Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 
| **x**                                                       | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT  OF 1934**  |
|-------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
| ** **                                                  |
| **For the Quarterly Period Ended September 30,  2008** |
|                                                        |
| **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 tobe filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  x  No o

 

Indicate by a check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  accelerated Filer o Non-accelerated Filer o (Do not check if a smaller reporting  company) |   | Accelerated filer x  Smaller reporting company o |
|---------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|

 

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

 

Yes  o No x

 

At October 31, 2008, the registrant had 14,757,022 shares ofcommon stock outstanding.

 

 

 

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**Cornell Companies, Inc.**

** **

**Tableof Contents**

 

**Form 10-Q**

 
| **Part I**  | ** **                                                                                  | ** ** |
|------------------|---------------------------------------------------------------------------------------------|------------|
| Item 1.          | Financial Statements (unaudited)                                                            | 5          |
| Item 2.          | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 29         |
| Item 3.          | Quantitative and Qualitative Disclosures  About Market Risk                                 | 46         |
| Item 4.          | Controls and Procedures                                                                     | 47         |
|             |                                                                                        |       |
| **Part II** | ** **                                                                                  | ** ** |
| Item 1.          | Legal Proceedings                                                                           | 48         |
| Item 1A.         | Risk Factors                                                                                | 48         |
| Item 2.          | Unregistered Sales of Equity Securities and  Use of Proceeds                                | 54         |
| Item 3.          | Defaults Upon Senior Securities                                                             | 54         |
| Item 4.          | Submission of Matters to a Vote of Security  Holders                                        | 54         |
| Item 5.          | Other Information                                                                           | 54         |
| Item 6.          | Exhibits                                                                                    | 54         |

 

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**Forward-LookingInformation**

 

The statements included in this quarterlyreport regarding future financial performance and results of operations andother statements that are not historical facts are forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. Forward-looking statements in this quarterly report include, but are notlimited to, statements about the following subjects:

 
| · | revenues,                                                                                                                                                                                                                                                                                                                                     |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | revenue  mix,                                                                                                                                                                                                                                                                                                                                 |
| · | expenses,  including personnel and medical costs                                                                                                                                                                                                                                                                                              |
| · | results  of operations,                                                                                                                                                                                                                                                                                                                       |
| · | operating  margins                                                                                                                                                                                                                                                                                                                            |
| · | supply  and demand,                                                                                                                                                                                                                                                                                                                           |
| · | market  outlook in our various markets                                                                                                                                                                                                                                                                                                        |
| · | our  other expectations with regard to market outlook,                                                                                                                                                                                                                                                                                        |
| · | utilization,                                                                                                                                                                                                                                                                                                                                  |
| · | parolee,  detainee, inmate and youth offender trends                                                                                                                                                                                                                                                                                          |
| · | pricing  and per diem rates,                                                                                                                                                                                                                                                                                                                  |
| · | contract  commencements,                                                                                                                                                                                                                                                                                                                      |
| · | new  contract opportunities,                                                                                                                                                                                                                                                                                                                  |
| · | operations  at, future contracts for, and results from our Regional Correctional Center,                                                                                                                                                                                                                                                      |
| · | the  timing (including construction, completion and ramp of facility population),  cost of completion and other aspects of planned expansions, including without  limitation the D. Ray James Prison, Great Plains Correctional Facility and  Walnut Grove Youth Correctional Facility expansions, and client contracts for  such facilities, |
| · | the construction and lease of the new facility in Hudson, Colorado  and our contracts with the Colorado Department of Corrections,                                                                                                                                                                                                            |
| · | impact from Hurricane Ike,                                                                                                                                                                                                                                                                                                                    |
| · | adequacy  of insurance,                                                                                                                                                                                                                                                                                                                       |
| · | debt  levels,                                                                                                                                                                                                                                                                                                                                 |
| · | debt  reduction,                                                                                                                                                                                                                                                                                                                              |
| · | the  effect of FIN No. 48,                                                                                                                                                                                                                                                                                                               |
| · | our  effective tax rate,                                                                                                                                                                                                                                                                                                                      |
| · | tax  assessments,                                                                                                                                                                                                                                                                                                                             |
| · | results  and effects of legal proceedings and governmental audits and assessments,                                                                                                                                                                                                                                                            |
| · | liquidity,  including future liquidity and our ability to obtain financing,                                                                                                                                                                                                                                                                   |
| · | financial  markets,                                                                                                                                                                                                                                                                                                                           |
| · | cash  flow from operations,                                                                                                                                                                                                                                                                                                                   |
| · | adequacy  of cash flow for our obligations,                                                                                                                                                                                                                                                                                                   |
| · | capital  requirements                                                                                                                                                                                                                                                                                                                         |
| · | capital  expenditures,                                                                                                                                                                                                                                                                                                                        |
| · | effects  of accounting changes and adoption of accounting policies,                                                                                                                                                                                                                                                                           |
| · | changes  in laws and regulations,                                                                                                                                                                                                                                                                                                             |
| · | adoption  of accounting policies,                                                                                                                                                                                                                                                                                                             |
| · | benefit  payments, and                                                                                                                                                                                                                                                                                                                        |
| · | changes  in laws and regulations.                                                                                                                                                                                                                                                                                                             |

 

Forward-lookingstatements in this quarterly report are identifiable by use of the followingwords and other similar expressions among others:

 
| · | “anticipates” |
|--------|-------------------------|
| · | “believes”    |
| · | “budgets”     |
| · | “could”       |
| · | “estimates”   |
| · | “expects”     |
| · | “forecasts”   |

 

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| · | “intends”   |
|--------|-----------------------|
| · | “may”       |
| · | “might”     |
| · | “plans”     |
| · | “predicts”  |
| · | “projects”  |
| · | “scheduled” |
| · | “should”    |

 

Such statements are subject to numerous risks,uncertainties and assumptions, including, but not limited to:

 
| · | those  described under “Item 1A. Risk Factors,”                                                                                                                            |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | the  adequacy of sources of liquidity,                                                                                                                                               |
| · | the  effect and results of litigation, audits and contingencies, and                                                                                                                 |
| · | other  factors discussed in this annual report and in the Company’s other filings  with the SEC, which are available free of charge on the SEC’s website at *www.sec.gov*. |

 

Shouldone or more of these risks or uncertainties materialize, or should underlyingassumptions prove incorrect, actual results may vary materially from thoseindicated.

 

Allsubsequent written and oral forward-looking statements attributable to theCompany or to persons acting on our behalf are expressly qualified in theirentirety by reference to these risks and uncertainties. You should not placeundue reliance on forward-looking statements. Each forward-looking statementspeaks only as of the date of the particular statement, and we undertake no obligationto publicly update or revise any forward-looking statements.

 

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

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

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

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

 
| ** **                                                                                                                                                                      | ** ** | **September 30,** | ** **    | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|---------------|-----------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **2008**               | ** **    | **2007**              | ** ** |
| **ASSETS**                                                                                                                                                                      | ** ** | ** **             | ** **    | ** **            | ** ** |
|                                                                                                                                                                            |       |                   |          |                  |       |
| **CURRENT  ASSETS:**                                                                                                                                                            | ** ** | ** **             | ** **    | ** **            | ** ** |
| Cash and cash  equivalents                                                                                                                                                      |       | $                      |  1,784   |                  | $          |  3,028 |   |
| Investment securities  available for sale                                                                                                                                       |       | —                 |          | 250                   |       |
| Accounts receivable -  trade (net of allowance for doubtful accounts of $3,445 and $4,372,  respectively)                                                                  |       | 72,891                 |          | 69,787                |       |
| Other receivables (net  of allowance for doubtful accounts of $4,926 and $5,126, respectively)                                                                                  |       | 9,720                  |          | 3,201                 |       |
| Debt service fund and other  restricted assets                                                                                                                                  |       | 24,489                 |          | 27,523                |       |
| Deferred tax assets                                                                                                                                                             |       | 8,044                  |          | 6,750                 |       |
| Prepaid expenses and  other                                                                                                                                                     |       | 6,434                  |          | 6,131                 |       |
| Total current assets                                                                                                                                                            |       | 123,362                |          | 116,670               |       |
| **PROPERTY  AND EQUIPMENT, net**                                                                                                                                                |       | 441,047                |          | 383,952               |       |
| **OTHER  ASSETS:**                                                                                                                                                              | ** ** | ** **             | ** **    | ** **            | ** ** |
| Debt service reserve  fund                                                                                                                                                      |       | 23,776                 |          | 23,638                |       |
| Goodwill, net                                                                                                                                                                   |       | 13,308                 |          | 13,355                |       |
| Intangible assets, net                                                                                                                                                          |       | 3,062                  |          | 4,520                 |       |
| Deferred costs and  other                                                                                                                                                       |       | 23,552                 |          | 20,152                |       |
| **Total  assets**                                                                                                                                                               |       | $                      |  628,107 |                  | $          |  562,287 |   |
| ** **                                                                                                                                                                      | ** ** | ** **             | ** **    | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                   | ** ** | ** **             | ** **    | ** **            | ** ** |
| ** **                                                                                                                                                                      | ** ** | ** **             | ** **    | ** **            | ** ** |
| **CURRENT  LIABILITIES:**                                                                                                                                                       | ** ** | ** **             | ** **    | ** **            | ** ** |
| Accounts payable and  accrued liabilities                                                                                                                                       |       | $                      |  71,962  |                  | $          |  57,502 |   |
| Current portion of  long-term debt                                                                                                                                              |       | 12,412                 |          | 11,411                |       |
| **Total  current liabilities**                                                                                                                                                  |       | 84,374                 |          | 68,913                |       |
| **LONG-TERM  DEBT, net of current portion**                                                                                                                                     |       | 306,027                |          | 275,298               |       |
| **DEFERRED  TAX LIABILITIES**                                                                                                                                                   |       | 15,268                 |          | 13,226                |       |
| **OTHER  LONG-TERM LIABILITIES**                                                                                                                                                |       | 3,172                  |          | 4,401                 |       |
| **Total  liabilities**                                                                                                                                                          |       | 408,841                |          | 361,838               |       |
| ** **                                                                                                                                                                      | ** ** | ** **             | ** **    | ** **            | ** ** |
| **MINORITY  INTEREST**                                                                                                                                                          |       | 87                     |          | —                |       |
|                                                                                                                                                                            |       |                   |          |                  |       |
| **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, 16,260,465 and 16,068,677 shares  issued and 14,754,302 and 14,553,631 shares outstanding, respectively |       | 16                     |          | 16                    |       |
| Additional paid-in  capital                                                                                                                                                     |       | 163,585                |          | 160,319               |       |
| Retained earnings                                                                                                                                                               |       | 65,936                 |          | 51,127                |       |
| Treasury stock  (1,506,163 and 1,515,046 shares of common stock, at cost, respectively)                                                                                         |       | (12,034                | )             | (12,105               | )          |
| Accumulated other  comprehensive income                                                                                                                                         |       | 1,676                  |          | 1,092                 |       |
| **Total  stockholders’ equity**                                                                                                                                            |       | 219,179                |          | 200,449               |       |
| **Total  liabilities and stockholders’ equity**                                                                                                                            |       | $                      | 628,107       |                  | $          | 562,287 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVEINCOME**

