**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC20549**

 

**FORM 10-Q**

 

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the QuarterlyPeriod Ended June 30, 2004**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period                   to                   **

 

**Commission FileNumber 1-14472**

 

**CORNELLCOMPANIES, INC.**

(Exactname of registrant as specified in its charter)

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

 

Indicate by a check mark whetherRegistrant (1) has filed all reports required to be filed by Sections 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months,and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý  No o

 

Indicate by a check mark whetherRegistrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes ý  No o

 

At July 31, 2004 Registranthad outstanding 13,293,781 shares of its Common Stock.

 

 

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

 

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

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Unaudited)**

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

 
| ** **                                                                                                                           | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                               |       |                    |       |                        |       |
| CURRENT  ASSETS:                                                                                                                     |       |                    |       |                        |       |
| Cash  and cash equivalents                                                                                                           |       | $                       | 76,297     |                        | $          | 40,171 |   |
| Accounts  receivable - trade (net of allowance for doubtful accounts of $1,991 and  $1,929, respectively)                            |       | 47,138                  |       | 52,772                      |       |
| Other  receivables (net of allowance for doubtful accounts of $5,386)                                                                |       | 3,478                   |       | 3,769                       |       |
| Other  restricted assets                                                                                                             |       | 22,906                  |       | 22,185                      |       |
| Deferred  tax asset                                                                                                                  |       | 3,411                   |       | 3,411                       |       |
| Prepaids  and other                                                                                                                  |       | 6,551                   |       | 8,789                       |       |
| Total  current assets                                                                                                                |       | 159,781                 |       | 131,097                     |       |
| PROPERTY  AND EQUIPMENT, net                                                                                                         |       | 282,782                 |       | 267,903                     |       |
| OTHER  ASSETS:                                                                                                                       |       |                    |       |                        |       |
| Debt  service reserve fund                                                                                                           |       | 24,020                  |       | 23,800                      |       |
| Intangible  assets, net                                                                                                              |       | 13,108                  |       | 13,287                      |       |
| Deferred  costs and other                                                                                                            |       | 23,369                  |       | 12,070                      |       |
| Total  assets                                                                                                                        |       | $                       | 503,060    |                        | $          | 448,157 |   |
|                                                                                                                                 |       |                    |       |                        |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                           |       |                    |       |                        |       |
|                                                                                                                                 |       |                    |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                |       |                    |       |                        |       |
| Accounts  payable and accrued liabilities                                                                                            |       | $                       | 32,547     |                        | $          | 36,577 |   |
| Current  portion of long-term debt                                                                                                   |       | 8,301                   |       | 8,306                       |       |
| Total  current liabilities                                                                                                           |       | 40,848                  |       | 44,883                      |       |
| LONG-TERM  DEBT, net of current portion                                                                                              |       | 284,852                 |       | 227,292                     |       |
| DEFERRED  TAX LIABILITIES                                                                                                            |       | 6,866                   |       | 7,006                       |       |
| OTHER  LONG-TERM LIABILITIES                                                                                                         |       | 4,140                   |       | 2,741                       |       |
| Total  liabilities                                                                                                                   |       | 336,706                 |       | 281,922                     |       |
|                                                                                                                                 |       |                    |       |                        |       |
| COMMITMENTS  AND CONTINGENCIES                                                                                                       |       |                    |       |                        |       |
|                                                                                                                                 |       |                    |       |                        |       |
| STOCKHOLDERS’  EQUITY:                                                                                                          |       |                    |       |                        |       |
| Preferred  stock, $.001 par value, 10,000,000 shares authorized, none issued                                                         |       | —                  |       | —                      |       |
| Common  stock, $.001 par value, 30,000,000 shares authorized, 14,711,367 and 14,578,505  shares issued and outstanding, respectively |       | 15                      |       | 15                          |       |
| Additional  paid-in capital                                                                                                          |       | 144,827                 |       | 143,735                     |       |
| Retained  earnings                                                                                                                   |       | 33,825                  |       | 34,218                      |       |
| Treasury  stock (1,545,356 and 1,537,583 shares of common stock, respectively, at cost)                                              |       | (12,530                 | )          | (12,458                     | )          |
| Deferred  compensation                                                                                                               |       | (684                    | )          | (803                        | )          |
| Other  comprehensive income                                                                                                          |       | 901                     |       | 1,528                       |       |
| Total  stockholders’ equity                                                                                                     |       | 166,354                 |       | 166,235                     |       |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                       | 503,060    |                        | $          | 448,157 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

2

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

**(Unaudited)**

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

 
| ** **                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| REVENUES                                                      |       | $                                     | 69,993     |                                | $          | 67,586 |   | $ | 139,317 |   | $ | 133,612 |   |
| OPERATING  EXPENSES                                           |       | 54,115                                |       | 51,758                              |       | 108,629 |   | 103,452 |   |
| PRE-OPENING  AND START-UP EXPENSES                            |       | 2,384                                 |       | 306                                 |       | 4,030 |   | 393 |   |
| DEPRECIATION  AND AMORTIZATION                                |       | 3,179                                 |       | 2,604                               |       | 6,338 |   | 5,173 |   |
| GENERAL  AND ADMINISTRATIVE EXPENSES                          |       | 5,605                                 |       | 4,722                               |       | 9,765 |   | 8,620 |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| INCOME  FROM OPERATIONS                                       |       | 4,710                                 |       | 8,196                               |       | 10,555 |   | 15,974 |   |
| INTEREST  EXPENSE                                             |       | 4,662                                 |       | 4,946                               |       | 9,681 |   | 9,793 |   |
| INTEREST  INCOME                                              |       | (447                                  | )          | (440                                | )          | (817 | ) | (825 | ) |
| LOSS  ON EXTINGUISHMENT OF DEBT                               |       | 2,357                                 |       | —                              |       | 2,357 |   | — |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| INCOME  (LOSS) BEFORE PROVISION (BENEFIT) FOR INCOME TAXES    |       | (1,862                                | )          | 3,690                               |       | (666 | ) | 7,006 |   |
| PROVISION  (BENEFIT) FOR INCOME TAXES                         |       | (763                                  | )          | 1,513                               |       | (273 | ) | 2,873 |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| NET  INCOME (LOSS)                                            |       | $                                     | (1,099     | )                                   | $          | 2,177 |   | $ | (393 | ) | $ | 4,133 |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| EARNINGS  (LOSS) PER SHARE:                                   |       |                                  |       |                                |       |   |   |   |   |
| BASIC                                                         |       | $                                     | (.08       | )                                   | $          | .17 |   | $ | (.03 | ) | $ | .32 |   |
| DILUTED                                                       |       | $                                     | (.08       | )                                   | $          | .17 |   | $ | (.03 | ) | $ | .32 |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| NUMBER  OF SHARES USED IN PER SHARE COMPUTATION:              |       |                                  |       |                                |       |   |   |   |   |
| BASIC                                                         |       | 13,146                                |       | 12,854                              |       | 13,114 |   | 12,817 |   |
| DILUTED                                                       |       | 13,146                                |       | 13,173                              |       | 13,114 |   | 13,055 |   |
|                                                          |       |                                  |       |                                |       |   |   |   |   |
| COMPREHENSIVE  INCOME (LOSS):                                 |       |                                  |       |                                |       |   |   |   |   |
| NET  INCOME (LOSS)                                            |       | $                                     | (1,099     | )                                   | $          | 2,177 |   | $ | (393 | ) | $ | 4,133 |   |
| UNREALIZED  GAIN (LOSS) ON DERIVATIVE INSTRUMENTS, NET OF TAX |       | (1,085                                | )          | 981                                 |       | (627 | ) | 1,430 |   |
| COMPREHENSIVE  INCOME (LOSS)                                  |       | $                                     | (2,184     | )                                   | $          | 3,158 |   | $ | (1,020 | ) | $ | 5,563 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

3

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**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                                 | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                                                     |       |                                |       |   |   |
| Net  income (loss)                                                                                                         |       | $                                   | (393       | ) | $ | 4,133 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities -  Loss on extinguishment of debt |       | 2,357                               |       | — |   |
| Depreciation                                                                                                               |       | 5,799                               |       | 4,734 |   |
| Amortization  of intangibles and other assets                                                                              |       | 539                                 |       | 439 |   |
| Amortization  of deferred compensation                                                                                     |       | 127                                 |       | 290 |   |
| Amortization  of deferred financing costs                                                                                  |       | 578                                 |       | 578 |   |
| Provision  for bad debts                                                                                                   |       | 343                                 |       | 1,224 |   |
| (Gain)  loss on sale of property and equipment                                                                             |       | (10                                 | )          | 46 |   |
| Deferred  income taxes                                                                                                     |       | 296                                 |       | 870 |   |
| Change  in assets and liabilities:                                                                                         |       |                                |       |   |   |
| Accounts  receivable                                                                                                       |       | 1,265                               |       | 2,324 |   |
| Restricted  assets                                                                                                         |       | (418                                | )          | 47 |   |
| Other  assets                                                                                                              |       | 2,180                               |       | (1,140 | ) |
| Accounts  payable and accrued liabilities                                                                                  |       | (4,680                              | )          | (3,462 | ) |
| Deferred  revenues and other liabilities                                                                                   |       | (41                                 | )          | (1,238 | ) |
| Net  cash provided by operating activities                                                                                 |       | 7,942                               |       | 8,845 |   |
|                                                                                                                       |       |                                |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                                                     |       |                                |       |   |   |
| Capital  expenditures                                                                                                      |       | (20,559                             | )          | (6,447 | ) |
| Receipt  from restricted escrow arrangement                                                                                |       | 5,000                               |       | — |   |
| Escrow  deposit on non-compete agreement                                                                                   |       | —                              |       | (1,000 | ) |
| Purchase  of facility management contract                                                                                  |       | (2,900                              | )          | — |   |
| Return  of restricted assets from deferred bonus plan                                                                      |       | 86                                  |       | — |   |
| Payments  to restricted debt payment account, net                                                                          |       | (5,523                              | )          | (4,557 | ) |
| Proceeds  from sale of property and equipment                                                                              |       | 163                                 |       | — |   |
| Net  cash used in investing activities                                                                                     |       | (23,733                             | )          | (12,004 | ) |
|                                                                                                                       |       |                                |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                                                     |       |                                |       |   |   |
| Proceeds  from long-term debt and line of credit                                                                           |       | 69,000                              |       | 641 |   |
| Payments  on line of credit                                                                                                |       | (71,000                             | )          | — |   |
| Payments  on Synthetic Lease                                                                                               |       | (52,495                             | )          | — |   |
| Proceeds  from Senior Notes, net of discount                                                                               |       | 110,527                             |       | — |   |
| Payments  for debt issuance and other financing costs                                                                      |       | (5,033                              | )          | — |   |
| Payments  of capital lease obligations                                                                                     |       | (6                                  | )          | (14 | ) |
| Proceeds  from exercise of stock options and warrants                                                                      |       | 1,040                               |       | 2,054 |   |
| Purchases  of treasury stock                                                                                               |       | (116                                | )          | (591 | ) |
| Net  cash provided by financing activities                                                                                 |       | 51,917                              |       | 2,090 |   |
|                                                                                                                       |       |                                |       |   |   |
| NET  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                                                      |       | 36,126                              |       | (1,069 | ) |
| CASH  AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                                          |       | 40,171                              |       | 52,610 |   |
| CASH  AND CASH EQUIVALENTS AT END OF PERIOD                                                                                |       | $                                   | 76,297     |   | $ | 51,541 |   |
|                                                                                                                       |       |                                |       |   |   |
| OTHER  NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                                        |       |                                |       |   |   |
| Purchases  of treasury stock by deferred bonus plan                                                                        |       | $                                   | —     |   | $ | 146 |   |
| Other  comprehensive income (loss), net of tax                                                                             |       | (627                                | )          | 1,430 |   |
| Borrowings  under capital leases                                                                                           |       | —                              |       | 3 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

4

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**CORNELLCOMPANIES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

The accompanying unaudited consolidatedfinancial statements have been prepared by Cornell Companies, Inc. (the “Company”)pursuant to the rules and regulations of the Securities and ExchangeCommission.  Certain information andfootnote 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 andregulations.  In the opinion ofmanagement, adjustments and disclosures necessary for a fair presentation ofthese financial statements have been included. Estimates were used in the preparation of these financialstatements.  Actual results could differfrom those estimates.  These financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s 2003 Annual Report on Form 10-K asfiled with the Securities and Exchange Commission.

 

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

 

See a description of the Company’saccounting policies in the Company’s 2003 Annual Report on Form 10-K.

 

***AccountingFor Stock-Based Compensation***

 

The Company accounts for its stock-basedcompensation plans in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (APB No. 25).  In accordance with the provisions of APB No.25, stock-based employee compensation cost is not reflected in net income, asall options granted under those plans had an exercise price equal to or inexcess of the market value of the underlying common stock on the date ofgrant.  The following table illustrates,in accordance with Statement of Financial Accounting Standard (SFAS) No. 148,the effect of net income and earnings per share as if the Company had appliedthe fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,expect per share amounts):

 
| ** **                                                                                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Net  income (loss), as reported                                                                                                             |       | $                                     | (1,099     | )                                   | $          | 2,177 |   | $ | (393 | ) | $ | 4,133 |   |
| Less:  total stock-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (311                                  | )          | (345                                | )          | (467 | ) | (880 | ) |
| Pro  forma net income (loss)                                                                                                                |       | $                                     | (1,410     | )                                   | $          | 1,832 |   | $ | (860 | ) | $ | 3,253 |   |
| Earnings  (loss) per share:                                                                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Basic,  as reported                                                                                                                         |       | $                                     | (.08       | )                                   | $          | .17 |   | $ | (.03 | ) | $ | .32 |   |
| Basic,  pro forma                                                                                                                           |       | (.11                                  | )          | .14                                 |       | (.07 | ) | .25 |   |
| Diluted,  as reported                                                                                                                       |       | (.08                                  | )          | .17                                 |       | (.03 | ) | .32 |   |
| Diluted,  pro forma                                                                                                                         |       | (.11                                  | )          | .14                                 |       | (.07 | ) | .25 |   |

 

5

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TheFinancial Accounting Standards Board (FASB) has proposed to mandate expenserecognition for stock options and other types of equity-based compensationbased on the fair value of the options at the grant date.  Additionally, the FASB is evaluatingalternatives regarding how to develop a measure of the fair value of anoption.  Based on the final outcome ofthe FASB proposal, the Company may be required to recognize expense related tostock options and other types of equity-based compensation in futureperiods.  Additionally, the Company maybe required to change its current method for determining the fair value ofstock options.  In July 2004, theHouse of Representatives approved legislation to (1) prevent the FASB fromissuing the proposed guidance on expensing stock options and (2) block themandatory expensing of stock options until the Secretary of Commerce and theSecretary of Labor complete a one-year joint study on the economic impact ofthe FASB’s proposal.  If the bill ispassed into law, companies would only need to expense the stock options grantedto the five highest paid executives and would allow, but not require, companiesto expense stock options granted to all employees under existing accountingguidance.  The FASB is expected toredeliberate its proposed guidance during the third quarter and issue a finalstandard by the end of 2004.

 

***Recently IssuedAccounting Standard***

 

The FASB issued Interpretation No. 46R, Consolidation of VariableInterest Entities (FIN 46R) which addresses the consolidation of variableinterest entities (VIEs) by business enterprises that are the primarybeneficiaries.  A VIE is an entity thatdoes not have sufficient equity investment at risk to permit it to finance itsactivities without additional subordinated financial support, or whose equityinvestors lack the characteristics of a controlling financial interest.  The primary beneficiary of a VIE is theenterprise that has the majority of the risks or rewards associated with theVIE.  The Company’s adoption of FIN 46Rdid not change the Company’s accounting for the 2001 Sale and LeasebackTransaction, which is consolidated for reporting purposes.  The Company has no other arrangements subjectto the provisions of FIN 46R.

 

**3.****             ****Acquisition of the Walnut Grove Youth Correctional FacilityManagement Contract**

 

InJune 2004, the Company acquired a management agreement to operate a 976bed secure youthful offender correctional facility in Walnut Grove,Mississippi, the Walnut Grove Youth Correctional Facility, from TuscolametaInc.  This facility houses 13-20 year-oldmales and provides academic and vocational training, along with drug andalcohol education and treatment.  Groupand individual counseling and recreational opportunities are also provided. Theunderlying management agreement is with the Walnut Grove CorrectionalAuthority, which holds a contract with the Mississippi Department ofCorrections. The management agreement has a remaining term of 2 1⁄2 years with arenewal option for an additional two-year term at the option of the contractingparties.

 

TheCompany acquired the management contract and certain assets and liabilities fora total purchase price of approximately $3.0 million, which was allocated asfollows (in thousands):

 
| Accounts receivable                      |   | $     | 584    |   |
|------------------------------------------|--------|-------|--------|--------|
| Contract value                           |   | 2,405 |   |
| Prepaid supplies                         |   | 188   |   |
| Fixed assets                             |   | 271   |   |
| Non-compete agreement                    |   | 300   |   |
| Accounts payable and accrued liabilities |   | (748  | )      |
| Net assets                               |   | $     | 3,000  |   |

 

Thefair market value of the contract was determined based on future discountedcash flows.  The Company is amortizingthe contract value of approximately $2.4 million over the remaining term of themanagement contract of 2 1⁄2 years.  As ofJune 30, 2004, the Company had funded $2.9 million of the purchase price.  The remaining $0.1 million is expected to befunded in the third quarter of 2004.

