endedSeptember 30, 2005.  The average perdiem rate for our residential adult community-based facilities was $61.38 and$61.44 for the nine months ended September 30, 2006 and 2005,respectively.   The averagefee-for-service rate for our non-residential adult community-based programs was$10.10 and $9.48 for the nine months ended September 30, 2006 and 2005,respectively.   There were no revenuesattributable to start-up operations for the nine months endedSeptember 30, 2006 and 2005.

***Operating Expenses.***Operating expenses increased approximately $28.9 million, or 16.5%, to $203.7 millionfor the nine months ended September 30, 2006 from $174.8 million for thenine months ended September 30, 2005.

***Adult Secure.***Adultsecure institutional services division operating expenses increasedapproximately $26.1 million, or 40.8%, to $90.1 million for the nine monthsended September 30, 2006 from $64.0 million for the nine months endedSeptember 30, 2005 due primarily to (1) an increase inoperating expenses of approximately $8.9 million at the Moshannon ValleyCorrectional Center which opened in April 2006 (operating expenses ofapproximately $0.3 million incurred during the same period of 2005 werereported as pre-opening and start-up expenses), (2) operating expenses ofapproximately $3.8 million at the Mesa Verde Community Correctional Centerwhich we began operating in January 2006, (3) an increase in operating expensesof approximately $8.9 million at the Regional Correctional Center (expenses ofapproximately $6.4 million incurred in the same period of 2005 were reported aspre-opening and start-up expenses), (4) an increase in operating expenses ofapproximately $0.9 million at our two secure facilities in California due toincreased occupancy and (5) an increase in operating expenses of $0.6 millionat Donald D. Wyatt Detention Center due to increased occupancy. The remainingnet increase in operating expenses of $3.0 million was due to variousfluctuations in operating expenses at our other adult secure facilities.

As a percentageof segment revenues, adult secure institutional services division operatingexpenses were 68.8% for the nine months ended September 30, 2006 comparedto 67.8% for the nine months ended September 30, 2005.  Excluding approximately $3.3 million ofrevenues attributable to the start-up operations of the Regional CorrectionalCenter in the nine 

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months ended September 30,2005, adult secure institutional services division operating expenses, as apercentage of segment revenues, were 70.3% for the nine months ended September30, 2005.  

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses were approximately $74.8 millionfor the nine months ended September 30, 2006 and 2005.  Significant changes in operatingexpenses included (1) a decrease in operating expenses of approximately $2.8million due to the temporary closure of the Campbell Griffin Treatment Centerin October 2005, (2) a decrease in operating expenses of $1.9 million at theDanville Center for Adolescent Females due to reduced occupancy preceding theconclusion of our management contract in March 2006, (3) a decrease inoperating expenses of approximately $0.8 million due to the expiration of ourmanagement contract for the South Mountain Secure Treatment Unit effective June30, 2006, (4) a decrease in operating expenses of approximately $0.9 million atthe  Harrisburg Alternative Schoolresulting from a contract renewal change in July 2005, (5) an increase inoperating expenses of $2.9 million at the Southern Peaks Regional TreatmentCenter as a portion of the 2005 expenses were reported as pre-opening andstart-up expenses, (6) an increase in operating expenses of approximately $1.2million at the Reading Alternative School which we began managing in July 2005 and(7) an increase in operating expenses of approximately $0.5 million at theAlexander Youth Center due to increased occupancy.  The remaining net increase in operatingexpenses of approximately $1.8 million was due to various other insignificantchanges in operating expenses at our other juvenile facilities and programs.