**(Unaudited)**

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

 
| ** **                                                                                                                                   | ** ** | **Three Months Ended** | ** **   | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|--------------|---------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **September 30,**           | ** **   | **September 30,**          | ** ** |
| ** **                                                                                                                                   | ** ** | **2008**                         | ** **   | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| REVENUES                                                                                                                                     |       | $                                |  95,187 |                            | $          |  87,327 |   | $ |  285,225 |   | $ |  268,465 |   |
| OPERATING EXPENSES                                                                                                                           |       | 71,234                           |         | 68,485                          |       | 209,723 |   | 206,458 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                                |       | 4,466                            |         | 3,988                           |       | 12,843 |   | 11,740 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                                          |       | 5,450                            |         | 4,316                           |       | 19,217 |   | 19,848 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                                       |       | 14,037                           |         | 10,538                          |       | 43,442 |   | 30,419 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| INTEREST EXPENSE                                                                                                                             |       | 6,162                            |         | 6,340                           |       | 19,074 |   | 19,808 |   |
| INTEREST INCOME                                                                                                                              |       | (408                             | )            | (309                            | )          | (1,459 | ) | (1,223 | ) |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| INCOME BEFORE PROVISION  FOR INCOME TAXES AND MINORITY INTEREST                                                                              |       | 8,283                            |         | 4,507                           |       | 25,827 |   | 11,834 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| PROVISION FOR INCOME TAXES                                                                                                                   |       | 3,368                            |         | 2,090                           |       | 10,931 |   | 5,308 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| MINORITY INTEREST IN  CONSOLIDATED SPECIAL PURPOSE ENTITY                                                                                    |       | 87                               |         | —                          |       | 87 |   | — |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| NET INCOME                                                                                                                                   |       | $                                |  4,828  |                            | $          |  2,417 |   | $ |  14,809 |   | $ |  6,526 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| EARNINGS PER SHARE:                                                                                                                          |       |                             |         |                            |       |   |   |   |   |
| BASIC                                                                                                                                        |       | $                                |  .34    |                            | $          |  .17 |   | $ |  1.04 |   | $ |  .46 |   |
| DILUTED                                                                                                                                      |       | $                                |  .33    |                            | $          |  .17 |   | $ |  1.01 |   | $ |  .45 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| NUMBER OF SHARES USED  IN PER SHARE COMPUTATION:                                                                                             |       |                             |         |                            |       |   |   |   |   |
| BASIC                                                                                                                                        |       | 14,306                           |         | 14,214                          |       | 14,288 |   | 14,116 |   |
| DILUTED                                                                                                                                      |       | 14,763                           |         | 14,559                          |       | 14,691 |   | 14,443 |   |
|                                                                                                                                         |       |                             |         |                            |       |   |   |   |   |
| COMPREHENSIVE INCOME:                                                                                                                        |       |                             |         |                            |       |   |   |   |   |
| Net income                                                                                                                                   |       | $                                |  4,828  |                            | $          |  2,417 |   | $ |  14,809 |   | $ |  6,526 |   |
| Unrealized gain on  derivative instruments, net of tax provision of $324 and $406  in 2008 and $465 and $89 in 2007 |       | 467                              |         | 669                             |       | 584 |   | 127 |   |
| Comprehensive income                                                                                                                         |       | $                                |  5,295  |                            | $          |  3,086 |   | $ |  15,393 |   | $ |  6,653 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**CORNELLCOMPANIES, INC.**

# **CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                    | ** ** | **Nine Months Ended** | ** **   |
|---------------------------------------------------------------------------------------------------------------|------------|---------------------------------|--------------|
| ** **                                                                                                    | ** ** | **September 30,**          | ** **   |
| ** **                                                                                                    | ** ** | **2008**                        | ** **   | **2007** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                                        |       |                            |         |   |   |
| Net income                                                                                                    |       | $                               |  14,809 |   | $ |  6,526 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                            |       |                            |         |   |   |
| Depreciation                                                                                                  |       | 11,386                          |         | 10,063 |   |
| Impairment of  long-lived assets                                                                              |       | 250                             |         | — |   |
| Minority interest in  consolidated special purpose entity                                                     |       | 87                              |         | — |   |
| Amortization of  intangibles and other assets                                                                 |       | 1,593                           |         | 1,677 |   |
| Amortization of  deferred financing costs                                                                     |       | 952                             |         | 1,183 |   |
| Amortization of Senior  Notes discount                                                                        |       | 138                             |         | 138 |   |
| Stock-based  compensation                                                                                     |       | 2,519                           |         | 1,929 |   |
| Provision for bad debts                                                                                       |       | 1,638                           |         | 1,416 |   |
| Loss (gain) on sale of  property and equipment                                                                |       | 82                              |         | (279 | ) |
| Deferred income taxes                                                                                         |       | 341                             |         | (50 | ) |
| Change in assets and  liabilities, net of acquisitions:                                                       |       |                            |         |   |   |
| Accounts receivable                                                                                           |       | (17,308                         | )            | 673 |   |
| Other restricted assets                                                                                       |       | (806                            | )            | (167 | ) |
| Other assets                                                                                                  |       | (8                              | )            | 542 |   |
| Accounts payable and  accrued liabilities                                                                     |       | 5,531                           |         | (6,023 | ) |
| Deferred revenues and  other liabilities                                                                      |       | (238                            | )            | (10 | ) |
| Net cash provided by  operating activities                                                                    |       | 20,966                          |         | 17,618 |   |
|                                                                                                          |       |                            |         |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                        |       |                            |         |   |   |
| Capital expenditures                                                                                          |       | (59,282                         | )            | (30,555 | ) |
| Purchases of investment  securities                                                                           |       | —                          |         | (241,425 | ) |
| Sales of investment  securities                                                                               |       | 250                             |         | 252,600 |   |
| Facility acquisitions                                                                                         |       | —                          |         | (18,554 | ) |
| Site acquisitions                                                                                             |       | —                          |         | (5,053 | ) |
| Withdrawals from restricted  debt payment account, net                                                        |       | 3,702                           |         | 4,586 |   |
| Proceeds from sale of  property and equipment                                                                 |       | 791                             |         | 371 |   |
| Net cash used in  investing activities                                                                        |       | (54,539                         | )            | (38,030 | ) |
|                                                                                                          |       |                            |         |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                        |       |                            |         |   |   |
| Payment of MCF bonds                                                                                          |       | (11,400                         | )            | (10,500 | ) |
| Borrowing on line of  credit                                                                                  |       | 43,000                          |         | 10,000 |   |
| Payments of capital  lease obligations                                                                        |       | (8                              | )            | (8 | ) |
| Tax benefit of stock  option exercises                                                                        |       | 140                             |         | 508 |   |
| Proceeds from exercise  of stock options                                                                      |       | 597                             |         | 2,786 |   |
| Net cash provided by  financing activities                                                                    |       | 32,329                          |         | 2,786 |   |
|                                                                                                          |       |                            |         |   |   |
| NET DECREASE IN CASH  AND CASH EQUIVALENTS                                                                    |       | (1,244                          | )            | (17,626 | ) |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                                             |       | 3,028                           |         | 18,529 |   |
| CASH AND CASH  EQUIVALENTS AT END OF PERIOD                                                                   |       | $                               |  1,784  |   | $ |  903 |   |
|                                                                                                          |       |                            |         |   |   |
| OTHER NON-CASH  INVESTING AND FINANCING ACTIVITIES:                                                           |       |                            |         |   |   |
| Increase in fair value  of interest rate swap                                                                 |       | $                               |  — |   | $ |  883 |   |
| Other comprehensive income,  net of tax                                                                       |       | 584                             |         | 127 |   |
| Common stock issued for  board of directors fees                                                              |       | 380                             |         | 135 |   |
| Purchases and additions  to property and equipment included in accounts payable and accrued  liabilities |       | 10,322                          |         | 6,263 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**CORNELLCOMPANIES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**1.     Basis ofPresentation**

** **

Theaccompanying unaudited consolidated financial statements have been prepared byCornell Companies, Inc. (collectively with its subsidiaries andconsolidated special purpose entities, unless the context requires otherwise,the “Company,” “we,” “us” or “our”) pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with generally accepted accountingprinciples in the United States (“GAAP”) have been condensed or omittedpursuant to such rules and regulations. The year-end consolidated balance sheet was derived from auditedfinancial statements but does not include all disclosures required by GAAP. Inthe opinion of management, adjustments and disclosures necessary for a fairpresentation of these financial statements have been included.  Estimates were used in the preparation ofthese financial statements.  Actualresults could differ from those estimates. These financial statements should be read in conjunction with thefinancial statements and notes thereto included in the Company’s 2007 AnnualReport on Form 10-K as filed with the Securities and Exchange Commission.

 

**2.     AccountingPolicies**

** **

Seea description of our accounting policies in our 2007 Annual Report on Form 10-K.

 

**3.     Stock-Based Compensation**

** **

We have an employee stock purchaseplan (“ESPP”) underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yearbegins on January 1st (the “Beginning Date”) and ends on December 31st(the “Ending Date”). For 2007, however, the plan year began April 1, 2007.Purchases of common stock are made at the end of the year using the lower ofthe fair market value on either the Beginning Date or Ending Date, less a 15%discount. Under SFAS No. 123Rour employee-stock purchase plan is considered to be a compensatory ESPP, andtherefore, we recognize compensation expense over the requisite service periodfor grants made under the ESPP.

 

Ourstock incentive plans provide for the granting of stock options (both incentivestock options and nonqualified stock options), stock appreciation rights,restricted stock shares and other stock-based awards to officers, directors andemployees of the Company. Grants of stock options made to date under theseplans vest over periods up to seven years after the date of grant and expire nomore than 10 years after grant.

 

AtSeptember 30, 2007, 132,500 shares of restricted stock outstanding weresubject to performance-based vesting criteria (37,500 of these restrictedshares were considered market-based restricted stock under SFAS No. 123R).There were also 79,000 stock options outstanding subject to performance-basedvesting criteria. We recognized $0.1 million and $0.4 million of expenseassociated with these shares of restricted stock and stock options during thethree and nine months ended September 30, 2007, respectively.

 

AtSeptember 30, 2008, 202,000 shares of restricted stock were outstandingsubject to performance-based vesting criteria (32,500 of these restrictedshares were considered market-based restricted stock under SFAS No. 123R).There were also 52,700 stock options outstanding subject to performance-basedvesting criteria. We recognized $0.04 million and $0.6 million of expenseassociated with these shares of restricted stock and stock options during thethree and nine months ended September 30, 2008, respectively.

 

The amounts above relate to theimpact of recognizing compensation expense related to stock options andrestricted stock. Compensation expense related to stock options (52,700 shares)and restricted stock (169,500 shares) that vest based upon performanceconditions is not recorded for such performance-based awards until it has beendeemed probable that the related performance targets allowing the vesting ofthese options and restricted stock will be met. We are required to periodicallyre-assess the probability that these performance-based awards will vest andrecord expense at that point in time. During the nine months ended September 30,2008 it was deemed probable that certain performance targets pertaining tocertain restricted stock and stock options would be achieved by their vestingdate. Accordingly, compensation expense of approximately $0.5 million wasrecognized in the nine months ended September 30, 2008 related to theseperformance-based awards (none in the three months ended September 30,2008).

 

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

 

***Assumptions***

 

The fair values for the significant stock-based awards granted duringthe nine months ended September 30, 2008 and 2007 were estimated at thedate of grant using a Black-Scholes option pricing model with the followingweighted-average assumptions:

 

| ** **                       | ** ** | **Nine Months Ended   September 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                                  | ** ** | **2007** | ** ** |
|                             |       |                                                      |       |   |   |
| Risk-free rate of return         |       | 3.35                                                      | %          | 4.56 | % |
| Expected life of award           |       | 5.7 years                                                 |       | 5.6 years |   |
| Expected dividend yield of stock |       | 0                                                         | %          | 0 | % |
| Expected volatility of stock     |       | 38.74                                                     | %          | 42.19 | % |
| Weighted-average fair value      |       | $                                                         |  9.46 |   | $ |  9.86 |   |
|                                  |            |                                                           |            |  |  |  |  |

 

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 generally considered the “simplified”method for “plain vanilla” options to estimate the expected term of optionsgranted during 2008 and 2007 (where appropriate).  For those grants during these periods whereinwe had sufficient historical or impartial data to better estimate the expectedterm, we have done so.

 

Stock-based award activity during the nine months ended September 30,2008 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 December 31, 2007                   |       | 490,842                |       | $                                      |  14.19 |                                                | 7.3        |                            | $          |  7.0 |   |
| Granted                                                 |       | 45,000                 |       | 22.68                                  |        |                                                |       |                            |       |
| Exercised                                               |       | (36,390                | )          | 12.20                                  |        |                                                |       |                            |       |
| Canceled                                                |       | —                 |       | —                                 |        |                                                |       |                            |       |
|                                                    |       |                   |       |                                   |        |                                                |       |                            |       |
| Outstanding at September  30,  2008           |       | 499,452                |       | $                                      |  15.11 |                                                | 6.8        |                            | $          |  7.5 |   |
|                                                    |       |                   |       |                                   |        |                                                |       |                            |       |
| Vested and expected to vest at  September 30, 2008 |       | 436,703                |       | $                                      |  15.01 |                                                | 6.7        |                            | $          |  6.6 |   |
|                                                    |       |                   |       |                                   |        |                                                |       |                            |       |
| Exercisable at September 30, 2008                  |       | 379,761                |       | $                                      |  14.57 |                                                | 6.6        |                            | $          |  5.5 |   |

 

The total intrinsic value of stock options exercised during the ninemonths ended September 30, 2008 and 2007 was $0.5 million and $1.4million, respectively. Net cash proceeds from the exercise of stock optionswere approximately $0.6 million and $2.8 million for the nine months ended September 30,2008 and 2007, respectively.