 

6

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**4.****             ****Intangible Assets**

 

Intangible assets at June 30, 2004and December 31, 2003 consisted of the following (in thousands):

 
| ** **                | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                      |       |                    |       |                        |       |
| Non-compete  agreements   |       | $                       | 9,780      |                        | $          | 9,420 |   |
| Accumulated  amortization |       | (4,393                  | )          | (3,854                      | )          |
| Intangibles,  net         |       | 5,387                   |       | 5,566                       |       |
| Goodwill                  |       | 7,721                   |       | 7,721                       |       |
| Total  intangibles, net   |       | $                       | 13,108     |                        | $          | 13,287 |   |

 

Amortization expense for non-competeagreements was approximately $270,000 and $539,000 for the three and six monthsended June 30, 2004, respectively. Amortization expense for non-compete agreements was approximately$220,000 and $439,000 for the three and six months ended June 30, 2003,respectively.  Amortization expense fornon-compete agreements is expected to be approximately $1.1 million foreach of the fiscal years ended December 31 for the next five years.

 

**5.****             ****Credit Facilities**

 

The Company’s long-term debt atJune 30, 2004 and December 31, 2003 consisted of the following (inthousands):

 
| ** **                                                                                                | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                      |       |                    |       |                        |       |
| **Debt of Cornell Companies, Inc.:**                                                                      |       |                    |       |                        |       |
| Senior  Notes, unsecured, due July 2012, with an interest rate of 10.75%, net of  discount           |       | $                       | 110,527    |                        | $          | — |   |
| Fair-value  adjustment of Senior Notes as a result of interest rate swap                                  |       | (377                    | )          |                        |       |
| Revolving  Line of Credit, repaid in June 2004, interest rate of prime plus 2.0% or  LIBOR plus 3.0% |       | —                  |       | 2,000                       |       |
| Capital  lease obligations                                                                                |       | 3                       |       | 8                           |       |
| Subtotal                                                                                                  |       | 110,153                 |       | 2,008                       |       |
|                                                                                                      |       |                    |       |                        |       |
| **Debt of Consolidated Special Purpose  Entities:**                                                       |       |                    |       |                        |       |
| Synthetic  Lease Investor Note A, repaid in June 2004, interest rate of LIBOR plus  3.25%            |       | —                  |       | 42,255                      |       |
| Synthetic  Lease Investor Note B, repaid in June 2004, interest rate of LIBOR plus  3.50%            |       | —                  |       | 8,335                       |       |
| MCF  8.47% Bonds due 2016                                                                                 |       | 183,000                 |       | 183,000                     |       |
| Subtotal                                                                                                  |       | 183,000                 |       | 233,590                     |       |
|                                                                                                      |       |                    |       |                        |       |
| Consolidated  total debt                                                                                  |       | 293,153                 |       | 235,598                     |       |
|                                                                                                      |       |                    |       |                        |       |
| Less:  current maturities                                                                                 |       | (8,301                  | )          | (8,306                      | )          |
|                                                                                                      |       |                    |       |                        |       |
| Consolidated  long-term debt                                                                              |       | $                       | 284,852    |                        | $          | 227,292 |   |

 

7

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The Company’s 2000 Credit Facility, asamended, provided for borrowings of up to $45.0 million under a revolving lineof credit.  The commitment amount wasreduced by $1.6 million quarterly beginning in July 2002 and byoutstanding letters of credit.  Theamended 2000 Credit Facility bore interest,  at the election of the Company, at either theprime rate plus a margin of 2.0%, or a rate which was 3.0% above the applicableLIBOR rate.  Additionally, the amended2000 Credit Facility provided the Company with the ability to enter intosynthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provided for funding to the lessor under the operatingleases of up to $100.0 million.

 

OnJune 24, 2004, the Company entered into a revolving credit facility (the“2004 Credit Facility”) by and among the Company and certain lenders to fundworking capital for acquisitions, to refinance existing debt, to fund capitalexpenditures and other general corporate purposes. The 2004 Credit Facilityprovides for borrowings of up to $60.0 million under a revolving line of creditand is reduced by outstanding letters of credit.  The available commitment under the 2004 CreditFacility was approximately $53.5 million at June 30, 2004.  The Company had outstanding letters of creditof approximately $6.5 million at June 30, 2004.  Subject to certain requirements, the Companyhas the right to increase the aggregate commitments under the 2004 CreditFacility to an aggregate amount of up to $100.0 million.  The 2004 Credit Facility matures inJune 2008 and bears interest, at the election of the Company and,depending on the Company’s total leverage ratio, at either the prime rate plusa margin ranging from 0.75% to 2.00%, or a rate which ranges from 2.25% to 3.50%above the applicable LIBOR rate.

 

The 2004 Credit Facility iscollateralized by substantially all of the Company’s assets, including theassets and stock of all of the Company’s subsidiaries.  The 2004 Credit Facility is not secured bythe assets of MCF.  The 2004 CreditFacility contains standard covenants including compliance with laws, limitationson capital expenditures, restrictions on dividend payments, limitations on mergersand compliance with financial covenants.

 

In June 2004, the Company issued$112.0 million in principal of 10.75% Senior Notes (the “Senior Notes”) dueJuly 1, 2012.  The Senior Notes areunsecured senior indebtedness and are guaranteed by all of the Company’sexisting and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”).  Interest on theSenior Notes accrued as of June 24, 2004 and is payable semi-annually onJanuary 1 and July 1 of each year, commencing January 1,2005.  On or after July 1, 2008, theCompany may redeem all or a portion of the Senior Notes at the redemptionprices (expressed as a percentage of the principal amount) listed below, plusaccrued and unpaid interest, if any, on the Senior Notes redeemed, to theapplicable 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 toJuly 1, 2007, the Company may redeem up to 35% of the original aggregateprincipal amount of the Senior Notes at a redemption price of 110.75% of theprincipal amount thereof with the net cash of public offerings of equity,provided that at least 65% of the original aggregate principal amount of the SeniorNotes remains outstanding after the redemption and other conditions aremet.  Upon the occurrence of specifiedchange of control events, unless the Company has exercised its option to redeemall the Senior Notes as described above, each holder will have the right torequire the Company to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”), which limits the ability of the Company and theGuarantors 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 the Company, enter into transactions withaffiliates, and engage in mergers, consolidations and certain sales of assets.

 

8

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The net proceeds from thesale of the Senior Notes was approximately $107.2 million, which was used torepay and refinance the indebtedness under the Company’s amended 2000 CreditFacility and synthetic lease obligations as of June 24, 2004.  The Company recognized a charge ofapproximately $2.4 million related to the write-off of unamortized deferredfinancing costs and charges related to the extinguishment of the syntheticlease obligations.

 

In conjunction with theissuance of the Senior Notes, the Company entered into an interest rate swaptransaction with a financial institution to hedge the Company’s exposure tochanges in the fair value on $84.0 million of its Senior Notes.  The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a lowervariable rate in an attempt to realize savings on the Company’s future interestpayments.  The terms of the interest rateswap contract and the underlying debt instrument are identical.  The Company has designated the swap agreementas a fair 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, the Company pays on a semi-annual basis (each January 1 andJuly 1) a floating rate based on a six-month U.S. dollar LIBOR rate, plusa spread, and receives a fixed-rate interest of 10.75%.  During the three months ended June 30,2004, the Company recorded interest savings related to this interest rate swapof approximately $53,000, which is reflected as a reduction to interest expensein the accompanying financial statements. At June 30, 2004, the fair value of this derivative instrument wasapproximately $0.4 million and is included in other long-term liabilities inthe accompanying financial statements. The carrying value of the Company’sSenior Notes as of June 30, 2004 was reduced by the same amount.

 

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

 

In January 2003, the Company executed a five-year lease, with fiveone-year renewal options, for the Regional Correctional Center in Albuquerque,New Mexico.  This 970 bed facilityconsists of two units, the 528 bed South Tower and the 442 bed NorthTower.  The Company renovated the SouthTower and opened the 528 bed unit in July 2004.  The Company began renovating the North Tower inAugust 2004 and anticipates opening the 442 bed unit in fourth quarter of2004. Management currently anticipates that the facility will reach fullcapacity of 970 beds by the second quarter of 2005.  As of June 30, 2004, the Company hadspent approximately $4.3 million on renovations and anticipates spending anadditional $3.7 million to complete renovations of the North Tower.  For the three and six months endedJune 30, 2004, the Company incurred pre-opening and start-up expenses ofapproximately $514,000 and $670,000, respectively, related to this project.

 

Construction of the Southern Peaks Regional Treatment Center wassubstantially completed in July 2004. The Companypurchased the property in June 2004 and has served as the constructionsupervisor in lieu of the developer and assumed the developer’s rights andobligations under the construction contract (except that the developer willremain as contractor for certain of the infrastructure serving thefacility).  As of June 30, 2004, theCompany had invested approximately $12.0 million in the property.  The Company began receiving clients inAugust 2004.  The Company currentlyanticipates that the facility will be fully ramped up by year end.

 

The Plankinton Regional Detention Center, a 40 bed juvenile justicecenter in South Dakota, was activated early in May 2004 and the PlankintonRegional Treatment Center was scheduled to open in August 2004.  Both facilities were expected to be fullyramped up by year end.  The Company basedits plans to open and operate these facilities on a commitment from theappropriate state officials to create a special rate that would allow theCompany to meet the needs of clients rejected by other providers in thestate.  However, the Company has learnedthat it was awarded an initial per diem rate that, while as it is the highestrate in South Dakota, is insufficient to support the level of care andtreatment required for the center’s clients. The state is currently in a rate-setting process that will takeapproximately six months.  While theCompany intends to pursue this project through the delay, it is not willing toopen the programs without sufficient resources or to operate at a loss, and hasdecided to delay the opening of the Regional Treatment Center and totemporarily suspend operations at the Regional Detention Center.

 

The Company closed the New Morgan Academy in the fourth quarter of 2002and is currently considering several options ranging from the utilization ofthe facility for another type of program or the sale or lease of the facility.As of June 30, 2004, management is focusing its efforts on reactivatingthe facility. The primary use currently under

 

9

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consideration is using the facility to house illegal non-criminal andlow-security adult detainees.  Managementis discussing these opportunities with the Bureau of Immigration and CustomsEnforcement (ICE), which has indicated a level of interest, but the partieshave not progressed to the contract phase. There can be no assurance that the Company will be successful insecuring a contract with ICE.  Before theCompany can house adult detainees, the Company will need to obtain a change inthe zoning of the Academy, which is currently zoned only for the housing ofjuveniles.  Management of the Companybelieves that there is a market for the services the Company could provide atthe facility at per diem rates that will support the recovery of the cost ofthe facility.  The Company will continueto evaluate any offers to buy or lease the facility.  The Company is maintaining a small staff to secure and maintain thefacility.  The Company is incurringinterest expense of approximately $140,000per month related to the borrowings for the facility and depreciation expenseof approximately $46,000 per monthfor the building.

 

Thecarrying value of the property and equipment at the New Morgan Academy wasapproximately $30.0 million at June 30, 2004.  As of June 30, 2004, management believesthat, pursuant to the provisions of SFAS No. 144, an impairment allowance isnot necessary.  However, managementestimates that, were the Company to sell the facility, it is reasonablypossible that the Company would not be able to fully recover the carrying valueof its long-lived assets for this facility.

 

InMarch 2003, the Company reached an agreement with the Commonwealth ofPennsylvania that resolved all outstanding administrative issues relative tothe contract awarded to the Company by the Federal Bureau of Prisons (BOP) tooperate the Moshannon Valley Correctional Center. In October 2003, theCompany received final approval from the BOP of a revised building design forthe facility.  Construction plans are completed for the new design and work is expectedto begin during the third quarter of 2004.  In April 2004, the Companyreceived notice of a draft supplemental environmental assessment indicating apopulation of 1,300 consisting of 1,000 low-security adult male offenders and300 minimum-security adult female offenders.

 

As of June 30, 2004, the Company had incurred approximately $18.6million for the design, construction and development costs and capitalizedinterest related to the Moshannon Valley Correctional Center facility.  The Company is in the process of submitting aclaim to the BOP for reimbursement of costs related to the originalconstruction efforts incurred beginning in 1999. The Company estimates anadditional capital investment of approximately $79.3 million to completeconstruction of the facility.  Managementbelieves that existing cash and credit facilities will provide adequate fundingfor the construction of the Moshannon Valley Correctional Center.

 

According to the BOP contract, as amended, the Company is required tocomplete the construction of the facility by August 15, 2004.  TheCompany anticipates obtaining another long-term contract amendment from the BOPextending the construction deadline. In the event the Company is not able tonegotiate a contract amendment with the BOP, then the BOP may have the right toassert that the Company has not completed construction of the facility withinthe time frame provided in the BOP contract, as amended. Management expectsthat the contract will be amended to address cost and construction timingmatters resulting from the extended delay. In the event that the BOP decides not to continue with the constructionof the Moshannon Valley Correctional Center and terminates the contract,management believes that the Company has the right to and will recover itsinvested costs. In the event any portion of these costs are determined not tobe recoverable upon contract termination by the BOP, such costs would becharged to expense.

 

Separatefrom a possible recovery in the event that the BOP terminates the MoshannonValley Correctional Center contract, the Company is pursuing a claim for thereimbursement of a portion of its expenses incurred in connection with theissuance of the Stop-Work Order and the delay of the project (included amongthese expenses is approximately $1.4 million in accounts receivable for expensesincurred by the Company after the June 1999 issuance of the Stop –WorkOrder).  This reimbursement claim isindependent of the amendment to the contract. The Company is finalizing its claim with the BOP and expects to reach aresolution before the end of the third quarter of 2004.  The BOP has asserted that it is onlyresponsible for reimbursing that portion of the investment lost due to theissuance of the Stop-Work Order. Although the Company believes that the BOP will reimburse more than the$1.4 million in accounts receivable at June 30, 2004, it is uncertain howmuch the BOP will agree to pay in connection with the Company’s claim for

 

10

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reimbursement.  Any amounts not reimbursed by the BOP will beexpensed by the Company.

 

**7.****             ****Earnings Per Share**

 

Basic earnings per share (EPS) iscomputed by dividing net income by the weighted average number of shares ofcommon stock outstanding during the period. Diluted EPS reflects the potential dilution from common stockequivalents such as stock options and warrants. For the three months ended June 30, 2004 and 2003, there were 423,229shares ($13.61 average price) and 360,489 shares ($14.16 average price),respectively, of stock options that were not included in the computation ofdiluted EPS because to do so would have been anti-dilutive.  For the six months ended June 30, 2004and 2003 there were 856,201 shares ($13.33 average price) and 633,946 shares($12.38 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.

 

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

 
| ** **                                                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Nine Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **2004**                         | ** ** | **2003**                        | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Net earnings (loss)                                                      |       | $                                | (1,099     | )                               | $          | 2,177 |   | $ | (393 | ) | $ | 4,133 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  share outstanding                               |       | 13,146                           |       | 12,854                          |       | 13,114 |   | 12,818 |   |
| Weighted average common  share equivalents outstanding                   |       | —                           |       | 319                             |       | — |   | 237 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 13,146                           |       | 13,173                          |       | 13,114 |   | 13,055 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic earnings (loss)  per share                                         |       | $                                | (0.08      | )                               | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.32 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Diluted earnings (loss)  per common share                                |       | $                                | (0.08      | )                               | $          | 0.17 |   | $ | (0.03 | ) | $ | 0.32 |   |

 

**8.****             ****Commitments and Contingencies**

 

**Legal Proceedings**

 

***Southern PeaksRegional Treatment Center***

 

OnJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled Cornell Corrections of California, Inc. v. Longboat Global Advisors,LLC, et al., No.2004 CV79761 in the Superior Court of Fulton County, Georgiaunder theories of fraud, conversion, breach of contract and other theories todetermine the location of and to recover funds previously deposited by theCompany into what it believed to be an escrow account in connection with thedevelopment and construction of the Southern Peaks Regional Treatment Center. Ofthe funds previously deposited, approximately $5.4 million remains to berecovered.  The Company has obtainedtemporary restraining orders freezing any and all financial accounts of theconstruction lender, one of its principals and certain other defendantsidentified during discovery.  The frozenaccounts include one of the construction lender’s bank accounts which containsapproximately $0.4 million.

 

***Shareholder Lawsuits***

 

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

 

11

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

 

OnJanuary 27, 2004, the Company received a letter from William Williams, theplaintiff in the *William Williams*action discussed above, demanding that the Company pursue breach of fiduciaryduty claims against various officers and directors based on theAugust 2001 sale leaseback transaction and the subsequent restatement.  The Company has issued a preliminary responseto the letter indicating that the Board will consider the request and informMr. Williams of its decision.

 

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

 

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

 

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

 

***Securities and Exchange CommissionInvestigation***

 

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

 

Depending on the scope, timing and result of the SEC investigation,management’s attention and the Company’s resources could be diverted fromoperations, which could adversely affect the Company’s operating results andcontribute to future stock price volatility. The SEC investigation could also require that the Company take other actionsnot currently contemplated.  In addition,the SEC investigation or its outcome may increase the costs of defending orresolving current litigation.

 

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The SEC has not given the Company any indication as to the outcome ofits investigation.  If the SEC makes adetermination adverse to the Company, the Company and its officers anddirectors may face penalties, including, but not limited to, monetary fines andinjunctive relief.  The Company has notrecorded a loss accrual related to this matter. In addition, in the event of an adverse determination by the SEC againstthe Company or its officers or directors, federal and/or state agencies may bereluctant to enter into or prohibited from entering into contracts for theCompany’s services.  Any such reactionfrom the Company’s customer base could have a material adverse effect on itsbusiness.

