**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM10-Q**

 
| **ý**                                        | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|------------------------------------------------------------------------------------------------|
| ** **                                        |
| **For the Quarterly Period Ended March 31, 2006** |
|                                              |
| **OR**                                            |
|                                              |
| **o**                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**For the transition period from                to               **

** **

**Commission File Number 1-14472**

 

**CORNELLCOMPANIES, INC.**

(Exact Name of Registrant as Specified in ItsCharter)

 

| **Delaware**                                                    | ** **                                                                          | **76-0433642**                        |
|-----------------------------------------------------------------|-------------------------------------------------------------------------------------|---------------------------------------|
| (State or Other Jurisdiction  of Incorporation or Organization) |                                                                                | (I.R.S. Employer  Identification No.) |
|                                                            |                                                                                |                                  |
| **1700 West Loop South, Suite 1500, Houston, Texas**            | ** **                                                                          | **77027**                             |
| (Address of Principal Executive Offices)                        |                                                                                | (Zip Code)                            |
|                                                            |                                                                                |                                  |
|                                                            | Registrant’s  Telephone Number, Including Area Code:   **(713) 623-0790** |
|                                                                 |                                                                                     |                                       |  |

 

Indicateby a check mark whether Registrant (1) has filed all reports required to befiled by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes  ý  No o

 

Indicate by a check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| Large accelerated Filer o | Accelerated  filer ý | Non-accelerated filer o |
|---------------------------|---------------------------|-------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

 

Yes  o No ý

 

At May 1, 2006, the registrant had 13,981,266 shares of common stockoutstanding.

 

 

----

 

**Cornell Companies, Inc.**

** **

**Table of Contents**

 

**Form 10-Q**

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

 

2

----

 

**PART I      FINANCIALINFORMATION**

**ITEM 1.      FinancialStatements.**

** **

**CORNELL COMPANIES, INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**

 
| ** **                                                                                                                                                     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                                     | ** ** | ** **          | ** ** | ** **             | ** ** |
| **CURRENT ASSETS:**                                                                                                                                            | ** ** | ** **          | ** ** | ** **             | ** ** |
| Cash and cash equivalents                                                                                                                                      |       | $                   | 1,721      |                   | $          | 13,723 |   |
| Investment securities available for sale                                                                                                                       |       | 7,975               |       | 7,250                  |       |
| Accounts receivable – trade (net of allowance for doubtful accounts  of $3,846 and $3,278, respectively)                                                  |       | 64,455              |       | 58,701                 |       |
| Other receivables (net of allowance for doubtful accounts of $5,040)                                                                                           |       | 186                 |       | 9,726                  |       |
| Debt service fund and other restricted assets                                                                                                                  |       | 20,735              |       | 22,219                 |       |
| Deferred tax assets                                                                                                                                            |       | 5,089               |       | 5,089                  |       |
| Prepaid expenses and other                                                                                                                                     |       | 9,089               |       | 9,076                  |       |
| **Total current assets**                                                                                                                                       |       | 109,250             |       | 125,784                |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                |       | 327,616             |       | 323,861                |       |
| **OTHER ASSETS:**                                                                                                                                              |       |                |       |                   |       |
| Debt service reserve fund                                                                                                                                      |       | 23,800              |       | 23,802                 |       |
| Goodwill, net                                                                                                                                                  |       | 12,577              |       | 12,577                 |       |
| Intangible assets, net                                                                                                                                         |       | 8,559               |       | 9,089                  |       |
| Deferred costs and other                                                                                                                                       |       | 16,565              |       | 15,515                 |       |
| **Total assets**                                                                                                                                               |       | $                   | 498,367    |                   | $          | 510,628 |   |
|                                                                                                                                                           |       |                |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                  | ** ** | ** **          | ** ** | ** **             | ** ** |
|                                                                                                                                                           |       |                |       |                   |       |
| **CURRENT  LIABILITIES:**                                                                                                                                      | ** ** | ** **          | ** ** | ** **             | ** ** |
| Accounts payable and accrued liabilities                                                                                                                       |       | $                   | 43,343     |                   | $          | 58,797 |   |
| Current portion of long-term debt                                                                                                                              |       | 9,701               |       | 9,701                  |       |
| **Total current liabilities**                                                                                                                                  |       | 53,044              |       | 68,498                 |       |
| **LONG-TERM  DEBT, net of current portion**                                                                                                                    |       | 264,948             |       | 266,659                |       |
| **DEFERRED  TAX LIABILITIES**                                                                                                                                  |       | 7,171               |       | 6,708                  |       |
| **OTHER  LONG-TERM LIABILITIES**                                                                                                                               |       | 5,580               |       | 3,302                  |       |
| **Total liabilities**                                                                                                                                          |       | 330,743             |       | 345,167                |       |
|                                                                                                                                                           |       |                |       |                   |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                                                                             | ** ** | ** **          | ** ** | ** **             | ** ** |
|                                                                                                                                                           |       |                |       |                   |       |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                                | ** ** | ** **          | ** ** | ** **             | ** ** |
| Preferred stock, $.001 par value,  10,000,000 shares authorized, none issued                                                                                   |       | ––        |       | ––           |       |
| Common stock, $.001 par value, 30,000,000  shares authorized, 15,482,480 and 15,352,159 shares issued and 13,942,086 and  13,789,172 outstanding, respectively |       | 16                  |       | 15                     |       |
| Additional paid-in capital                                                                                                                                     |       | 152,703             |       | 151,329                |       |
| Retained earnings                                                                                                                                              |       | 27,775              |       | 27,091                 |       |
| Treasury stock (1,540,394 and 1,562,987  shares of common stock, at cost, respectively)                                                                        |       | (12,308             | )          | (12,573                | )          |
| Deferred compensation                                                                                                                                          |       | (850                | )          | (990                   | )          |
| Accumulated other comprehensive income                                                                                                                         |       | 288                 |       | 589                    |       |
| **Total stockholders’ equity**                                                                                                                            |       | 167,624             |       | 165,461                |       |
| **Total liabilities and stockholders’ equity**                                                                                                            |       | $                   | 498,367    |                   | $          | 510,628 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

3

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**CORNELL COMPANIES, INC.****CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)****(Unaudited)(in thousands, except per share data)**

 
| ** **                                                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                    | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                                                          |       |                              |       |   |   |
| REVENUES                                                                                      |       | $                                 | 83,847     |   | $ | 73,640 |   |
| OPERATING  EXPENSES                                                                           |       | 65,143                            |       | 54,531 |   |
| PRE-OPENING  AND START-UP EXPENSES                                                            |       | 2,657                             |       | 4,694 |   |
| DEPRECIATION  AND AMORTIZATION                                                                |       | 3,726                             |       | 3,729 |   |
| GENERAL AND  ADMINISTRATIVE EXPENSES                                                          |       | 5,112                             |       | 6,338 |   |
|                                                                                          |       |                              |       |   |   |
| INCOME FROM  OPERATIONS                                                                       |       | 7,209                             |       | 4,348 |   |
| INTEREST  EXPENSE                                                                             |       | 5,565                             |       | 6,339 |   |
| INTEREST  INCOME                                                                              |       | (522                              | )          | (595 | ) |
|                                                                                          |       |                              |       |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS  BEFORE PROVISION (BENEFIT) FOR INCOME TAXES         |       | 2,166                             |       | (1,396 | ) |
| PROVISION  (BENEFIT) FOR INCOME TAXES                                                         |       | 956                               |       | (556 | ) |
|                                                                                          |       |                              |       |   |   |
| INCOME  (LOSS) FROM CONTINUING OPERATIONS                                                     |       | 1,210                             |       | (840 | ) |
|                                                                                          |       |                              |       |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT  OF $283 AND $776, RESPECTIVELY                   |       | (526                              | )          | (1,433 | ) |
|                                                                                          |       |                              |       |   |   |
| NET INCOME  (LOSS)                                                                            |       | $                                 | 684        |   | $ | (2,273 | ) |
|                                                                                          |       |                              |       |   |   |
| EARNINGS  (LOSS) PER SHARE:                                                                   |       |                              |       |   |   |
| BASIC                                                                                         |       |                              |       |   |   |
| Income (loss) from continuing operations                                                      |       | $                                 | .09        |   | $ | (.06 | ) |
| Loss from discontinued operations, net of  tax                                                |       | (.04                              | )          | (.11 | ) |
| Net income (loss)                                                                             |       | $                                 | .05        |   | $ | (.17 | ) |
|                                                                                          |       |                              |       |   |   |
| DILUTED                                                                                       |       |                              |       |   |   |
| Income (loss) from continuing operations                                                      |       | $                                 | .09        |   | $ | (.06 | ) |
| Loss from discontinued operations, net of  tax                                                |       | (.04                              | )          | (.11 | ) |
| Net income (loss)                                                                             |       | $                                 | .05        |   | $ | (.17 | ) |
|                                                                                          |       |                              |       |   |   |
| NUMBER OF  SHARES USED IN PER SHARE COMPUTATION:                                              |       |                              |       |   |   |
| BASIC                                                                                         |       | 13,851                            |       | 13,428 |   |
| DILUTED                                                                                       |       | 13,953                            |       | 13,428 |   |
|                                                                                          |       |                              |       |   |   |
| COMPREHENSIVE  INCOME (LOSS):                                                                 |       |                              |       |   |   |
| Net income (loss)                                                                             |       | $                                 | 684        |   | $ | (2,273 | ) |
| Unrealized loss on derivative instruments,  net of tax benefit of $209 and $427, respectively |       | (301                              | )          | (881 | ) |
| Comprehensive income (loss)                                                                   |       | $                                 | 383        |   | $ | (3,154 | ) |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

4

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**CORNELL COMPANIES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(in thousands)**

 
| ** **                                                                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                      | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                                          |       |                              |       |   |   |
| Net income (loss)                                                                                               |       | $                                 | 684        |   | $ | (2,273 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used) in operating activities –– |       |                              |       |   |   |
| Depreciation                                                                                                    |       | 3,216                             |       | 3,385 |   |
| Amortization of intangibles and other  assets                                                                   |       | 561                               |       | 428 |   |
| Amortization of deferred compensation                                                                           |       | 37                                |       | (488 | ) |
| Amortization of deferred financing costs                                                                        |       | 443                               |       | 487 |   |
| Amortization of Senior Notes Discount                                                                           |       | 46                                |       | 46 |   |
| Stock-based compensation                                                                                        |       | 654                               |       | 3⁄4 |   |
| Provision for bad debts                                                                                         |       | 1,866                             |       | 1,099 |   |
| Gain (loss) on sale of property and  equipment                                                                  |       | 1                                 |       | (10 | ) |
| Deferred income taxes                                                                                           |       | 599                               |       | (3,446 | ) |
| Change in assets and liabilities:                                                                               |       |                              |       |   |   |
| Accounts receivable                                                                                             |       | (6,655                            | )          | 7,049 |   |
| Other restricted assets                                                                                         |       | 1,077                             |       | 158 |   |
| Other assets                                                                                                    |       | 876                               |       | 336 |   |
| Accounts payable and accrued liabilities                                                                        |       | (9,104                            | )          | (564 | ) |
| Deferred revenues and other liabilities                                                                         |       | 19                                |       | 119 |   |
| Net cash (used in) provided by operating  activities                                                            |       | (5,680                            | )          | 6,326 |   |
|                                                                                                            |       |                              |       |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                                          |       |                              |       |   |   |
| Capital expenditures                                                                                            |       | (6,980                            | )          | (5,383 | ) |
| Purchases of investment securities                                                                              |       | (84,125                           | )          | (335,495 | ) |
| Sale of investment securities                                                                                   |       | 83,400                            |       | 345,610 |   |
| Deposits in restricted debt payment  account, net                                                               |       | 409                               |       | 823 |   |
| Net cash (used in) provided by investing  activities                                                            |       | (7,296                            | )          | 5,555 |   |
|                                                                                                            |       |                              |       |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                                          |       |                              |       |   |   |
| Payments on capital lease obligations                                                                           |       | 3⁄4                            |       | (1 | ) |
| Tax benefit of stock option exercises                                                                           |       | 73                                |       | 3⁄4 |   |
| Proceeds from exercise of stock options and  warrants                                                           |       | 901                               |       | 1,358 |   |
| Net cash provided by financing activities                                                                       |       | 974                               |       | 1,357 |   |
|                                                                                                            |       |                              |       |   |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                           |       | (12,002                           | )          | 13,238 |   |
| CASH AND  CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                               |       | 13,723                            |       | 9,895 |   |
| CASH AND  CASH EQUIVALENTS AT END OF PERIOD                                                                     |       | $                                 | 1,721      |   | $ | 23,133 |   |
|                                                                                                            |       |                              |       |   |   |
| OTHER  NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                             |       |                              |       |   |   |
| Other comprehensive loss                                                                                        |       | $                                 | (301       | ) | $ | (881 | ) |
| Common stock issued for board of directors  fees                                                                |       | 139                               |       | 58 |   |
| Decrease in fair value of interest rate  swap                                                                   |       | 1,749                             |       | 2,681 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

5

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** **

**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

 

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

 

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

### * *

Our stock incentiveplans provide for the granting of incentive options and nonqualified options toofficers, directors and key employees of the Company. Grants under these plansvest over periods up to seven years after the date of grant and expire no morethan 10 years after grant.