 

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As of September 30, 2008, approximately $0.3 million of estimatedexpense with respect to time-based nonvested stock-based awards has yet to berecognized and will be amortized into expense over the employee’s remainingrequisite service period of approximately 9.3 months.

 

The following table summarizes information with respect to stockoptions outstanding and exercisable at September 30, 2008.

 
| **Range of Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** **  | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|-------------|-------------------------|------------|----------------------------------------|------------|
|                                        |       |                    |       |                                                |       |                                   |        |                    |       |                                   |       |
| $3.75  to  $10.00       |       | 20,855                  |       | 2.8                                                 |       | $                                      |  5.90  |                    | 20,855     |                                   | $          |  5.90 |   |
| $10.01  to  $13.50      |       | 160,897                 |       | 5.9                                                 |       | 12.81                                  |        | 142,756                 |       | 12.82                                  |       |
| $13.51  to $14.50            |       | 193,500                 |       | 6.9                                                 |       | 13.95                                  |        | 135,000                 |       | 13.88                                  |       |
| $14.51  to $25.00            |       | 124,200                 |       | 8.6                                                 |       | 21.42                                  |        | 81,150                  |       | 21.03                                  |       |
|                                        |       | 499,452                 |       | 6.8                                                 |       | $                                      |  15.11 |                    | 379,761    |                                   | $          |  14.57 |   |

 

Stock-based award activity for nonvested awards during the nine monthsended September 30, 2008 is as follows:

 
| ** **                           | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** **  |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|-------------|
| Nonvested at December 31, 2007  |       | 217,659                |       | $                                                           |  14.99 |   |
| Granted                              |       | 45,000                 |       | 22.68                                                       |        |
| Vested                               |       | (142,968               | )          | 15.90                                                       |        |
| Canceled                             |       | —                 |       | —                                                      |        |
|                                 |       |                   |       |                                                        |        |
| Nonvested at September 30, 2008 |       | 119,691                |       | $                                                           |  16.80 |   |

 

***Restricted Stock***

 

We havepreviously issued restricted stock under certain employment agreements andstock incentive plans which vests either over a specific period of time,generally three to five years, or which will vest subject to certain market orperformance conditions.  During the ninemonths ended September 30, 2008, we issued restricted stock as part of ournormal equity awards under our 2006 Equity Incentive Plan.  These shares of restricted common stock aresubject to restrictions on transfer and certain conditions to vesting.

 

Restrictedstock activity for the nine months ended September 30, 2008 was asfollows:

 
| ** **                           | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** **  |
|--------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|-------------|
| Nonvested at December 31, 2007  |       | 303,000                |       | $                                                           |  21.75 |   |
| Granted                              |       | 159,500                |       | 22.43                                                       |        |
| Vested                               |       | (33,876                | )          | 16.77                                                       |        |
| Canceled                             |       | (1,000                 | )          | 22.27                                                       |        |
|                                 |       |                   |       |                                                        |        |
| Nonvested at September 30, 2008 |       | 427,624                |       | $                                                           |  22.39 |   |

 

We recognized $0.4 million and $1.1 million of expense associated withnonvested time-based restricted stock awards during the three and nine monthsended September 30, 2008, respectively. As of September 30, 2008, approximately $3.5 million of estimatedexpense with respect to nonvested time-based restricted stock awards had yet tobe recognized and will be amortized over a weighted average period of 2.5years. Approximately $3.9 million of estimated expense withrespect to nonvested performance-based restricted stock option awards had yetto be recognized as of September 30, 2008.

 

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**4.      Terminated Merger Agreement**

** **

On October 6, 2006, we entered into an Agreement and Plan ofMerger (the “Merger Agreement”) with The Veritas Capital Fund III, L.P., aDelaware limited partnership (“Veritas”), Cornell Holding Corp., a Delawarecorporation (“Parent”) and CCI Acquisition Corp., a Delaware corporation andwholly owned subsidiary of Parent (“Merger Sub”), pursuant to which the MergerSub would be merged with and into us (the “Merger”), with Cornell survivingafter the Merger as a wholly owned subsidiary of Parent.

 

Our Board of Directors unanimously approved the Merger Agreement. Inconnection with the Merger, the Parent and certain of our stockholders enteredinto a Voting Agreement dated on or about October 6, 2006, whereby suchstockholders agreed, among other things, to vote their respective shares of ourstock in favor of the Merger Agreement, the Merger and the transactionscontemplated thereby.  At a specialmeeting of our stockholders held on January 23, 2007, the proposed MergerAgreement was rejected.

 

Under the terms of the Merger Agreement, because the Merger wasterminated, we reimbursed $2.5 million of costs incurred by Veritas, Parent andMerger Sub in connection with the proposed merger in February 2007. Suchcosts for legal and external professional and consulting fees are reflected ingeneral and administrative expenses for the nine months ended September 30,2007.

 

**5.      Intangible Assets**

 

Intangibleassets at September 30, 2008 and December 31, 2007 consisted of thefollowing (in thousands):

 

| ** **                                              | ** ** | **September 30,  2008** | ** **   | **December 31,  2007** | ** ** |
|---------------------------------------------------------|------------|------------------------------|--------------|-----------------------------|------------|
|                                                    |       |                         |         |                        |       |
| Non-compete agreements                                  |       | $                            |  9,040  |                        | $          |  9,040 |   |
| Accumulated amortization – non-compete  agreements |       | (8,171                       | )            | (7,541                      | )          |
| Acquired contract value                                 |       | 6,442                        |         | 6,442                       |       |
| Accumulated amortization – contract value          |       | (4,249                       | )            | (3,421                      | )          |
| Identified intangibles, net                             |       | 3,062                        |         | 4,520                       |       |
| Goodwill, net                                           |       | 13,308                       |         | 13,355                      |       |
| Total intangibles, net                                  |       | $                            |  16,370 |                        | $          |  17,875 |   |

 

Thechanges in the carrying amount of goodwill in the nine months ended September 30,2008 are as follows (in thousands):

 

| ** **                            | ** ** | **Adult  Secure** | ** ** | **Abraxas  Youth and  Family** | ** ** | **Adult  Community-  Based** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|-------------------|------------|--------------------------------|------------|------------------------------|------------|-----------|------------|
|                                  |       |              |       |                           |       |                         |       |      |       |
| Balance as of December 31, 2007  |       | $                 | 2,902      |                           | $          | 1,060                        |       | $         | 9,393      |   | $ | 13,355 |   |
| Reduction to goodwill                 |       | —            |       | —                         |       | (47                          | )          | (47       | )          |
| Balance as of September 30, 2008 |       | $                 | 2,902      |                           | $          | 1,060                        |       | $         | 9,346      |   | $ | 13,308 |   |

 

During the ninemonths ended September 30, 2008, a reduction to goodwill was recorded toreflect the final release of amounts previously placed in escrow related to theacquisition of Correctional Systems, Inc. in April 2005.

 

Amortization expense for our non-compete agreementswas approximately $0.2 million and $0.3 million for the three months ended September 30,2008 and 2007, respectively, and approximately $0.6 million and $0.8 millionfor the nine months ended September 30, 2008 and 2007, respectively.Amortization expense for our non-compete agreements is expected to beapproximately $0.8 million for the year ended December 31, 2008 andapproximately $0.6 million for the  yearended December 31, 2009.

 

Amortization expense for our acquired contract valuewas approximately $0.3 million for the three months ended September 30,2008 and 2007 and approximately $0.8 million for the nine months ended September 30,2008 and 2007. Amortization expense for our acquired contract value is expectedto be approximately $1.1 million for each of the next two years ended December 31and approximately $0.6 million for the year ended December 31, 2010.

 

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**6.     Impairment ofLong-Lived Assets**

 

**       **We evaluate the realization of our long-livedassets at least annually or when changes in circumstances or a specifictriggering event indicates that the carrying value of the asset may not berecoverable.  As a part of ourevaluation, we make judgments regarding such factors as estimated market valuesand the potential future operating results and undiscounted cash flowsassociated with individual facilities or assets.  Additionally, should we decide to sell afacility or other asset, realization is evaluated based on the estimated salesprice based on the best market information available. In conjunction with ourreview of certain of our long-lived assets based on estimated market valuesassociated with these assets, we determined that our carrying value for acurrently vacant site of land was not fully recoverable and exceeded its fairvalue and, as a result, we recorded an impairment charge of $0.3 million in thenine months ended September 30, 2008 (none in the nine months ended September 30,2007).  This charge was based on the bestinformation available.  This charge isreflected in general and administrative expenses in the accompanying financialstatements.

 

**7.****    ****New AccountingPronouncements**

 

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

 

In September 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework formeasuring fair value within generally accepted accounting principles andexpands disclosures about fair value measurements for financial assets andliabilities, as well as for any other assets and liabilities that are carriedat fair value on a recurring basis in the financial statements. SFAS No. 157became effective for financial statements issued for fiscal years beginningafter November 15, 2007, and interim periods within those fiscalyears.  This statement appliesprospectively to financial assets and liabilities. In February 2008, theFASB issued FSP 157-2, which delayed the effective date of SFAS No. 157 byone year for nonfinancial assets and liabilities.  Our adoption of SFAS No. 157 on January 1,2008 with respect to financial assets and liabilities did not have a materialfinancial impact on our consolidated results of operations or financialcondition.  We are currently evaluatingthe impact of implementation with respect to nonfinancial assets andliabilities on our consolidated financial statements.

 

We adopted SFAS No. 157 on January 1, 2008 for our financialassets and liabilities measured on a recurring basis.  As defined in SFAS No. 157, fair valueis the price that would be received to sell an asset or paid to transfer aliability in an orderly transaction between market participants at themeasurement date (“exit price”).  SFAS No. 157requires disclosure that establishes a framework for measuring fair value andexpands disclosures about fair value measurements.  SFAS No. 157 requires that fair valuemeasurements be classified and disclosed in one of the following categories:

 
| Level 1 | Unadjusted quoted prices in active markets that are accessible at the  measurement date for identical, unrestricted assets or liabilities;                                       |
|---------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |                                                                                                                                                                             |
| Level 2 | Quoted prices in markets that are not active, or inputs that are  observable, either directly or indirectly, for substantially the full term of  the asset or liability; and     |
|    |                                                                                                                                                                             |
| Level 3 | Prices or valuation techniques that require inputs that are both  significant to the fair value measurement and unobservable (i.e., supported  by little or no market activity). |

 

As required by SFAS No. 157, financial assets and liabilities areclassified based on the lowest level of input that is significant for the fairvalue measurement.  The following table summarizesthe valuation of our financial assets and liabilities by pricing levels, asdefined by the provisions of SFAS No. 157, as of September 30, 2008:

 
| ** **                                  | ** ** | **Fair Value as of   September 30, 2008 (in thousands)** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Level 1**                                                                                 | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Assets:                                     |       |                                                                                             |       |   |   |   |   |   |   |
| Cash and Cash Equivalents                   |       | $                                                                                                | 1,784      |   | $ | — |   | $ | — |   | $ | 1,784 |   |
| Corporate Bonds                             |       | —                                                                                           |       | 4,337 |   | — |   | 4,337 |   |
| Money Market Funds                          |       | —                                                                                           |       | 40,773 |   | — |   | 40,773 |   |
| Liabilities:                                |       |                                                                                             |       |   |   |   |   |   |   |
| Derivative Instruments (Debt Service Funds) |       | $                                                                                                | —     |   | $ | — |   | $ | 1,160 |   | $ | 1,160 |   |

 

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The corporate bonds and money market funds are carried in debt servicefund and other restricted assets and the debt service reserve fund in theaccompanying balance sheet. The derivative instrument is carried in other longterm liabilities in the accompany balance sheet.