As a percentageof segment revenues, juvenile services division operating expenses were 86.5%for the nine months ended September 30, 2006 compared to 82.7% for the ninemonths ended September 30, 2005.  Excluding approximately $1.5 million ofrevenues attributable to the start-up operations of the Southern Peaks RegionalTreatment Center in the nine months ended September 30, 2005, juvenileservices division operating expenses, as a percentage of segment revenues, were84.1%.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses increasedapproximately $2.7 million, or 7.5%, to $38.8 million for the nine months endedSeptember 30, 2006 from $36.1 million for the nine months endedSeptember 30, 2005 due primarily to operating expenses ofapproximately $3.0 million from the facilities and programs acquired from CSIin April 2005.  The remaining netdecrease in operating expenses of approximately $0.3 million was due variousinsignificant fluctuations in operating expenses at our other adultcommunity-based facilities and programs.

As a percentage of segment revenues, adultcommunity-based corrections and treatment services division operating expenseswere 78.7% for the nine months ended September 30, 2006 compared to 77.5%for the nine months ended September 30, 2005.

***Pre-Opening and Start-up Expenses.*** Pre-openingand start-up expenses for the nine months ended September 30, 2006 wereapproximately $2.7 million and were attributable to the pre-opening activitiesof the Moshannon Valley Correctional Center. Pre-opening and start-up expenses for the nine months ended September 30,2005 were approximately $8.5 million and were attributable to the pre-openingand start-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center and the Moshannon Valley Correctional Center. 

***Depreciation and Amortization*****.** Depreciation and amortization increasedapproximately $0.9 million, or 7.9%, to $12.3 million for the nine months endedSeptember 30, 2006 compared to $11.4 million for the nine months endedSeptember 30, 2005 due primarily to depreciation of the building andrelated furniture and equipment at the Moshannon Valley Correctional Centerwhich opened in April 2006.  Amortizationof intangibles was approximately $1.7 million and $1.5 million for the ninemonths ended September 30, 2006 and 2005, respectively.  

***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $0.6 million, or 3.8%, to $16.6million for the nine months ended September 30, 2006 from $16.0 millionfor the nine months ended September 30, 2005 due primarily toprofessional and consulting expenses of approximately $1.3 million incurred inconjunction with our review of strategic alternatives and subsequent decisionto enter into the Merger Agreement with Veritas, which was executed in October2006. In addition, there was an increase in compensation expense of approximately$1.6 million resulting from adoption of FAS 123R.  The increase was offset by a restructuringcharge of approximately $1.1 million in the nine months ended September 30,2005 for personnel costs associated with management’s streamlining initiativesimplemented in the first quarter of 2005. The increase also was offset by higher professional and consultingexpenses of approximately $1.1 million in 2005 incurred in conjunction with ourSarbanes-Oxley compliance and with the 2005 proxy process.

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***Interest.*** Interest expense, net of interestincome, increased to $18.1 million for the nine months ended September 30,2006 from $16.7 million for the nine months ended September 30, 2005.  For the nine months ended September 30, 2006,we recognized interest expense related to the interest rate swap ofapproximately $0.6 million compared to interest income of approximately $1.0million in the nine months ended September 30, 2005.  At current interest rate levels, we wouldexpect to incur additional interest expense under our interest rate swap.  Any additional rise in interest rates wouldincrease our interest expense. Additionally, MCF made an annual principal payment of $9.7 million ontheir outstanding bonds, which reduced interest expense for the nine monthsended September 30, 2006 by approximately $0.2 million as compared to the ninemonths ended September 30, 2005. Furthermore, interest expense increased approximately $0.7 million dueto a decrease in capitalized interest during 2006.  For the nine months ended September 30, 2006,we capitalized interest of approximately $1.5 million related to theconstruction of the Moshannon Valley Correctional Center compared toapproximately $2.2 million in the nine months ended September 30, 2005.

***Income Taxes.*** For thenine months ended September 30, 2006, we recognized a provision for incometaxes on our income from continuing operations at an estimated effective rateof 41.1%.  For the nine months endedSeptember 30, 2005, we recognized a provision for income taxes on ourincome from continuing operations at an estimated effective rate of 47.1%.  The change in our estimated effective rate in2006 was related to an increase in operating income across certain of our businesssegments relative to prior periods which reduces the net impact of certainnon-deductible expenses such as lobbying and tax-exempt interest income.