 

Prior to January 1,2006, we accounted for our stock option and stock-based compensation plansusing the intrinsic-value method outlined by Accounting Principles Board(“APB”) Opinion No. 25. Accordingly, we computed compensation cost for eachemployee stock option granted as the amount by which the quoted market price ofour shares on the date of grant exceeded the amount the employee must pay toacquire the shares. The amount of compensation cost, if any, would be chargedto income over the vesting period, No compensation cost had been recognized forthe options granted, as the grant price was equal to the market price.

 

EffectiveJanuary 1, 2006, we adopted the provisions of the Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”)No. 123R, “Share Based Payment” and elected to use the modifiedprospective transition method. Under this method, compensation cost recognized for the quarter ended March 31,2006, includes the applicable amounts of: (a) compensation cost of allstock-based awards granted prior to, but not yet vested, as of January 1, 2006(based on the grant-date fair value estimated in accordance with the originalprovisions of SFAS No. 123 and previously presented in pro forma footnotedisclosures), and (b) compensation cost for all stock-based awards grantedsubsequent to January 1, 2006 (based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123(R)). Results for prior periodshave not been restated

 

Additionally, we have an employee stockpurchase plan (“ESPP”)under whichemployees can make contributions to purchase our common stock. Participation inthe plan is elected annually by employees. The plan year begins each January1st (the “Grant Date”) and ends on December 31st (the “Exercise Date”).Purchases of common stock are made at the end of the year using the lower ofthe fair market value on either the Grant Date or Exercise Date, less a 15%discount. Prior to January 1, 2006, we were not required to recognizeany compensation cost related to our employee-stock purchase Plan. Under SFAS No. 123R our employee-stockpurchase plan is considered to be a compensatory ESPP and; therefore, we arerequired to recognize compensation cost over the requisite service period forgrants made under the ESPP.

 

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

 

OnMarch 29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 107 to addresscertain issues related to SFAS No. 123R. SAB 107 provides guidance ontransition methods, valuation methods, income tax effects and other share-basedpayment topics, and we had also applied this guidance in our adoption of SFASNo. 123R.

 

OnNovember 10, 2005, the Financial Accounting Standards Board (the “FASB”) issuedFASB Staff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related toAccounting for Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). FSP123R-3 provides for an alternative transition method for establishing thebeginning balance of the additional paid-in capital pool (“APIC pool”) relatedto the tax effects of employee share-based compensation, which is available toabsorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R.We have elected to adopt this alternative transition method, otherwise known asthe “simplified method,” in establishing our beginning APIC pool at January 1,2006.

 

6

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

 

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

 
| ** **                                                | ** ** | **Three Months  Ended March 31,  2006** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------------------------------|------------|
|                                                      |       |                                                   |       |
| Stock-based compensation expense – stock  options    |       | $                                                      | 575        |   |
| Stock-based compensation expense – restricted  stock |       | 55                                                     |       |
| Employee-stock purchase plan                              |       | 24                                                     |       |
| Related deferred income tax benefit                       |       | $                                                      | 271        |   |
|                                                      |       |                                                   |       |
| Decrease in basic earnings per share                      |       | $                                                      | 0.03       |   |
|                                                      |       |                                                   |       |
| Decrease in diluted earnings per share                    |       | $                                                      | 0.03       |   |

 

At March 31, 2006,60,000 restricted shares of our common stock were outstanding subject toperformance-based vesting criteria (30,000 of these are considered market-basedrestricted stock under SFAS No, 123 (R)). Additionally, 39,200 stock optionswere outstanding subject to performance-based vesting criteria (19,600 of theseare considered market-based options under SFAS No, 123 (R)).

 

The 30,000 shares ofrestricted stock and the 19,600 stock options which are considered market-basedrestricted stock were valued using a Monte Carlo simulation probability modelto estimated future stock returns. The grant date fair value of theseshares  was $9.05 per share for a totalvalue of $0.5 million. We recognized $0.04 million of expense associated withthese options during the first quarter of 2006.

 

Theamounts above relate to the impact of recognizing compensation expense relatedto  stock options, restricted stock andour employee-stock purchase plan. Compensation expense related to stock options(19,600 shares) and restricted stock grants (30,000 shares) that vest basedupon performance conditions are not included above. No compensation expense hasbeen recorded for our performance-based awards because it has not been deemedprobable that the related performance targets will be met. We are required toperiodically re-assess the probability and record expense at the point in time,if ever, it becomes probable these options will vest.

 

We recognize expensefor our stock-based compensation over the vesting period, which represents theperiod in which an employee is required to provide service in exchange for theaward. We recognize compensation expense for stock-based awards immediately ifthe award has immediate vesting.

 

*Prior Period Pro FormaPresentation*

 

Under the modifiedprospective application method, results for prior periods have not beenrestated to reflect the effects of implementing SFAS No, 123 (R). The followingpro forma information, as required by SFAS No. 148, “Accounting for Stock-BasedCompensation Transition and Disclosure, an Amendment of FASB Statement No. 123”is presented for comparative purposes and illustrates the pro forma effect onnet income and earnings per ordinary share for the period presented as if wehad applied the fair value recognition provisions of SFAS No. 123 to stock-basedemployee compensation prior to January 1, 2006 (in thousands, except per-shareamounts):

 

7

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| ** **                                                                                                                                  | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
|                                                                                                                                        |       |                                    |       |
| Net loss, as reported                                                                                                                       |       | $                                       | (2,273     | ) |
| Add: total stock-based compensation  recorded, net of tax                                                                                   |       | 34                                      |       |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | 371                                     |       |
| Pro forma net loss                                                                                                                          |       | $                                       | (2,678     | ) |
|                                                                                                                                        |       |                                    |       |   |
| Loss per share:                                                                                                                             |       |                                    |       |
| Basic, as reported                                                                                                                          |       | $                                       | (.17       | ) |
| Basic, pro forma                                                                                                                            |       | $                                       | (.20       | ) |
| Diluted, as reported                                                                                                                        |       | $                                       | (.17       | ) |
| Diluted, pro forma                                                                                                                          |       | $                                       | (.20       | ) |

 

*Assumptions*

 

The fair values for the significant stock-based awards granted duringthe three months ended March 31, 2006 and 2005 were estimated at the dateof grant using a Black-Scholes option pricing model with the followingweighted-average assumptions:

 
| ** **                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
|                              | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                              |       |                              |       |   |   |
| Risk-free  rate of return         |       | 4.31                              | %          | 4.42 | % |
| Expected  life of award           |       | 5 years                           |       | 7 years |   |
| Expected  dividend yield of stock |       | 0                                 | %          | 0 | % |
| Expected  volatility of stock     |       | 45.48                             | %          | 53.59 | % |
| Weighted-average  fair value      |       | $                                 | 6.24       |   | $ | 8.09 |   |
|                                   |            |                                   |            |  |  |  |  |

 

The expected volatility of stock assumption was derived by referring tochanges in the Company’s historical common stock prices over a timeframesimilar to that of the expected life of the award. We currently have no reasonto believe that future stock volatility will significantly differ fromhistorical stock volatility. Estimated forfeiture rates are derived fromhistorical forfeiture patterns. We believe the historical experience method isthe best estimate of forfeitures currently available.

 

In accordance with SAB 107, we used the "simplified" methodfor "plain vanilla" options to estimate the expected term of optionsgranted during the first quarter of 2006.

 

Stock-based award activity during the three months ended March 31,2006 was as follows (aggregate intrinsic value in millions):

 
| ** **                     | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
|                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at January 1, 2006 |       | 697,706                |       | $                                      | 12.21      |                                                | 7.2        |                            | $          | 8.5 |   |
| Granted                        |       | 45,000                 |       | 13.71                                  |       | 10.0                                                |       | 0.6                             |       |
| Exercised                      |       | (61,101                | )          | 10.28                                  |       |                                                |       | 0.2                             |       |
| Canceled                       |       | (30,770                | )          | 13.23                                  |       |                                                |       | 0.8                             |       |
|                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at March 31, 2006  |       | 650,835                |       | $                                      | 12.45      |                                                | 7.46       |                            | $          | 8.1 |   |
|                           |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at March 31, 2006  |       | 364,035                |       | $                                      | 11.81      |                                                | 6.41       |                            | $          | 4.3 |   |

 

8

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The total intrinsic value ofstock options exercised during the three months ended March 31, 2006 and2005 was $.2 million and $.5 million, respectively. Net cash proceeds from theexercise of stock options were approximately $0.6 million and $1.4 million forthe three months ended March 31, 2006 and 2005, respectively.

 

As of March 31, 2006, approximately $1.8 million of estimated expensewith respect to nonvested stock-based awards has yet to be recognized and willbe amortized into expense over the employee’s remaining requisite serviceperiod.

 

The following table summarizes information with respect to stockoptions outstanding and exercisable at March 31, 2006.

 
| **Range of Exercise Prices**     | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
|                                            |       |                    |       |                                                |       |                                   |       |                    |       |                                   |       |
| $3.75  to  $6.50            |       | 33,000                  |       | 4.7                                                 |       | $                                      | 4.08       |                    | 33,000     |                                   | $          | 4.08 |   |
|   6.51  to  10.00 |       | 57,085                  |       | 6.0                                                 |       | 8.55                                   |       | 55,139                  |       | 8.56                                   |       |
| 10.01  to  13.50            |       | 260,150                 |       | 7.5                                                 |       | 12.27                                  |       | 115,046                 |       | 11.73                                  |       |
| 13.51  to  16.00            |       | 300,600                 |       | 8.0                                                 |       | 14.26                                  |       | 160,850                 |       | 14.57                                  |       |
|                                            |       | 650,835                 |       | 7.5                                                 |       | 12.45                                  |       | 364,035                 |       | 11.81                                  |       |
|                                                 |            |                         |            |                                                     |            |                                        |            |                         |            |                                        |            |  |  |

 

Stock-based award activity for nonvested awards during the three monthsended March 31, 2006 is as follows:

 
| ** **                   | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at January 1, 2006 |       | 343,309                |       | $                                                           | 7.80       |   |
| Granted                      |       | 45,000                 |       | 6.24                                                        |       |
| Vested                       |       | (77,089                | )          | 7.54                                                        |       |
| Canceled                     |       | (24,420                | )          | 8.13                                                        |       |
|                         |       |                   |       |                                                        |       |
| Nonvested at March 31, 2006  |       | 286,800                |       | $                                                           | 7.82       |   |

 

9

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***Reclassifications***

 

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

 

**3.****             ****Discontinued Operations andManagement Restructuring**

 

We classify as discontinued operations those components of our businessthat we hold for sale or that have been disposed and have cash flows that areclearly distinguishable operationally and for financial reporting purposes fromthe rest of our operations. For those components, we have no significantcontinuing involvement after completion of disposal and their operations areeliminated from our ongoing operations. During the year ended December 31,2005, we classified certain components as discontinued operations. This was theresult of a management decision to close certain facilities in the first andsecond quarter of 2005. Notifications were made to the required contractingentities regarding the termination of the related programs. At March 31,2006, we did not have any significant net property and equipment balances pertainingto these operations.  There were norevenues generated by these discontinued operations in the three months endedMarch 31, 2006. These discontinued operations generated revenues ofapproximately $1.9 million in the three months ended March 31, 2005.