 

SFAS No. 157requires a reconciliation of the beginning and ending balances for fair valuemeasurements using Level 3 inputs. The table below sets forth a reconciliationfor assets and liabilities measured at fair value on a recurring basis usingsignificant unobservable inputs (Level 3) during the nine months ended September 30,2008 (in thousands):

 
| Derivative instruments as of  December 31, 2007  |   | $    | 2,151  |   |
|-------------------------------------------------------|--------|------|--------|--------|
| Unrealized gain, net                                  |   | (735 | )      |
| Tax provision                                         |   | (511 | )      |
| Derivative instruments as of March 31,  2008     |   | 905  |   |
| Unrealized loss, net                                  |   | 618  |   |
| Tax benefit                                           |   | 428  |   |
| Derivative instruments as of June 30,  2008      |   | $    | 1,951  |   |
| Unrealized gain, net                                  |   | (467 | )      |
| Tax provision                                         |   | (324 | )      |
| Derivative instruments as of  September 30, 2008 |   | $    | 1,160  |   |

 

***FASB Staff Position SFAS No. 157-3***

 

In October 2008, the FASB issued FSP SFAS No. 157-3, “Determining theFair Value of a Financial Asset When the Market for That Asset Is Not Active”(“FSP SFAS 157-3”).  This FSP clarifiesthe application of SFAS No. 157 in a market that is not active and provides anexample to illustrate key considerations in determining the fair value of afinancial asset when the market for that financial asset is not active.  This FSP was effective upon issuance,including prior periods for which financial statements have not beenissued.   We applied this FSP tofinancial assets measured at fair value on a recurring basis at September 30,2008.  See Note 7 – New AccountingPronouncements – “Statement of Financial Accounting Standards No. 157”.  The adoption of FSP SFAS 157-3 did not have asignificant impact on our consolidated financial position, results ofoperations or cash flows.”

 

***Statement of Financial AccountingStandards No. 159***

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Optionfor Financial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115” (“SFAS No. 159”). SFAS No. 159 permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue and establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159became effective for financial statements issued for fiscal years beginningafter November 15, 2007, provided the entity elects to apply theprovisions of SFAS No. 157. Our adoption of SFAS No. 159 on January 1,2008 did not have any impact on our consolidated results of operations orfinancial condition as we have elected not to apply the provisions of SFAS No. 159to our financial instruments or other eligible items that are not required tobe measured at fair value.

 

**New Accounting Pronouncements Not Yet Adopted**

*** ***

***Statement of Financial Accounting Standards No. 141(Revised)***

 

InDecember 2007, the FASB issued SFAS No. 141 (Revised 2007), “BusinessCombinations” (“SFAS No. 141R”). SFAS No. 141R significantly changes the accounting for businesscombinations.  Under SFAS No. 141R,an acquiring entity will be required to recognize all the assets acquired andliabilities assumed in a transaction at the acquisition-date fair value withlimited exceptions.  SFAS No. 141Rchanges the accounting treatment for certain specific items, includingacquisition costs, noncontrolling interests, acquired contingent liabilities,in-process research and development costs, restructuring costs and changes indeferred tax asset valuation allowances and income tax uncertainties subsequentto the acquisition date.  SFAS No. 141Rapplies prospectively to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlieradoption is not permitted.

 

***FASB Staff Position No. FAS 142-3***

** **

This FASB Staff Position (“FSP”) amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under SFAS No. 142, “Goodwilland Other Intangible Assets”.  The intentof this FSP is to improve the consistency between the useful life of arecognized intangible asset under SFAS No. 142 and the period of expectedcash flows used to measure the fair value of the asset under SFAS No. 141(Revised 2007), “Business Combinations” and other U.S. generally acceptedaccounting principles.  This FSP iseffective for financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those fiscal years.  Early adoption is not permitted.  We do not expect this FSP to have asignificant impact on our consolidated financial position, results ofoperations or cash flows.

 

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***Statement ofFinancial Accounting Standards No. 160***

 

InDecember 2007, the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — An Amendment of ARB No. 51”(“SFAS No. 160”).  SFAS No. 160establishes new accounting and reporting standards for the noncontrollinginterest in a subsidiary and for the deconsolidation of a subsidiary.  SFAS No. 160 requires the recognition ofa noncontrolling interest (minority interest) as equity in the consolidatedfinancial statements and separate from the parent’s equity.  The amount of net income attributable to thenoncontrolling interest will be included in consolidated net income on the faceof the income statement.  This statementclarifies that changes in a parent’s ownership interest in a subsidiary that donot result in deconsolidation are equity transactions if the parent retains itscontrolling financial interest.  Inaddition, this statement requires that a parent recognize a gain or loss in netincome when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of thenoncontrolling equity investment on the deconsolidation date.  SFAS No. 160 also includes expandeddisclosure requirements regarding the interests of the parent and itsnoncontrolling interest.  SFAS No. 160is effective for fiscal years, and interim periods within those fiscal years,beginning on or after December 15, 2008. Earlier adoption is prohibited.

 

***Statement of Financial Accounting Standards No. 161***

 

In March 2008, the FASB issued SFAS No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities — an Amendment of FASBStatement 133” (“SFAS No. 161”). SFAS No. 161 is intended to improve financial reporting aboutderivatives and hedging activities by requiring enhanced qualitative andquantitative disclosures regarding derivative instruments, gains and losses onsuch instruments and their effects on an entity’s financial position, financialperformance and cash flows.  SFAS No. 161is effective for fiscal years and interim periods beginning after November 15,2008. We are currently evaluating the impact that this pronouncement may haveon our consolidated financial statements.

 

***Statement of FinancialAccounting Standards No. 162***

*** ***

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy ofGenerally Accepted Accounting Principles (“SFAS No. 162”).  SFAS No. 162 identifies the sources ofaccounting principles and the framework for selecting the principles to be usedin the preparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles in theUnited States of America.  SFAS No. 162is effective sixty days following the SEC’s approval of Public CompanyAccounting Oversight Board amendments to AU Section 411, “The Meaning of ‘PresentFairly’ in Conformity with Generally Accepted Accounting Principles.”  We do not expect this pronouncement to have asignificant impact on our consolidated financial position, results ofoperations or cash flows.

 

***FASB Staff Position No. EITF03-6-1***

*** ***

This FASB Staff Position (“FSP”)addresses whether instruments granted in share-based payment transactions areparticipating securities prior to vesting and, therefore, need to be includedin the earnings allocation in computing earnings per share (“EPS”) under thetwo-class method described in FASB Statement No. 128, “Earnings Per Share”.  This FSP is effective for financialstatements issued for fiscal years beginning after December 15, 2008, andthe interim periods within those years. All prior-period EPS data will have to be adjusted retrospectively(including interim financial statements, summaries of earnings, and selectedfinancial data) to conform to the provisions of this FSP.  Early application is not permitted.  We do not expect this FSP to have asignificant impact on our consolidated financial position, results ofoperations or cash flows.

 

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**8.     Credit Facilities**

 

Our long-termdebt at September 30, 2008 and December 31, 2007 consisted of thefollowing (in thousands):

 
| ** **                                                                                                                                                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| **Debt  of Cornell Companies, Inc.:**                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount                                                                                   |       | $                      | 111,310    |                  | $          | 111,172 |   |
| Revolving Line of  Credit due December 2011 with an interest rate of LIBOR plus 1.50%  to 2.25% or prime plus 0.00% to 0.75% (the “Amended Credit Facility”) |       | 73,000                 |       | 30,000                |       |
| Capital lease  obligations                                                                                                                                                            |       | 29                     |       | 37                    |       |
| Subtotal                                                                                                                                                                              |       | 184,339                |       | 141,209               |       |
| ** **                                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Debt  of Special Purpose Entity:**                                                                                                                                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| 8.47% Bonds due 2016                                                                                                                                                                  |       | 134,100                |       | 145,500               |       |
|                                                                                                                                                                                  |       |                   |       |                  |       |
| Total consolidated debt                                                                                                                                                               |       | 318,439                |       | 286,709               |       |
|                                                                                                                                                                                  |       |                   |       |                  |       |
| Less: current  maturities                                                                                                                                                             |       | (12,412                | )          | (11,411               | )          |
|                                                                                                                                                                                  |       |                   |       |                  |       |
| Consolidated long-term  debt                                                                                                                                                          |       | $                      | 306,027    |                  | $          | 275,298 |   |

 

***Long-Term Credit Facilities.***Our Amended Credit Facility provides for borrowings up to $100.0 million(including letters of credit), matures in December 2011 and bearsinterest, at our election depending on our total leverage ratio, at either theLIBOR rate plus a margin ranging from 1.50% to 2.25%, or a rate which rangesfrom 0.00% to 0.75% above the applicable prime rate. The available commitment under our AmendedCredit Facility was approximately $11.4 million at September 30,2008.  We had outstanding borrowingsunder our Amended Credit Facility of $73.0 million and we had outstandingletters of credit of approximately $15.6 million at September 30,2008.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million, although the indenture for our Senior Notes limits ourability, subject to certain conditions, to expand the Amended Credit Facilitybeyond $100.0 million.  The AmendedCredit Facility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries. The Amended Credit Facility is not secured bythe assets of MCF, a special purpose entity. Our Amended Credit Facilitycontains commonly used covenants including compliance with laws and limitationson certain financing transactions and mergers and also includes variousfinancial covenants.  We believe the mostrestrictive covenant under our Amended Credit Facility is the fixed chargecoverage ratio.  At September 30,2008, we were in compliance with all of our debt financial covenants.

 

MCF is obligated for the outstandingbalance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal 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, 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 (in which we sold elevenfacilities  to MCF).  The bonds are not guaranteed by Cornell.

 

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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 unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (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, wemay redeem all or a portion of the Senior Notes at the redemption prices(expressed as a percentage of the principal amount) listed below, plus accruedand unpaid interest, if any, on the Senior Notes redeemed, to the applicabledate of redemption, if redeemed during the 12-month period commencing on July 1of each of the years indicated below:

 

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

 

As the Senior Notes are now redeemable at our option (subject to therequirements noted) we anticipate we will monitor the capital markets andcontinue to assess our capital needs and our capital structure, including apotential refinancing of the Senior Notes.

 

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 the aggregateprincipal amount of the notes repurchased plus accrued and unpaid interest, ifany, on the Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture which limits our ability and the ability of our Guarantors to, amongother things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

In conjunction with the issuance of the SeniorNotes, we entered into an interest rate swap transaction with a financialinstitution to hedge our exposure to changes in the fair value on $84.0 millionof 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 ofthe interest rate swap contract and the underlying debt instrument wereidentical.  The swap agreement wasdesignated as a fair value hedge.  Theswap had a notional amount of $84.0 million and matured in July 2012 tomirror the maturity of the Senior Notes. Under the agreement, we paid, on a semi-annual basis (each January 1and July 1), a floating rate based on a six-month U.S. dollar LIBOR rate,plus a spread, and received a fixed-rate interest of 10.75%. For the three andnine months ended September 30, 2007, we recorded interest expense relatedto this interest rate swap of approximately $0.07 million and $0.2 million,respectively. The swap agreement was marked to market each quarter witha corresponding mark-to-market adjustment reflected as either a discount orpremium on the Senior Notes.  Thecarrying value of the Senior notes as of this date was adjusted accordingly bythe same amount. Because the swap agreement was an effective fair-value hedge,there was no effect on our results of operations from the mark-to-marketadjustment as long as the swap was in effect. In October 2007, weterminated the swap agreement. We received approximately $0.2 million inconjunction with the termination, which is being amortized over the remainingterm of the Senior Notes.

 

**9.      Income Taxes**

 

InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes – anInterpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 established a single model to addressthe accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing aminimum recognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance on the measurement, recognition,classification and disclosure of tax positions, as well as the accounting forthe related interest and penalties, transition and accounting in interimperiods.