 

***Other***

 

Additionally, the Company currently and from time to time is subject toclaims and suits arising in the ordinary course of business, including claimsfor damages for personal injuries or for wrongful restriction of orinterference with offender privileges and employment matters.  If an adverse decision in these mattersexceeds the Company’s insurance coverage, or if the Company’s coverage isdeemed not to apply to these matters, or if the underlying insurance carrierwere unable to fulfill their obligation under the insurance coverage provided,it could have a material adverse effect on the Company’s financial position,results of operations or cash flows.

 

**9.****             ****Segment Disclosure**

 

The Company’s three operating divisionsare its reportable segments.  The adultsecure institutional segment consists of the operation of secure adultincarceration facilities.  The juvenileservices segment provides residential treatment and educational programs andnon-residential community-based programs to juveniles between the ages of tenand 17 who have either been adjudicated or suffer from behavioral problems. Theadult community-based corrections and treatment services segment providespre-release and halfway house programs for adult offenders who are either onprobation or serving the last three to six months of their sentences on paroleand preparing for re-entry into society at large as well as community-basedtreatment and education programs as an alternative to incarceration.  All of the Company’s customers and long-livedassets are located in the United States of America.  The accounting policies of the Company’s reportable segments are thesame as those described in the summary of accounting policies in the Company’s2003 10-K.  Intangible assets are notincluded in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome.  The Company evaluatesperformance based on income or loss from operations before general andadministrative expenses, incentive bonuses, amortization of intangibles,interest and income taxes.  Corporate andother assets are comprised primarily of cash, accounts receivable, deposits,property and equipment, deferred taxes, deferred costs and other assets.

 

13

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The only significant non-cash itemreported in the respective segment’s income from operations is depreciation andamortization (excluding intangibles) (in thousands).

 
| ** **                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                               | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                     |       |                                  |       |                                |       |   |   |   |   |
| Revenues                                 |       |                                  |       |                                |       |   |   |   |   |
| Adult  secure institutional              |       | $                                     | 26,681     |                                | $          | 25,593 |   | $ | 52,465 |   | $ | 50,656 |   |
| Juvenile                                 |       | 31,198                                |       | 29,463                              |       | 62,336 |   | 58,029 |   |
| Adult  community-based                   |       | 12,114                                |       | 12,530                              |       | 24,516 |   | 24,927 |   |
| Total  revenues                          |       | $                                     | 69,993     |                                | $          | 67,586 |   | $ | 139,317 |   | $ | 133,612 |   |
|                                     |       |                                  |       |                                |       |   |   |   |   |
| Pre-opening  and start-up expenses       |       |                                  |       |                                |       |   |   |   |   |
| Adult  secure institutional              |       | $                                     | 514        |                                | $          | 62 |   | $ | 670 |   | $ | 149 |   |
| Juvenile                                 |       | 1,870                                 |       | 244                                 |       | 3,360 |   | 244 |   |
| Adult  community-based                   |       | —                                |       | —                              |       | — |   | — |   |
| Total  pre-opening and start-up expenses |       | $                                     | 2,384      |                                | $          | 306 |   | $ | 4,030 |   | $ | 393 |   |
|                                     |       |                                  |       |                                |       |   |   |   |   |
| Income  from operations                  |       |                                  |       |                                |       |   |   |   |   |
| Adult  secure institutional              |       | $                                     | 5,908      |                                | $          | 6,600 |   | $ | 11,832 |   | $ | 13,276 |   |
| Juvenile                                 |       | 2,788                                 |       | 3,917                               |       | 5,573 |   | 7,001 |   |
| Adult  community-based                   |       | 2,168                                 |       | 2,599                               |       | 4,305 |   | 5,060 |   |
| Subtotal                                 |       | 10,864                                |       | 13,116                              |       | 21,710 |   | 25,337 |   |
| General  and administrative expense      |       | (5,605                                | )          | (4,722                              | )          | (9,765 | ) | (8,620 | ) |
| Amortization  of intangibles             |       | (270                                  | )          | (220                                | )          | (539 | ) | (439 | ) |
| Corporate  and other                     |       | (279                                  | )          | 22                                  |       | (851 | ) | (304 | ) |
| Total  income from operations            |       | $                                     | 4,710      |                                | $          | 8,196 |   | $ | 10,555 |   | $ | 15,974 |   |

 
| ** **                  | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Assets                      |       |                    |       |                        |       |
| Adult  secure institutional |       | $                       | 159,753    |                        | $          | 152,229 |   |
| Juvenile                    |       | 121,667                 |       | 110,748                     |       |
| Adult  community-based      |       | 59,316                  |       | 57,787                      |       |
| Intangible  assets, net     |       | 13,108                  |       | 13,287                      |       |
| Corporate  and other        |       | 149,216                 |       | 114,106                     |       |
| Total  assets               |       | $                       | 503,060    |                        | $          | 448,157 |   |

 

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**10.****      ****Guarantor Disclosures**

 

The Company completed an offering of$112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofthe Company’s subsidiaries (Guarantor Subsidiaries).  MCF does not guarantee the Senior Notes(Non-Guarantor Subsidiary).  Theseguarantees are joint and several obligations of the Guarantor Subsidiaries.  The following condensed consolidatingfinancial information presents the financial condition, results of operationsand cash flows of the Company, the Guarantor Subsidiaries and the Non-GuarantorSubsidiary, together with the consolidating adjustments necessary to presentthe Company’s results on a consolidated basis.

 

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**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**AS OFJUNE 30, 2004**

**(inthousands)**

**(unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                          |       |             |       |             |       |
| Current assets:                                  |       |       |       |                        |       |                          |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 76,174     |                        | $          | 73                            |       | $                | 50         |             | $          | — |   | $ | 76,297 |   |
| Accounts  receivable                             |       | 251        |       | 50,227                      |       | 138                           |       | —           |       | 50,616           |       |
| Restricted  assets                               |       | 215        |       | 2,490                       |       | 20,201                        |       | —           |       | 22,906           |       |
| Prepaids and  other                              |       | 8,834      |       | 1,128                       |       | —                        |       | —           |       | 9,962            |       |
| Total current  assets                            |       | 85,474     |       | 53,918                      |       | 20,389                        |       | —           |       | 159,781          |       |
| Property and  equipment, net                     |       | 71         |       | 128,131                     |       | 160,975                       |       | (6,395           | )          | 282,782          |       |
| Other assets:                                    |       |       |       |                        |       |                          |       |             |       |             |       |
| Debt service  reserve fund                       |       | —     |       | —                      |       | 24,020                        |       | —           |       | 24,020           |       |
| Deferred  costs and other                        |       | 31,467     |       | 22,051                      |       | 9,657                         |       | (26,698          | )          | 36,477           |       |
| Investment in  subsidiaries                      |       | 33,444     |       | 1,856                       |       | —                        |       | (35,300          | )          | —           |       |
| Total assets                                     |       | $          | 150,456    |                        | $          | 205,956                       |       | $                | 215,041    |             | $          | (68,393 | ) | $ | 503,060 |   |
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| **Liabilities and  stockholders’ equity**   |       |       |       |                        |       |                          |       |             |       |             |       |
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| Current  liabilities:                            |       |       |       |                        |       |                          |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $          | 24,635     |                        | $          | 3,797                         |       | $                | 6,447      |             | $          | (2,332 | ) | $ | 32,547 |   |
| Current  portion of long-term debt               |       | —     |       | 1                           |       | 8,300                         |       | —           |       | 8,301            |       |
| Total current  liabilities                       |       | 24,635     |       | 3,798                       |       | 14,747                        |       | (2,332           | )          | 40,848           |       |
| Long-term  debt, net of current portion          |       | 110,152    |       | —                      |       | 174,700                       |       | —           |       | 284,852          |       |
| Deferred tax  liabilities                        |       | 7,302      |       | —                      |       | —                        |       | (436             | )          | 6,866            |       |
| Other  long-term liabilities                     |       | 6,356      |       | 57                          |       | 24,558                        |       | (26,831          | )          | 4,140            |       |
| Intercompany                                     |       | (164,343   | )          | 164,343                     |       | —                        |       | —           |       | —           |       |
| Total  liabilities                               |       | (15,898    | )          | 168,198                     |       | 214,005                       |       | (29,599          | )          | 336,706          |       |
| Stockholders’  equity                       |       | 166,354    |       | 37,758                      |       | 1,036                         |       | (38,794          | )          | 166,354          |       |
| Total  liabilities and stockholders’ equity |       | $          | 150,456    |                        | $          | 205,956                       |       | $                | 215,041    |             | $          | (68,393 | ) | $ | 503,060 |   |

 

16

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**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**AS OFDECEMBER 31, 2003**

**(in thousands)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                       |       |       |       |                        |       |                          |       |             |       |             |       |
| Current  assets:                                 |       |       |       |                        |       |                          |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 39,827     |                        | $          | 289                           |       | $                | 55         |             | $          | — |   | $ | 40,171 |   |
| Accounts  receivable                             |       | 110        |       | 55,980                      |       | 451                           |       | —           |       | 56,541           |       |
| Restricted  assets                               |       | 205        |       | 7,301                       |       | 14,679                        |       | —           |       | 22,185           |       |
| Prepaids and  other                              |       | 10,472     |       | 1,728                       |       | —                        |       | —           |       | 12,200           |       |
| Total current  assets                            |       | 50,614     |       | 65,298                      |       | 15,185                        |       | —           |       | 131,097          |       |
| Property and  equipment, net                     |       | 2,443      |       | 108,916                     |       | 163,086                       |       | (6,542           | )          | 267,903          |       |
| Other assets:                                    |       |       |       |                        |       |                          |       |             |       |             |       |
| Debt service  reserve fund                       |       | —     |       | —                      |       | 23,800                        |       | —           |       | 23,800           |       |
| Deferred  costs and other                        |       | 23,133     |       | 15,340                      |       | 9,952                         |       | (23,068          | )          | 25,357           |       |
| Investment in  subsidiaries                      |       | 38,777     |       | 1,856                       |       | —                        |       | (40,633          | )          | —           |       |
| Total assets                                     |       | $          | 114,967    |                        | $          | 191,410                       |       | $                | 212,023    |             | $          | (70,243 | ) | $ | 448,157 |   |
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| **Liabilities and  stockholders’ equity**   |       |       |       |                        |       |                          |       |             |       |             |       |
| Current  liabilities:                            |       |       |       |                        |       |                          |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $          | 26,912     |                        | $          | 5,248                         |       | $                | 6,512      |             | $          | (2,095 | ) | $ | 36,577 |   |
| Current  portion of long-term debt               |       | 5          |       | 1                           |       | 8,300                         |       | —           |       | 8,306            |       |
| Total current  liabilities                       |       | 26,917     |       | 5,249                       |       | 14,812                        |       | (2,095           | )          | 44,883           |       |
| Long-term  debt, net of current portion          |       | 2,000      |       | 50,592                      |       | 174,700                       |       | —           |       | 227,292          |       |
| Deferred tax  liabilities                        |       | 7,006      |       | —                      |       | —                        |       | —           |       | 7,006            |       |
| Other  long-term liabilities                     |       | 6,176      |       | 68                          |       | 19,888                        |       | (23,391          | )          | 2,741            |       |
| Intercompany                                     |       | (93,367    | )          | 93,367                      |       | —                        |       | —           |       | —           |       |
| Total  liabilities                               |       | (51,268    | )          | 149,276                     |       | 209,400                       |       | (25,486          | )          | 281,922          |       |
| Stockholders’  equity                       |       | 166,235    |       | 42,134                      |       | 2,623                         |       | (44,757          | )          | 166,235          |       |
| Total  liabilities and stockholders’ equity |       | $          | 114,967    |                        | $          | 191,410                       |       | $                | 212,023    |             | $          | (70,243 | ) | $ | 448,157 |   |

 

17

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**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**THREE MONTHSENDED June 30, 2004**

**(in thousands)**

**(unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| Revenues                                         |       | $          | 4,531      |                        | $          | 78,217                        |       | $                | 4,502      |             | $          | (17,257 | ) | $ | 69,993 |   |
| Operating  expenses                              |       | 5,900      |       | 65,189                      |       | 23                            |       | (16,997          | )          | 54,115           |       |
| Pre-opening  and start-up expenses               |       | —     |       | 2,384                       |       | —                        |       | —           |       | 2,384            |       |
| Depreciation  and amortization                   |       | (20        | )          | 2,220                       |       | 1,055                         |       | (76              | )          | 3,179            |       |
| General and  administrative expenses             |       | 5,574      |       | —                      |       | 19                            |       | 12               |       | 5,605            |       |
| Income (loss)  from operations                   |       | (6,923     | )          | 8,423                       |       | 3,405                         |       | (195             | )          | 4,710            |       |
| Overhead  allocations                            |       | (8,604     | )          | 8,604                       |       | —                        |       | —           |       | —           |       |
| Interest, net                                    |       | (1,117     | )          | 1,688                       |       | 3,633                         |       | 11               |       | 4,215            |       |
| Loss on  extinguishment of debt                  |       | —     |       | 2,357                       |       | —                        |       | —           |       | 2,357            |       |
| Equity (loss)  in subsidiaries                   |       | (3,475     | )          | —                      |       | —                        |       | 3,475            |       | —           |       |
| Income (loss)  before provision for income taxes |       | (677       | )          | (4,226                      | )          | (228                          | )          | 3,269            |       | (1,862           | )          |
| Provision  (benefit) for income taxes            |       | 422        |       | (1,080                      | )          | —                        |       | (105             | )          | (763             | )          |
| Net income  (loss)                               |       | $          | (1,099     | )                           | $          | (3,146                        | )          | $                | (228       | )                | $          | 3,374 |   | $ | (1,099 | ) |

 

18

----

 

**CORNELL COMPANIES, INC.**

**CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS**

**THREE MONTHS ENDED JUNE 30, 2003**

**(in thousands)**

**(unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| Revenues                                         |       | $          | 4,529      |                        | $          | 75,074                        |       | $                | 4,502      |             | $          | (16,519 | ) | $ | 67,586 |   |
| Operating  expenses                              |       | 4,440      |       | 63,825                      |       | 5                             |       | (16,512          | )          | 51,758           |       |
| Pre-opening  and start-up expenses               |       | —     |       | 306                         |       | —                        |       | —           |       | 306              |       |
| Depreciation  and amortization                   |       | —     |       | 1,583                       |       | 1,055                         |       | (34              | )          | 2,604            |       |
| General and  administrative expenses             |       | 4,703      |       | —                      |       | 19                            |       | —           |       | 4,722            |       |
| Income (loss)  from operations                   |       | (4,614     | )          | 9,360                       |       | 3,423                         |       | 27               |       | 8,196            |       |
| Overhead  allocations                            |       | (8,908     | )          | 8,908                       |       | —                        |       | —           |       | —           |       |
| Interest, net                                    |       | (1,216     | )          | 1,872                       |       | 3,838                         |       | 12               |       | 4,506            |       |
| Equity (loss)  in subsidiaries                   |       | (1,481     | )          | —                      |       | —                        |       | 1,481            |       | —           |       |
| Income (loss)  before provision for income taxes |       | 4,029      |       | (1,420                      | )          | (415                          | )          | 1,496            |       | 3,690            |       |
| Provision  (benefit) for income taxes            |       | 1,852      |       | (146                        | )          | —                        |       | (193             | )          | 1,513            |       |
| Net income  (loss)                               |       | $          | 2,177      |                        | $          | (1,274                        | )          | $                | (415       | )                | $          | 1,689 |   | $ | 2,177 |   |

 

19

----

 

**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**SIX MONTHS ENDEDJUNE 30, 2004**

**(in thousands)**

**(unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| Revenues                                         |       | $          | 9,088      |                        | $          | 156,291                       |       | $                | 9,004      |             | $          | (35,066 | ) | $ | 139,317 |   |
| Operating  expenses                              |       | 11,723     |       | 131,630                     |       | 23                            |       | (34,747          | )          | 108,629          |       |
| Pre-opening  and start-up expenses               |       | —     |       | 4,030                       |       | —                        |       | —           |       | 4,030            |       |
| Depreciation  and amortization                   |       | —     |       | 4,374                       |       | 2,111                         |       | (147             | )          | 6,338            |       |
| General and  administrative expenses             |       | 9,715      |       | —                      |       | 38                            |       | 12               |       | 9,765            |       |
| Income (loss)  from operations                   |       | (12,350    | )          | 16,257                      |       | 6,832                         |       | (184             | )          | 10,555           |       |
| Overhead  allocations                            |       | (15,834    | )          | 15,834                      |       | —                        |       | —           |       | —           |       |
| Interest, net                                    |       | (1,970     | )          | 3,427                       |       | 7,386                         |       | 21               |       | 8,864            |       |
| Loss on  extinguishment of debt                  |       | —     |       | 2,357                       |       | —                        |       | —           |       | 2,357            |       |
| Equity (loss)  in subsidiaries                   |       | (4,706     | )          | —                      |       | —                        |       | 4,706            |       | —           |       |
| Income (loss)  before provision for income taxes |       | 748        |       | (5,361                      | )          | (554                          | )          | 4,501            |       | (666             | )          |
| Provision  (benefit) for income taxes            |       | 1,141      |       | (1,163                      | )          | —                        |       | (251             | )          | (273             | )          |
| Net income  (loss)                               |       | $          | (393       | )                           | $          | (4,198                        | )          | $                | (554       | )                | $          | 4,752 |   | $ | (393 | ) |