 

During the first quarter of 2005, a review was performed of ourmanagement structure and as a result, approximately 14 positions wereeliminated.  In conjunction with this, acharge was recorded of approximately $2.1 million in the quarter ended March31, 2005.  The charge was recorded inoperating expenses (approximately $1.0 million) and general and administrativeexpenses (approximately $1.1 million). The reduction in the accrued liability pertaining to this charge(approximately $0.7 million outstanding balance at March 31, 2006) is due tocash payments.

 

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

 

Intangible assets at March31, 2006 and December 31, 2005 consisted of the following (in thousands):

 
| ** **                  | ** ** | **March 31,****2006** | ** ** | **December 31,****2005** | ** ** |
|-----------------------------|------------|-----------------------|------------|--------------------------|------------|
|                        |       |                  |       |                     |       |
| Non-compete  agreements     |       | $                     | 9,990      |                     | $          | 9,960 |   |
| Acquired  contract value    |       | 6,442                 |       | 6,442                    |       |
| Accumulated  amortization   |       | (7,873                | )          | (7,313                   | )          |
| Identified intangibles, net |       | 8,559                 |       | 9,089                    |       |
| Goodwill,  net              |       | 12,577                |       | 12,577                   |       |
| Total intangibles, net      |       | $                     | 21,136     |                     | $          | 21,666 |   |

 

There were no changes inthe carrying amount of goodwill for the three months ended March 31, 2006.

 

Amortization expense for our non-compete agreements was approximately$0.3 million for the three months ended March 31, 2006 and 2005.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the nextfour years ended December 31 and approximately $0.7 million for the fifth year.

 

Amortization expense for our acquired contract value was approximately$0.3 million and $0.1 million for the three months ended March 31, 2006 and2005, respectively.  Amortization expensefor our acquired contract value is expected to be approximately $1.1 millionfor each of the next four years ended December 31 and approximately $0.6million for the fifth year.

 

10

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

 

Our long-term debt consisted of the following (in thousands):

 
| ** **                                                                                                                                            | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
|                                                                                                                                                  |       |                |       |                   |       |
| **Debt of  Cornell Companies, Inc.:**                                                                                                                 | ** ** | ** **          | ** ** | ** **             | ** ** |
| Senior Notes, unsecured, due July 2012 with  an interest rate of 10.75%, net of discount                                                              |       | $                   | 110,841    |                   | $          | 110,803 |   |
| Fair-value adjustment of Senior Notes as a  result of interest rate swap                                                                              |       | (1,894              | )          | (145                   | )          |
| Revolving Line of Credit (“Credit  Facility”) due June 2008 with an interest rate of LIBOR plus 2.25% to 3.5% or  prime plus 0.75% to 2.00% |       | —              |       | —                 |       |
| Capital lease obligations                                                                                                                             |       | 2                   |       | 2                      |       |
| Subtotal                                                                                                                                              |       | 108,949             |       | 110,660                |       |
|                                                                                                                                                  |       |                |       |                   |       |
| **Debt of  Special Purpose Entity:**                                                                                                                  | ** ** | ** **          | ** ** | ** **             | ** ** |
| 8.47% Bonds due 2016                                                                                                                                  |       | 165,700             |       | 165,700                |       |
|                                                                                                                                                  |       |                |       |                   |       |
| Total consolidated  debt                                                                                                                              |       | 274,649             |       | 276,360                |       |
|                                                                                                                                                  |       |                |       |                   |       |
| Less:  current maturities                                                                                                                             |       | (9,701              | )          | (9,701                 | )          |
|                                                                                                                                                  |       |                |       |                   |       |
| Consolidated  long-term debt                                                                                                                          |       | $                   | 264,948    |                   | $          | 266,659 |   |

 

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $48.9 million at March 31, 2006.  We had no outstanding borrowings on ourCredit Facility at March 31, 2006, but we had outstanding letters of credit ofapproximately $11.1 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder our Credit Facility up to an aggregate amount of $100.0 million.  Our Credit Facility matures in June 2008 andbears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standard covenantsincluding compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

 

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

 

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

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

 

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Any time prior to July 1, 2007, we may redeemup to 35% of the original aggregate principal amount of the Senior Notes at aredemption price of 110.75% of the principal amount thereof with the net cashof public offerings of equity, provided that at least 65% of the originalaggregate principal amount of the Notes remains outstanding after theredemption and other conditions are met. Upon the occurrence of specified change of control events, unless wehave exercised our option to redeem all the Senior Notes as described above,each holder will have the right to require us to repurchase all or a portion ofsuch holder’s Senior Notes at a purchase price in cash equal to 101% of theaggregate principal amount of the notes repurchased plus accrued and unpaidinterest, if any, on the Senior Notes repurchased, to the applicable date ofpurchase.  The Senior Notes were issuedunder an indenture (the “Indenture”) that limits our ability and the ability ofour Guarantors to, among other things, incur additional indebtedness, paydividends or make other distributions, make other restricted payments andinvestments, create liens, incur restrictions on the ability of the Guarantorsto pay dividends or other payments to us, enter into transactions withaffiliates, and engage in mergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap transaction with afinancial institution to hedge our exposure to changes in the fair value on$84.0 million of our Senior Notes.  Thepurpose of this transaction was to convert future interest due on $84.0 millionof the Senior Notes to a variable rate. The terms of the interest rate swap contract and the underlying debtinstrument are identical.  We havedesignated the swap agreement as a fair value hedge.  The swap has a notional amount of $84.0million and matures in July 2012 to mirror the maturity of the SeniorNotes.  Under the agreement, we pay on asemi-annual basis (each January 1 and July 1) a floating rate based on asix-month U.S. dollar LIBOR rate, plus a spread, and receive a fixed-rateinterest of 10.75%.  For the three monthsended March 31, 2006 and 2005, we recorded interest savings related to thisinterest rate swap of approximately $0.1 million and $0.5 million,respectively, which is reflected as a reduction to interest expense in theaccompanying financial statements.  Theswap agreements are marked to market each quarter with a correspondingmark-to-market adjustment reflected as either a discount or premium on theSenior Notes.  At March 31, 2006 andDecember 31, 2005, the fair value of this derivative instrument wasapproximately ($1.9) million and ($0.1) million, respectively, and is includedin other liabilities.  The carrying valueof the Senior Notes as of these dates was reduced by the same amount. Becausethe swap agreement is an effective fair-value hedge, there is no effect on ourresults of operations from the mark-to-market adjustment as long as the swap isin effect.

 

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

 

***Moshannon Valley Correctional Center***

 

As of March 31, 2006, we had incurred approximately $70.4 millionfor the design, construction and development costs and capitalized interestrelated to the Moshannon Valley Correctional Center facility.  In April 2006, we received a Notice toProceed from the Federal Bureau of Prisons (“BOP”).  The facility began operations in April 2006.

 

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

 

Basicearnings per share (“EPS”) is computed by dividing net income by the weightedaverage number of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended March 31, 2006 and2005, there were 114,600 shares ($15.13 average price) and 297,071 shares ($14.51average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

 

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Thefollowing table summarizes the calculation of net earnings and weighted averagecommon shares and common equivalent shares outstanding for purposes of thecomputation of earnings per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                               | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                                     |       |                              |       |   |   |
| Net earnings (loss)                                                      |       | $                                 | 684        |   | $ | (2,273 | ) |
|                                                                     |       |                              |       |   |   |
| Weighted average common share outstanding                                |       | 13,851                            |       | 13,428 |   |
| Weighted average common share equivalents  outstanding                   |       | 102                               |       | 3⁄4 |   |
| Weighted average common  shares and common share equivalents outstanding |       | 13,953                            |       | 13,428 |   |
|                                                                     |       |                              |       |   |   |
| Basic earnings (loss) per share                                          |       | $                                 | .05        |   | $ | (.17 | ) |
| Diluted earnings (loss) per common share                                 |       | $                                 | .05        |   | $ | (.17 | ) |

 

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

 

***LegalProceedings***

*** ***

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

##### *** ***

InAugust 2005, a lawsuit was filed by a detainee at the Lincoln County DetentionCenter (“LCDC”) in the U.S. District Court of New Mexico (Santa Fe) seekingunspecified damages. The lawsuit relates to the former LCDC policy thatrequired strip and visual body cavity searches for all detainees and inmatesand alleges that such policy violates a detainee’s Fourth and FourteenthAmendment right. The lawsuit was filed as a putative class action lawsuitbrought on behalf of all inmates who were searched at the LCDC from May 2002 toJuly 2005. This lawsuit is inits early stages and no material discovery has been conducted. In the yearended December 31, 2005, we recorded a charge of $0.2 million related to thislawsuit. As of March 31, 2006, we have estimated our range of additionalexposure to be approximately $0.3 million. We have adequate insurance coveragein the event our actual exposure exceeds our estimated exposure. In addition,in connection with our acquisition of the LCDC facility, certain amounts wereplaced in escrow to offset any undisclosed liability relating to suchacquisition. We have given notice to the prior owner of LCDC that we will seekto recover from the escrow any losses we may incur as a result of thislitigation. The ultimate outcome of the lawsuit cannot be determined at thistime and we intend to aggressively defend this lawsuit.

 

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

 

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas.  The lawsuitalleges that we violated the rights of Lakeisha Shantrail Brown, the deceaseddaughter of Juana Michelle Brown, under the Eighth Amendment of theConstitution of the United States and the laws of the State of Arkansas bydenying Ms. Brown medical treatment that caused her death and seeks unspecifiedactual and punitive damages.  Thislawsuit is in its very early stages and no discovery has been conducted.  We are therefore unable to estimate ourfinancial exposure relating to this lawsuit. We have adequate insurance coverage. We intend to vigorously defend this lawsuit; however, the ultimateoutcome of this lawsuit cannot be determined at this time.

##### *** ***

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

##### *** ***

InJanuary 2004, we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us into what we believed to be an escrowaccount in connection with the development and construction of the SouthernPeaks Regional Treatment Center. Of the funds previously deposited,approximately $5.3 million remains to be recovered at March 31, 2006. InDecember 2004, the case was tried before a jury and the jury verdictawarded approximately $6.5 million in compensatory damages and approximately$1.4 million in punitive damages, plus attorneys’ fees. We expect that theactual damages awarded under the verdict will be adjusted downward to the $5.4million actually lost by us and that the punitive damages award may be adjusteddownward because of a Georgia statute regarding caps on punitive damagesawards. No

 

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judgment has yet been enteredon this verdict. The award for compensatory damages accrues pre-judgmentinterest at a rate of seven percent from the date of loss through the date ofjudgment. Following the jury verdicts, we collected approximately $0.4million in January 2005 in funds that had been previously frozen under atemporary restraining order issued at the time that we commenced thislitigation. Currently, certain of the defendants have filed motions for a newtrial. No judgment will be entered on the verdict until after these motions fora new trial have been heard and ruled on by the court. Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.0 million in an allowance for doubtful accounts.