 

Weadopted the provisions of FIN 48 effective January 1, 2007.  As a result of our adoption of FIN 48, werecorded an adjustment of approximately $0.3 million which increased retainedearnings at January 1, 2007.  Therewere no material changes to the total amount of our unrecognized tax benefitsin the three and nine months ended September 30, 2008.

 

Estimatedinterest and penalties related to the underpayment of income taxes areclassified as a component of income tax expense in the accompanyingConsolidated Statements of Income and Comprehensive Income.  There were no material changes to our accruedinterest and penalties in the three and nine months end September 30,2008.

 

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Weare subject to income tax in the United States and many of the individualstates we operate in.  We currently havesignificant operations in Texas, California, Oklahoma, Georgia, Illinois andPennsylvania.  State income tax returnsare generally subject to examination for a period of three to five years afterfiling.  The state impact of any changesmade to the federal return remains subject to examination by various states fora period up to one year after formal notification to the state.  We are open to United States Federal IncomeTax examinations for the tax years December 31, 2004 through December 2007.The IRS has commenced an examination of tax year 2006. Although the ultimateoutcome is uncertain at this point, we do not believe the matter will result ina material financial statement impact.

 

We do not anticipate a significant change in thebalance of our unrecognized tax benefits within the next 12 months.

 

**10.  Earnings Per Share**

 

Basic earningsper share (EPS) is computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the period. Diluted EPSreflects the potential dilution from common stock equivalents such as stockoptions and warrants. For the three months ended September 30, 2008 therewere no anti-dilutive shares. For the three months ended September 30, 2007,there were 15,000 shares ($25.00 average price) of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive. For the nine months ended September 30, 2008 and 2007 therewere 19,200 shares ($24.56 average price) of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.

 

The following tablesummarizes the calculation of net earnings and weighted average common sharesand common equivalent shares outstanding for purposes of the computation ofearnings per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                               | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income                                                               |       | $                                | 4,828      |                            | $          | 2,417 |   | $ | 14,809 |   | $ | 6,526 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 14,306                           |       | 14,214                          |       | 14,288 |   | 14,116 |   |
| Weighted average common  share equivalents outstanding                   |       | 457                              |       | 345                             |       | 403 |   | 327 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 14,763                           |       | 14,559                          |       | 14,691 |   | 14,443 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic earnings per  share                                                |       | $                                | .34        |                            | $          | .17 |   | $ | 1.04 |   | $ | .46 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Diluted earnings per  share                                              |       | $                                | .33        |                            | $          | .17 |   | $ | 1.01 |   | $ | .45 |   |

 

**11.****      ****Commitments and Contingencies**

 

***Financial Guarantees***

 

During the normal course of business, weenter into contracts that contain a variety of representations and warrantiesand provide general indemnifications. Our maximum exposure under thesearrangements is unknown as this would involve future claims that may be madeagainst us that have not yet occurred. However, based on experience, we believethe risk of loss to be remote.

 

***Legal Proceedings***

 

We are party to various legal proceedings, including those noted below.While management presently believes that the ultimate outcome of theseproceedings will not have a material adverse effect on our financial position,overall trends in results of operations or cash flows, litigation is subject toinherent uncertainties, and unfavorable rulings could occur. An unfavorableruling could include monetary damages or equitable relief, and could have amaterial adverse impact on the net income of the period in which the rulingoccurs or in future periods.

 

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***Valencia CountyDetention Center***

 

In April 2007, a lawsuit was filed against the Company in theFederal District court in Albuquerque, New Mexico, by Joe Torres and EufrasioArmijo, who each alleged that he was strip searched at the Valencia CountyDetention Center (“VCDC”) in New Mexico in violation of his federal rightsunder the Fourth, Fourteenth and Eighth amendments to the U.S. Constitution. The claimants also allege violation of their rights under state law and seek tobring the case as a class action on behalf of themselves and all detainees atVCDC during the applicable statutes of limitation.  The plaintiffs seekdamages and declaratory and injunctive relief.  Valencia County is also anamed defendant in the case and operated the VCDC for a significantly greaterportion of the period covered by the lawsuit. Discovery has commenced in the case but the ultimate outcome of the lawsuitcannot be determined at this time. We intend to vigorously defend this lawsuit.

 

***Lincoln CountyDetention Center***

 

In August 2005, a lawsuit was filed by a detainee at the LincolnCounty Detention Center (“LCDC”) in the U.S. District Court of New Mexico(Santa Fe) seeking unspecified damages. The lawsuit relates to the former LCDCpolicy that required strip and visual body cavity searches for all detaineesand inmates and alleges that such policy violates a detainee’s Fourth andFourteenth Amendment rights under the U.S. Constitution. The lawsuit was filedas a putative class action lawsuit brought on behalf of all inmates who weresearched at the LCDC from May 2002 to July 2005. In September 2006,we agreed to a proposed stipulation of settlement and the court haspreliminarily approved the settlement. The settlement amount under the terms ofthe agreement is $1.6 million, and was funded principally through our generalliability and professional liability coverage.

 

In the year ended December 31, 2005, we recorded a charge of $0.2million related to this lawsuit. In addition, we previously have providedinsurance reserves for this matter (as part of our regular review of reportedand unreported claims) totaling approximately $0.5 million. During the third quarterof 2006, we recorded an additional settlement charge of approximately $0.9million and the related reimbursement from our general liability andprofessional liability insurance. The charge and reimbursement were recognizedin general and administrative expenses for the year ended December 31,2006. The reimbursement was funded by the insurance carrier in the firstquarter of 2007 into a settlement account. The court granted preliminaryapproval of the settlement in the second quarter of 2007. The claimsadministration process is now complete and the final court approval of thesettlement has now been obtained.

 

***Shareholder Lawsuits***

 

OnOctober 19, 2006, a purported class action complaint was filed in theDistrict Court of Harris County, Texas, 269th Judicial District (No. 2006-67413)by Ted Kinbergy, an alleged stockholder of Cornell. The complaint names asdefendants Cornell and each member of our board of directors as well as VeritasCapital Fund III, L.P. (“Veritas”). The complaint alleges, among other things,that (i) the defendants have breached fiduciary duties they assertedlyowed to our stockholders in connection with our entering into the Agreement andPlan of Merger, dated as of October 6, 2006, with Veritas, Cornell HoldingCorp., and CCI Acquisition Corp., and (ii) the merger consideration isunfair and inadequate. The plaintiffs sought, among other things, an injunctionagainst the consummation of the merger. The proposed merger was rejected at aspecial meeting of our stockholders held on January 23, 2007.Consequently, we believe the case is moot and are in discussions with plaintiff’scounsel concerning potential legal fees that may be owed.  We do not expect the resolution of thismatter to have a material adverse effect on our financial condition, results ofoperations or 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.

 

While the outcome of such other matters cannot be predicated withcertainty, based on the information known to date, we believe that the ultimateresolution of these matters will not have a material adverse effect on ourfinancial condition, but could be material to operating results or cash flowsfor a particular reporting period.

 

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**12.  DerivativeFinancial Instruments and Guarantees**

 

***DebtService Reserve Fund and Debt Service Fund***

*** ***

In August 2001, MCF, aspecial purpose entity, completed a bond offering to finance the 2001 Sale andLeaseback Transaction in which we sold eleven facilities (see Part 1, Item1 in our Form 10-K for the year ended December 31, 2007) to MCF. Inconnection with this bond offering, two reserve fund accounts were establishedby MCF pursuant to the terms of the indenture: (1) MCF’s Debt ServiceReserve Fund, aggregating approximately $23.8 million at September 30,2008, was established to make payments on MCF’s outstanding bonds in the eventwe (as lessee) should fail to make the scheduled rental payments to MCF and (2) MCF’sDebt Service Fund, aggregating approximately $21.3 million at September 30,2008, used to accumulate the monthly lease payments that MCF receives from us untilsuch funds are used to pay MCF’s semi-annual bond interest and annual bondprincipal payments. Both reserve fund accounts are subject to the agreementswith the MCF Equity Investors whereby guaranteed rates of return of 3.0% and5.08%, respectively, are provided for in the balance of the Debt ServiceReserve Fund and the Debt Service Fund. The guaranteed rates of return arecharacterized as cash flow hedge derivative instruments. At inception, thederivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income. At September 30, 2008 and December 31,2007, the fair value of these derivative instruments was approximately $1.2million and $2.2 million, respectively. Our Consolidated Statements ofOperations and Comprehensive Income include comprehensive income, net of taxes,of approximately $0.4 million and $0.5 million for the three and nine monthsended September 30, 2008, respectively. For the three and nine monthsended September 30, 2007, we reported comprehensive income, net of taxes,of approximately $0.7 million and $0.1 million, respectively.

 

In connectionwith MCF’s bond offering, the MCF Equity Investor provided a guarantee of theDebt Service Reserve Fund if a bankruptcy of the Company were to occur and atrustee for the estate of the Company were to include the Debt Service ReserveFund as an asset of the Company’s estate. This guarantee is characterized as aninsurance contract and is being amortized to expense over the life of the debt.

 

**13.****      ****Segment Disclosure**

 

Our three operatingdivisions are our reportable segments. The Adult Secure Services segmentconsists of the operations of secure adult incarceration facilities. TheAbraxas Youth and Family Services segment consists of providing residentialtreatment and educational programs and non-residential community-based programsto juveniles between the ages of 10 and 18 who have either been adjudicated orsuffer from behavioral problems and to certain adults as well. The AdultCommunity-Based Services segment consists of providing pre-release and halfwayhouse programs 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 as well as community-based treatment and education programs as analternative to incarceration. All of our customers and long-lived assets arelocated in the United States of America. The accounting policies of ourreportable segments are the same as those described in the summary ofsignificant accounting policies in Note 2 in our 2007 Annual Report on Form 10-K.  Intangible assets are not included in eachsegment’s reportable assets, and the amortization of intangible assets is notincluded in the determination of a reportable segment’s operating income. Weevaluate performance based on income or loss from operations before general andadministrative expenses, amortization of intangibles, interest and incometaxes. Corporate and other assets are comprised primarily of cash, investmentsecurities available for sale, accounts receivable, debt service and debtservice reserve funds, deposits, property and equipment, deferred taxes,deferred costs and other assets. Corporate and other expenses from operationsconsists of depreciation and amortization on the corporate office facility andequipment and specific general and administrative charges pertaining tocorporate personnel. Such expenses are presented separately, as they cannot bereadily identified for allocation to a particular segment.

 

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The following table excludes the results ofdiscontinued operations for the revenue, pre-opening and start-up expenses andincome from operations categories for all periods presented. The onlysignificant non-cash item reported in the respective segment’s income fromoperations is depreciation and amortization (excluding intangibles) (inthousands).