**Liquidity andCapital Resources**

***General*****.**Ourprimary capital requirements for (1) purchases, construction or renovationof new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operatingcontracts, (5) acquisitions, (6) information systems hardware andsoftware, and (7) furniture, fixtures and equipment.  Working capital requirements generallyincrease immediately prior to commencing management of a new facility as weincur start-up costs and purchase necessary equipment and supplies beforefacility management revenue is realized.

***Cash Flows From Operating Activities.*** Cashprovided by operations was approximately $11.6 million for the nine monthsended September 30, 2006.  Cash provided byoperations was approximately $18.0 million for the nine months endedSeptember 30, 2005. The decrease in 2006 is principally due to an increasein accounts receivable due to the activation/ramp-up of several facilities in2006 including the Moshannon Valley Correctional Center, the Mesa VerdeCorrectional Center and the Regional Correctional Center, as well as therelated timing of accounts receivable collections in 2006 and 2005.

***Cash Flows From Investing Activities*****. **Cash usedin investing activities was approximately $6.5 million for the nine monthsended September 30, 2006 due to capital expenditures of approximately $10.6million and net purchases of investment securities of $2.7 million, offset bynet withdrawals from the restricted debt payment account of $3.9 million andproceeds from the sale of property and equipment of approximately $2.9 million.** **Cashused in investing activities was approximately $10.7 million for the ninemonths ended September 30, 2005 due to net sales of investment securitiesof $30.9 million offset by capital expenditures of $46.4 million comprised ofapproximately $37.3 million for the development and construction of the MoshannonValley Correctional Center and approximately $9.1 million (net) for theacquisition of CSI.  Additionally, therewere net withdrawals from the restricted debt payment account of approximately$4.2 million and proceeds of $0.6 million from the sale of property andequipment.

***Cash Flows From Financing Activities*****. **Cashflows used in financing activities was approximately $7.4 million for the ninemonths ended September 30, 2006 due primarily to MCF’s annual bond principalpayment of $9.7 million made in July 2006 offset by proceeds from the exerciseof stock options of $2.1 million and the tax benefit of stock option exercisesof $0.2 million. Cash usedin financing activities was approximately $7.0 million for the nine monthsended September 30, 2005 due primarily to a $9.0 million annual principalpayment on MCF’s bonds and the repayment of approximately $1.9 million in debtacquired from CSI offset by proceeds from the exercise of stock options of $4.1million.

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $50.4 million at September 30, 2006.  We had no outstanding borrowings on ourCredit Facility at September 30, 2006, but we had outstanding letters of creditof approximately $9.6 million.  Subjectto certain requirements, we have the right to increase the aggregatecommitments under our Credit Facility up to an aggregate amount of $100.0million.  Our Credit Facility matures inJune 2008 and bears interest, at our election, depending on our total leverageratio, at either the prime rate plus a margin ranging from 0.75% to 2.00%, or arate which ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit 

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Facilitycontains standard covenants including compliance with laws, limitations oncapital expenditures, restrictions on dividend payments, limitations on mergersand compliance with financial covenants.

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

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes (the “SeniorNotes”) due July 1, 2012.  The SeniorNotes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of each year,commencing January 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:

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

 

Any time prior to July 1, 2007, we may redeem up to 35% of the originalaggregate principal amount of the Senior Notes at a redemption price of 110.75%of the principal amount thereof with the net cash of public offerings ofequity, provided that at least 65% of the original aggregate principal amountof the Senior Notes remains outstanding after the redemption and otherconditions are met.  Upon the occurrenceof specified change of control events, unless we have exercised our option toredeem all the Senior Notes as described above, each holder will have the rightto require us to repurchase all or a portion of such holder’s Senior Notes at apurchase price in cash equal to 101% of the aggregate principal amount of thenotes repurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to pay dividendsor other payments to us, enter into transactions with affiliates, and engage inmergers, consolidations and certain sales of assets.