 

###### ***ShareholderLawsuits***

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

In March and April 2002, Cornell, Steven W. Logan (our formerPresident and Chief Executive Officer), and John L. Hendrix (our former ChiefFinancial Officer), were named as defendants in four federal putative classaction lawsuits styled as follows: (1) *GraydonWilliams, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc, et al.*, No. H-02-0866, in the United StatesDistrict Court for the Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the SouthernDistrict of Texas, Houston Division; (3) *LouisA. Daly, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.,* No. H-02-1522, in the UnitedStates District Court for the Southern District of Texas, Houston Division, and(4) *Anthony J. Scolaro, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., etal.,* No. H-02-1567, in the United States District Court for theSouthern District of Texas, Houston Division. The aforementioned lawsuits wereputative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 2002 of certain financial statements. The lawsuits involveddisclosures made concerning two prior transactions executed by us: theAugust 2001 sale leaseback transaction and the 2000 synthetic leasetransaction. These four lawsuits were consolidated into the *Graydon Williams* action and FlylinePartners, LP was appointed lead plaintiff. As a result, a consolidated complaintwas filed by Flyline Partners, LP. Richard Picard and Anthony Scolaro were alsonamed as plaintiffs. Since then, the court allowed plaintiffs to file anamended consolidated complaint. The amended consolidated complaint alleges thatthe defendants violated Section 10(b) of the Securities Exchange Actof 1934 (the “Exchange Act”), Rule 10b-5 promulgated underSection 10(b) of the Exchange Act, Section 20(a) of theExchange Act, Section 11 of the Securities Act of 1933 (the “SecuritiesAct”) and/or Section 15 of the Securities Act. The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees. In February 2006, the court approved the settlement of thismatter. Under the settlement agreement, Cornell has not admitted anywrongdoing. Settlement in the amount of $7.0 million has been funded throughour directors’ and officers’ liability insurance. During the fourth quarter of2005, we recorded the settlement charge of $7.0 million and the relatedreimbursement of $7.0 million from our director’s and officer’s liabilityinsurance. The charge and reimbursement was recognized in general andadministrative expenses in our Consolidated Statements of Operations andComprehensive Income (Loss) for the year ended December 31, 2005. The liabilitywas carried in accounts payable and accrued liabilities and the reimbursementwas included in other receivables at December 31, 2005. The reimbursement wasfunded by the insurance carrier in 2005 into a trust account and funds weredisbursed from the trust account to plaintiffs’ counsel’s escrow account uponcourt approval of the settlement in February 2006.

 

In March 2002, Cornell, its directors, and its former independentauditor Arthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas. The lawsuit related to our restatement in 2002 of certainfinancial statements. The lawsuit alleged breaches of fiduciary duty by all ofthe individual defendants and asserted breach of contract and professional negligenceclaims only against Arthur Andersen LLP. This lawsuit has been dismissedwithout prejudice by agreement. In January 2004, we received a letter fromWilliam Williams, the plaintiff in the *WilliamWilliams* action discussed above, demanding that we pursue breach offiduciary duty claims against various officers and directors based on theAugust 2001 sale leaseback transaction and the subsequent restatement. Wehave issued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision. InMay and September 2002, the Company and our then directors were suedin three other derivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of HarrisCounty, Texas. These lawsuits relate to our restatement in 2002 of certainfinancial statements. These lawsuits all allege breaches of fiduciary duty andwaste of corporate assets by all of the defendants and seeks unspecifieddamages. A motion to dismiss the *Guitierrez*and *Pagano* lawsuits was filed.The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action. The court granted the motion to dismiss the *Guitierrez* action and the plaintiffs have appealed thatruling. The *Menning* action hasbeen dismissed, but with an agreement that the

 

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plaintiff’s claims as toCornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.The plaintiffs in these cases have not quantified their claim of damages andthe outcome of the matters discussed above cannot be predicted with certainty.However, our management believes that we have good defenses and intends tovigorously defend against the claims asserted in these actions. We have notrecorded any loss accruals related to these claims.

 

Certain insurance policiesheld by us to cover potential director and officer liability may limit our cashoutflows in the event of a decision adverse to us in the matters discussedabove. However, if an adverse decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations and cash flows.

 

***Other***

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier was unable tofulfill its obligation under the insurance coverage provided, it could have amaterial adverse effect on our financial condition, results of operations orcash flows.

 

  During the period of August 2000 throughMay 2003, our general liability and professional liability coverage wasprovided by Specialty Surplus Insurance Company, a Kemper Insurance Company (“Kemper”)group member. In June 2004, the Illinois Department of Insurance gaveKemper permission to proceed with a run-off plan it had previously submitted.The three-year plan is designed to help Kemper meet its goal of resolving, tothe maximum extent possible, all valid policyholder claims. In view of therisks and uncertainties involved in implementing the plan, including the needto achieve significant policy buybacks, commutation of reinsurance agreements,and further agreements with regulators, no assurance can be given that the planwill be successfully implemented by Kemper. In the year ended December 31,2004, we accrued a provision of $0.6 million, and estimated our range ofadditional exposure to be approximately $0.5 million with respect tooutstanding claims incurred during this policy period with Kemper which wouldbecome our obligation to resolve if not settled through Kemper. During the yearended December 31, 2005, Kemper continued to implement its run-off plan. As aresult, several of our significant claims were settled by Kemper in the secondquarter of 2005. In conjunction with these settlements, we recorded a chargeagainst our existing accrual in the amount of $0.3 million. We believe that theuncertainty surrounding the ability of Kemper to settle our remainingoutstanding claims still exists. Based on our analysis of the claims activityduring the third quarter of 2005, we felt it necessary to accrue an additionalprovision in the amount of approximately $0.2 million during the third quarterof 2005. At March 31, 2006, we believe our estimated range of exposure, aboveour existing $0.5 million accrual, to be approximately $0.1 million related tothe outstanding claims which could become our obligation to resolve if notsettled through Kemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialcondition, operating results or cash flows.

 

***9.***              Derivative Financial Instruments and Guarantees

 

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

 

In August 2001, MCFcompleted a bond offering to finance the 2001 Sale and LeasebackTransaction.  In connection with thisbond offering, two reserve fund accounts were established by MCF pursuant tothe terms of the indenture: (1) MCF’s Debt Service Reserve Fund, aggregating$23.8 million at March 31, 2006, was established to make payments on MCF’soutstanding bonds in the event we (as lessee) should fail to make the scheduledrental payments to MCF and (2) MCF’s Debt Service Fund, aggregating $19.2million and $19.6 million at March 31, 2006 and December 31, 2005,respectively, used to accumulate the monthly lease payments that MCF receivesfrom us until such funds are used to pay MCF’s semi-annual bond interest andannual bond principal payments.  Bothreserve fund accounts are subject to the agreements with the MCF EquityInvestors whereby guaranteed rates of return of 3.0% and 5.08%, respectively,are provided for in the balance of the Debt Service Reserve Fund and the DebtService Fund.  The guaranteed rates ofreturn are characterized as cash flow hedge derivative instruments.  At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a deferred liability in our Consolidated Balance Sheets.Changes in the fair value of the derivative instruments are recorded as anadjustment to other long-term liabilities and reported as other comprehensiveincome (loss) in our Consolidated Statements of Operations and ComprehensiveIncome (Loss).  At March 31, 2006 andDecember 31, 2005, the fair value of these derivative instruments wasapproximately

 

15

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$3.5 million and $3.0 million,respectively.  As a result, ourConsolidated Statements of Operations and Comprehensive Income (Loss) includeother comprehensive loss of approximately $0.3 million and $0.9 million for thethree months ended March 31, 2006 and 2005, respectively.  The $0.9 million net unrealized loss reportedin comprehensive income (loss) for the three months ended March 31, 2005includes an adjustment of $0.6 million for the cumulative tax effect of changesin fair value during the years ended December 31, 2002 and 2003.

 

In connection with MCF’sbond offering, the MCF Equity Investor provided a guarantee of the Debt ServiceReserve Fund if a bankruptcy of the Company were to occur and a trustee for theestate of the Company were to include the Debt Service Reserve Fund as an assetof the Company’s estate.  This guaranteeis characterized as an insurance contract and is being amortized to expenseover the life of the debt.

 

**10.****      ****Segment Disclosure**

 

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems.  The adult community-based corrections andtreatment services segment consists of providing pre-release and halfway houseprograms for adult offenders who are either on probation or serving the lastthree to six-months of their sentences on parole and preparing for re-entryinto society at large as well as community-based treatment and educationprograms as an alternative to incarceration. All of our customers and long-lived assets are located in the UnitedStates of America.  The accountingpolicies of our reportable segments are the same as those described in thesummary of significant accounting policies in our 2005 Annual Report on Form10-K.  Intangible assets are not includedin each segment’s reportable assets, and the amortization of intangible assetsis not included in the determination of a segment’s operating income.  We evaluate performance based on income orloss from operations before general and administrative expenses, incentivebonuses, amortization of intangibles, interest and income taxes.  Corporate and other assets are comprisedprimarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferredtaxes, deferred costs and other assets. Corporate and other expense from operations primarily consists ofdepreciation and amortization on the corporate office facilities and equipment,and is presented separately as such charges cannot be readily identified forallocation to a particular segment.

 

16

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The only significant non-cash items reported in the respective segments’income from operations is depreciation and amortization (excluding intangibles)and impairment of long-lived assets (in thousands).

 
| ** **                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                         | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                               |       |                              |       |   |   |
| Revenues:                                          |       |                              |       |   |   |
| Adult secure institutional                         |       | $                                 | 38,321     |   | $ | 30,857 |   |
| Juvenile                                           |       | 29,292                            |       | 30,137 |   |
| Adult community-based                              |       | 16,234                            |       | 12,646 |   |
| Total revenues                                     |       | $                                 | 83,847     |   | $ | 73,640 |   |
|                                               |       |                              |       |   |   |
| Pre-opening  and start-up expenses:                |       |                              |       |   |   |
| Adult secure institutional                         |       | $                                 | 2,657      |   | $ | 2,890 |   |
| Juvenile                                           |       | —                            |       | 1,804 |   |
| Adult community-based                              |       | —                            |       | — |   |
| Total  pre-opening and start-up expenses           |       | $                                 | 2,657      |   | $ | 4,694 |   |
|                                               |       |                              |       |   |   |
| Income from  operations:                           |       |                              |       |   |   |
| Adult secure institutional                         |       | $                                 | 7,596      |   | $ | 6,077 |   |
| Juvenile                                           |       | 2,693                             |       | 3,190 |   |
| Adult community-based                              |       | 2,903                             |       | 2,255 |   |
| Sub-total                                          |       | 13,192                            |       | 11,522 |   |
| General and administrative expenses                |       | (5,112                            | )          | (6,338 | ) |
| Amortization of intangibles                        |       | (560                              | )          | (428 | ) |
| Corporate and other                                |       | (311                              | )          | (408 | ) |
| Total income  from operations                      |       | $                                 | 7,209      |   | $ | 4,348 |   |
|                                               |       |                              |       |   |   |
| Loss on  discontinued operations, net of tax:      |       |                              |       |   |   |
| Adult secure institutional                         |       | $                                 | —     |   | $ | — |   |
| Juvenile                                           |       | (524                              | )          | (1,448 | ) |
| Adult community-based                              |       | (2                                | )          | 15 |   |
| Total loss  on discontinued operations, net of tax |       | $                                 | (526       | ) | $ | (1,433 | ) |

 

 
| ** **                 | ** ** | **March 31,   2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------|------------|----------------------|------------|------------------------|------------|
| Assets:                    |       |                 |       |                   |       |
| Adult secure institutional |       | $                    | 226,594    |                   | $          | 213,107 |   |
| Juvenile                   |       | 102,552              |       | 106,457                |       |
| Adult community-based      |       | 66,405               |       | 67,298                 |       |
| Intangible assets, net     |       | 21,136               |       | 21,666                 |       |
| Corporate and other        |       | 81,680               |       | 102,100                |       |
| Total assets               |       | $                    | 498,367    |                   | $          | 510,628 |   |

 

17

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**11.   Guarantor Disclosures**

 

We completed an offering of $112.0million of Senior Notes in June 2004. The Senior Notes are jointly and severally, unconditionally guaranteedby each of our subsidiaries (Guarantor Subsidiaries).  MCF does not guarantee the Senior Notes (“Non-GuarantorSubsidiary”). These guarantees are joint and several obligations of theGuarantor Subsidiaries.  The followingcondensed consolidating financial information presents the financial condition,results of operations and cash flows for the parent company, the GuarantorSubsidiaries and the Non-Guarantor Subsidiary, together with the consolidatingadjustments necessary to present our results on a consolidated basis.