 

20

----

**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF OPERATIONS**

**SIX MONTHS ENDEDJUNE 30, 2003**

**(in thousands)**

**(unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                          |       |             |       |             |       |
| Revenues                                         |       | $          | 9,061      |                        | $          | 152,261                       |       | $                | 9,004      |             | $          | (36,714 | ) | $ | 133,612 |   |
| Operating  expenses                              |       | 8,654      |       | 131,384                     |       | 19                            |       | (36,605          | )          | 103,452          |       |
| Pre-opening  and start-up expenses               |       | —     |       | 393                         |       | —                        |       | —           |       | 393              |       |
| Depreciation  and amortization                   |       | —     |       | 3,124                       |       | 2,111                         |       | (62              | )          | 5,173            |       |
| General and  administrative expenses             |       | 8,557      |       | —                      |       | 63                            |       | —           |       | 8,620            |       |
| Income (loss)  from operations                   |       | (8,150     | )          | 17,360                      |       | 6,811                         |       | (47              | )          | 15,974           |       |
| Overhead  allocations                            |       | (16,895    | )          | 16,895                      |       | —                        |       | —           |       | —           |       |
| Interest, net                                    |       | (2,440     | )          | 3,598                       |       | 7,788                         |       | 22               |       | 8,968            |       |
| Equity (loss)  in subsidiaries                   |       | (3,486     | )          | —                      |       | —                        |       | 3,486            |       | —           |       |
| Income (loss)  before provision for income taxes |       | 7,699      |       | (3,133                      | )          | (977                          | )          | 3,417            |       | 7,006            |       |
| Provision  (benefit) for income taxes            |       | 3,566      |       | (242                        | )          | —                        |       | (451             | )          | 2,873            |       |
| Net income  (loss)                               |       | $          | 4,133      |                        | $          | (2,891                        | )          | $                | (977       | )                | $          | 3,868 |   | $ | 4,133 |   |

 

21

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**CORNELL COMPANIES,INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**SIX MONTHS ENDEDJUNE 30, 2004**

**(in thousands)**

**(unaudited)**

 
| ** **                                               | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Net cash  provided by (used in) operating activities     |       | $          | (20,656    | )                           | $          | 23,080                        |       | $                | 5,518      |             | $          | — |   | $ | 7,942 |   |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash flows from investing activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Capital  expenditures                                    |       | —     |       | (20,559                     | )          | —                        |       | —           |       | (20,559          | )          |
| Purchase of  facility management contract                |       | —     |       | (2,900                      | )          | —                        |       | —           |       | (2,900           | )          |
| Refund from  restricted escrow arrangement               |       | 5,000      |       | —                      |       | —                        |       | —           |       | 5,000            |       |
| Payments to  restricted debt payment account, net        |       | —     |       | —                      |       | (5,523                        | )          | —           |       | (5,523           | )          |
| Return of  restricted assets from deferred bonus plan    |       | 86         |       | —                      |       | —                        |       | —           |       | 86               |       |
| Proceeds from  sale of property and equipment            |       | —     |       | 163                         |       | —                        |       | —           |       | 163              |       |
| Net cash  provided by (used in) investing activities     |       | 5,086      |       | (23,296                     | )          | (5,523                        | )          | —           |       | (23,733          | )          |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash flows from financing activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Proceeds from  long-term debt and line of credit         |       | 69,000     |       | —                      |       | —                        |       | —           |       | 69,000           |       |
| Payments on  line of credit                              |       | (71,000    | )          | —                      |       | —                        |       | —           |       | (71,000          | )          |
| Payments on  Synthetic Lease                             |       | —     |       | (52,495                     | )          | —                        |       | —           |       | (52,495          | )          |
| Intercompany  transfers                                  |       | (52,495    | )          | 52,495                      |       | —                        |       | —           |       | —           |       |
| Proceeds from  Senior Notes, net of discount             |       | 110,527    |       | —                      |       | —                        |       | —           |       | 110,527          |       |
| Payment for  debt issuance and other financing costs     |       | (5,033     | )          | —                      |       | —                        |       | —           |       | (5,033           | )          |
| Payments on  capital lease obligations                   |       | (6         | )          | —                      |       | —                        |       | —           |       | (6               | )          |
| Proceeds from  exercise of stock options                 |       | 1,040      |       | —                      |       | —                        |       | —           |       | 1,040            |       |
| Purchases of  treasury stock                             |       | (116       | )          | —                      |       | —                        |       | —           |       | (116             | )          |
| Net cash  provided by (used in) financing activities     |       | 51,917     |       | —                      |       | —                        |       | —           |       | 51,917           |       |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Net increase (decrease) in cash and cash equivalents** |       | 36,347     |       | (216                        | )          | (5                            | )          | —           |       | (36,126          | )          |
| ** **                                               |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash and cash equivalents at beginning of period**     |       | 39,827     |       | 289                         |       | 55                            |       | —           |       | 40,171           |       |
| ** **                                               |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash and cash equivalents at end of period**           |       | $          | 76,174     |                        | $          | 73                            |       | $                | 50         |             | $          | — |   | $ | 76,297 |   |

 

22

----

 

**CORNELLCOMPANIES, INC.**

**CONDENSEDCONSOLIDATING STATEMENTS OF CASH FLOWS**

**SIX MONTHS ENDEDJUNE 30, 2003**

**(in thousands)**

**(unaudited)**

 
| ** **                                               | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|------------------|------------|
| **Cash flows from operating activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Net cash  provided by (used in) operating activities     |       | $          | (2,619     | )                           | $          | 6,875                         |       | $                | 4,589      |             | $          | — |   | $ | 8,845 |   |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash flows from investing activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Capital  expenditures                                    |       | —     |       | (6,447                      | )          | —                        |       | —           |       | (6,447           | )          |
| Escrow  deposit on non-compete agreement                 |       | —     |       | (1,000                      | )          | —                        |       | —           |       | (1,000           | )          |
| Payments to  restricted debt payment account, net        |       | —     |       | —                      |       | (4,557                        | )          | —           |       | (4,557           | )          |
| Net cash used  in investing activities                   |       | —     |       | (7,447                      | )          | (4,557                        | )          | —           |       | (12,004          | )          |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash flows from financing activities:**                |       |       |       |                        |       |                          |       |             |       |             |       |
| Proceeds from  long-term debt                            |       | —     |       | 641                         |       | —                        |       | —           |       | 641              |       |
| Payments on  capital lease obligations                   |       | (14        | )          | —                      |       | —                        |       | —           |       | (14              | )          |
| Proceeds from  exercise of stock options                 |       | 2,054      |       | —                      |       | —                        |       | —           |       | 2,054            |       |
| Purchases of  treasury stock                             |       | (591       | )          | —                      |       | —                        |       | —           |       | (591             | )          |
| Net cash  provided by financing activities               |       | 1,449      |       | 641                         |       | —                        |       | —           |       | 2,090            |       |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Net increase (decrease) in cash and cash equivalents** |       | (1,170     | )          | 69                          |       | 32                            |       | —           |       | (1,069           | )          |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash and cash equivalents at beginning of period**     |       | 52,407     |       | 157                         |       | 46                            |       | —           |       | 52,610           |       |
|                                                     |       |       |       |                        |       |                          |       |             |       |             |       |
| **Cash and cash equivalents at end of period**           |       | $          | 51,237     |                        | $          | 226                           |       | $                | 78         |             | $          | — |   | $ | 51,541 |   |

 

23

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

 

**General**

 

The Company is a leadingprovider of correctional, treatment and educational services outsourced byfederal, state and local governmental agencies. The Company provides a diversified portfolio of services for adults andjuveniles through its three operating divisions: (1) adult secure institutionalservices, (2) juvenile justice, educational and treatment services; and (3) adultcommunity-based corrections and treatment services.  At June 30, 2004, the Company operated66 facilities in 15 states and the District of Columbia.  Additionally, the Company had five facilitiesunder development, construction or renovation, including one facility in anadditional state.  As of June 30,2004, total available residential service capacity was 13,530 includingcapacity for 2,726 individuals that will be available upon completion ofconstruction or renovation of residential facilities, and total availablenon-residential service capacity was 4,090. The following table sets forth for the periods indicated totalresidential service capacity and contracted beds in operation at the end of theperiods shown, average occupancy percentages and total non-residential servicecapacity.

 
| ** **                                                                | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Residential**                                                           |       |                    |       |                    |       |
| Service  capacity (1)                                                     |       | 13,530                  |       | 12,378                  |       |
| Contracted  beds in operation (end of period) (2)                         |       | 10,410                  |       | 9,492                   |       |
| Average  contract occupancy based on contracted beds in operation (3) (4) |       | 100.9                   | %          | 99.9                    | %          |
| Average  contract occupancy excluding start-up operations (3) (4)         |       | 101.2                   | %          | 100.0                   | %          |
| **Non-Residential**                                                       |       |                    |       |                    |       |
| Service  capacity (5)                                                     |       | 4,090                   |       | 4,136                   |       |

 

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

(2)          Atcertain residential facilities, the contracted capacity is lower than thefacility’s service capacity.  The Companycould increase a facility’s contracted capacity by obtaining additionalcontracts or by renegotiating existing contracts to increase the number of bedscovered.  However, there is no guaranteethat the Company will be able to obtain contracts that provide occupancy levelsat a facility’s service capacity or that current contracted capacities can bemaintained in future periods.

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

(4)          Averagecontract occupancy percentages are calculated based on actual occupancy for theperiod as a percentage of the contracted capacity for residential facilities inoperation.  These percentages do not reflectthe operations of non-residential community-based programs.  At certain residential facilities, ourcontracted capacity is lower than the facility’s service capacity.  Additionally, certain facilities have and arecurrently operating above the Company’s contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

(5)          Service capacity for non-residential programsis based on either contractual terms or the Company’s estimate of the number ofclients to be served.  These estimatesare updated by the Company at least annually based on the program’s budget andother factors.

 

TheCompany derives substantially all its revenues from providing adult correctionsand treatment and juvenile justice, educational and treatment servicesoutsourced by federal, state and local governmental agencies in the UnitedStates.  Revenues for the Company’sservices are generally recognized on a per diem rate based upon the number ofoccupant days or hours served for the period, on a guaranteed take-or-pay basisor on a cost-plus reimbursement basis.  For the three months ended June 30, 2004,the Company’s revenue base consisted of 73.0% for services provided under perdiem contracts, 9.2% for services provided under take-or-pay and managementcontracts, 9.6% for services provided under cost-plus reimbursement contracts,6.4% for services provided under fee-for-service contracts and 1.8% from othermiscellaneous sources.  For the sixmonths ended June 30, 2004, the Company’s revenue base consisted of 72.8%for services provided under per diem contracts, 9.2% for services providedunder take-or-pay and management contracts, 9.8% for services provided undercost-plus reimbursement contract, 6.4% for services provided underfee-for-services contracts and 1.8% from other miscellaneous sources.  These percentages are generally consistentwith comparable statistics for the three and six

 

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months ended June 30, 2003.  Revenuescan fluctuate from period to period due to changes in government fundingpolicies, changes in the number of clients referred to the Company’s facilitiesby governmental agencies and the services to be provided, the opening of newfacilities or the expansion of existing facilities and the termination ofcontracts for a facility or the closure of a facility.

 

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

 

Revenuesfor the Company’s adult secure institutional services division are primarilygenerated from per diem, take-or-pay and management contracts.  For the three months ended June 30, 2004and 2003, the Company realized average per diem rates for its adult secureinstitutional services division of approximately $49.37 and $47.97,respectively.  The increase in theaverage per diem rate in 2004 is due primarily to per diem rate increases atthe Big Spring Correctional Center in June 2003 and mid-March 2004offset, in part, by a 5% per diem rate reduction at the D. Ray James Prison inthe second half of 2003 (the Company mitigated a portion of this rate reductionby negotiating reductions in the level of services provided).  Additionally, the average per diem rate forthe three months ended June 30, 2004 was unfavorably affected by a changeto the management agreement for the Donald D. Wyatt Detention Center wherebythe Company receives a fixed fee for a certain occupancy level and a lower perdiem rate for occupancy in excess of the fixed fee occupancy.  Due to an increase in occupancy at thisfacility in the three months ended June 30, 2004, the average per diemrate was lower than in the same period of 2004. For the six months ended June 30, 2004 and 2003, the Companyrealized average per diem rates of approximately $48.70 and $48.18,respectively.  In the past year, theCompany has experienced increasing pressure from contracting governmentalagencies to limit or even reduce per diem rates.  Many of these governmental entities are undersevere budget pressures and it is possible more governmental agencies mayapproach the Company about per diem rate concessions.  Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely effect our current estimate ofadult secure institutional services division revenues for the year endingDecember 31, 2004.

 

Revenues for the Company’s juvenile justice, educational and treatmentservices division are primarily generated from per diem, fee-for-service andcost-plus reimbursement contracts.  Forthe three months ended June 30, 2004 and 2003, the Company realizedaverage per diem rates on its residential juvenile facilities of approximately$158.85 and $160.25, respectively.  Thedecrease in the average per diem rate in the 2004 period is due primarily to(1) thetermination of the Santa Fe County Youth Development Program inJanuary 2004, (2) a reduction in the per diem rate at the Salt Lake ValleyDetention Center and (3) a decrease in the per diem rates at certain juvenilefacilities in Illinois.  The decrease wasoffset, in part, by the per diem rate for the Texas Adolescent Center.  For the six months ended June 30,2004 and 2003, the Company realized average per diem rates of approximately$160.23 and $161.43, respectively.  Forthe three months ended June 30, 2004 and 2003, the Company realized averagefee-for-service rates on its non-residential community-based juvenilefacilities and programs, including rates that are limited by Medicaid and otherprivate insurance providers, of approximately $26.66 and $26.70,respectively.   For the six months endedJune 30, 2004 and 2003, the Company realized average fee-for-service ratesof approximately $27.02 and $26.99, respectively.  The majority of the Company’s juvenileservices contracts renew annually.

 

Revenues for the Company’s adult community-based corrections andtreatment services division are primarily generated from per diem andfee-for-service contracts.  For the threemonths ended June 30, 2004 and 2003, the Company realized average per diemrates for its residential adult community-based facilities of approximately$63.26 and $58.81, respectively.  For thesix months ended June 30, 2004 and 2003, the Company realized average perdiem rates of $60.93 and $58.71, respectively. The increase in the average per diem rate in the 2004 period is due primarily to rate increases in the latterhalf of 2003 at certain residential facilities as a result of contractrenewals.  For the three monthsended June 30, 2004 and 2003, the Company realized average fee-for-servicerates on its non-residential adult community-based programs of approximately$8.84 and $9.26, respectively.  For thesix months ended June 30, 2004 and 2003, the Company realized averagefee-for-service rates of approximately $8.97 and $9.14, respectively.  The decreasein the average fee-for-service rates in 2004 is due to changes inthe mix of services provided by the Company’s various non-residential adultcommunity-based programs.

 

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Factorsthe Company considers in determining billing rates to charge include (1) theprograms specified by the contract and the related staffing levels, (2) wagelevels customary in the respective geographic areas, (3) whether the proposedfacility is to be leased or purchased and (4) the anticipated average occupancylevels that management believes can reasonably be maintained.

 

TheCompany has historically experienced higher operating margins in its adultsecure institutional services and adult community-based corrections andtreatment services divisions as compared to the juvenile justice, educationaland treatment services division. Additionally, the Company’s operating margins within a division can varyfrom facility to facility based on a number of factors including, but notlimited, to staffing costs, whether the Company manages a facility or whetherthe Company owns or leases the facility, the level of competition for thecontract award, the occupancy levels for the facility and the level of capitalcommitment required to operate the facility. In contrast to take-or-pay contracts, per diem contracts are basedon a net rate per day times population and, as a result, are sensitive tooccupancy levels.  A decline in occupancy of certain juvenilefacilities can have a more significant impact on operating results than theadult secure institutional division due to higher per diem rates at certainjuvenile facilities.  The Companyhas experienced and expects to continue to experience interim period operatingmargin fluctuations due to the number of calendar days in the period, higherpayroll taxes in the first half of the year, and salary and wage increases andinsurance cost increases that are incurred prior to certain contract rateincreases.  Additionally,  a decrease in per diem rates without acorresponding decrease in operating expenses could adversely affect theCompany’s operating margin.

 

The Company is responsible for all facility operating costs, except forcertain debt service and interest or lease payments for facilities where theCompany has a management contract only. For facilities that the Company has a management contract only, thefacility owner is responsible for all debt service and interest or leasepayments related to the facility. As a result, these types of projects allowthe Company to grow its operations with comparatively lower capital outlay.  The Company is responsible for all otheroperating expenses at these facilities. The Company operated 11 and 10 facilities under management contracts atJune 30, 2004 and 2003, respectively.

 

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

 

TheCompany incurs pre-opening and start-up expenses including payroll, benefits,training and other operating costs prior to opening a new or expanded facilityand during the period of operation while occupancy is ramping up.  These costs vary by contract.  Since pre-opening and start-up costs aregenerally factored into the revenue per diem rate that is charged to acontracting agency, the Company typically expects to recover these upfrontcosts over the life of a contract. Because occupancy rates during a facility’s start-up phase typicallyresult in capacity under-utilization for at least 90 to 180 days, the Companymay incur additional post-opening start-up costs.  The Company does not anticipate incurringpost-opening start-up costs at adult secure facilities operated under anyfuture contracts with the BOP because the BOP has consistently entered intotake-or-pay contracts with private prison operations since 1999.  Under these contracts the BOP pays privateoperators at least 80.0% of the contracted occupancy once the facility opens,regardless of actual occupancy.