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and nine months ended September 30, 2006, we recorded interest expenserelated to this interest rate swap of approximately $0.1 million and $0.2million, respectively, which is reflected as interest expense in theaccompanying financial statements.  Forthe three and nine months ended September 30, 2005, we recorded interest incomerelated to this interest rate swap of approximately $0.2 million and $1.0million, respectively, which is reflected as a reduction to interest expense inthe accompanying financial statements. The swap agreement are marked to market each quarter with acorresponding mark-to-market adjustment reflected as either a discount orpremium on the Senior Notes.  AtSeptember 30, 2006 and December 31, 2005, the fair value of this derivative instrumentwas approximately ($1.0) million and ($0.1) million, respectively, and isincluded in other liabilities.  Thecarrying value of the Senior Notes as of these dates was reduced by the sameamount. Because the swap agreement is an effective fair-value hedge, there isno effect on our results of operations from the mark-to-market adjustment aslong as the swap is in effect.

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

***Big Spring Correctional Center.***   The Federal Bureau of Prisons (“BOP”) issoliciting a Request for Proposals (“RFP”) for services to house approximately7,000 low security non-United States citizen sentenced males in an existingsecure correctional institution procured from private sources or state andlocal governments, with excess capacity, located in Arizona, California,Louisiana, New Mexico, Oklahoma or Texas to replace several existingintergovernmental agreements 

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(“IGA”) for suchservices, including the IGA relating to our Big Spring CorrectionalCenter.  We submitted a response to theRFP on August 8, 2006.  Our failure tosuccessfully respond to this RFP would materially adversely affect ourfinancial condition, results of operations and liquidity.

***Alexander Youth Services Center.*** In November2006, the Arkansas Department of Health and Human Services (“DHHS”) notified usof their interest to terminate our management contract to manage the AlexanderYouth Services Center. We currently anticipate the transition of this contractto occur no later than the first quarter of 2007. This contract generatedrevenues of approximately $9.9 million in 2005 and $7.8 million in the ninemonths ended September 30, 2006. We do not maintain any significant netproperty and equipment pertaining to this contract.

***New Morgan Academy.***We closed theNew Morgan Academy in the fourth quarter of 2002 and considered several optionsranging from the utilization of the facility for another type of program or thesale or lease of the facility. In 2005 we began focusing our efforts on thereopening of the facility in the fourth quarter of 2006. The facility, whichreopened in October 2006, will operate as a residential treatment facility foryouth sex offenders. We recognized pre-tax costs of $1.3 million and $3.3million in our Consolidated Statements of Operations and Comprehensive Income(Loss) for the three and nine months ended September 30, 2006, respectively,for related holding costs (depreciation, interest, property, taxes and othermaintenance costs). We recognized pre-tax costs of $0.9 million and $2.6million in the three and nine months ended September 30, 2005, respectively,related to these costs.  The expenses forthe 2006 periods increased in conjunction with the reopening of the facility inOctober 2006.

As of September 30, 2006, we believe that, pursuant to the provisionsof SFAS No. 144, no impairment allowance is necessary. The carrying valueof the property and equipment for the New Morgan Academy was approximately$19.5 million and $19.9 million at September 30, 2006 and December 31,2005, respectively.

***Regional Correctional Center.***InJanuary 2003, we executed a five-year lease for the Regional CorrectionalCenter in Albuquerque, New Mexico. This 970 bed facility consists of two units,the 528 South Tower and the 442 bed North Tower. As of September 30, 2006, wehad invested approximately $10.0 million on renovations and furniture andequipment for both towers. While there have been periods that the facility hasreached substantial capacity during 2006, we many not be able to maintainenough volume at the facility to assure its profitability. The lease for thefacility requires monthly rental payments of approximately $113,000 for thefirst two years and $130,000 for the last three years of the lease.