 

# **Condensed Consolidating Balance Sheet as of March 31, 2006 (inthousands)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                  |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 831        |                        | $          | 861                               |       | $                | 29         |             | $          | — |   | $ | 1,721 |   |
| Investment securities                            |       | 7,975      |       | —                      |       | —                            |       | —           |       | 7,975            |       |
| Accounts receivable                              |       | 583        |       | 63,856                      |       | 202                               |       | —           |       | 64,641           |       |
| Other restricted assets                          |       | —     |       | 1,558                       |       | 19,177                            |       | —           |       | 20,735           |       |
| Prepaids and other                               |       | 11,815     |       | 2,363                       |       | —                            |       | —           |       | 14,178           |       |
| Total current assets                             |       | 21,204     |       | 68,638                      |       | 19,408                            |       | —           |       | 109,250          |       |
| Property and equipment, net                      |       | 95         |       | 179,620                     |       | 153,586                           |       | (5,685           | )          | 327,616          |       |
| Other assets                                     |       |       |       |                        |       |                              |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —                      |       | 23,800                            |       | —           |       | 23,800           |       |
| Deferred costs and  other                        |       | 43,419     |       | 24,623                      |       | 8,624                             |       | (38,965          | )          | 37,701           |       |
| Investment in  subsidiaries                      |       | 14,638     |       | 2,088                       |       | —                            |       | (16,726          | )          | —           |       |
| Total assets                                     |       | $          | 79,356     |                        | $          | 274,969                           |       | $                | 205,418    |             | $          | (61,376 | ) | $ | 498,367 |   |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Liabilities  and Stockholders’ Equity**   | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 34,510     |                        | $          | 8,935                             |       | $                | 2,401      |             | $          | (2,503 | ) | $ | 43,343 |   |
| Current portion of  long-term debt               |       | —     |       | 1                           |       | 9,700                             |       | —           |       | 9,701            |       |
| Total current  liabilities                       |       | 34,510     |       | 8,936                       |       | 12,101                            |       | (2,503           | )          | 53,044           |       |
| Long-term debt, net of current portion           |       | 108,956    |       | (8                          | )          | 156,000                           |       | —           |       | 264,948          |       |
| Deferred tax liabilities                         |       | 8,749      |       | (1,763                      | )          | —                            |       | 185              |       | 7,171            |       |
| Other long-term liabilities                      |       | 7,171      |       | 108                         |       | 37,216                            |       | (38,915          | )          | 5,580            |       |
| Intercompany                                     |       | (247,654   | )          | 247,654                     |       | —                            |       | —           |       | —           |       |
| Total liabilities                                |       | (88,268    | )          | 254,927                     |       | 205,317                           |       | (41,233          | )          | 330,743          |       |
| Stockholders’ equity                        |       | 167,624    |       | 20,042                      |       | 101                               |       | (20,143          | )          | 167,624          |       |
| Total liabilities and  stockholders’ equity |       | $          | 79,356     |                        | $          | 274,969                           |       | $                | 205,418    |             | $          | (61,376 | ) | $ | 498,367 |   |

 

18

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# **Condensed Consolidating Balance Sheet as of December 31, 2005 (inthousands)**

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

 

19

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**CondensedConsolidating Statement of Operations for the three months ended March 31, 2006(in thousands)**

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

 

20

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# ** **

# **Condensed Consolidating Statement ofOperations for the three months ended March 31, 2005**(in thousands)

 
| ** **                                                        | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                                              |       |       |       |                        |       |                              |       |             |       |             |       |
| Revenues                                                          |       | $          | 4,527      |                        | $          | 83,457                            |       | $                | 4,502      |             | $          | (18,846 | ) | $ | 73,640 |   |
| Operating expenses                                                |       | 4,265      |       | 68,769                      |       | 10                                |       | (18,513          | )          | 54,531           |       |
| Pre-opening and  start-up expenses                                |       | 3⁄4     |       | 4,694                       |       | 3⁄4                            |       | 3⁄4           |       | 4,694            |       |
| Depreciation and  amortization                                    |       | 21         |       | 2,749                       |       | 1,056                             |       | (97              | )          | 3,729            |       |
| General and  administrative expenses                              |       | 6,319      |       | 3⁄4                      |       | 19                                |       | 3⁄4           |       | 6,338            |       |
| Income (loss) from  operations                                    |       | (6,078     | )          | 7,245                       |       | 3,417                             |       | (236             | )          | 4,348            |       |
| Overhead allocations                                              |       | (8,925     | )          | 8,925                       |       | 3⁄4                            |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                     |       | 921        |       | 1,273                       |       | 3,540                             |       | 10               |       | 5,744            |       |
| Equity loss in  subsidiaries                                      |       | (4,706     | )          | 3⁄4                      |       | 3⁄4                            |       | 4,706            |       | 3⁄4           |       |
| Loss before benefit for income taxes and  discontinued operations |       | (2,780     | )          | (2,953                      | )          | (123                              | )          | 4,460            |       | (1,396           | )          |
| Benefit for income  taxes                                         |       | (507       | )          | 3⁄4                      |       | 3⁄4                            |       | (49              | )          | (556             | )          |
| Loss before  discontinued operations                              |       | (2,273     | )          | (2,953                      | )          | (123                              | )          | 4,509            |       | (840             | )          |
| Discontinued operations, net of income tax  benefit of $776       |       | 3⁄4     |       | (1,433                      | )          | 3⁄4                            |       | 3⁄4           |       | (1,433           | )          |
| Net loss                                                          |       | $          | (2,273     | )                           | $          | (4,386                            | )          | $                | (123       | )                | $          | 4,509 |   | $ | (2,273 | ) |

 

21

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

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

 

22

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**Condensed Consolidating Statement of CashFlows for the three months ended March 31, 2005 (in thousands)**

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|
| **Cash  flows from operating activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Net cash (used in) provided by operating  activities |       | $          | 1,703      |                        | $          | 5,430                             |       | $                | (807       | ) | $ | 6,326 |   |
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Capital expenditures                                 |       | 3⁄4     |       | (5,383                      | )          | 3⁄4                            |       | (5,383           | )          |
| Purchase of investment securities                    |       | (335,495   | )          | 3⁄4                      |       | 3⁄4                            |       | (335,495         | )          |
| Sales of investment securities                       |       | 345,610    |       | 3⁄4                      |       | 3⁄4                            |       | 345,610          |       |
| Deposits in restricted debt payment  account, net    |       | 3⁄4     |       | 3⁄4                      |       | 823                               |       | 823              |       |
| Net cash (used in)  provided by investing activities |       | 10,115     |       | (5,383                      | )          | 823                               |       | 5,555            |       |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| **Cash  flows from financing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Payments on capital lease obligations                |       | 3⁄4     |       | (1                          | )          | 3⁄4                            |       | (1               | )          |
| Proceeds from exercise of stock options              |       | 1,358      |       | 3⁄4                      |       | 3⁄4                            |       | 1,358            |       |
| Net cash (used in)  provided by financing activities |       | 1,358      |       | (1                          | )          | 3⁄4                            |       | 1,357            |       |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| Net increase in cash and cash equivalents            |       | 13,176     |       | 46                          |       | 16                                |       | 13,238           |       |
| Cash and cash equivalents at beginning of  period    |       | 9,559      |       | 296                         |       | 40                                |       | 9,895            |       |
| Cash and cash equivalents at end of period           |       | $          | 22,735     |                        | $          | 342                               |       | $                | 56         |   | $ | 23,133 |   |

 

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**ITEM2.**                 Management’s Discussion and Analysisof Financial Condition and Results of Operations.

 

**General**

 

We are a leading provider of correctional,detention, educational, rehabilitation and treatment services outsourced byfederal, state and local government agencies. We provide a diversifiedportfolio of services for adults and juveniles through our three operatingdivisions: (1) adult secure institution and detention services; (2) juvenilejustice, educational and treatment services and (3) adult community-basedcorrections and treatment services. At March 31, 2006, we operated79 facilities with a total service capacity of 17,800 and had one facilityunder construction with an aggregate service capacity of 1,300 upon completion.We also had three facilities that were substantially vacant with an aggregateservice capacity of 406. Our facilities are located in 18 states and theDistrict of Columbia.

 

The following table (whichexcludes data related to discontinued operating facilities) sets forth for theperiods indicated total residential service capacity and contracted beds inoperation at the end of the periods shown, average contract occupancypercentages and total non-residential service capacity.

 
| ** **                                                                              | ** ** | **March 31,  2006** | ** ** | **March 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
|                                                                                    |       |                     |       |                     |       |
| **Residential**                                                                         |       |                     |       |                     |       |
| Service capacity (1) (2)                                                           |       | 13,008                   |       | 13,336                   |       |
| Contracted beds in operation (end of  period) (1) (3)                              |       | 12,124                   |       | 11,353                   |       |
| Average contract occupancy based on  contracted beds in operation (1) (4) (5) |       | 99.1                     | %          | 93.6                     | %          |
| Average contract occupancy excluding  start-up operations (1) (4) (5)         |       | 99.1                     | %          | 100.7                    | %          |
| **Non-Residential**                                                                     |       |                     |       |                     |       |
| Service capacity (1) (6)                                                           |       | 4,792                    |       | 3,852                    |       |

 

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(1)          Data presented excludes discontinued operating facilities.

(2)          Residential service capacity is comprised of the number of bedscurrently available for service or available upon the completion ofconstruction or renovation of residential facilities.

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

(4)          Occupancy percentagesreflect less than normalized occupancy during the start-up phase of anyapplicable facility, resulting in a lower average occupancy in periods when wehave substantial start-up activities.

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

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

 

We derive substantially allof our revenues from providing adult corrections and treatment and juvenilejustice, educational and treatment services outsourced by federal, state andlocal government agencies in the United States. Revenues for our services aregenerally recognized on a per diem rate based upon the number of occupant daysor hours served for the period, on a guaranteed take-or-pay basis or on acost-plus reimbursement basis. For the three months ended March 31, 2006,our revenue base consisted of 77.4% for services provided under per diemcontracts, 9.6% for services provided under take-or-pay and managementcontracts, 8.9% for services provided under cost-plus reimbursement contracts,2.8% for services provided under fee-for-service contracts and 1.2% from othermiscellaneous sources. While these percentages are generally consistent withcomparable statistics for the three months ended March 31, 2005, there hasbeen an increase in the percentage of revenues for services provided under perdiem contracts and a decrease in the percentage of revenues for services underfee-for-service contracts between the comparable periods. The increase in thepercentage of revenues provided under per diem contracts is primarily due tothe acquisition of Correctional Systems, Inc. (“CSI”) in April 2005,as well as the increased operations of the Regional Correctional Center.Revenues can fluctuate from period to period due to changes in governmentfunding policies, changes in the number of clients referred to our facilitiesby governmental agencies, the opening of new facilities or the expansion ofexisting facilities and the termination of contracts for a facility or theclosure of a facility.

 

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Revenues for our adultsecure institutional services division are primarily generated from per diem,take-or-pay and management contracts. For the three months ended March 31,2006 and 2005, we realized average per diem rates on our adult secureinstitutional facilities of approximately $53.67 and $48.47, respectively. Theincrease in the average per diem rate is due to operations at the RegionalCorrectional Center, commencement of operations in January 2006 at theMesa Verde Community Correctional Facility and the acquisition of CSI in April 2005.Decreases in, or the lack of anticipated increases in, per diem rates couldadversely impact our operating margin.