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                |       |                             |       |                            |       |   |   |   |   |
| Revenues:                           |       |                             |       |                            |       |   |   |   |   |
| Adult secure services               |       | $                                | 51,470     |                            | $          | 43,088 |   | $ | 151,673 |   | $ | 137,373 |   |
| Abraxas youth and  family services  |       | 26,231                           |       | 27,084                          |       | 80,891 |   | 80,648 |   |
| Adult community-based  services     |       | 17,486                           |       | 17,155                          |       | 52,661 |   | 50,444 |   |
| Total revenues                      |       | $                                | 95,187     |                            | $          | 87,327 |   | $ | 285,225 |   | $ | 268,465 |   |
|                                |       |                             |       |                            |       |   |   |   |   |
| Income from operations:             |       |                             |       |                            |       |   |   |   |   |
| Adult secure services               |       | $                                | 13,896     |                            | $          | 8,651 |   | $ | 44,782 |   | $ | 32,279 |   |
| Abraxas youth and  family services  |       | 1,696                            |       | 2,684                           |       | 5,831 |   | 8,804 |   |
| Adult community-based  services     |       | 4,603                            |       | 4,281                           |       | 14,090 |   | 11,434 |   |
| Subtotal                            |       | 20,195                           |       | 15,616                          |       | 64,703 |   | 52,517 |   |
| General and  administrative expense |       | (5,450                           | )          | (4,316                          | )          | (19,217 | ) | (19,848 | ) |
| Amortization of  intangibles        |       | (484                             | )          | (556                            | )          | (1,458 | ) | (1,677 | ) |
| Corporate and other                 |       | (224                             | )          | (206                            | )          | (586 | ) | (573 | ) |
| Total income from  operations       |       | $                                | 14,037     |                            | $          | 10,538 |   | $ | 43,442 |   | $ | 30,419 |   |

 
| ** **                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Assets                             |       |                   |       |                  |       |
| Adult secure services              |       | $                      | 360,479    |                  | $          | 290,930 |   |
| Abraxas youth and  family services |       | 111,760                |       | 109,478               |       |
| Adult community-based  services    |       | 63,130                 |       | 63,008                |       |
| Intangible assets, net             |       | 16,370                 |       | 17,875                |       |
| Corporate and other                |       | 76,368                 |       | 81,496                |       |
| Total assets                       |       | $                      | 628,107    |                  | $          | 562,787 |   |

 

**14.****      ****Guarantor Disclosures**

 

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

 

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**Condensed Consolidating Balance Sheet as of September 30, 2008 (inthousands) (unaudited)**

 
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                                      |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                           |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                                |       | $          | 1,566      |             | $          | 180                 |       | $                | 38         |             | $          | — |   | $ | 1,784 |   |
| Accounts receivable                                       |       | 1,837      |       | 80,562           |       | 212                 |       | —           |       | 82,611           |       |
| Debt service fund and  other restricted assets            |       | —     |       | 3,154            |       | 21,335              |       | —           |       | 24,489           |       |
| Prepaids and other                                        |       | 12,948     |       | 1,530            |       | —              |       | —           |       | 14,478           |       |
| Total current assets                                      |       | 16,351     |       | 85,426           |       | 21,585              |       | —           |       | 123,362          |       |
| Property and equipment,  net                              |       | 343        |       | 302,009          |       | 143,030             |       | (4,335           | )          | 441,047          |       |
| Other assets:                                             |       |       |       |             |       |                |       |             |       |             |       |
| Debt service reserve  fund                                |       | —     |       | —           |       | 23,776              |       | —           |       | 23,776           |       |
| Deferred costs and  other                                 |       | 60,426     |       | 27,761           |       | 5,534               |       | (53,799          | )          | 39,922           |       |
| Investment in  subsidiaries                               |       | 63,868     |       | 1,856            |       | —              |       | (65,724          | )          | —           |       |
| Total assets                                              |       | $          | 140,988    |             | $          | 417,052             |       | $                | 193,925    |             | $          | (123,858 | ) | $ | 628,107 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’ Equity**             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                                      |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                                      |       |       |       |             |       |                |       |             |       |             |       |
| Accounts payable and  accrued liabilities                 |       | $          | 47,845     |             | $          | 22,186              |       | $                | 1,893      |             | $          | 38 |   | $ | 71,962 |   |
| Current portion of  long-term debt                        |       | —     |       | 12               |       | 12,400              |       | —           |       | 12,412           |       |
| Total current  liabilities                                |       | 47,845     |       | 22,198           |       | 14,293              |       | 38               |       | 84,374           |       |
| Long-term debt, net of  current portion                   |       | 184,310    |       | 17               |       | 121,700             |       | —           |       | 306,027          |       |
| Deferred tax  liabilities                                 |       | 14,022     |       | 94               |       | —              |       | 1,152            |       | 15,268           |       |
| Other long-term  liabilities                              |       | 6,170      |       | 203              |       | 54,720              |       | (57,921          | )          | 3,172            |       |
| Intercompany                                              |       | (330,538   | )          | 330,543          |       | —              |       | (5               | )          | —           |       |
| Total liabilities                                         |       | (78,191    | )          | 353,055          |       | 190,713             |       | (56,736          | )          | 408,841          |       |
| Minority interest in  consolidated special purpose entity |       | —     |       | —           |       | 87                  |       | —           |       | 87               |       |
| Stockholders’ equity                                 |       | 219,179    |       | 63,997           |       | 3,125               |       | (67,122          | )          | 219,179          |       |
| Total liabilities and  stockholders’ equity          |       | $          | 140,988    |             | $          | 417,052             |       | $                | 193,925    |             | $          | (123,858 | ) | $ | 628,107 |   |

 

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**Condensed ConsolidatingBalance Sheet as of December 31, 2007 (in thousands)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 2,565      |             | $          | 408                 |       | $                | 55         |             | $          | — |   | $ | 3,028 |   |
| Investment securities                            |       | 250        |       | —           |       | —              |       | —           |       | 250              |       |
| Accounts receivable                              |       | 1,814      |       | 70,495           |       | 679                 |       | —           |       | 72,988           |       |
| Debt service fund and  other restricted assets   |       | —     |       | 2,486            |       | 25,629              |       | (592             | )          | 27,523           |       |
| Prepaids and other                               |       | 11,362     |       | 1,519            |       | —              |       | —           |       | 12,881           |       |
| Total current assets                             |       | 15,991     |       | 74,908           |       | 26,363              |       | (592             | )          | 116,670          |       |
| Property and equipment,  net                     |       | 270        |       | 242,297          |       | 146,197             |       | (4,812           | )          | 383,952          |       |
| Other assets:                                    |       |       |       |             |       |                |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,638              |       | —           |       | 23,638           |       |
| Deferred costs and  other                        |       | 56,500     |       | 24,460           |       | 6,035               |       | (48,968          | )          | 38,027           |       |
| Investment in  subsidiaries                      |       | 41,445     |       | 1,856            |       | —              |       | (43,301          | )          | —           |       |
| Total assets                                     |       | $          | 114,206    |             | $          | 343,521             |       | $                | 202,233    |             | $          | (97,673 | ) | $ | 562,287 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’ Equity**    | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |                |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 37,751     |             | $          | 15,463              |       | $                | 5,186      |             | $          | (898 | ) | $ | 57,502 |   |
| Current portion of  long-term debt               |       | —     |       | 11               |       | 11,400              |       | —           |       | 11,411           |       |
| Total current  liabilities                       |       | 37,751     |       | 15,474           |       | 16,586              |       | (898             | )          | 68,913           |       |
| Long-term debt, net of  current portion          |       | 141,172    |       | 26               |       | 134,100             |       | —           |       | 275,298          |       |
| Deferred tax  liabilities                        |       | 12,387     |       | 94               |       | —              |       | 745              |       | 13,226           |       |
| Other long-term  liabilities                     |       | 6,705      |       | 162              |       | 49,702              |       | (52,168          | )          | 4,401            |       |
| Intercompany                                     |       | (284,258   | )          | 284,263          |       | —              |       | (5               | )          | —           |       |
| Total liabilities                                |       | (86,243    | )          | 300,019          |       | 200,388             |       | (52,326          | )          | 361,838          |       |
| Stockholders’ equity                        |       | 200,449    |       | 43,502           |       | 1,845               |       | (45,347          | )          | 200,449          |       |
| Total liabilities and  stockholders’ equity |       | $          | 114,206    |             | $          | 343,521             |       | $                | 202,233    |             | $          | (97,673 | ) | $ | 562,287 |   |

 

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**CondensedConsolidating Statement of Operations for the three months ended September 30,2008**

**(inthousands) (unaudited)**

 
| ** **                                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                        |       | $          | 4,502      |             | $          | 108,050             |       | $                | 4,502      |             | $          | (21,867 | ) | $ | 95,187 |   |
| Operating expenses                                              |       | 4,976      |       | 87,989           |       | 11                  |       | (21,742          | )          | 71,234           |       |
| Depreciation and amortization                                   |       | —     |       | 3,570            |       | 1,056               |       | (160             | )          | 4,466            |       |
| General and administrative  expenses                            |       | 5,429      |       | —           |       | 21                  |       | —           |       | 5,450            |       |
| Income (loss) from operations                                   |       | (5,903     | )          | 16,491           |       | 3,414               |       | 35               |       | 14,037           |       |
| Overhead allocations                                            |       | (8,760     | )          | 8,760            |       | —              |       | —           |       | —           |       |
| Interest, net                                                   |       | 1,811      |       | 1,274            |       | 2,732               |       | (63              | )          | 5,754            |       |
| Equity earnings in subsidiaries                                 |       | 6,849      |       | —           |       | —              |       | (6,849           | )          | —           |       |
| Income before provision for  income taxes and minority interest |       | 7,895      |       | 6,457            |       | 682                 |       | (6,751           | )          | 8,283            |       |
| Provision for income taxes                                      |       | 3,067      |       | —           |       | —              |       | 301              |       | 3,368            |       |
| Minority interest in consolidated  special purpose entity       |       | —     |       | —           |       | 87                  |       | —           |       | 87               |       |
| Net income                                                      |       | $          | 4,828      |             | $          | 6,457               |       | $                | 595        |             | $          | (7,052 | ) | $ | 4,828 |   |

 

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**CondensedConsolidating Statement of Operations for the three months ended September 30,2007**

**(inthousands) (unaudited)**

 
| ** **                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                  |       | $          | 4,502      |             | $          | 98,980              |       | $                | 4,502      |             | $          | (20,657 | ) | $ | 87,327 |   |
| Operating expenses                        |       | 5,695      |       | 83,324           |       | 38                  |       | (20,572          | )          | 68,485           |       |
| Depreciation and amortization             |       | —     |       | 3,089            |       | 1,056               |       | (157             | )          | 3,988            |       |
| General and administrative  expenses      |       | 4,297      |       | —           |       | 19                  |       | —           |       | 4,316            |       |
| Income (loss) from operations             |       | (5,490     | )          | 12,567           |       | 3,389               |       | 72               |       | 10,538           |       |
| Overhead allocations                      |       | (10,556    | )          | 10,556           |       | —              |       | —           |       | —           |       |
| Interest, net                             |       | 1,620      |       | 1,274            |       | 3,208               |       | (71              | )          | 6,031            |       |
| Equity earnings in subsidiaries           |       | 928        |       | —           |       | —              |       | (928             | )          | —           |       |
| Income before provision for  income taxes |       | 4,374      |       | 737              |       | 181                 |       | (785             | )          | 4,507            |       |
| Provision for income taxes                |       | 1,957      |       | —           |       | —              |       | 133              |       | 2,090            |       |
| Net income                                |       | $          | 2,417      |             | $          | 737                 |       | $                | 181        |             | $          | (918 | ) | $ | 2,417 |   |

 

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**CondensedConsolidating Statement of Operations for the nine months ended September 30,2008**

**(inthousands) (unaudited)**

 
| ** **                                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non- Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**          | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **              | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                        |       | $          | 13,506     |             | $          | 324,295                 |       | $                | 13,506     |             | $          | (66,082 | ) | $ | 285,225 |   |
| Operating expenses                                              |       | 12,165     |       | 263,302          |       | 41                      |       | (65,785          | )          | 209,723          |       |
| Depreciation and amortization                                   |       | —     |       | 10,154           |       | 3,167                   |       | (478             | )          | 12,843           |       |
| General and administrative  expenses                            |       | 19,161     |       | —           |       | 56                      |       | —           |       | 19,217           |       |
| Income (loss) from operations                                   |       | (17,820    | )          | 50,839           |       | 10,242                  |       | 181              |       | 43,442           |       |
| Overhead allocations                                            |       | (26,419    | )          | 26,419           |       | —                  |       | —           |       | —           |       |
| Interest, net                                                   |       | 5,698      |       | 3,820            |       | 8,284                   |       | (187             | )          | 17,615           |       |
| Equity earnings in subsidiaries                                 |       | 21,904     |       | —           |       | —                  |       | (21,904          | )          | —           |       |
| Income before provision for  income taxes and minority interest |       | 24,805     |       | 20,600           |       | 1,958                   |       | (21,536          | )          | 25,827           |       |
| Provision for income taxes                                      |       | 9,996      |       | —           |       | —                  |       | 935              |       | 10,931           |       |
| Minority interest in  consolidated special purpose entity       |       | —     |       | —           |       | 87                      |       | —           |       | 87               |       |
| Net income                                                      |       | $          | 14,809     |             | $          | 20,600                  |       | $                | 1,871      |             | $          | (22,471 | ) | $ | 14,809 |   |

 

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**CondensedConsolidating Statement of Operations for the nine months ended September 30,2007**