***Central California Treatment Center.***InJanuary 2004, we purchased a building in Los Angeles, California for whichour carrying value was approximately $2.7 million at December 31, 2005. In2005, we received notice from a local governmental agency indicating a desireto acquire the facility. In early 2006, the governmental agency initiatedcondemnation proceedings relating to the facility and deposited approximately$2.9 million of condemnation proceeds with the court, which we received in July2006. We also have commenced litigation contesting the valuation of thefacility submitted by the governmental agency.

***Campbell GriffinTreatment Center.***In October 2005, we initiated thetemporary closure of this leased facility in San Antonio, Texas. It is ourintent to reactivate this facility during the first quarter of 2007.Accordingly, it has not been included in discontinued operations.

***Great Plains Correctional Facility.***  We believe that our existing contract withthe Oklahoma Department of Corrections (“OK DOC”) with respect to our GreatPlains Correctional Facility expired in July 2006. Despite negotiations withthe OK DOC since early 2006, we have been unable to agree on terms for a newcontract.  As a result, to preserve ourrights relative to other business opportunities, in October 2006 we notified OKDOC of our intent to terminate the contract. With our Great Plains Correctional Facility, as with all our facilities,we seek to maximize the operating potential based on an assessment of whichpotential customer(s) would enable us to realize the highest economic value. Todate, we do not have an alternate customer for this facility. Our inability tomaintain a customer for this facility could have an adverse effect on ourfinancial condition, results of operations and liquidity.

***Future Liquidity*****.**Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts within the next twelve months. To the extent our cash and currentfinancing arrangements do not provide sufficient financing to fund constructioncosts related to future adult secure institutional contract awards orsignificant facility expansions, we anticipate obtaining additional sources offinancing to fund such activities. However, there can be no assurance that suchfinancing will be available or will be available on terms favorable to us.

***Contractual Obligations and Commercial Commitments*****.** We have assumed various financialobligations and commitments in the ordinary course of conducting ourbusiness.  We have contractualobligations requiring future cash payments under our existing contractualarrangements, such as management, consultative and non-competition agreements.

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We maintainoperating leases in the ordinary course of our business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthese agreements range from 2006 until 2075. As of September 30, 2006, our total commitment under theseoperating leases was approximately $31.7 million.

The followingtable details our known future cash payments (on an undiscounted basis) relatedto various contractual obligations as of September 30, 2006 (inthousands): 
|                                                 | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | ** **                                | ** ** | ** ** | ** ** | **2007 -** | ** ** | **2009 -** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **Total**                                 | ** ** | **2006** | ** ** | **2008** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|                                            |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                      |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell  Companies, Inc. |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| ·  Special  Purpose Entities     |       | 156,000                                   |       | — |   | 21,900 |   | 25,800 |   | 108,300 |   |
| Long-term debt - interest (1)                   |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell  Companies, Inc. |       | 70,938                                    |       | 3,102 |   | 24,689 |   | 24,663 |   | 18,484 |   |
| ·  Special  Purpose Entities     |       | 82,473                                    |       | — |   | 25,537 |   | 22,666 |   | 34,270 |   |
| Capital lease  obligations                      |       |                                      |       |   |   |   |   |   |   |   |   |
| ·  Cornell  Companies, Inc. |       | 50                                        |       | 10 |   | 20 |   | 20 |   | — |   |
| Operating leases                                |       | 31,672                                    |       | 1,602 |   | 11,050 |   | 8,540 |   | 10,480 |   |
| Consultative and  non-competition agreements    |       | 994                                       |       | 216 |   | 778 |   | — |   | — |   |
| Total contractual cash  obligations             |       | $                                         | 454,127    |   | $ | 4,930 |   | $ | 83,974 |   | $ | 81,689 |   | $ | 283,534 |   |

 

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(1)   We have an interest rate swap agreement underwhich we receive a fixed interest rate and pay a floating interest rate. Thefuture cash payments on the interest related to Cornell Companies, Inc.long-term debt assume an effective rate of 10.945% on the related interest rateswap contract. An increase in the six-month U.S. dollar LIBOR rate wouldincrease future interest payments as required under this arrangement.