 

Revenues for our juvenile justice,educational and treatment services division are primarily generated from perdiem, fee-for-service and cost-plus reimbursement contracts. For the threemonths ended March 31, 2006 and 2005, we realized average per diem rateson our residential juvenile justice, educational and treatment facilities ofapproximately $172.85 and $167.49, respectively. For the three months ended March 31,2006 and 2005, we realized average fee-for-service rates for ournon-residential community-based juvenile facilities and programs, includingrates that are limited by Medicaid and other private insurance providers, ofapproximately $34.93 and $30.78, respectively.  The increase in the average fee-for-servicerate for 2006 is due to changes in the mix of the services provided by ourvarious juvenile justice, educational and treatment programs and facilities, aswell as the addition of several new alternative education programs in 2005. Themajority of our juvenile services contracts renew annually.

 

Revenues for our adult community-basedcorrections and treatment services division are primarily generated from perdiem contracts and fee-for-service contracts. For the three months ended March 31,2006 and 2005, we realized average per diem rates on our residential adultcorrections and treatment facilities of approximately $63.92 and $62.39,respectively. For the three months ended March 31, 2006 and 2005, werealized average fee-for-service rates on our non-residential adultcommunity-based corrections and treatment facilities and programs ofapproximately $9.11 and $6.83, respectively. Our average fee-for-service ratesfluctuate from year to year principally due to changes in the mix of servicesprovided by our various adult community-based programs and facilities.

 

Factors considered in determining billing rates tocharge include: (1) the programs specified by the contract and the relatedstaffing levels, (2) wage levels customary in the respective geographicareas, (3) whether the proposed facility is to be leased or purchased and (4) theanticipated average occupancy levels that could reasonably be maintained.

 

We have historically experienced higher operatingmargins in our adult secure institutional services and adult community-basedcorrections and treatment services as compared to the juvenile justice,educational and treatment services division. Additionally, our operatingmargins within a division can vary from facility to facility based on whether afacility is owned or leased, the level of competition for the contract award,the proposed length of the contract, the occupancy levels for a facility, thelevel of capital commitment required with respect to a facility, theanticipated changes in operating costs over the term of the contract, and our abilityto increase a facility’s contract revenue. A decline in occupancy of certainjuvenile justice, educational and treatment facilities can have a moresignificant impact on operating results than the adult secure institutionalservices division due to higher per diem rates at certain juvenile facilities. Wehave experienced and expect 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. Moreover, many of the governmental agencies with whom we contract havebeen and may continue to experience budget pressures and may approach usto limit or reduce per diem rates. Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely impact our operating margin.Additionally, a decrease in per diem rates without a corresponding decrease inoperating expenses could also adversely affect our operating margin.

 

We are responsible for all facility operating costs,except for certain debt service and interest or lease payments for facilitieswhere we have a management contract only. At these facilities, the facilityowner is responsible for all debt service and interest or lease paymentsrelated to the facility. We are responsible for all other operating expenses atthese facilities. We operated 20 facilities under management contracts at March 31,2006 and 11 facilities at March 31, 2005. The increase in facilitiesoperated under management contracts in 2005 was principally due to thosecontracts obtained as a result of the acquisition of CSI in April 2005.

 

A majority of our facility operating costs consistsof fixed costs. These fixed costs include lease and rental expense, insurance,utilities and depreciation. As a result, when we commence operation of new orexpanded facilities, fixed operating costs increase. The amount of our variableoperating costs, including food, medical services, supplies and clothing,depend on occupancy levels at the facilities we operate. Our largest singleoperating cost, facility payroll expense and related employment taxes andexpenses, has both a fixed and a variable component. We can adjust a facility’sstaffing levels and the related payroll expense to a certain extent based onoccupancy at a facility, however a minimum fixed number of employees isrequired to operate and maintain any facility regardless of occupancy levels. Personnelcosts are subject to increases in tightening labor markets based on localeconomic and other conditions.

 

25

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

 

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

 

Working capital requirementsgenerally increase immediately prior to commencing management of a new orexpanded facility as we incur start-up costs and purchase necessary equipmentand supplies before facility management revenue is realized.

 

General and administrative expenses consistprimarily of costs for corporate and administrative personnel who providesenior management, legal, finance, accounting, human resources, payroll andinformation systems, costs of business development and outside professional andconsulting fees.

 

#### **Recent Developments**

 

***Moshannon Valley Correctional Center***

 

In April 2006, wereceived a Notice to Proceed from the Federal Bureau of Prisons (“BOP”) at theMoshannon Valley Correctional Center in Pennsylvania. The facility beganoperations in April 2006.

 

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

### * *

OnJanuary 1, 2006, we adopted the provisions of the Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standard (“SFAS”) No. 123R,“Share Based Payment” and elected to use the modified prospective transitionmethod. The modified prospective transition method requires that compensationcost be recognized in the financial statements for all awards granted after thedate of adoption as well as for existing awards for which the requisite servicehas not been rendered as of the date of adoption and requires that priorperiods not be restated. Our stock incentive plans provide for the granting ofincentive options and nonqualified options to officers, directors and keyemployees of the Company. Outstanding options vest over periods up to sevenyears after the date of grant and expire no more than 10 years after grant. Priorto the adoption of SFAS No. 123R, we used the intrinsic-value based methodto account for stock options and recorded no charges against earnings withrespect to options granted. We have elected to use the “short-cut method” tocalculate the historical pool of windfall tax benefits upon adoption of SFAS123R. The election to use the “short-cut method” had no effect on ourconsolidated financial statements.

 

Theadoption of SFAS No. 123R reduced income from continuing operations beforeincome taxes for the three months ended March 31, 2006 by approximately $0.7million and reduced net income for the three months ended March 31, 2006by approximately $0.4 million ($.03 per basic and diluted share). The adoptionof SFAS No. 123R had an immaterial effect on our Consolidated Statement ofCash Flows for the three months ended March 31, 2006. Refer to Part I,Item 1, Footnote 2 to the consolidated financial statements for furtherinformation concerning the adoption of SFAS No. 123R.

 

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***Employee-Stock Purchase Plan***

 

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

 

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**Results of Operations**

 

The following table setsforth for the periods indicated the percentages of revenues represented bycertain items in our consolidated statements of operations.

 
| ** **                                                                            | ** ** | **Three Months  Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                                                  |       |                                   |       |   |   |
| Revenues                                                                              |       | 100.0                                  | %          | 100.0 | % |
| Operating expenses                                                                    |       | 77.7                                   |       | 74.0 |   |
| Pre-opening and start-up expenses                                                     |       | 3.2                                    |       | 6.4 |   |
| Depreciation and amortization                                                         |       | 4.4                                    |       | 5.1 |   |
| General and administrative expenses                                                   |       | 6.1                                    |       | 8.6 |   |
| Income from operations                                                                |       | 8.6                                    |       | 5.9 |   |
| Interest expense, net                                                                 |       | 6.0                                    |       | 7.8 |   |
| Income  (loss) from continuing operations before provision (benefit) for income taxes |       | 2.6                                    |       | (1.9 | ) |
| Provision (benefit) for income taxes                                                  |       | 1.2                                    |       | (0.8 | ) |
| Income (loss) from continuing operations                                              |       | 1.4                                    |       | (1.1 | ) |
| Discontinued operations, net of tax                                                   |       | (0.6                                   | )          | (2.0 | ) |
| Net income (loss)                                                                     |       | 0.8                                    | %          | (3.1 | )% |

 

##### ***Three Months Ended March 31,2006 Compared to Three Months Ended March 31, 2005***

##### *** ***

Certain comparisons of revenue, expenses and averagecontract occupancy contained herein have been made excluding the effect ofpre-opening and start-up expenses and revenues. Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent measurescalculated in a manner that is not consistent with U.S. generally acceptedaccounting principles (GAAP). We believe exclusion of the non-recurring effectof pre-opening and start-up expenses and revenues increases the reader’sunderstanding of our operating trends.

 

***Revenues***. Revenues increased approximately $10.2million, or 13.9%, to $83.8 million for the three months ended March 31,2006 from approximately $73.6 million for the three months ended March 31,2005.

 

***Adult Secure***. Adult secure institutional servicesdivision revenues increased approximately $7.4 million, or 23.9%, to $38.3million for the three months ended March 31, 2006 from approximately $30.9million for the three months ended March 31, 2005 due to (1) anincrease in revenues of approximately $3.9 million at the Regional CorrectionalCenter; included in this amount is a contract-based revenue adjustment for thecontract year ended March 2006 in the amount of $2.6 million,  (2) the commencement of our managementcontract at the Mesa Verde Community Correctional Facility in January 2006which increased revenues by approximately $1.5 million, (3) an increase inrevenues of approximately $0.7 million at the D. Ray James Prison due toimproved occupancy coupled with a per diem rate increase received mid-year 2005and (4) revenues of approximately $0.4 million generated by the facilityacquired from CSI in April 2005. The remaining net increase in revenues of$0.9 million was due to various insignificant fluctuations in the revenuesgenerated by our other adult secure facilities.

 

Our adult secure institutional servicesdivision revenues are generated primarily from contracts with federal and stateagencies. At March 31,2006, we operated 10 adult secure institutional facilities with an aggregateservice capacity of 8,286.

 

Average contract occupancywas 98.5% for the three months ended March 31, 2006 compared to 92.6% forthe three months ended March 31, 2005. Excluding the actual occupancy andcontract capacity for the start-up activities of the Regional CorrectionalCenter in 2005, the average contract occupancy was 102.9% for the three monthsended March 31, 2005. The average per diem rate was approximately $53.67and $48.47 for the three months ended March 31, 2006 and 2005,respectively. There were no revenues attributable to start-up operations forthe three months ended March 31, 2006. Revenues attributable to start-upoperations for the three months ended March 31, 2005 were approximately$1.5 million and were attributable solely to the Regional Correctional Center.

 

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***Juvenile***. Juvenile justice, educational and treatmentservices division revenues decreased approximately $0.8 million, or 2.7%, to$29.3 million for the three months ended March 31, 2006 from $30.1 millionfor the three months ended March 31, 2005. This was due primarily to the temporaryclosure of the Campbell Griffin Treatment Center in October 2005 whichreduced first quarter 2006 revenues by approximately $1.5 million, offset in part byan increase in revenues of approximately $0.6 million at the Southern PeaksRegional Treatment Center due to improved occupancy. We currently plan tore-activate the Campbell Griffin Treatment Center in the latter half of 2006.

 

***At March 31, 2006, we operated 19 residential juvenilefacilities and 14 non-residential community-based programs with an aggregateservice capacity of 4,165. Our contracts for these facilities and programs areprimarily with state and local government agencies and generally renewannually.***

*** ***

***Average contract occupancy for the three months ended March 31,2006 was 91.4% compared to 88.7% for the three months ended March 31, 2005.Excluding the actual occupancy and contracted capacity for the start-upoperations of the Southern Peaks Regional Treatment Center in 2005, averagecontract occupancy was 90.5% for the three months ended March 31, 2005.***

*** ***

***The average per diem rate for our residential juvenilefacilities was approximately $172.85 for the three months ended March 31,2006 compared to $167.49 for the three months ended March 31, 2005. Ouraverage fee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $34.93 for the three months ended March 31,2006 compared to approximately $30.78 for the three months ended March 31,2005.***

*** ***

***There were no revenues attributable to start-up operationsfor the three months ended March 31, 2006. Revenues attributable tostart-up operations for the three months ended March 31, 2005 wereapproximately $1.5 million and were attributable to the start-up operations ofthe Southern Peaks Regional Treatment Center.***

*** ***

***AdultCommunity-Based***.Adult community-based corrections and treatment services division revenuesincreased approximately $3.6 million, or 28.6%, to $16.2 million for the threemonths ended March 31, 2006 from $12.6 million for the three months ended March 31,2005 primarily due to revenues of approximately $3.1 million from theoperations of the adult community-based programs and facilities acquired fromCSI in April 2005. The remaining net increase in revenues of approximately$0.5 million was due to various insignificant fluctuations in revenues at ourother adult community-based programs and facilities.