 

The Company anticipates incurring pre-opening and start-up costs ofapproximately $5.5 million, net of start-up revenue, in the year endingDecember 31, 2004 for the pre-opening and start-up activities of theJos-Arz Residential Treatment Center, the Southern Peaks Regional TreatmentCenter, the Regional Correctional Center in New Mexico, the Plankinton RegionalTreatment Center, the Plankinton Regional Detention Center, the MoshannonValley Correctional Center, the Walnut Grove Youth Correctional Facility andthe Las Vegas Center.  Unforeseenconstruction or renovation delays, occupancy levels below management’s currentestimates,

 

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or additional development projects not included within currentestimates, could affect the Company’s projected pre-opening and start-up costs.

 

Managementexpects an increase of approximately $0.2 million in amortization expense inthe year ending December 31, 2004 due to the amortization of twonon-compete agreements resulting from the acquisition of the Jos-ArzResidential Treatment Center management contract in June 2003 and theWalnut Grove Youth Correctional Facility management contract in June 2004.

 

Newly opened facilities are staffed according to applicable regulatoryor contractual requirements when the Company begins receiving offenders orclients.  Offenders or clients aretypically assigned to a newly opened facility on a phased-in basis over a one-to six-month period.  The Company’s start-up period for newjuvenile operations is up to 12 months from the date the Company beginsrecognizing revenue unless break-even occupancy levels are achieved beforethen.  The Company’s start-up period fornew adult operations is up to nine months from the date the Company beginsrecognizing revenue unless break-even occupancy levels are achieved beforethen.  Although the Company typicallyrecovers these upfront costs over the life of the contract, quarterly resultscan be substantially affected by the timing of the commencement of operationsas well as the development and construction of new facilities.

 

Workingcapital requirements generally increase immediately prior to the Company’scommencing operation of a new facility or upon the expansion of an existingfacility as the Company incurs pre-opening and start-up costs and purchasesnecessary equipment and supplies.

 

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

 

**Management Overview**

 

***Demand*.**The Company’s business is driven generally by demand for incarceration ortreatment services, and specifically by demand for private incarceration ortreatment services, within its three primary business segments: adult secureinstitutional services; juvenile justice, educational and treatment services;and adult community-based corrections and treatment services.  The demand for adult and juvenile correctionsand treatment services has generally increased at a steady rate over the pastten years, largely as a result of increasingly long sentences and/or mandatorysentences for criminals, increasing demand for incarceration of illegal aliensand a public recognition of the need to provide services to juveniles that willimprove the possibility that they will lead productive lives.  Growth within our three business segments hasnot, on a capacity basis, increased as rapidly as the increase in overalldemand for correctional services.  Recentsuggestions by social commentators and various political or governmentalrepresentatives suggest that community-based corrections of adults may beemphasized in the future as alternatives to traditional incarceration which hashistorically had higher margins.  Amongother things, the Company’s management monitors federal, state and industrystatistics relative to trends in prison populations, juvenile justicestatistics and initiatives, and developments in alternatives to traditionalincarceration or detention of adults.

 

The federal government increasingly is turning to private providers forthe incarceration of adults, whether they are serving prison sentences,detained as illegal aliens, detained in anticipation of pending judicialadministration or transitioning from prison to society.   The Bureau of Justice Statistics reportsthat privately operated facilities housed approximately 5.7% of state offendersand 12.5% of federal offenders as of June 30, 2003, an increase from of5.5% and 2.8%, respectively, as of December 31, 1999. The primary federalagencies which use private providers are the Federal Bureau of Prisons (BOP),The Bureau of Immigration, Customs and Enforcement, and the U.S. MarshalsService.  The Company providesadult-secure and adult community-based services to the federal government.  Most of the federal involvement in juvenileadministration in the federal system is handled through Medicare and Medicaidassistance to state governments. Although there are circumstances in which theCompany may contract with a federal agency on a sole source basis, the primarymeans by which the Company secures a contract with a federal agency is via aRequest for Proposal (RFP) bidding process. From time to time, the Company contracts to provide management servicesto a local

 

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government, which then bids on a federal contract.

 

States and smaller governmental units are divided on the issue ofprivate prisons and private provision of juvenile and community-based programs,although a majority of states permit private provision of these services.  The Company anticipates that increasing budgetpressure on states and smaller governmental units will cause more states andsmaller governmental units to turn to private providers such as the Company toprovide these services on a more economical basis.  Although it varies from governmental unit togovernmental unit, the primary political opposition to privatization of prisonscomes from organized labor and religious groups.

 

Private juvenile and community-based programs are much more widelyaccepted and utilized by states and local governmental units than adult securefacilities.  Many private providers areorganized on a not-for-profit basis, but there are a number of large,for-profit providers, such as the Company, of juvenile and community-basedprograms.  The Company’s managementmonitors opportunities in these segments via its corporate and regionaldevelopment officials.  Many of theseopportunities are not published in any manner and, accordingly, the Companybelieves that taking initiative at the state and local level is key indeveloping sole source opportunities, which have become a focus of the Company.

 

***Performance*.**Management tracks a number of factors as it monitors the Company’s financialperformance.  Chief among them are:

 

•                  capacity (thenumber of beds within each business segment’s facilities);

•                  occupancy(utilization);

•                  per diemreimbursement rates; and

•                  operatingexpenses.

 

The Company’s profitability is primarily impacted by the number andsize of the facilities owned or leased by the Company and the facilities whichare not owned or leased by the Company, but which are managed by the Company onbehalf of a third party owner or lessee. Management views capacity primarily as a measure of its developmentefforts, which may increase capacity by adding new projects or adding to existingprojects.  The Company has a number ofprojects in development which it expects to be placed into service in 2004 and2005.  As part of measuring itsdevelopment efforts, management assesses (a) whether a given developmentproject was brought into service in accordance with management’s expectation asto time and expense; and (b) the number of projects in development at therelevant point in time.  In addition tothe focus on new projects, capacity will reflect management’s success inrenewing and maintaining existing contracts and facilities.  Recently, we have been confronted with thepossibility that state or local budgetary limitations may cause the contractualcommitment at a given facility to be reduced or even eliminated, which wouldrequire us to secure an alternate customer for the facility or close thefacility.

 

Management looks at occupancy to assess the efficacy of both itsefforts to market its facilities and its efforts to retain existing customersor contracts.  Because revenue variesdirectly with occupancy, occupancy is a driver of the Company’s revenues.  For the three and six months endedJune 30, 2004, 4.5% and 4.6%, respectively, of the Company’s revenues werederived from contracts that were “take-or-pay,” meaning that the agency makinguse of the facility is obligated to pay for beds even if they are notused.  Historically, the Company’soccupancy has been very high and management is mindful of the need to maintainhigh occupancy levels.  As newdevelopment projects are brought into service, occupancy percentages may declineuntil the projects reach full utilization. Where the Company has commitments for utilization before thecommencement of operations, occupancy reflects the speed at which the Companyachieves full service/implementation. However, the Company often undertakesdevelopment projects without written commitments to make use of a facility. Inthese instances, the Company has performed its own assessment, based onconversations with local government representatives and other factors, of thedemand for services at the facility. There can be no assurance that the Company will recover its investmentin these cases.  The Company plans tomonitor occupancy in order to measure the accuracy of management’s estimationof the demand for the services of these facilities.

 

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Per diem reimbursement rates are also a key driver of the Company’sgross revenue and operating margin since revenues from per diem contractsrepresent a majority of our revenues (73.0% and 72.8% during the three and sixmonths ended June 30, 2004, respectively). Per diem rates are a function of negotiation between the Company and agovernmental unit at the inception of a contract or through the RFP process.  Actual per diem rates vary dramaticallyacross the Company’s business segments, and within each business segmentdepending upon the particular service or program provided. Initial per diemrates often change during the term of a contract in accordance with a schedule.  The amount of the change can be a fixedamount set forth within the contract, an amount determined by formulas setforth within the contract or an amount determined by negotiations between theCompany and the governmental entity. These negotiations are typically similarto the original per diem negotiation, including a review of the Company’sexpenses and approval of an amount to compensate the Company for expenses andassure the Company the potential of an operating profit.  In recent years, as budgetary pressures ongovernmental units have increased, the Company has granted a few of itscustomers relief from formulaic increase provisions in their agreements andsome of our customers have declined to include their appropriation legislationamounts that would increase the per diem rates payable to the Company. Suchincreases are often necessary for the Company to offset operating expenseincreases.  Although the Company hasmitigated a portion of the impact of these developments by reducing services orobtaining commitments for increased volume, it has taken steps, primarily inthe area of legislative and governmental monitoring and lobbying, in an effortto minimize these sorts of adverse developments in the future.  The Company plans to continue to monitor perdiem rates as a measure of negotiation skill, customer service, management andmaintenance, political and business astuteness.

 

Management continually monitors its operating expenses.  Foremost among these expenses are employeecompensation and benefits, risk related expenses such as general liability,medical and workers’ compensation, client and inmate costs such as food,clothing and programming costs, financing costs and administrative overheadexpenses. Increases or decreases in one or more of these items, such as the Company’srecent experience with rising insurance costs, can have a material effect onthe Company’s performance.  Management isparticularly monitoring the costs of complying with the Sarbanes-Oxley Act of2002 in terms of fees paid to third parties, such as independent auditors andconsultants, and internal administrative costs.   The Company spent approximately $331,000 and$496,000 in the three and six months ended June 30, 2004, respectively,for professional expenses incurred to comply with the requirements of theSarbanes-Oxley Act.

 

Management of the Company recognizes that its operating margins aresubject to pressure from a variety of factors, but most notably rising costsand governmental and agency budgetary constraints.  Management also believes that successfuldevelopment of higher margins and low capital projects is key to mitigatingsuch pressure.  The Company has severaldevelopment projects committed and in various stages of completion. Until thoseprojects are completed and brought into service, management will monitoroperations and existing customer relationships to minimize start-up costs.

 

**Recent Developments**

 

***WalnutGrove Youth Correctional Facility***

 

InJune 2004, the Company acquired a management agreement to operate a976-bed secure youthful offender correctional facility in Walnut Grove,Mississippi, the Walnut Grove Youth Correctional Facility, from TuscolametaInc.  This facility houses 13-20 year-oldmales and provides academic and vocational training, along with drug andalcohol education and treatment.  Groupand individual counseling and recreational opportunities are also provided. Theunderlying management agreement is with the Walnut Grove CorrectionalAuthority, which holds a contract with the Mississippi Department ofCorrections.  The management agreementhas a remaining term of 2 1⁄2 years with a renewal option for an additionaltwo-year term at the option of the contracting parties.

 

TheCompany acquired the management contract and certain assets and liabilities fora total purchase price of $3.0 million, which was allocated as follows (inthousands):

 

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| Accounts receivable                      |   | $     | 584    |   |
|------------------------------------------|--------|-------|--------|--------|
| Contract value                           |   | 2,405 |   |
| Prepaid supplies                         |   | 188   |   |
| Fixed assets                             |   | 271   |   |
| Non-compete agreement                    |   | 300   |   |
| Accounts payable and accrued liabilities |   | (748  | )      |
| Net assets                               |   | $     | 3,000  |   |

 

Thefair market value of the contract was determined based on discounted futurecash flows.  The Company is amortizingthe contract value of approximately $2.4 million over the remaining term of themanagement contract of 2 1⁄2 years.  As ofJune 30, 2004, the Company had funded $2.9 million of the purchaseprice.  The remaining $0.1 million isexpected to be funded in the third quarter of 2004.  Management currently estimates that thefacility will contribute approximately $10.8 million in annualized revenues.

 

***Southern PeaksRegional Treatment Center***

 

OnJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled Cornell Corrections of California, Inc. v. Longboat Global Advisors,LLC, et al., No.2004 CV79761 in the Superior Court of Fulton County, Georgiaunder theories of fraud, conversion, breach of contract and other theories todetermine the location of and to recover funds previously deposited by theCompany into what it believed to be an escrow account in connection with thedevelopment and construction of the Southern Peaks Regional Treatment Center. Ofthe funds previously deposited, approximately $5.4 million remains to berecovered.  The Company has obtainedtemporary restraining orders freezing any and all financial accounts of theconstruction lender, one of its principals and certain other defendantsidentified during discovery.  The frozenaccounts include one of the construction lender’s bank accounts which containsapproximately $0.4 million.

 

Construction of the Southern Peaks Regional Treatment Center wassubstantially completed in July 2004. The Company purchased the property in June 2004 and has served as theconstruction supervisor in lieu of the developer and assumed the developer’srights and obligations under the construction contract (except that thedeveloper will remain as contractor for certain of the infrastructure servingthe facility).  As of June 30, 2004, theCompany had invested approximately $12.0 million in the property.  The Company began receiving clients in August2004 and currently anticipates that the facility will be fully ramped up byyear end.

 

### ***Las VegasCenter***

 

In June 2003, the BOPissued a RFP for the operation of a 65 bed adult community-based correctionalcenter in Clark County, Nevada.  TheCompany submitted a proposal in September 2003 and received requests forclarifications to its proposal in January and February 2004. TheCompany purchased a building in January 2004 for approximately $1.3million in anticipation of winning the contract award.  The Company was awarded the contract in July 2004 and is scheduledto assume the contract from the current operator in December 2004.  The initial contract is for two years withthree one-year renewal options and will generate an estimated $1.3 million inannualized revenue. The population for the contract will consist of 10% adultfemales and 90% adult males.  The Companywill operate this program from the building purchased in January 2004which is being renovated at an estimated total cost of approximately $0.8million.  The service capacity of thefacility will be 100 beds after renovations.

 

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

 

In January 2004, theCompany purchased a building in Los Angeles, California for approximately $2.5million.  The Company anticipatesrenovation costs of approximately $2.0 million. This new facility could provide services to 220 inmates in awork-furlough type program.  Although theCompany does not currently have a contract for this facility, it believes thatdue to the growth of the inmate population, severe budget crisis and recentlegal settlement requiring additional community services, this facility willfill a small part of the overall demand for such services in California.  The potential uses for the facility rangefrom a “halfway back” program to a comprehensive drug and alcohol treatmentprogram.

 

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***Baker Community Correctional Center***

### * *

In April 2004, the Company purchased the Baker CommunityCorrectional Center, which it previously leased, at a purchase price ofapproximately $2.0 million.  TheCompany’s current operating contract for this facility expired inJune 2004.  The Company is still operating the facilityand anticipates obtaining a new contract in the third quarter of 2004.  The state of California’s final approved statebudget includes appropriations for the continued operation of the facility.  The Company anticipates receiving a contractrenewal for the facility in the third quarter of 2004.

 

***Plankinton RegionalDetention Center***

 

The Plankinton Regional Detention Center, a 40 bed juvenile justicecenter in South Dakota, was activated early in May 2004 and the PlankintonRegional Treatment Center was scheduled to open in August 2004.  Both facilities were expected to be fullyramped up by year end.  The Company basedits plans to open and operate these facilities on a commitment from theappropriate state officials to create a special rate that would allow theCompany to meet the needs of clients rejected by other providers in thestate.  However, the Company has learnedthat it was awarded an initial per diem rate that, while as it is the highestrate in South Dakota, is insufficient to support the level of care andtreatment required for the center’s clients. The state is currently in the middle of a rate-setting process that willtake approximately six months.  While theCompany intends to pursue this project through the delay, it is not willing toopen the programs without sufficient resources or to operate at a loss, and hasdecided to delay the opening of the Regional Treatment Center and totemporarily suspend operations at the Regional Detention Center.

 

**Recently Issued Accounting Standard**

 

The FASB issued Interpretation No. 46R, Consolidation of VariableInterest Entities (FIN 46R) which addresses the consolidation of variableinterest entities (VIEs) by business enterprises that are the primarybeneficiaries.  A VIE is an entity thatdoes not have sufficient equity investment at risk to permit it to finance itsactivities without additional subordinated financial support, or whose equityinvestors lack the characteristics of a controlling financial interest.  The primary beneficiary of a VIE is theenterprise that has the majority of the risks or rewards associated with theVIE.  The Company’s adoption of FIN 46Rdid not change the Company’s accounting for the 2001 Sale and Leaseback Transaction,which is consolidated for reporting purposes. The Company has no other arrangements subject to the provisions of FIN46R.

 

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**Results of Operations**

 

The following table sets forth for theperiods indicated the percentages of revenue represented by certain items inthe Company’s historical consolidated statements of operations.

 
| ** **                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                       |       |                                  |       |                                |       |   |   |   |   |
| Revenues                                                   |       | 100.0                                 | %          | 100.0                               | %          | 100.0 | % | 100.0 | % |
| Operating  expenses                                        |       | 77.3                                  |       | 76.6                                |       | 78.0 |   | 77.4 |   |
| Pre-opening  and start-up expenses                         |       | 3.4                                   |       | 0.5                                 |       | 2.9 |   | 0.3 |   |
| Depreciation  and amortization                             |       | 4.5                                   |       | 3.8                                 |       | 4.5 |   | 3.9 |   |
| General  and administrative expenses                       |       | 8.0                                   |       | 7.0                                 |       | 7.0 |   | 6.5 |   |
| Income  from operations                                    |       | 6.8                                   |       | 12.1                                |       | 7.6 |   | 11.9 |   |
| Interest  expense, net                                     |       | 6.0                                   |       | 6.7                                 |       | 6.4 |   | 6.7 |   |
| Loss  on extinguishment of debt                            |       | 3.4                                   |       | —                              |       | 1.7 |   | — |   |
| Income  (loss) before provision (benefit) for Income taxes |       | (2.6                                  | )          | 5.4                                 |       | (0.5 | ) | 5.2 |   |
| Provision  (benefit) for income taxes                      |       | (1.1                                  | )          | 2.2                                 |       | (0.2 | ) | 2.2 |   |
| Net  income (loss)                                         |       | (1.5                                  | )%         | 3.2                                 | %          | (0.3 | )% | 3.0 | % |

 

***ThreeMonths Ended June 30, 2004 Compared to Three Months Ended June 30,2003***

 

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

 

***Revenues*****.** Revenues increased approximately $2.4 million, or 3.7%, to $70.0 millionfor the three months ended June 30, 2004, from $67.6 million for the threemonths ended June 30, 2003.