**(inthousands) (unaudited)**

 
| ** **                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                  |       | $          | 13,506     |             | $          | 303,582             |       | $                | 13,506     |             | $          | (62,129 | ) | $ | 268,465 |   |
| Operating expenses                        |       | 14,870     |       | 253,382          |       | 80                  |       | (61,874          | )          | 206,458          |       |
| Depreciation and amortization             |       | —     |       | 9,043            |       | 3,167               |       | (470             | )          | 11,740           |       |
| General and administrative  expenses      |       | 19,792     |       | —           |       | 56                  |       | —           |       | 19,848           |       |
| Income (loss) from operations             |       | (21,156    | )          | 41,157           |       | 10,203              |       | 215              |       | 30,419           |       |
| Overhead allocations                      |       | (34,493    | )          | 34,493           |       | —              |       | —           |       | —           |       |
| Interest, net                             |       | 5,182      |       | 3,820            |       | 9,203               |       | 380              |       | 18,585           |       |
| Equity earnings in subsidiaries           |       | 3,337      |       | —           |       | —              |       | (3,337           | )          | —           |       |
| Income before provision for  income taxes |       | 11,492     |       | 2,844            |       | 1,000               |       | (3,502           | )          | 11,834           |       |
| Provision for income taxes                |       | 4,966      |       | —           |       | —              |       | 342              |       | 5,308            |       |
| Net income                                |       | $          | 6,526      |             | $          | 2,844               |       | $                | 1,000      |             | $          | (3,844 | ) | $ | 6,526 |   |

 

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**CondensedConsolidating Statement of Cash Flows for the nine months ended September 30,2008**

**(inthousands) (unaudited)**

 
| ** **                                             | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Consolidated** | ** ** |
| **Cash flows from  operating activities:**             |       |       |       |             |       |                |       |             |       |
| Net cash provided by (used in)  operating activities   |       | $          | (44,986    | )                | $          | 58,271              |       | $                | 7,681      |   | $ | 20,966 |   |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash flows from  investing activities:**             |       |       |       |             |       |                |       |             |       |
| Capital expenditures                                   |       | —     |       | (59,282          | )          | —              |       | (59,282          | )          |
| Sales of investment securities                         |       | 250        |       | —           |       | —              |       | 250              |       |
| Withdrawals from restricted debt  payment account, net |       | —     |       | —           |       | 3,702               |       | 3,702            |       |
| Proceeds from the sale of  property and equipment      |       | —     |       | 791              |       | —              |       | 791              |       |
| Net cash provided by (used in)  investing activities   |       | 250        |       | (58,491          | )          | 3,702               |       | (54,539          | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash flows from  financing activities:**             |       |       |       |             |       |                |       |             |       |
| Borrowing on line of credit                            |       | 43,000     |       | —           |       | —              |       | 43,000           |       |
| Payment of MCF bonds                                   |       | —     |       | —           |       | (11,400             | )          | (11,400          | )          |
| Payments of capital lease  obligations                 |       | —     |       | (8               | )          | —              |       | (8               | )          |
| Tax benefit of stock option  exercises                 |       | 140        |       | —           |       | —              |       | 140              |       |
| Proceeds from exercise of stock  options               |       | 597        |       | —           |       | —              |       | 597              |       |
| Net cash provided by (used in)  financing activities   |       | 43,737     |       | (8               | )          | (11,400             | )          | 32,329           |       |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Net decrease in  cash and cash equivalents**         |       | (999       | )          | (228             | )          | (17                 | )          | (1,244           | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at beginning of period**  |       | 2,565      |       | 408              |       | 55                  |       | 3,028            |       |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at end of period**        |       | $          | 1,566      |             | $          | 180                 |       | $                | 38         |   | $ | 1,784 |   |

 

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**CondensedConsolidating Statement of Cash Flows for the nine months ended September 30,2007**

**(inthousands) (unaudited)**

 
| ** **                                             | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Consolidated** | ** ** |
| **Cash flows from  operating activities:**             |       |       |       |             |       |                |       |             |       |
| Net cash provided by (used in)  operating activities   |       | $          | (41,918    | )                | $          | 53,652              |       | $                | 5,884      |   | $ | 17,618 |   |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash flows from  investing activities:**             |       |       |       |             |       |                |       |             |       |
| Capital expenditures                                   |       | —     |       | (30,555          | )          | —              |       | (30,555          | )          |
| Purchases of investment  securities                    |       | (241,425   | )          | —           |       | —              |       | (241,425         | )          |
| Sales of investment securities                         |       | 252,600    |       | —           |       | —              |       | 252,600          |       |
| Facility acquisitions                                  |       | —     |       | (18,554          | )          | —              |       | (18,554          | )          |
| Site acquisition                                       |       | —     |       | (5,053           | )          | —              |       | (5,053           | )          |
| Withdrawals from restricted debt  payment account, net |       | —     |       | —           |       | 4,586               |       | 4,586            |       |
| Proceeds from the sale of  property and equipment      |       | —     |       | 371              |       | —              |       | 371              |       |
| Net cash provided by (used in)  investing activities   |       | 11,175     |       | (53,791          | )          | 4,586               |       | (38,030          | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash flows from  financing activities:**             |       |       |       |             |       |                |       |             |       |
| Payment of MCF bonds                                   |       | —     |       | —           |       | (10,500             | )          | (10,500          | )          |
| Borrowing on line of credit                            |       | 10,000     |       | —           |       | —              |       | 10,000           |       |
| Payments of capital lease  obligations                 |       | —     |       | (8               | )          | —              |       | (8               | )          |
| Tax benefit of stock option  exercises                 |       | 508        |       | —           |       | —              |       | 508              |       |
| Proceeds from exercise of stock  options               |       | 2,786      |       | —           |       | —              |       | 2,786            |       |
| Net cash provided by (used in)  financing activities   |       | 13,294     |       | (8               | )          | (10,500             | )          | 2,786            |       |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Net decrease in  cash and cash equivalents**         |       | (17,449    | )          | (147             | )          | (30                 | )          | (17,626          | )          |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at beginning of period**  |       | 18,083     |       | 371              |       | 75                  |       | 18,529           |       |
| ** **                                             | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at end of period**        |       | $          | 634        |             | $          | 224                 |       | $                | 45         |   | $ | 903 |   |

 

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

 

**General**

** **

Cornell Companies, Inc. (together with itssubsidiaries and predecessors, unless the context requires otherwise, “Cornell,”the “Company,” “we,” “us” or “our”) is a leading provider of correctional,detention, educational, rehabilitation and treatment services outsourced byfederal, state, county and local government agencies. We provide a diversifiedportfolio of services for adults and juveniles through our three operatingdivisions: (1) Adult Secure Services; (2) Abraxas Youth and FamilyServices and (3) Adult Community-Based Services. At September 30,2008, we operated 70 facilities with a total service capacity of 20,121. Wealso had one vacant facility with a service capacity of 70. Our facilities arelocated in 15 states and the District of Columbia.

 

The followingtable (which excludes data related to discontinued operating facilities) setsforth for the periods indicated total residential service capacity andcontracted beds in operation at the end of the periods shown, average contractoccupancy percentages and total non-residential service capacity.

 
| ** **                                                                          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                          | ** ** | **2008**               | ** ** | **2007**               | ** ** |
| **Residential**                                                                     | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (1)                                                                |       | 17,788                 |       | 14,581                 |       |
| Contracted beds in operation  (end of period) (2)                                   |       | 17,017                 |       | 13,472                 |       |
| Average contract occupancy based  on contracted beds in operation (3) (4) |       | 92.7                   | %          | 102.1                  | %          |
| **Non-Residential**                                                                 | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (5)                                                                |       | 2,403                  |       | 3,021                  |       |

 

----

(1)          Residentialservice capacity is comprised of the number of beds currently available forservice in our residential facilities.

(2)          At certainresidential facilities, the contracted capacity is lower than the facility’sservice capacity. We could increase a facility’s contracted capacity byobtaining additional contracts or by renegotiating existing contracts toincrease the number of beds covered. However, we may not be able to obtaincontracts that provide occupancy levels at a facility’s service capacity or beable to maintain current contract capacities in future periods.

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

(4)          Averagecontract occupancy percentages are calculated based on actual occupancy for theperiod as a percentage of the contracted capacity for residential facilities inoperation. These percentages do not 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.

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

 

Ouroperating results for the nine months ended September 30, 2008 wereimpacted by a few significant events.  Wecompleted a 300 bed expansion at the D. Ray James Prison and activated thesebeds in February 2008.  We alsocompleted and activated the 1,100 bed expansion at the Great PlainsCorrectional Facility and the 500 bed expansion of the Walnut Grove YouthCorrectional Facility in September 2008 and continued the 700 bedexpansion at the D. Ray James Prison.  Inaddition, we recorded a contract-based revenue adjustment (in March 2008)of approximately $1.5 million at the Regional Correctional Center for thecontract year ended March 2008 (no such adjustment was required for thecontract year ended March 2007).

 

We believe we will continue to see steady demandacross our various business segments and our customer base (federal, state andlocal). We continue to monitor government budget plans and the effect tightenedspending plans could have on our business, particularly in light of recentdevelopments in the financial markets and the overall economy. While we believegovernmental budget pressures will provide opportunities for our business,tightening budgets can also place pressure on our pricing and other aspects ofour business. A key driver for our performance is expected to be our ability tomanage our various facility expansions in process and bring them on streamunder contracts. We also plan to remain focused on increasing utilization andimproving customer mix as we believe those initiatives are key elements of ourfinancial performance.

 

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We derive substantially all of our revenues fromproviding adult corrections and treatment and juvenile justice, educational andtreatment services outsourced by federal, state and local government agenciesin the United States. Revenues for our services are generally recognized on aper diem rate based upon the number of occupant days or hours served for theperiod, on a guaranteed take-or-pay basis or on a cost-plus reimbursementbasis. For the three months ended September 30, 2008 our revenue baseconsisted of 54.3% for services provided under per diem contracts, 40.2% forservices provided under take-or-pay and management contracts, 3.4% for servicesprovided under cost-plus reimbursement contracts, 1.9% for services providedunder fee-for-service contracts and 0.2% from other miscellaneous sources.For the threemonths ended September 30, 2007, our revenue base consisted of 72.7% forservices provided under per diem contracts, 20.4% for services provided undertake-or-pay and management contracts, 4.5% for services provided undercost-plus reimbursement contracts, 2.0% for services provided underfee-for-service contracts and 0.4% from other miscellaneous sources. Theincrease in the percentage of revenues provided under take-or-pay andmanagement contracts in the three months ended September 30, 2008 was dueprimarily to the take-or-pay contract awarded by the Federal Bureau of Prisons(“BOP”) to our Big Spring Correctional Center in 2007 and the 916 inmatetake-or-pay contract awarded by the Arizona Department of Corrections at ourGreat Plains Correctional Facility under which we began operations in September 2007.  The increase in the percentage of revenuesprovided under take-or-pay contracts was partially offset by 1) the transitionof our management contract for the Donald W. Wyatt Detention Center to thefacility owner in July 2007 and 2) the termination of our managementcontract for the Harrisburg Alternative Education School Program for the2007-2008 school year.  The decrease inthe percentage of revenues provided under per diem contracts in the threemonths ended September 30, 2008 as compared to the same period of theprior year was due primarily to the transition of the contracts at the GreatPlains Correctional Facility and the Big Spring Correctional Center aspreviously noted.

 

For the nine months ended September 30, 2008our revenue base consisted of 52.4% for services provided under per diemcontracts, 41.6% for services provided under take-or-pay and managementcontracts, 3.8% for services provided under cost-plus reimbursement contracts,2.0% for services provided under fee-for-service contracts and 0.2% from othermiscellaneous sources. For the nine months ended September 30, 2007, ourrevenue base consisted of 69.0% for services provided under per diem contracts,23.7% for services provided under take-or-pay and management contracts, 4.7%for services provided under cost-plus reimbursement contracts, 2.1% forservices provided under fee-for-service contracts and 0.5% from othermiscellaneous sources. The increase in the percentage of revenues providedunder take-or-pay and management contracts in the nine months ended September 30,2008 was due primarily to the take-or-pay contract awarded by the BOP to ourBig Spring Correctional Center in 2007 and the 916 inmate take-or-pay contractawarded by the Arizona Department of Corrections at our Great PlainsCorrectional Facility under which we began operations in September 2007.  The increase in the percentage of revenuesprovided under take-or-pay contracts was partially offset by 1) the transitionof our management contract for the Donald W. Wyatt Detention Center to thefacility owner in July 2007 and 2) the termination of our managementcontract for the Harrisburg Alternative Education School Program for the2007-2008 school year (due to lack of funding by the contracting agency).  The decrease in the percentage of revenuesprovided under per diem contracts in the nine months ended September 30,2008 as compared to the same period of the prior year was due primarily to thetransition of the contracts at the Great Plains Correctional Facility and theBig Spring Correctional Center as previously noted.  This decrease was partially offset by theaddition of the High Plains Correctional Facility acquired in May 2007.