 

At March 31, 2006, we operated 26residential adult community-based facilities and 10 non-residentialcommunity-based programs with an aggregate service capacity of 5,349. Average contract occupancy for the threemonths ended March 31, 2006 was 106.0% compared to 99.5% for the threemonths ended March 31, 2005. The average per diem rate for ourresidential adult community-based facilities was $63.92 for the three monthsended March 31, 2006 compared to $62.39 for the three months ended March 31,2005. The average fee-for-service rate for our non-residential adultcommunity-based programs was $9.11 for the three months ended March 31,2006 compared to $6.83 for the three months ended March 31, 2005. Therewere no revenues attributable to start-up operations for the three months endedMarch 31, 2006 and 2005.

 

***OperatingExpenses****.*Operatingexpenses increased approximately $10.6 million, or 19.4%, to $65.1 million forthe three months ended March 31, 2006 from $54.5 million for the threemonths ended March 31, 2005.

 

***Adult Secure***. Adult secure institutional servicesdivision operating expenses increased approximately $6.2 million, or 30.5%, to$26.5 million for the three months ended March 31, 2006 from $20.3 millionfor the three months ended March 31, 2005. The increase inoperating expenses was primarily due to (1) an increase in operatingexpenses of approximately $3.5 million at the Regional Correctional Center asthe expenses for the same period of 2005 were reported as start-up expenses, (2) thecommencement of our management contract at the Mesa Verde CommunityCorrectional Facility in January 2006 which increased operating expensesby approximately $1.1 million and (3) operating expenses of approximately$0.4 million from the facility acquired from CSI in April 2005. Theremaining net increase in operating expenses of $1.2 million is due variousfluctuations in operating expenses at our other adult secure facilities.

 

As a percentage of segment revenues, adultsecure institutional services division operating expenses were 69.2% for thethree months ended March 31, 2006 compared to 65.7% for the three monthsended March 31, 2005. Excluding $1.5 million of revenues attributable tothe start-up operations of the Regional Correctional Center in 2005, adultsecure institutional services division operating expenses were 69.1% for thethree months ended March 31, 2005.

 

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***Juvenile***.****Juvenilejustice, educational and treatment services division operating expensesincreased approximately $1.4 million, or 5.7%, to $25.8 million for the threemonths ended March 31, 2006 from $24.4 million for the three months ended March 31,2005 due to an increase in operating expenses of approximately $2.0million at the Southern Peaks Regional Treatment Center as the expenses for thesame period of 2005 were reported as start-up expenses offset, in part, by adecrease in operating expenses of approximately $0.9 million due to the temporaryclosure of the Campbell Griffin Treatment Center in October 2005. Additionally,operating expenses for the three months ended March 31, 2005 included arestructuring charge of approximately $1.0 million for personnel costsassociated with management streamlining initiatives implemented in the firstquarter of 2005.

 

As a percentage of segment revenues, juvenileservices division operating expenses were 88.0% for the three months ended March 31,2006 compared to 80.8% for the three months ended March 31, 2005.Excluding approximately $1.5 million of revenues attributable to the start-upoperations of the Southern Peaks Regional Treatment Center in 2005, juvenileservices division operating expenses were 85.1% for the three months ended March 31,2005.

 

***AdultCommunity-Based***.Adult community-based corrections and treatment services division operatingexpenses increased approximately $3.0 million, or 30.3%, to $12.9 million forthe three months ended March 31, 2006 from $9.9 million for the three months ended March 31, 2005 dueprimarily to operating expenses of $2.7 million attributable to the adultcommunity-based programs and facilities acquired from CSI in April 2005.As a percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 79.2% for the three monthsended March 31, 2006 compared to 78.3% for the three months ended March 31,2005.

 

***Pre-opening andstart-up expenses.*******Pre-openingand start-up expenses for the three months ended March 31, 2006 wereapproximately $2.7 million and were primarily attributable to the MoshannonValley Correctional Center.****Pre-openingand start-up expenses for the three months ended March 31, 2005 wereapproximately $4.7 million and were attributable to the pre-opening andstart-up operations of the Regional Correctional Center and the Southern PeaksRegional Treatment Center. These expenses consisted primarily ofpersonnel and related expenses, facility rent, professional and recruitingexpenses.

 

***Depreciation andAmortization*****.**Depreciationand amortization was approximately $3.7 million for the three months ended March 31,2006 and 2005. Amortization of intangibles was approximately $0.6 million and$0.4 million for the three months ended March 31, 2006 and 2005,respectively. The increase in amortization of intangibles for the threemonths ended March 31, 2006 is due to amortization of the April 2005purchased contract value related to the acquisition of CSI.

 

***General andAdministrative Expenses.***General and administrative expenses decreased approximately $1.2million, or 19.0%, to $5.1 million for the three months ended March 31,2006 from approximately $6.3 million for the three months ended March 31,2005. The decrease was primarily due to a restructuring charge ofapproximately $1.1 million recorded in the three months ended March 31,2005 for personnel costs associated with management streamlining initiatives,as well as a reduction in professional and consulting expenses (related toSarbanes-Oxley compliance and other matters). These reductions were partially offsetby the charge of approximately $0.7 million recorded in the three months endedMarch 31, 2006 pertaining to the adoption of SFAS No. 123R.

 

***Interest.***Interest expense, net of interest income, decreasedto approximately $5.0 million for the three months ended March 31, 2006from approximately $5.7 million for the three months ended March 31, 2005due primarily to an increase in capitalized interest for the three months endedMarch 31, 2006 of approximately $1.0 million. Capitalized interest wasapproximately $1.5 million and $0.5 million for the three months ended March 31,2006 and 2005, respectively, and was attributable to capitalized interest ondevelopment and construction costs for the Moshannon Valley CorrectionalCenter.

 

***Income Taxes.***Forthe three months ended March 31, 2006, we recognized an income taxprovision on our income from continuing operations at an estimated effectiverate of 44.1%. For the three months ended March 31, 2005, we recognized anincome tax benefit on our loss from continuing operations at an estimatedeffective rate of 39.8%. Additionally, we recognized an income tax benefit onour loss from discontinued operations for both periods at an estimatedeffective rate of 35.0%. The change inour estimated effective tax rate in 2006 is related to the net impact ofcertain non-deductible expenses such as lobbying and interest on tax-exemptinvestment securities.

 

## ***DiscontinuedOperations, net of tax.***The lossfrom discontinued operations was approximately $0.5 million for the threemonths ended March 31, 2006 compared to a net loss of $1.4 million for thethree months ended March 31, 2005. The reduction in loss in 2006 is aresult of the declining operations and related closure costs incurred in thethree months ended March 31, 2005 as the facilities were being closed.

## ** **

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## **Liquidity and Capital Resources**

## ** **

***General*****.**Our primary capital requirements are for (1) purchases,construction or renovation of new facilities, (2) expansions of existingfacilities, (3) working capital, (4) pre-opening and start-up costsrelated to new operating contracts, (5) acquisitions, (6) informationsystems hardware and software and (7) furniture, fixtures and equipmentpurchases. Working capital requirements generally increase immediately prior tocommencing management of a new facility as we incur start-up costs and purchasenecessary equipment and supplies before facility management revenue is realized.

 

***Cash Flows FromOperating Activities.*** Cash flows used in operationswas approximately $5.6 million for the three months ended March 31, 2006compared to approximately $6.3 million for the three months ended March 31,2005. The decrease in 2006 is principally due to the pre-opening and start-upactivities at Moshannon Valley Correctional Center as well as a decrease inaccounts payable and accrued liabilities due to the timing of payments withinthe quarter ended March 31, 2006. 

 

***Cash Flows FromInvesting Activities*****.** Cash used in investing activities wasapproximately $7.3 million for the three months ended March 31, 2006 dueprimarily to net purchases of investment securities of $0.7 million and capitalexpenditures of approximately $7.0 million, principally for the construction ofand acquisition of the equipment for the Moshannon Valley Correctional Center. Additionally,there were withdrawals from the restricted debt payment account, net ofdeposits, of $0.4 million. Cash provided by investing activities wasapproximately $5.6 million for the three months ended March 31, 2005 dueprimarily to net sales of investment securities of $10.1 million offset bycapital expenditures of $5.4 million principally attributable to constructionof the Moshannon Valley Correctional Center. Additionally, there werewithdrawals from the restricted debt payment account, net of deposits, of $0.8million.

 

***Cash Flows FromFinancing Activities*****.  **Cashprovided by financing activities was approximately $0.9 million and $1.4 millionfor the three months ended March 31, 2006 and 2005, respectively, dueprimarily to proceeds from the exercise of stock options.

 

***TreasuryStock/Repurchases.*** We did not purchase any of our commonshares in the three months ended March 31, 2006 and 2005.

 

***Long-Term CreditFacilities.*** Our Credit Facility provides for borrowings ofup to $60.0 million under a revolving line of credit, and is reduced byoutstanding letters of credit. The available commitment under our CreditFacility was approximately $48.9 million at March 31, 2006. We had nooutstanding borrowings on our Credit Facility at March 31, 2006, but wehad outstanding letters of credit of approximately $11.1 million. Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder our Credit Facility up to an aggregate amount of $100.0 million. OurCredit Facility matures in June 2008 and bears interest, at our election,depending on our total leverage ratio, at either the prime rate plus a marginranging from 0.75% to 2.00%, or a rate which ranges from 2.25% to 3.50% abovethe applicable LIBOR rate. Our Credit Facility is collateralized bysubstantially all of our assets, including the assets and stock of all of oursubsidiaries. Our Credit Facility is not secured by the assets of MCF. The 2004Credit Facility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

 

MCF is obligatedfor the outstanding balance of its 8.47% Taxable Revenue Bonds, Series 2001.The bonds bear interest at a rate of 8.47% per annum and are payable insemi-annual installments of interest and annual installments of principal. Allunpaid principal and accrued interest on the bonds is due on the earlier of August 1,2016 (maturity) or as noted under the bond documents. The bonds are limited,nonrecourse obligations of MCF and secured by the property and equipment, bondreserves, assignment of subleases and substantially all assets related to thefacilities included in the 2001 Sale and Leaseback Transaction. The bonds arenot guaranteed by us.

 

In June 2004,we issued $112.0 million in principal of 10.75% Senior Notes (the “Senior Notes”)due July 1, 2012. The Senior Notes are unsecured senior indebtedness andare guaranteed by all of our existing and future subsidiaries (collectively,the “Guarantors”). The Senior Notes are not guaranteed by MCF (the “Non-Guarantor”). Interest on the Senior Notes is payablesemi-annually on January 1 and July 1 of each year, commencing January 1,2005. On or after July 1, 2008, we may redeem all or a portion of theSenior Notes at the redemption prices (expressed as a percentage of theprincipal amount) listed below, plus accrued and unpaid interest, if any, onthe Senior Notes redeemed, to the applicable date of redemption, if redeemedduring the 12-month period commencing on July 1 of the years indicatedbelow:

 

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

 

Any time priorto July 1, 2007, we may redeem up to 35% of the original aggregateprincipal amount of the Senior Notes at a redemption price of 110.75% of theprincipal amount thereof with the net cash of public offerings of equity,provided that at least 65% of the original aggregate principal amount of theNotes remains outstanding after the redemption and other conditions are met. Uponthe occurrence of specified change of control events, unless we have exercisedour option to redeem all the Senior Notes as described above, each holder willhave the right to require us to repurchase all or a portion of such holder’sSenior Notes at a purchase price in cash equal to 101% of the aggregateprincipal amount of the notes repurchased plus accrued and unpaid interest, ifany, on the Senior Notes repurchased, to the applicable date of purchase. TheSenior Notes were issued under an indenture (the “Indenture”) which limits ourability and the ability of our Guarantors to, among other things, incuradditional indebtedness, pay dividends or make other distributions, make otherrestricted payments and investments, create liens, incur restrictions on theability of the Guarantors to pay dividends or other payments to us, enter intotransactions with affiliates, and engage in mergers, consolidations and certainsales of assets.