 

***AdultSecure.***Adult secure institutional services divisionrevenues increased approximately $1.1 million, or 4.3%, to $26.7 million forthe three months ended June 30, 2004 from $25.6 million for the threemonths ended June 30, 2003 due primarily to (1) a 32 bed expansionat the Big Spring Correctional Center completed in April 2003, (2) perdiem rate increases for the Big Spring Correctional Center in June 2003and mid-March 2004 and (3) increased occupancy at the Donald W. WyattDetention Center.   The increase inrevenue due to the above was offset, in part, by a decrease in revenue ofapproximately $300,000 at the D. Ray James Prison due to a 5.0% reduction inthe contracted per diem rate in the second half of 2003.

 

The Company’s adult secure institutional services division revenues areprimarily generated from contracts with federal and state governmentalagencies.  At June 30, 2004, theCompany operated seven adult secure facilities with an aggregate servicecapacity of 5,917.  The remainingcontract terms for these facilities range from one to seven years.

 

Average contract occupancy was 101.6% for the three months endedJune 30, 2004 compared to 100.3% for three months ended June 30,2003.  The average per diem rate wasapproximately $49.37 and $48.75 for the three months ended June 30, 2004and 2003, respectively.  The increase inthe average per diem rate was due primarily to the rate increases received atthe Big Spring Correctional Center. There were no revenues attributable to start-up operations for the threemonths ended June 30, 2004 and 2003.

 

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***Juvenile.***Juvenile justice, educational and treatment services divisionrevenues increased approximately $1.7 million, or 5.9%, to $31.2 million forthe three months ended June 30, 2004 from $29.5 million for the threemonths ended June 30, 2003 due to (1) the opening of the TexasAdolescent Center in October 2003 which contributed revenue ofapproximately $1.5 million, (2) an increase in revenue of approximately $0.5million as a result of increased occupancy at the Cornell Abraxas I (A-1)facility and (3) the acquisition of the Jos-Arz Residential Treatment Centermanagement contract in June 2003 which contributed revenue ofapproximately $0.8 million.  Thisincrease in revenue was offset, in part, by a decrease in revenue ofapproximately $1.0 million due to the Company’s termination of the Santa FeCounty Youth Development Program contract effective January 28, 2004.  Additionally, the Company did not receivecustomary mid-year per diem rate increases at its juvenile facilities andprograms in Pennsylvania in 2003.** **The Company did receive mid-year per diem rate increases for thesefacilities and programs in July 2004.

 

At June 30, 2004 the Company operated 23 residential juvenilefacilities and 15 non-residential community-based programs with an aggregateservice capacity of 5,233.  The Company’scontracts for these facilities and programs are generally with state and localgovernment agencies and renew annually.

 

Average contract occupancy for the threemonths ended June 30, 2004 was 95.6% compared to 91.1% for the threemonths ended June 30, 2003. Excluding the occupancy and contract capacity for the start-up operationsof the Jos-Arz Residential Treatment Center in 2003 and 2004, and thePlankinton Regional Detention Center in 2004, average contract occupancy was98.0% and 92.0% for the three months ended June 30, 2004 and 2003,respectively.  Although the exclusion ofthe actual occupancy and contract capacity for start-up operations is anon-GAAP measure, management believes it is important to provide averagecontract occupancy rates excluding start-up operations so as to provide morecomparable information with other periods. The average per diem rate for the Company’s residential juvenilefacilities was approximately $158.85 for the three months ended June 30,2004 compared to $160.25 for the three months ended June 30, 2003.  The decrease in the average per diem rate in2004 is due to (1) the termination of the Santa Fe County YouthDevelopment Program in January 2004, (2) a reduction in the per diem rateat the Salt Lake Valley Detention Center and (3) a decrease in the per diemrates at certain juvenile facilities in Illinois.  The decrease was offset, in part, by the perdiem rate for the Texas Adolescent Center which opened in October 2003.  The Company’s average fee-for-service rate forits non-residential juvenile community-based facilities and programs wasapproximately $26.66 for the three months ended June 30, 2004 compared to$26.70 for the three months ended June 30, 2003.

 

Revenues attributable to start-up operations were approximately$838,000 for the three months ended June 30, 2004 and were attributable tothe start-up operations of the Jos-Arz Residential Treatment Center and thePlankinton Regional Detention Center. Revenues attributable to start-up operations were approximately $54,000for the three months ended June 30, 2003 and were attributable to thestart-up operations of the Jos-Arz Residential Treatment Center.

 

***AdultCommunity-Based.*****Adultcommunity-based corrections and treatment services division revenues decreasedapproximately $0.4 million, or 3.3%, to $12.1 million for the three monthsended June 30, 2004 from $12.5 million for the three months ended June 30,2003 due to (1) a decrease in occupancy at the Dallas County Judicial TreatmentCenter, (2) termination of the Inglewood Men’s Center contract inJune 2003 and (3) termination of the Santa Fe Electronic MonitoringProgram in the first quarter of 2004.

 

Average contract occupancy was 103.3% forthe three months ended June 30, 2004 compared to 109.7% for the threemonths ended June 30, 2003.  Theaverage per diem rate for the Company’s residential adult community-basedfacilities was approximately $62.36 for the three months ended June 30,2004 compared to $58.81 for the three months ended June 30, 2003.  The increase in the average per diem rate wasdue to rate increases obtained mid-year 2003. The average fee-for-service rate for the Company’s non-residential adultcommunity-based programs was $8.84 for the three months ended June 30,2004 compared to $9.26 for the three months ended June 30, 2003.  The decrease in the average fee-for-servicerate in 2004 is due to changes in the mix of services provided by the Company’svarious non-residential adult community programs.

 

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***OperatingExpenses****.*Operatingexpenses increased approximately $2.4 million, or 4.6%, to $54.1 million forthe three months ended June 30, 2004 from $51.8 million for the threemonths ended June 30, 2003.

 

***AdultSecure.***Adult secure institutional services divisionoperating expenses increased approximately $1.2 million, or 6.6%, to $19.2million for the three months ended June 30, 2004 from $18.0 million forthe three months ended June 30, 2003 due to increased occupancy atthe Big Spring Correctional Center due to a 32 bed expansion completed inApril 2003 and increased occupancy at the Donald D. Wyatt DetentionCenter.  Additionally, operating expenses for the Big Spring Correctional Centerinclude a charge of approximately $190,000 pertaining to medical servicesreimbursement.

 

Asa percentage of segment revenues, adult secure institutional services divisionoperating expenses were 71.9%for the three months ended June 30, 2004 compared to 70.3% for the threemonths ended June 30, 2003.  Thedecrease in the 2004 margin is due to the medical services reimbursement chargediscussed above as well as higher employee and insurance costs in the threemonths ended June 30, 2004 as compared to the same period of 2003.  The 2004 operating margin was favorablyimpacted by a reduction in rent expense due to the September 30, 2003repurchase of furniture and equipment formerly leased under a sale andleaseback transaction in 1999.

 

***Juvenile.***Juvenile justice, educational and treatment services division operatingexpenses increased approximately $1.0 million, or 4.4%, to $25.6 millionfor the three months ended June 30, 2004 from $24.6 million for the threemonths ended June 30, 2003 due to (1) the opening of the Texas Adolescent Center in October 2003, (2)costs associated with the Plankinton Regional Detention Center, (3) an increasein the accounts receivable provision for certain programs and (4) increasedexpenses at the A-1 facility as result of the increase in occupancy.  The increase in operating expenses wasoffset, in part, by a decrease in expenses of approximately $1.3 million due tothe Company’s termination of the Santa Fe County Youth Development Program inJanuary 2004.

 

As a percentage of segment revenues, juvenilejustice, educational and treatment services division operating expenses were 82.2%for the three months ended June 30, 2004 compared to 83.5% for threemonths ended June 30, 2003.  Excluding $0.8 million of revenueattributable to the start-up operations of the Jos-Arz Residential TreatmentCenter and the Plankinton Regional Detention Center in 2004, juvenile servicesdivision operating expenses were 84.5%. The 2004 operating margin was unfavorably impacted by an increase in theprovision for bad debts and increases in employee insurance and legalcosts.  The 2004 operating margin wasfavorably impacted by a reduction to rent expense due to the September 2003repurchase of furniture and equipment that was formerly leased under a sale andleaseback transaction in 1999.

 

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services operating expenses decreased approximately $28,000, or 0.3%,to $9.4 million for the three months ended June 30, 2004 from $9.5million for the three months ended June 30, 2003.  As a percentage of segment revenues, adultcommunity-based corrections and treatment services division operating expenseswere 77.9% for the three months ended June 30, 2004 compared to 75.6% forthe three months ended June 30, 2003. The 2004 operating margin was unfavorably impacted by an increase inemployee insurance and legal costs and the decline in revenue for the threemonths ended June 2004 as compared to the 2003 period.  The 2004 operating margin was favorablyimpacted by a reduction in rent expense due the September 2003 repurchase offurniture and equipment that was formerly leased under a sale and leasebacktransaction in 1999.

 

***Pre-Openingand Start-up Expenses.*** Pre-opening and start-up expensesfor the three months ended June 30, 2004 were approximately $2.4 millionand related to the pre-opening and start-up activities of the Jos-ArzResidential Treatment Center, the Plankinton Regional Detention Center, theRegional Correctional Center in New Mexico and the Southern Peaks RegionalTreatment Center.  Pre-opening andstart-up expenses for the three months ended June 30, 2003 wereapproximately $306,000 and related to the pre-opening and start-up operationsof the Jos-Arz Residential Treatment Center, the Regional Correctional Centerand the Texas Adolescent Center.

 

***Depreciationand Amortization*****.**Depreciationand amortization was approximately $3.2 million for the three months ended June 30,2004 compared to $2.6 million for the three months ended June 30, 2003.  The increase in depreciation and amortizationexpense was primarily due to depreciation resulting from theSeptember 2003 repurchase of furniture and equipment formerly leased undera 1999 sale and leaseback transaction combined with depreciation expense on propertyand equipment purchases in the last half of 2003 and the first quarter of 2004.  Amortization of intangibles was approximately$270,000 and $220,000 for the three months ended June 30, 2004 and 2003,respectively. The increase inamortization expense for the three months ended June 30, 2004 is due toamortization expense resulting from the non-compete agreements entered into aspart of the Jos-Arz Residential Treatment Center management contractacquisition in June 2003.

 

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***Generaland Administrative Expenses.*** General and administrativeexpenses increased approximately $884,000, or 18.7%, to $5.6 million for thethree months ended June 30, 2004 from $4.7 million for the three monthsended June 30, 2003.  The increase in general and administrativeexpenses is primarily due to increased professional and consulting expensesrelated to, among other things, Sarbanes-Oxley compliance and the SouthernPeaks Regional Treatment Center litigation. Additionally, there was an increase in certain insurance costs.  The increase was offset, in part, by adecrease in rent expense due to the September 2003 repurchase of furnitureand equipment formerly leased under a sale and leaseback transaction in 1999.  Included in general and administrativeexpenses for the three months ended June 30, 2003 were costs ofapproximately $0.6 million for site acquisition costs and legal expensesprimarily associated with the Company’s increased development activity and acharge related to the deferred compensation plan.

 

***Interest.***Interest expense, net of interest income, decreased to approximately $4.2million for the three months ended June 30, 2004 from $4.5 million for thethree months ended June 30, 2003 primarily due to capitalized interest forthe three months ended June 30, 2004 of approximately $341,000 related toconstruction of the Southern Peaks Regional Treatment Center.  Totalcapitalized interest for the three months ended June 30, 2004 wasapproximately $524,000 and related to the construction of the Southern PeaksRegional Treatment Center and the Moshannon Valley Correctional Center.  Capitalized interest for the three monthsended June 30, 2003 was approximately $198,000 and related to theMoshannon Valley Correctional Center.

 

***Loss on Extinguishment ofDebt.***In June 2004,the Company recognized a loss on the extinguishment of debt of approximately$2.4 million related to the early retirement of the Synthetic Lease InvestorNotes A and B and the Company’s revolving line of credit under the Amended 2000Credit Facility.

 

***IncomeTaxes.*** For the three months ended June 30, 2004 and 2003, theCompany recognized a provision for income taxes at an estimated effective rateof 41.0%.

 

***SixMonths Ended June 30, 2004 Compared to Six Months Ended June 30, 2003***

 

***Revenues*****.** Revenues increased approximately $5.7million, or 4.3%, to $139.3 million for the six months ended June 30, 2004from $133.6 million for the six months ended June 30, 2003.

 

***AdultSecure.***Adult secure institutional services divisionrevenues increased approximately $1.8 million, or 3.6%, to $52.5 million forthe six months ended June 30, 2004 from $50.7 million for the six monthsended June 30, 2003 due primarily to (1) an expansion at the Big SpringCorrectional Center in 2003, (2) per diem rate increases at the Big SpringCorrectional Center in June 2003 and mid-March 2004 and (3) increasedoccupancy at the Donald D. Wyatt Detention Center.  This increase in revenue was offset, in part,by a decrease in revenue of approximately $0.5 million at the D. Ray James Prisonas a result of a 5% reduction in the per diem rate in the second half of 2003.

 

Averagecontract occupancy was 101.4% for the six months ended June 30, 2004compared to 99.0% for the six months ended June 30, 2003.  The average per diem rate was approximately$48.70 and $48.18 for the six months ended June 30, 2004 and 2003,respectively.  There were no revenuesattributable to start-up operations for the six months ended June 30, 2004and 2003.

 

***Juvenile.***Juvenile justice, educational and treatment services divisionrevenues increased approximately $4.3 million, or 7.4%, to $62.3 million forthe six months ended June 30, 2004 from $58.0 million for the six monthsended June 30, 2003 due to(1) the opening of the Texas Adolescent Center in October 2003 whichcontributed revenue of approximately $2.7 million, (2) the acquisition of theJos-Arz Residential Treatment Center management contract in June 2003which contributed revenue of approximately $1.3 million and (3) an increase inrevenue of approximately $1.8 million due to improved occupancy at the A-1 facilityand the Cornell Abraxas A-3 facility. This increase in revenue was offset, in part, by a decrease in revenueof approximately $1.8 million due to the Company’s termination of the Santa FeCounty Youth Development Program in January 2004.

 

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Averagecontract occupancy was 93.9% for the six months ended June 30, 2004compared to 91.8% for the six months ended June 30, 2003.  Excluding the start-up operations of theJos-Arz Residential Treatment Center and the Plankinton Regional DetentionCenter in 2004 and the Jos-Arz Residential Treatment Center in 2003, averagecontract occupancy was 93.9% for the six months ended June 30, 2004compared to 92.3% for the six months ended June 30, 2003.  Although the exclusion of actual occupancyand contract capacity for start-up operations is a non-GAAP measure, theCompany believes it is important to provide average contract occupancy ratesexcluding start-up operations so as to provide more comparable information withother periods.  The average per diem ratefor the Company’s residential juvenile facilities was approximately $160.23 and$161.43 for the six months ended June 30, 2004 and 2003,respectively.  The Company’s averagefee-for-service rate for its non-residential juvenile community-basedfacilities and programs was approximately $27.02 and 26.99 for the six monthsended June 30, 2004 and 2003.

 

Revenues attributable to start-upoperations were approximately $1.4 million for the six months endedJune 30, 2004 and were attributable to the start-up operations of theJos-Arz Residential Treatment Center and the Plankinton Regional DetentionCenter.  Revenues attributable tostart-up operations were approximately $54,000 for the six months ended June 30,2003 and were attributable to the start-up operations of the Jos-ArzResidential Treatment Center.

 

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division revenues decreased approximately $0.4 million, or1.6%, to $24.5 million for the six months ended June 30, 2004 from $24.9million for the six months ended June 30, 2003 due primarily to (1) reduced occupancy at the Dallas CountyJudicial Treatment Center, (2) the Company’s termination of the Inglewood Men’sCenter contract in June 2003 and (3) the Company’s termination of theSanta Fe Electronic Monitoring Program in January 2004.

 

Averagecontract occupancy was 105.9% for the six months ended June 30, 2004compared to 109.7% for the six months ended June 30, 2003.  The average per diem rate for the Company’sresidential adult community-based facilities was $60.93 and $58.71 for the sixmonths ended June 30, 2004 and 2003, respectively.  The increase in the average per diem rate isdue to rate increases obtained mid-year 2003. The average fee-for-service rate for the Company’s non-residential adultcommunity-based programs was $8.97 and $9.14 for the six months endedJune 30, 2004 and 2003, respectively. The decrease in the average fee-for-service rate is due to changes inthe mix of services provided by the Company. There were no revenues attributable to start-up operations for the sixmonths ended June 30, 2004 and 2003.