We enter intoletters of credit in the ordinary course of our operating and financingactivities.  As of September 30, 2006,we had outstanding letters of credit of approximately $9.6 million related toinsurance and other operating activities. The following table details our letter of credit commitments as of September 30,2006 (in thousands):
|                           | ** ** | **Total**     | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Over** | ** ** |
| ** **                | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
|                      |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Commercial Commitments:   |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of credit |       | $             | 9,620      |                                                                    | $          | 8,870 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                           |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

**ITEM 3.          Quantitative andQualitative Disclosures about Market Risk**

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

**Interest RateExposure**

Our exposure tochanges in interest rates primarily results from our long-term debt with bothfixed and floating interest rates.  Thedebt on our consolidated financial statements with fixed interest ratesconsists of the 8.47% Bonds issued by MCF in August 2001 in connectionwith the 2001 Sale and Leaseback Transaction and approximately $28.0 million ofthe Senior Notes (not hedged by our interest rate swap agreement).  At September 30, 2006, 31.6% ($84.0million of debt outstanding on the Senior Notes issued in June 2004) of ourconsolidated long-term debt was subject to variable interest rates.  The 

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detrimental effect of ahypothetical 100 basis point increase in interest rates would be to reduceincome before provision for income taxes by approximately $0.2 million and $0.6million for the three and nine months ended September 30, 2006.  At September 30, 2006, the fair value ofour consolidated fixed rate debt approximated carrying value based upondiscounted future cash flows using current market prices.

**ITEM 4.          Controlsand Procedures**

We maintain disclosure controls and proceduresdesigned to ensure that information disclosed in our annual and periodicreports is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms. Inaddition, we designed these disclosure controls and procedures to ensure thatthis information is accumulated and communicated to management, including thechief executive officer (CEO) and chief financial officer (CFO), to allowtimely decisions regarding required disclosures. SEC rules require that wedisclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

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

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we have evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, as amended (the Exchange Act) as of the end ofthe period required by this report. Based on that evaluation, our principalexecutive officer and principal financial officer have concluded that thesecontrols and procedures are effective as of that date.

In connection withthe evaluation described above, there have been no changes in our internalcontrol over financial reporting (as such term is defined inRules 13a-15(f) and 15d-15(f) under Exchange Act) during ourfiscal quarter ended September 30, 2006 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

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** **

**PART II         OTHERINFORMATION**

**ITEM 1.                   Legal Proceedings.**

See Part I, Item 1. FinancialStatements, Note 7.

**ITEM 1A.                Risk Factors.**

The risk factors as previously discussed in our Form 10-K for thefiscal year ended December 31, 2005 are incorporated herein by thisreference. There are no material changes to such risk factors.

**ITEM 2.                   Unregistered Sales ofEquity Securities and Use of Proceeds.**

None.

**ITEM 3.                   Defaults Upon SeniorSecurities.**

None.

## **ITEM 4.                   Submissionof Matters to a Vote of Security Holders.**

None

## **ITEM 5.                   OtherInformation.**

None.

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

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 906 Certificationof Chief Financial Officer

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*            Filed herewith.

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** **

**SIGNATURES**

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                                                 |   | **CORNELL COMPANIES,  INC.**           |
|-------------------------------------------------|--------|----------------------------------------|
|                                            |   |                                   |   |
|                                            |   |                                   |   |
| Date:   November 9, 2006    | By:    | /s/ James E. Hyman                     |   |
|                                            |   | JAMES E. HYMAN                         |   |
|                                            |   | Chief Executive Officer and            |   |
|                                            |   | Chairman of the Board                  |   |
|                                            |   | (Principal Executive Officer)          |   |
|                                            |   |                                   |   |
|                                            |   |                                   |   |
| Date:    November  9,  2006 | By:    | /s/ John R.  Nieser                    |   |
|                                            |   | JOHN R. NIESER                         |   |
|                                            |   | Chief Financial  Officer and Treasurer |   |
|                                            |   | (Principal  Financial Officer)         |   |

 

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