 

In conjunctionwith the issuance of the Senior Notes, we entered into an interest rate swaptransaction with a financial institution to hedge our exposure to changes inthe fair value on $84.0 million of our Senior Notes. The purpose of thistransaction was to convert future interest due on $84.0 million of the SeniorNotes to a variable rate. The terms of the interest rate swap contract and theunderlying debt instrument are identical. We have designated the swap agreementas a fair value hedge. The swap has a notional amount of $84.0 million andmatures in July 2012 to mirror the maturity of the Senior Notes. Under theagreement, we pay on a semi-annual basis (each January 1 and July 1)a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the three months ended March 31,2006 and 2005, we recorded interest savings related to this interest rate swapof approximately $0.1 million and $0.5 million, respectively, which isreflected as a reduction to interest expense in the accompanying financialstatements. The swap agreements are marked to market each quarter with acorresponding mark-to-market adjustment reflected as either a discount orpremium on the Senior Notes. At March 31, 2006 and December 31, 2005the fair value of this derivative instrument was approximately ($1.9) millionand ($0.1) million, respectively, and is included in other liabilities. Thecarrying value of the Senior Notes as of these dates was reduced by the sameamount. Because the swap agreement is considered an effective fair-value hedge,there will be no effect on our results of operations from the mark-to-marketadjustment as long as the swap is in effect.

 

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

 

***New Morgan Academy.***We closed the New MorganAcademy in the fourth quarter of 2002 and have considered several options rangingfrom the utilization of the facility for another type of program or the sale orlease of the facility. As of March 31, 2006, we are focusing our effortson the reopening of the facility by the fourth quarter of 2006. Once reopened,the facility will operate as a residential treatment facility for youth sexoffenders. We are maintaining a small staff to secure and maintain the facility during the finalization of thereactivation plans. We recognized pre-tax costs of $1.0 million and $0.9million in our Consolidated Statements of Operations and Comprehensive Income(Loss) for the three months ended March 31, 2006 and 2005, respectively,for related holding costs (depreciation, interest, property, taxes and othermaintenance costs).

 

As of March 31, 2006,we believe that, pursuant to the provisions of SFAS No. 144, no impairmentallowance is necessary. The carrying value of the property and equipment forthe New Morgan Academy was approximately $19.7 million and $19.9 million at March 31,2006 and December 31, 2005, respectively.

 

***RegionalCorrectional Center.***In January 2003, we executed a five-yearlease for the Regional Correctional Center in Albuquerque, New Mexico. This 970bed facility consists of two units, the 528 South Tower and the 442 bed North Tower.As of March 31, 2006, we had invested approximately $9.8 million onrenovations and furniture and equipment for both towers. While we currentlyanticipate that there will be periods that the facility will reach substantialcapacity during 2006, there can be no assurance that we will develop (maintain)enough volume at the facility to assure its profitability. The lease for thefacility requires monthly rental payments of approximately $113,000 for thefirst two years and $130,000 for the last three years of the lease.

 

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***Central California Treatment Center.***In January 2004, we purchased a building in Los Angeles,California for which our carrying value was approximately $2.7 million at December 31,2005. In 2005, we received notice from a local governmental agency indicating adesire to acquire the facility. In early 2006, the governmental agencyinitiated condemnation proceedings relating to the facility and depositedapproximately $2.9 million of condemnation proceeds with the court. We havepetitioned the court to release the deposit and we have commenced litigationcontesting the valuation of the facility submitted by the governmental agency.

*** ***

***CampbellGriffin Treatment Center.***In October 2005, weinitiated the temporary closure of this leased facility in San Antonio, Texas,and transferred the residents to our Texas Adolescent Treatment Center (alsolocated in San Antonio). It is our intent to reactivate this facility during2006. Accordingly, it has not been included in discontinued operations.

 

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

 

***ContractualObligations and Commercial Commitments*****.**We have assumed various financial obligationsand commitments in the ordinary course of conducting our business. We havecontractual obligations requiring future cash payments under our existingcontractual arrangements, such as management, consultative and non-competitionagreements.

 

We maintain operating leases in the ordinary courseof our business activities. These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthe agreements vary from 2006 until 2075. As of March 31, 2006, our totalcommitment under these operating leases was approximately $34.9 million.

 

The following table details known future cash payments(on an undiscounted basis) related to various contractual obligations as of March 31,2006 (in thousands):

 
| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **Total**                  | ** ** | **2006** | ** ** | **2007 -  2008** | ** ** | **2009 -  2010** | ** ** | **Thereafter** | ** ** |
|                                         |       |                       |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                     |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term  debt - principal                  |       |                       |       |   |   |   |   |   |   |   |   |
| - Cornell  Companies, Inc.         |       | $                          | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| - Special  Purpose Entities             |       | 165,700                    |       | 9,700 |   | 21,900 |   | 25,800 |   | 108,300 |   |
| Long-term  debt - interest (1)               |       |                       |       |   |   |   |   |   |   |   |   |
| - Cornell  Companies, Inc.         |       | 75,891                     |       | 9,133 |   | 24,296 |   | 24,271 |   | 18,191 |   |
| - Special  Purpose Entities             |       | 89,490                     |       | 7,017 |   | 25,537 |   | 22,666 |   | 34,270 |   |
| Construction commitments                     |       | 948                        |       | 948 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Capital lease obligations                    |       |                       |       |   |   |   |   |   |   |   |   |
| - Cornell  Companies, Inc.         |       | 2                          |       | 1 |   | 1 |   | — |   | — |   |
| Operating leases                             |       | 34,875                     |       | 4,805 |   | 11,050 |   | 8,540 |   | 10,480 |   |
| Consultative  and non-competition agreements |       | 1,609                      |       | 968 |   | 641 |   | — |   | — |   |
| Total contractual cash obligations           |       | $                          | 480,515    |   | $ | 32,572 |   | $ | 83,425 |   | $ | 81,277 |   | $ | 283,241 |   |

 

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(1)             We have an interest rateswap agreement under which we receive a fixed interest rate and pay a floatinginterest rate. The future cash payments on the Cornell Companies, Inc.long-term debt – interest assume an effective rate of 10.715% on the relatedinterest rate swap contract.

 

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We enter into letters ofcredit in the ordinary course of operating and financing activities. As of March 31,2006, we had outstanding letters of credit of approximately $11.1 million relatedto insurance and other operating activities. The following table details ourletter of credit commitments as of March 31, 2006 (in thousands):

 
| ** **                 | ** ** | **Total**              | ** ** | **Amount of Commitment Expiration  Per Period** | ** ** |
|----------------------------|------------|------------------------|------------|-------------------------------------------------|------------|
| ** **                 | ** ** | **Amounts  Committed** | ** ** | **Less than  1 Year**                           | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **Over  5 Years** | ** ** |
| ** **                 | ** ** | ** **             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Commercial Commitments:    | ** ** | ** **             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Standby  letters of credit |       | $                      | 11,112     |                                            | $          | 10,362 |   | $ | — |   | $ | 750 |   | $ | –– |   |
|                            |            |                        |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

In the normal course of business, we are exposed tomarket risk, primarily from changes in interest rates. We continually monitorexposure to market risk and develop appropriate strategies to manage this risk.We are not exposed to any other significant market risks, including commodityprice risk, foreign currency exchange risk or interest rate risks from the useof derivative financial instruments. In connection with the issuance of theSenior Notes, we entered into an interest rate swap of $84.0 million related tothe interest obligations under the Senior Notes in effect converting them to afloating rate based on six-month LIBOR.

 

**Interest Rate Exposure**

 

Our exposure to changes in interest rates primarilyresults from our long-term debt with both fixed and floating interest rates. Thedebt on our consolidated financial statements with fixed interest ratesconsists of the 8.47% Bonds issued by MCF in August 2001 in connectionwith the 2001 Sale and Leaseback Transaction and approximately $28.0 million ofthe Senior Notes (not hedged by the interest rate swap). At March 31,2006, approximately 30.6% ($84.0 million of debt outstanding on the Seniornotes issued in June 2004) of our consolidated long-term debt was subjectto variable interest rates. The detrimental effect of a hypothetical 100 basispoint increase in interest rates would be to reduce income before provision forincome taxes by approximately $0.2 million for the three months ended March 31,2006. At March 31, 2006, the fair value of our consolidated fixed ratedebt approximated carrying value based upon discounted future cash flows usingcurrent market prices.

 

**ITEM4.**                 Controls and Procedures.

 

We maintain disclosure controls and proceduresdesigned to ensure that information disclosed in our annual and periodicreports is recorded, processed, summarized and reported, within the timeperiods specified in the Securities and Exchange Commission’s rules andforms. In addition, we designed these disclosure controls and procedures toensure that this information is accumulated and communicated to management,including the chief executive officer (“CEO”) and chief financial officer (“CFO”),to allow timely decisions regarding required disclosures. SEC rules requirethat we disclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

 

We do not expect that ourdisclosure controls and procedures will prevent all errors or fraud. The designof disclosure controls and procedures must reflect the fact that there areresource constraints, and the benefits of controls must be considered relativeto their costs. Because of the inherent limitation in a cost-effective controlsystem, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within the Company have beendetected.

 

Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we have evaluated the effectiveness of the designand operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934, as amended (the ExchangeAct) as of the end of the period required by this report. Based on thatevaluation, our principal executive officer and principal financial officerhave concluded that these controls and procedures are effective as of thatdate.

 

In connection with theevaluation described above, there have been no changes in our internal controlover financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under Exchange Act) during our fiscal quarter ended March 31,2006 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II**               OTHERINFORMATION

 
| **ITEM 1.**  | ** ** | **Legal Proceedings.**                                                                                                                                                                                             |
|--------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
|         |       | See Part I, Item 1. Financial Statements, Note 8.                                                                                                                                                             |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
| **ITEM 1A.** | ** ** | **Risk Factors.**                                                                                                                                                                                                  |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
|         |       | The risk factors as previously discussed in our Form 10-K for  the fiscal year ended  December 31, 2005 are incorporated herein by this reference. There are  no material  changes to such risk factors. |
|         |       |                                                                                                                                                                                                               |
| **ITEM 2.**  | ** ** | **Unregistered Sales of Equity Securities and  Use of Proceeds.**                                                                                                                                                  |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 3.**  | ** ** | **Defaults Upon Senior Securities.**                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 4.**  | ** ** | **Submission of Matters to a  Vote of Security Holders.**                                                                                                                                                          |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 5.**  | ** ** | **Other Information.**                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 6.**  | ** ** | **Exhibits.**                                                                                                                                                                                                      |
| ** **   |       | 10.1                                                                                                                                                                                                               | 2006 Named Executive Officer Compensation  Agreements |
| ** **   |       | 31.1                                                                                                                                                                                                               | Section 302 Certification of Chief Executive Officer |
| ** **   |       | 31.2                                                                                                                                                                                                               | Section 302 Certification of Chief Financial Officer |
| ** **   |       | 32.1                                                                                                                                                                                                               | Section 906 Certification of Chief Executive Officer |
| ** **   |       | 32.2                                                                                                                                                                                                               | Section 906 Certification of Chief Financial Officer |

 

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**SIGNATURES**

 

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

 
| ** **                         | ** ** | **CORNELL COMPANIES, INC.**                                                  |
|------------------------------------|------------|-----------------------------------------------------------------------------------|
|                               |       |                                                                              |
|                               |       |                                                                              |
| Date:  May 10, 2006 | By:        | /s/ James E. Hyman                                                                |   |
|                               |       | JAMES E. HYMAN                                                                    |
|                               |       | Chief Executive Officer and  Chairman of the Board  (Principal Executive Officer) |
|                               |       |                                                                              |
|                               |       |                                                                              |
| Date:  May 10, 2006 | By:        | /s/ John R. Nieser                                                                |   |
|                               |       | JOHN R. NIESER                                                                    |
|                               |       | Chief Financial Officer and Treasurer  (Principal Financial Officer)              |

 

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