 

***OperatingExpenses.*** Operating expenses increased approximately$5.2 million, or 5.0%, to $108.6 million for the six months ended June 30,2004 from $103.5 million for the six months ended June 30, 2003.

 

***AdultSecure.***Adult secure institutional services divisionoperating expenses increased approximately $2.5 million, or 7.0%, to $37.8million for the six months ended June 30, 2004 from $35.3 million for thesix months ended June 30, 2003 due primarily to increased occupancy at theBig Spring Correctional Center and the Donald D. Wyatt Detention Center. Additionally, operating expenses for the BigSpring Correctional Center include a charge of approximately $190,000pertaining to medical services reimbursement.

 

As a percentage of segment revenues,adult secure institutional services division operating expenses were 72.1% forthe six months ended June 30, 2004 compared to 69.8% for the six monthsended June 30, 2003.  The decrease in the 2004 margin is due to themedical services reimbursement charge discussed above as well as higheremployee and insurance costs in the six months ended June 30, 2004.  The decrease in the 2004 operating margin wasoffset, in part, by a reduction in rent expense due to the September 2003repurchase of furniture and equipment that was formerly leased under a sale andleaseback transaction in 1999.

 

***Juvenile.***Juvenile justice, educational and treatment services division operatingexpenses increased approximately $2.2 million, or 4.4%, to $51.7 million forthe six months ended June 30, 2004 from $49.5 million for the six monthsended June 30, 2003 due primarily to (1) the opening of the Texas Adolescent Center in October 2003, (2)increased expenses at the A-1 due to increased occupancy, (3) costs associatedwith the Plankinton Regional Detention Center, (4) an increase in the provisionfor bad debts for certain facilities and programs and (5) an increase inemployee insurance and legal costs.  Theincrease due to the above was offset, in part, by a decrease in operatingexpenses of approximately $1.3 million due to the Company’s termination of theSanta Fe County Youth Development Program in January 2004.

 

As a percentage of segment revenues, divisionoperating expenses were 82.9% for the six months ended June 30, 2004compared to 85.4% for six months ended June 30, 2003.  Excluding $1.4 million of revenueattributable to the start-up operations of the Jos-Arz Residential TreatmentCenter and the Plankinton Regional Detention Center in 2004, juvenile servicesdivision operating expenses were 84.9% for the six months ended June 30, 2004.  The 2004 operating margin was unfavorablyimpacted by the increase in the accounts receivable reserve discussed above aswell as higher employee insurance and legal costs in the six months ended June30, 2004 as compared to 2003.  Thedecrease in the operating margin for 2004 was offset, in part, by a reductionin rent expense due to the September 2003 repurchase of furniture and equipmentthat was formerly leased under a sale and leaseback transaction in 1999.

 

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***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division operating expenses were approximately $19.2 millionfor the six months ended June 30, 2004 and 2003.

 

Asa percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 78.3% for the six monthsended June 30, 2004 compared to 76.8% for the six months endedJune 30, 2003.  The decline in the2004 operating margin was due an increase in employee insurance and legal costscoupled with the decrease in revenue for the six months ended June 30,2004.  The decrease in the 2004 operatingmargin was offset, in part, by a reduction in rent expense due to theSeptember 2003 repurchase of furniture and equipment that was formerly leasedunder a sale and leaseback transaction in 1999.

 

***Pre-Openingand Start-up Expenses.*** Pre-opening and start-up expensesfor the six months ended June 30, 2004 were approximately $4.0 million andwere attributable to the pre-opening and start-up activities of the RegionalCorrectional Center in New Mexico, the Jos-Arz Residential Treatment Center,the Southern Peaks Regional Treatment Center and the Plankinton RegionalDetention Center.  Pre-opening andstart-up expenses for the six months ended June 30, 2003 wereapproximately $0.4 million and were attributable to the pre-opening andstart-up operations of the Regional Correctional Center, the Jos-ArzResidential Treatment Center and the Texas Adolescent Center.

 

***Depreciationand Amortization*****.** Depreciation and amortization was $6.3 millionfor the six months ended June 30, 2004 compared to $5.2 million for thesix months ended June 30, 2003.  Theincrease in depreciation and amortization expense was primarily due todepreciation expense resulting from the September 2003 repurchase offurniture and equipment formerly leased under a 1999 sale and lease backtransaction and depreciation expense on property and equipment purchases in thesecond half of 2003 and the six months ended June 30, 2004.  Amortization of intangibles was approximately$539,000 and $439,000 for the six months ended June 30, 2004 and 2003,respectively. The increase inamortization expense in the six months ended June 30, 2004 is due toamortization expense resulting from the non-compete agreements entered into aspart of the Jos-Arz Residential Treatment Center management contract acquisitionin June 2003.

 

***Generaland Administrative Expenses.*** General and administrativeexpenses increased approximately $1.1 million, or 13.3%, to $9.8 million forthe six months ended June 30, 2004 from $8.6 million for the six monthsended June 30, 2003.  The increase in general and administrativeexpenses is primarily due to increased professional and consulting expensesrelated to, among other things, Sarbanes-Oxley compliance and the SouthernPeaks Regional Treatment Center litigation. Additionally, there was an increase in certain insurance costs.  The increase was offset, in part, by adecrease in rent expense due to the September 2003 repurchase of furnitureand equipment formerly leased under a sale and leaseback transaction in 1999.  Included in the general andadministrative expenses for the six months ended June 30, 2003 were costsof approximately $580,000 for site acquisition costs and legal expensesprimarily associated with the Company’s increased development activity and acharge related to the deferred compensation plan.

 

***Interest.***Interest expense, net of interest income, decreased to $8.9 million for the sixmonths ended June 30, 2004 from $9.0 million for the six months ended June 30,2003.  Capitalized interest for the sixmonths ended June 30, 2004 was approximately $0.7 million and related tothe Moshannon Valley Correctional Center and the Southern Peaks Regional TreatmentCenter.  Capitalized interest for the sixmonths ended June 30, 2003 was approximately $0.4 million and related tothe Moshannon Valley Correctional Center.

 

***Loss on Extinguishment ofDebt.*** InJune 2004, the Company recognized a loss on the extinguishment of debt ofapproximately $2.4 million related to the early retirement of the SyntheticLease Investor Notes A and B and the Company’s revolving line of credit underthe Amended 2000 Credit Facility.

 

***IncomeTaxes.*** For the six months ended June 30, 2004 and 2003, theCompany recognized a provision for income taxes at an estimated effective rateof 41.0%.

 

**Liquidity and CapitalResources**

 

***General*****.**The Company’s primary capitalrequirements for (1) purchases, construction or renovation of new facilities,(2) expansions of existing facilities, (3) working capital, (4) pre-opening andstart-up costs related to new operating contracts, (5) acquisitions, (6)information systems hardware and software, and (7) furniture, fixtures andequipment.  Working capital requirementsgenerally increase immediately prior to the Company commencing

 

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management of a new facility as theCompany incurs start-up costs and purchases necessary equipment and suppliesbefore facility management revenue is realized.

 

***CashFlows From Operating Activities.*** Cash provided by operations wasapproximately $7.9 million for the six months ended June 30, 2004 comparedto approximately $8.8 million for the six months ended June 30, 2003.  The decrease is primarily attributable to thenet loss for the six months ended June 30, 2004 and working capitalchanges.

 

***CashFlows From Investing Activities*****.** Cash used in investing activities wasapproximately $23.7 million for the six months ended June 30, 2004 dueprimarily to capital expenditures of $20.6 million for the purchase anddevelopment of the Southern Peaks Regional Treatment Center, the purchase andrenovations of the Las Vegas Center, the Baker Community Correctional Center andthe Central California Treatment Center buildings, renovation of the RegionalCorrectional Center in New Mexico, renovations to the Plankinton RegionalDetention Center, capitalized interest on the Moshannon Valley CorrectionalCenter and the Southern Peaks Regional Treatment Center and various otherfacility improvements and/or expansions and information technology and softwaredevelopment costs.  Additionally, therewere net payments to the restricted debt payment account of approximately $5.5million.  Additionally, the Companyreceived $5.0 million from its restricted escrow arrangement related to theSouthern Peaks Regional Treatment Center. Cash used in investing activities was approximately $12.0 millionfor the six months ended June 30, 2003 and included deposit payments tothe restricted debt payment account, net of amounts withdrawn for debt servicepayments, of approximately $4.6 million and capital expenditures ofapproximately $6.4 million related to the purchase and renovation of the TexasAdolescent Center, various facility improvements and/or expansions, informationtechnology and software development costs. Additionally, the Company made a deposit of $1.0 million into an escrowaccount for a non-compete agreement related to the Jos-Arz Residential TreatmentCenter management contract.

 

***CashFlows From Financing Activities*****.** Cash provided by financing activities wasapproximately $51.9 million for the six months ended June 30, 2004 dueprimarily to cash proceeds of $110.5 million from the issuance of the SeniorNotes in June 2004 offset by net repayments on the Company’s revolvingline of credit of $2.0 million and the repayment of the Synthetic LeaseInvestor Notes A and B of $52.5 million. Additionally, the Company made payment of approximately $5.0 millionrelated to the issuance of the Senior Notes and the Company’s new revolvingline of credit.  Cashprovided by financing activities was approximately $2.1 million for the sixmonths ended June 30, 2003 due primarily to proceeds from stock optionexercises of approximately $2.1 million and proceeds from borrowings on theCompany’s Synthetic Lease Facility of approximately $0.6 million offset, inpart, by purchases of approximately $0.6 million of treasury shares.

 

***TreasuryStock/Repurchases.*** The Company repurchased in the open market 10,000 shares of its commonstock for approximately $0.1 million in the six months ended June 30,2004.  There were no repurchases in threemonths ended June 30, 2004.

 

***Long-Term Credit Facilities.*** The Company’s 2000 Credit Facility, asamended, provided for borrowings of up to $45.0 million under a revolving lineof credit.  The commitment amount wasreduced by $1.6 million quarterly beginning in July 2002 and byoutstanding letters of credit.  Theamended 2000 Credit Facility bore interest, at the election of the Company, at either the prime rate plus a marginof 2.0%, or a rate which was 3.0% above the applicable LIBOR rate.  Additionally, the amended 2000 CreditFacility provided the Company with the ability to enter into synthetic leaseagreements for the acquisition or development of operating facilities.  This synthetic lease financing arrangement providedfor funding to the lessor under the operating leases of up to $100.0 million.

 

Effective June 24,2004, the Company entered into a revolving credit facility (the “2004 CreditFacility”) by and among the Company and certain lenders to fund working capitalfor acquisitions, to refinance existing debt, to fund capital expenditures andother general corporate purposes. The 2004 Credit Facility provides forborrowings of up to $60.0 million under a revolving line of credit, and isreduced by outstanding letters of credit. The available commitment under the 2004 Credit Facility was approximately$53.5 million at June 30, 2004.  TheCompany had outstanding letters of credit of approximately $6.5 million atJune 30, 2004.  Subject to certainrequirements, the Company has the right to increase the aggregate commitmentsunder the 2004 Credit Facility to an aggregate amount of up to $100.0million.  The

 

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2004 Credit Facility maturesin June 2008 and bears interest, at the election of the Company and,depending on the Company’s total leverage ratio, at either the prime rate plusa margin ranging from 0.75% to 2.00%, or a rate which ranges from 2.25% to 3.50%above the applicable LIBOR rate.

 

The 2004 Credit Facility iscollateralized by substantially all of the Company’s assets, including thestock of all of the Company’s subsidiaries. The 2004 Credit Facility is not secured by the assets of MCF.  The 2004 Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

 

On June 24, 2004, the Company issued$112.0 million in principal of 10.75% Senior Notes (the “Senior Notes”) dueJuly 1, 2012.  The Senior Notes areunsecured senior indebtedness and are guaranteed by all of the Company’s existingand future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed byMCF.  As of June 30, 2004, allsubsidiaries were Guarantors of the Senior Notes.  Interest on the Senior Notes accrued as ofJune 24, 2004 and is payable semi-annually on January 1 andJuly 1 of each year, commencing January 1, 2005.  On or after July 1, 2008, the Companymay redeem all or a portion of the Senior Notes at the redemption prices (expressedas a percentage of the principal amount) listed below, plus accrued and unpaidinterest, if any, on the Senior Notes redeemed, to the applicable date ofredemption, if redeemed during the 12-month period commencing on July 1 ofthe years indicated below:

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

 

Any time prior toJuly 1, 2007, the Company may redeem up to 35% of the original aggregateprincipal amount of the Senior Notes at a redemption price of 110.75% of theprincipal amount thereof with the net cash of public offerings of equity,provided that at least 65% of the original aggregate principal amount of the SeniorNotes remains outstanding after the redemption and other conditions aremet.  Upon the occurrence of specifiedchange of control events, unless the Company has exercised its option to redeemall the Senior Notes as described above, each holder will have the right torequire the Company to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) which limits the ability of the Company and theGuarantors 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 the Company, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

 

The net proceeds from thesale of the Senior Notes was approximately $107.2 million, which was used torepay and refinance existing indebtedness under the Company’s previouslyexisting 2000 Credit Facility and synthetic lease obligations as ofJune 24, 2004.  The Companyrecognized a charge of approximately $2.4 million related to the write-off ofunamortized deferred financing costs and the charges related to theextinguishment of the synthetic lease obligations.

 

In conjunction with theissuance of the Senior Notes, the Company entered into an interest rate swaptransaction with a financial institution to hedge the Company’s exposure tochanges in the fair value on $84 million of its Senior Notes.  The purpose of this transaction was toconvert future interest due on $84 million of the Senior Notes to a lowervariable rate in an attempt to realize savings on the Company’s future interestpayments.  The terms of the interest rateswap contract and the underlying debt instrument are identical.  The Company has designated the swap agreementas a fair 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, the Company pays on a semi-annual basis (each July 1 andJanuary 1) a floating rate based on a six-month U.S. dollar LIBOR rate,plus a spread, and receives a fixed-rate interest of 10 3⁄4%.  During the second quarter of 2004, theCompany recorded interest savings related to this interest rate swap of $0.05million, which

 

39

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served to reduce interestexpense.  The $0.4 million fair value ofthis derivative instrument is included in other long-term liabilities as ofJune 30, 2004.  The carrying valueof the Company’s Senior Notes was decreased by the same amount.

 

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

 

***RegionalCorrectional Center.***In January 2003, the Company executed afive-year lease for the Regional Correctional Center in Albuquerque, NewMexico.  This 970 bed facility consistsof two units, the 528 bed South Tower and the 442 bed North Tower.  The Company renovated the South Tower andopened the 528 bed unit in July 2004. The Company began renovating the North Tower in August 2004 andanticipates opening the 442 bed unit in the fourth quarter of 2004.  Management currently anticipates that thefacility will reach full capacity of 970 beds by the second quarter of2005.  As of June 30, 2004, theCompany had spent approximately $4.3 million on renovations and anticipatesspending an additional $3.7 million to complete renovations of the NorthTower.  For the three and six monthsended June 30, 2004, the Company incurred pre-opening and start-upexpenses of approximately $514,000 and $670,000, respectively, related to thisproject.  However, there can be noassurance that the Company will develop enough volume at the facility to assureits 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.  Depending on the ultimate services to be providedand the timing of occupancy ramp-up, management expects this facility willincur additional pre-opening and start-up costs of approximately $1.4 millionin the year ending December 31, 2004.

 

***Southern Peaks Regional Treatment Center.***On January 5, 2004, the Companyinitiated legal proceedings in the lawsuit styled Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al., No.2004 CV79761 inthe Superior Court of Fulton County, Georgia under theories of fraud,conversion, breach of contract and other theories to determine the location ofand to recover funds previously deposited by the Company into what it believedto be an escrow account in connection with the development and construction ofthe Southern Peaks Regional Treatment Center. Of the funds previouslydeposited, approximately $5.4 million remains to be recovered.  The Company has obtained temporaryrestraining orders freezing any and all financial accounts of the constructionlender, one of its principals and certain other defendants identified duringdiscovery.  The frozen accounts includeone of the construction lender’s bank accounts which contains approximately$0.4 million.

 

Construction of the Southern Peaks Regional Treatment Center wassubstantially completed in July 2004. The Companypurchased the property in June 2004 and has served as the constructionsupervisor in lieu of the developer and assumed the developer’s rights andobligations under the construction contract (except that the developer willremain as contractor for certain of the infrastructure serving thefacility).  As of June 30, 2004, theCompany had invested approximately $12.0 million in the property.  The Company began receiving clients inAugust 2004.  The Company currentlyanticipates that the facility will be fully ramped up by year end.

 

***Plankinton Regional Detention Center.***The PlankintonRegional Detention Center, a 40 bed juvenile justice center in South Dakota,was activated early in May 2004 and the Plankinton Regional Treatment Centerwas scheduled to open in August 2004. Both facilities were expected to be fully ramped up by year end.  The Company based its plans to open andoperate these facilities on a commitment from the appropriate state officialsto create a special rate that would allow the Company to meet the needs ofclients rejected by other providers in the state.  However, the Company learned it was awardedan initial rate that, while it is the highest rate in South Dakota, isinsufficient to support the level of care and treatment required for thecenter’s clients.  The state is currentlyin a rate-setting process that will take approximately six months.  While the Company intends to pursue thisproject through the delay, it is not willing to open the program withoutsufficient resources or to operate at a loss, and has decided to delay theopening of the Regional Treatment Center and to temporarily suspend operationsat the Detention Center.

 

***New Morgan Academy.***The Company closed the New Morgan Academy in the fourth quarter of 2002 and iscurrently considering several options ranging from the utilization of thefacility for another type of program or the sale or lease of the facility.  As of June 30, 2004, management isfocusing its efforts on reactivating the facility.  The primary use currently under considerationis using the facility to house illegal non-criminal and low-security adultdetainees.  Management is discussingthese opportunities with the Bureau of Immigration and Customs Enforcement(ICE), which has indicated a level of interest, but the parties have notprogressed to the contract phase.  Therecan be no assurance that the Company will be successful in securing a contractwith ICE.  Before the Company can houseadult detainees, the Company will need to obtain a change in the zoning of theAcademy, which is currently zoned only for the housing of juveniles.  Management of the Company believes that thereis a market for the services the Company could provide at the facility at perdiem rates that will support the recovery of the cost of the facility.  The Company will continue to evaluate anyoffers to buy or lease the facility.  The Company is maintaining a small staff tosecure and maintain the facility.  TheCompany is incurring interest expense of approximately $140,000 per month related to the borrowings for the facility anddepreciation expense of approximately $46,000per month for the building.

 

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Thecarrying value of the property and equipment at the New Morgan Academy wasapproximately $30.0 million at June 30, 2004.  As of June 30, 2004, management believesthat, pursuant to the provisions of Statement of Financial Accounting Standard(SFAS) No. 144, an impairment allowance is not necessary.  However, management estimates that, were theCompany to sell the facility, it is reasonably possible that the Company wouldnot be able to fully recover the carrying value of its long-lived assets forthis facility.

 

***Moshannon Valley Correctional Center.***In March 2003, the Company reached anagreement with the Commonwealth of Pennsylvania that resolved all outstandingadministrative issues relative to the contract awarded to the Company by theFederal Bureau of Prisons (BOP) to operate the Moshannon Valley Correctional Center.  In October 2003, the Company receivedfinal approval from the BOP of a revised building design for the facility.  Constructionplans have been completed for the new design and work is expected to begin inthe third quarter of 2004.  InApril 2004, the Company received notice of a draft supplementalenvironmental assessment indicating a population of 1,300 consisting of 1,000low-security adult male offenders and 300 minimum-security adult femaleoffenders.

 

As of June 30, 2004, the Company had incurred approximately $18.6million for the design, construction and development costs and capitalizedinterest related to the Moshannon Valley Correctional Center facility.  The Company is in the process of submitting aclaim to the BOP for reimbursement of costs related to the originalconstruction efforts incurred beginning in 1999.  The Company estimates an additional capitalinvestment of approximately $79.3 million to complete construction of thefacility.  Management believes thatexisting cash and credit facilities will provide adequate funding for theconstruction of the Moshannon Valley Correctional Center.

 

According to the BOP contract, as amended, the Company is required tocomplete the construction of the facility by August 15, 2004.  TheCompany anticipates obtaining another long-term contract amendment from the BOPextending the construction deadline. In the event the Company is not able tonegotiate a contract amendment with the BOP, then the BOP may have the right toassert that the Company has not completed construction of the facility withinthe time frame provided in the BOP contract, as amended. Management expectsthat the contract will be amended to address cost and construction timingmatters resulting from the extended delay. In the event that the BOP decides not to continue with the constructionof the Moshannon Valley Correctional Center and terminates the contract,management believes that the Company has the right to and will recover itsinvested costs. In the event any portion of these costs are determined not tobe recoverable upon contract termination by the BOP, such costs would becharged to expense.

 

Separatefrom a possible recovery in the event that the BOP terminates the MoshannonValley Correctional Center contract, the Company is pursuing a claim for thereimbursement of a portion of its expenses incurred in connection with theissuance of the Stop-Work Order and the delay of the project (included amongthese expenses is approximately $1.4 million in accounts receivable for expensesincurred by the Company after the June 1999 issuance of the Stop –WorkOrder).  This reimbursement claim isindependent of the amendment to the contract. The Company is finalizing its claim with the BOP and expects to reach aresolution before the end of the third quarter of 2004.  The BOP has asserted that it is onlyresponsible for reimbursing that portion of the investment lost due to theissuance of the Stop-Work Order. Although the Company believes that the BOP will reimburse more than the$1.4 million in accounts receivable at June 30, 2004, it is uncertain howmuch the BOP will agree to pay in connection with the Company’s claim forreimbursement.  Any amounts notreimbursed by the BOP will be expensed by the Company.

 

***FutureLiquidity*****.**Managementbelieves that the Company’s cash and the cash flows generated from operations,together with the credit available under the 2004 Credit Facility, will providesufficient liquidity to meet the Company’s committed capital and workingcapital requirements for currently awarded and future development contracts,including the construction of the Moshannon Valley Correctional Center. To theextent the Company’s cash and current financing arrangements do not providesufficient financing to fund construction costs related to future adult secureinstitutional contract awards or significant facility expansions, the Companyanticipates obtaining additional sources of financing to fund suchactivities.  However, there can be noassurance that such financing will be available or will be available on termsfavorable to the Company.

 

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***ContractualObligations and Commercial Commitments*****.** The Company has assumed variousfinancial obligations and commitments in the ordinary course of conducting itsbusiness.  The Company has contractualobligations requiring future cash payments under its existing contractualarrangements, such as management, consultative and non-competition agreements.

 

The Company maintains operating leases inthe ordinary course of its business activities. These leases include those for operating facilities, office space andoffice and operating equipment, and the terms of these agreements range from2004 until 2075.  As of June 30,2004, the Company’s total commitment under these operating leases wasapproximately $41.3 million.

 

The following table details the Company’sknown future cash payments (on an undiscounted basis) related to variouscontractual obligations as of June 30, 2004 (in thousands):

 
| ** **                                   | ** ** | **Payments Due by  Period** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **Total**                   | ** ** | **2004** | ** ** | **2005 -  2006** | ** ** | **2007 -  2008** | ** ** | **Thereafter** | ** ** |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                    |       |                        |       |   |   |   |   |   |   |   |   |
| Long-term  debt                              |       |                        |       |   |   |   |   |   |   |   |   |
| • Cornell Companies, Inc.               |       | $                           | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| • Special Purpose Entities              |       | 183,000                     |       | 8,300 |   | 18,700 |   | 21,900 |   | 134,100 |   |
| Capital  lease obligations                   |       |                        |       |   |   |   |   |   |   |   |   |
| • Cornell Companies, Inc.               |       | 3                           |       | 1 |   | 2 |   | 3⁄4 |   | 3⁄4 |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |
| Operating  leases                            |       | 41,335                      |       | 3,307 |   | 9,620 |   | 6,721 |   | 21,687 |   |
| Consultative  and non-competition agreements |       | 930                         |       | 210 |   | 720 |   | 3⁄4 |   | 3⁄4 |   |
| Total  contractual cash obligations          |       | $                           | 337,268    |   | $ | 11,818 |   | $ | 29,042 |   | $ | 28,621 |   | $ | 267,787 |   |

 

The Company enters into letters of creditin the ordinary course of its operating and financing activities.  As of June 30, 2004, the Company hadoutstanding letters of credit of approximately $6.5 million related toinsurance and other operating activities. The following table details the Company’s letter of credit commitmentsas of June 30, 2004 (in thousands):

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

 

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**ITEM 3.****                            ****Quantitative and Qualitative Disclosures about Market Risk**

 

In the normal course ofbusiness, the Company is exposed to market risk, primarily from changes ininterest rates.  The Company continually monitorsexposure to market risk and develops appropriate strategies to manage thisrisk.  The Company is not exposed to anyother significant market risks, including commodity price risk or foreigncurrency exchange risk from the use of derivative financial instruments.  In conjunction with the issuance of theSenior Notes, the Company entered into an interest rate swap of $84.0 millionnotional value related to the interest obligations under the Senior Notes convertingthem to a floating rate based on six-month LIBOR.

 

**Interest Rate Exposure**

 

The Company’s exposure to changes ininterest rates primarily results from its long-term debt with both fixed andfloating interest rates.  The debt on theCompany’s consolidated financial statements with fixed interest rates consistsof the 8.47% Bonds issued by MCF in August 2001 in connection with the2001 Sale and Leaseback Transaction and approximately $28.0 million of theSenior Notes (not hedged by the interest rate swap entered into by theCompany).  At June 30, 2004, 28.5%of the Company’s consolidated long-term debt ($84.0 million of debt outstandingon the Senior Notes issued in June 2004) was subject to variable interestrates.  The detrimental effect of ahypothetical 100 basis point increase in interest rates would be to reduceincome before provision for income taxes by approximately $210,000 and $420,000for the three and six months ended June 30, 2004.  At June 30, 2004, the fair value of theCompany’s consolidated fixed rate debt approximated carrying value based upondiscounted future cash flows using current market prices.

 

**Forward LookingStatement Disclaimer**

 

Thisquarterly report on Form 10-Q contains forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995. This reportcontains or incorporates by reference forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995.  These statements are based on current plansand actual future activities and results of operations to be materiallydifferent from those set forth in the forward-looking statements.  Important factors that could cause actualresults to differ include, among others (1) the outcomes of pending putativeclass action shareholder and derivative lawsuits, and related insurancecoverage, (2) the outcome of the pending SEC investigation of the Company, (3)the Company’s ability to win new contracts and to execute its growth strategy,(4) risks associated with acquisitions and the integration thereof (including theability to achieve administrative and operating cost savings and anticipatedsynergies), (5) the timing and costs of the opening of new programs andfacilities or the expansions of existing facilities, (6) the Company’s abilityto negotiate contracts at those facilities for which it currently does not havean operating contract, (7) significant charges to expense of deferred costsassociated with financing and other projects in development if managementdetermines that one or more of such projects is unlikely to be successfullyconcluded, (8) results from alternative deployment or sale of facilities suchas the new Morgan Academy or the inability to do so, (9) the Company’s abilityto negotiate a contract amendment with the BOP related to the Moshannon ValleyCorrectional Center and the Company’s ability to resume construction of thatfacility, (10) changes in governmental policy and/or funding to discontinue ornot renew existing arrangements, to eliminate or discourage the privatizationof correctional, detention and pre-release services in the United States, or toeliminate rate increase, (11) the availability of financing on terms that arefavorable to the Company, and (12) fluctuations in operating results because ofoccupancy levels and/or mix, competition (including competition from twocompetitors that are substantially larger than the Company), increases in costof operations, fluctuations in interest rates and risks of operations.

 

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

 

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

 

TheCompany does not expect that its 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 the Company’s management,including its principal executive officer and principal financial officer, theCompany has evaluated the effectiveness of the design and operation of itsdisclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)of the Securities Exchange Act of 1934, as amended (the Exchange Act) as of theend of the period required by this report. Based on that evaluation, theCompany’s principal executive officer and principal financial officer haveconcluded that these controls and procedures are effective as of that date.

 

Inconnection with the evaluation described above, there have been no changes inthe Company’s internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under Exchange Act) during its fiscalquarter ended June 30, 2004 that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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

 

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

 

***Southern Peaks Regional Treatment Center***

 

OnJanuary 5, 2004, the Company initiated legal proceedings in the lawsuitstyled *Cornell Corrections of California, Inc. v. LongboatGlobal Advisors, LLC, et al.*, No.2004 CV79761 in the Superior Courtof Fulton County, Georgia under theories of fraud, conversion, breach ofcontract and other theories to determine the location of and to recover fundspreviously deposited by the Company into what it believed to be an escrowaccount in connection with the development of the Southern Peaks RegionalTreatment Center. Of the funds previously deposited, approximately $5.4 millionremains to be recovered. The Company has obtained temporary restraining ordersfreezing any and all financial accounts of the construction lender, one of itsprincipals and certain other defendants identified during discovery.  The frozen accounts include one of theconstruction lender’s bank accounts which contains approximately $0.4 million.

 

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

 

None

 

**ITEM 3.          Defaults Upon Senior Securities**

 

None

 

**ITEM 4.****                            ****Submission of Matters to a Vote of Security Holders**

 

On June 3, 2004, the Company heldits 2004 Annual Meeting of Stockholders. The matters voted on at the meeting and the results thereof are asfollows:

 

Stockholders elected the persons listedbelow as directors whose terms expire at the 2005 Annual Meeting ofStockholders.  Results by nominee were:

 
| ** **              | ** ** | **Voted For** | ** ** | **Authority  Withheld** | ** ** |
|-------------------------|------------|---------------|------------|-------------------------|------------|
|                    |       |          |       |                    |       |
| Anthony  R. Chase       |       | 9,925,160     |       | 2,322,901               |       |
| Harry  J. Phillips, Jr. |       | 7,676,612     |       | 4,571,449               |       |
| D.  Stephen Slack       |       | 9,929,611     |       | 2,318,450               |       |
| Tucker  Taylor          |       | 9,929,560     |       | 2,318,501               |       |
| Robert  F. Vagt         |       | 9,929,231     |       | 2,318,830               |       |
| Marcus  A. Watts        |       | 7,921,094     |       | 4,326,967               |       |

 

Stockholders ratified the appointment ofPricewaterhouseCoopers LLP as the Company’s independent public accountants forthe fiscal year ending December 31, 2004, with 12,141,359 shares votedfor, 106,702 shares voted against and none abstained.

 

Stockholdersapproved an amendment to the 2000 Director’s Stock Plan to increase the numberof shares available for issuance with 8,526,040 shares voted for, 2,273,258shares voted against, 3,298 abstained and 1,445,465 shares not voted.

 

Stockholders approved an amendment to theEmployee Stock Purchase Plan to increase the number of shares available forsale with 8,848,468 shares voted for, 1,953,934 shares voted against, 194abstained and 1,445,465 shares not voted.

 

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

 

None

 

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**ITEM 6.****                          ****Exhibits and Reports on Form 8-K**

 

a.               Exhibits

 
| 4.1   |   | Indenture  dated as of June 24, 2004 among Cornell Companies, Inc., the Guarantors  named therein and JPMorgan Chase Bank, as trustee (Exhibit 4.1 to our Form  8-K filed June 25, 2004).                                                                                                             |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.2   |   | Form  of 10 3/4% Senior Notes due July 2012 (included in Exhibit 4.1 to our  Form 8-K filed June 25, 2004).                                                                                                                                                                                           |
| 10.1  |   | Registration  Rights Agreement dated as of June 24, 2004 among Cornell Companies, Inc.,  the Guarantors named therein and the Initial Purchasers named therein  (Exhibit 10.1 to our Form 8-K filed June 25, 2004).                                                                                   |
| 10.2  |   | Credit  Agreement dated as of June 24, 2004 among the Cornell Companies, Inc.,  as Borrower, such subsidiaries of the Borrower as named therein, JPMorgan  Chase Bank, as Administrative Agent, and such other lenders as named therein  (Exhibit 10.2 to our Form 8-K filed June 25, 2004).          |
| 10.3  |   | Negative  Pledge Agreement dated as of June 24, 2004 among Cornell Companies,  Inc., as Borrower, such subsidiaries of the Borrower as named therein, as  Pledgor(s) and JPMorgan Chase Bank, as Administrative Agent for a syndicate  of lenders (Exhibit 10.3 to our Form 8-K filed June 25, 2004). |
| 10.4  |   | Guarantee  dated as of June 24, 2004 by the subsidiaries of Cornell Companies, Inc.  named therein and accepted and agreed by JPMorgan Chase Bank, as  Administrative Agent for a syndicate of lenders (Exhibit 10.4 to our Form 8-K  filed June 25, 2004).                                           |
| *11.1 |   | Computation of Per Share Earnings                                                                                                                                                                                                                                                                               |
| *31.1 |   | Section 302 Certification of Chief  Executive Officer                                                                                                                                                                                                                                                      |
| *31.2 |   | Section 302 Certification of Chief  Financial Officer                                                                                                                                                                                                                                                      |
| *32.1 |   | Section 906 Certification of Chief  Executive Officer                                                                                                                                                                                                                                                      |
| *32.2 |   | Section 906 Certification of Chief  Financial Officer                                                                                                                                                                                                                                                      |

 

* Filed herewith

 

b.              Reportson Form 8-K

 

The Company furnished a Current Report onForm 8-K dated May 6, 2004 reporting a press release announcing its financialresults for the first quarter ended March 31, 2004.

 

TheCompany filed a Current Report on Form 8-K dated June 8, 2004 reporting apress release announcing its proposed private placement of Senior Notes.

 

TheCompany filed a Current Report on Form 8-K dated June 24, 2004 reporting apress release announcing its completed private placement of Senior Notes.

 

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|   |                |   | **CORNELL COMPANIES,  INC.**                  |
|--------|---------------------|--------|-----------------------------------------------|
|   |                |   |                                          |
|   |                |   |                                          |
| Date:  | August 9, 2004 | By:    | /s/ Harry J. Phillips, Jr.                    |   |
|   |                |   | HARRY J. PHILLIPS, JR.                        |
|   |                |   | Executive Chairman, Chairman of the           |
|   |                |   | Board and Director                            |
|   |                |   | (Principal Executive Officer)                 |
|   |                |   |                                          |
|   |                |   |                                          |
| Date:  | August 9, 2004 | By:    | /s/ John R. Nieser                            |   |
|   |                |   | JOHN R. NIESER                                |
|   |                |   | Treasurer and Acting Chief Financial  Officer |
|   |                |   | (Principal Financial Officer)                 |
|        |                     |        |                                               |  |  |

 

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