 

Revenues can fluctuate fromperiod to period due to changes in government funding policies, changes in thenumber of people referred to our facilities by governmental agencies, theopening of new facilities or the expansion of existing facilities and thetermination of contracts for a facility or the closure of a facility.

 

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.

 

Revenues for our Adult Secure Services division areprimarily generated from per diem and take-or-pay contracts. For the threemonths ended September 30, 2008 and 2007, we realized average per diemrates on our Adult Secure Services facilities of approximately $53.12 and$53.54, respectively. For the nine months ended September 30, 2008 and2007, we realized average per diem rates of approximately $54.00 and $54.65,respectively.

 

Revenues forour Abraxas Youth and Family Services division are primarily generated from perdiem, fee-for-service and cost-plus reimbursement contracts. For the threemonths ended September 30, 2008 and 2007, we realized average per diemrates on our residential Abraxas Youth and Family Services facilities ofapproximately $193.89 and $176.26, respectively. For the nine months ended September 30,2008 and 2007, we realized average per diem rates of approximately $191.03 and$171.11, respectively. The increase in average per diem rates is due to theincreased occupancy at the Cornell Abraxas Academy as well as changes in themix of services provided at other facilities. For the three months ended September 30,2008 and 2007, we realized average fee-for-service rates for ournon-residential community-based Abraxas 

 

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Youth andFamily Services facilities and programs, including rates that are limited byMedicaid and other private insurance providers, of approximately $45.32 and$44.81, respectively. For the nine months ended September 30, 2008 and2007, we realized average fee-for-service rates of approximately $47.85 and$44.81, respectively. The majority of our Abraxas Youth and Family Servicescontracts renew annually. Our average fee-for-service rates fluctuate fromperiod-to-period due to changes in the mix of services provided.

 

Revenues for our Adult Community-Based Servicesdivision are primarily generated from per diem and fee-for-service contracts.For the three months ended September 30, 2008 and 2007, we realized averageper diem rates on our residential Adult Community-Based Services facilities ofapproximately $68.46 and $62.61, respectively. For the nine months ended September 30,2008 and 2007, we realized average per diem rates of $66.44 and $62.47,respectively. For the three months ended September 30, 2008 and 2007, werealized average fee-for-service rates on our non-residential AdultCommunity-Based Services programs of approximately $11.90 and $11.34,respectively. For the nine months ended September 30, 2008 and 2007, werealized average fee-for-service rates of approximately $13.71 and $12.71,respectively. Our average fee-for-service rates can fluctuate from year-to-yeardue to changes in the mix of services provided by our various AdultCommunity-Based Services facilities and programs.

 

Wehave historically experienced higher operating margins in our Adult SecureServices and our Adult Community-Based Services divisions as compared to ourAbraxas Youth and Family Services division due to higher utilization andabsorption of fixed costs.  Our operatingmargin in a given period will be impacted by those facilities which may eitherbe dormant or have been reactivated during the period. We have reactivatedseveral facilities in recent periods including the Hector Garza ResidentialTreatment Center and the Great Plains Correctional Facility in 2007. We havealso activated facility expansions at D. Ray James Prison, Great PlainsCorrectional Facility and the Walnut Grove Youth Correctional Facility in 2008.Additionally, changes in contract terms resulting from contract renewals,revisions, or new contract awards can impact our operating margins.  Our operating margins within a division canvary from facility to facility based on various factors such as whether a facilityis owned or leased, the level of competition for the contract award, theproposed length of the contract, the mix of services provided, the occupancylevels for a facility, the level of capital commitment required with respect toa facility, the anticipated changes in operating costs over the term of thecontract and our ability to increase a facility’s contract revenue.  Under take-or-pay contracts for new or vacantfacilities, such as the contract at the Moshannon Valley Correctional Center,operating margins are typically higher during the early stages of the contractas the facility’s population increases (as revenues are received at contractpercentages regardless of occupancy level). As variable costs (primarily resident related and certain facilitycosts) increase with the increase in population, operating margins willgenerally decline to a stabilized level. A decline in occupancy at certain of our facilities can have asignificant impact on our operating margins due to reduced absorption of fixedcosts at these facilities.

 

Wehave experienced and expect to continue to experience interim period operatingmargin fluctuations due to various factors such as the number of calendar daysin the period, higher payroll taxes (generally in the first half of the year)and salary and wage increases and insurance cost increases that are incurredprior to certain contract rate increases. Periodically, many of thegovernmental agencies with whom we contract may experience budgetary pressuresand may approach us to limit or reduce per diem rates. Decreases in, orthe lack of anticipated increases in, per diem rates could adversely impact ouroperating margin. Additionally, a decrease in per diem rates without acorresponding decrease in operating expenses could also adversely affect ouroperating margin.

 

Weare responsible for all facility operating costs, except for certain debtservice and interest or lease payments for facilities where we have amanagement contract only. At these facilities, the facility owner isresponsible for all debt service and interest or lease payments related to thefacility. We are responsible for all other operating expenses at thesefacilities. We operated 16 facilities under management contracts at September 30,2008 and 2007.

 

Amajority of our facility operating costs consists of fixed costs. These fixedcosts include lease and rental expense, insurance, utilities and depreciation.As a result, when we commence operation of new or expanded facilities, fixedoperating costs increase. The amount of our variable operating costs, includingfood, medical services, supplies and clothing, depend on occupancy levels atthe facilities we operate. Our largest single operating cost, facility payrollexpense and related employment taxes and expenses, has both a fixed and avariable component. We can adjust a facility’s staffing levels and the relatedpayroll expense to a certain extent based on occupancy at a facility; however aminimum fixed number of employees is required to operate and maintain anyfacility regardless of occupancy levels. Personnel costs are subject toincreases in tightening labor markets based on local economic environments andother conditions.

 

Weincur pre-opening and start-up expenses including payroll, benefits, trainingand other operating costs prior to opening a new or expanded facility andduring the period of operation while occupancy is ramping up. These costs varyby contract. Since pre-opening and start-up costs are generally factored intothe revenue per diem rate that is charged to the 

 

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contractingagency, we typically expect to recover these upfront costs over the life of thecontract. Because occupancy rates during an adult secure facility’s start-upphase typically result in capacity under-utilization for at least 90 to 180days (and typically longer for a youth facility), we may incur additionalpost-opening start-up costs. We do not anticipate post-opening start-up costsat any Adult Secure Services facilities operated under any future contractswith the BOP because these contracts are currently expected to continue to betake-or-pay contracts, meaning that the BOP will pay at least 80.0% of thecontractual monthly revenue once the facility opens, regardless of actualoccupancy.

 

Newly opened facilities are staffed accordingto applicable regulatory or contractual requirements when we begin receivingoffenders or clients. Offenders or clients are typically assigned to a newlyopened facility on a phased-in basis over a one to six-month period. Ourstart-up period for new juvenile operations is twelve months from the date webegin recognizing revenue unless break-even occupancy levels are achievedbefore then. Our start-up period for new adult operations is nine months fromthe date we begin recognizing revenue unless break-even occupancy levels areachieved before then. Although we typically recover these upfront costs overthe life of the contract, quarterly results can be substantially affected bythe timing of the commencement of operations as well as the development andconstruction of new facilities.

 

Working capital requirements generally increaseimmediately prior to commencing operations of a new or expanded facility as weincur start-up costs and purchase necessary equipment and supplies beforefacility management revenue is realized.

 

General and administrative expenses consistprimarily of costs for corporate and administrative personnel who providesenior management, legal, finance, accounting, human resources, investorrelations, payroll and information systems, costs of business development andoutside professional and consulting fees.

 

#### **Recent Developments**

#### ** **

***D. Ray James Prison***

 

In February 2008, wecompleted the initial expansion of the D. Ray James Prison in Georgia toincrease its service capacity by approximately 300 beds to a total servicecapacity of 2,170 beds.

 

In August 2007, weannounced that we were initiating a second expansion of the D. Ray JamesPrison. This expansion project will increase the facility’s service capacity byan additional 700 beds for a total service capacity of approximately 2,800beds. This expansion project began in the first quarter of 2008 and is expectedto be completed in the first quarter of 2009. We are marketing this additionalexpansion and believe those beds are well suited for a Georgia Department ofCorrections (“DOC”) bid which requires use of an existing facility, although wecan make no assurance that we will successfully bid for this contract. Wecurrently estimate that the capital expenditures related to this expansionproject will be approximately $34.7 million. As of September 30, 2008, we had incurred and capitalized totalcosts of approximately $23.4 million related to this expansion. We believe thatour existing cash flow and available balance under our Amended Credit Facilitywill provide adequate funding to complete this facility expansion.

 

***GreatPlains Correctional Facility***

 

In May 2007, we wereawarded a contract by the Arizona Department of Corrections for our GreatPlains Correctional Facility in Hinton, Oklahoma. The contract calls for atotal of 2,000 medium-security inmates to be housed at the facility. Weinitially housed approximately 916 inmates and the remainder will be housedthrough a recently completed expansion of the existing facility. We expect tocomplete the ramp-up to 2,000 inmates during the fourth quarter of 2008. As of September 30,2008, we had incurred and capitalized total costs of approximately $45.8million related to this expansion. We believe that our existing cash flow andavailable balance under our Amended Credit Facility will provide adequatefunding to complete this facility expansion.

 

***Hudson, Colorado***

 

We entered into anagreement pursuant to which we will lease a new 1,250 male bed adult securefacility in Hudson, Colorado. The facility is owned by a third party and isbeing built on land we sold to the third party. We retained approximately 270acres out of the original 320 acres we acquired in 2007. We anticipate theconstruction, which began in the third quarter of 2008, to be completed in thefall of 2009. We have signed an implementation agreement with theColorado Department of Corrections (“Colorado DOC”), which governs theconstruction of the facility and contemplates a service agreement which can beentered into upon completion of the implementation agreement.  We expect to begin receiving inmates in thefourth quarter of 2009.  We expect toenter into a service agreement for the facility with the Colorado DOC but canmake no assurances that we will do so.

 

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***Hurricane Ike***

 

HurricaneIke, which came ashore in Texas in September 2008, damaged our BeaumontTransitional Treatment Center, Leidel Comprehensive Sanction Center and ReidCommunity Residential Facility. These damages are covered by our insurance,subject to normal deductibles, for which we have recorded a charge ofapproximately $0.5 million in the three months ended September 30, 2008.We expect the Leidel facility to continue near normal operations. The Reidfacility reopened in mid-October 2008 at approximately 40 percent of itsprevious capacity of approximately 500. We believe the remainder of theoperating capacity will be operational in the first quarter 2009. Reidgenerated revenues of approximately $4.1 million and $4.0 million in the ninemonths ended September 30, 2008 and 2007, respectively. The Beaumontfacility reopened in mid-October 2008 at near normal capacity.

 

***Regional Correctional Center***

 

In August 2007, theBureau of Immigration and Customs Enforcement (“ICE”) removed all ICE detaineesfrom the Regional Correctional Center in Albuquerque, New Mexico. ICE theninformed us in February 2008 that it would not resume use of thefacility.  Also, in February 2008,the client, the Office of Federal Detention Trustee (“OFDT”), attempted tounilaterally amend its agreement to reduce the number of minimum annualguaranteed mandays under the agreement. We do not believe OFDT has the right tomake such a change.  Refer to “-Resultsof Operations — Liquidity and Capital Resources - Contractual Uncertainties Related to Certain Facilities - RegionalCorrectional Center” for more information concerning this and otherdevelopments concerning the Regional Correctional Center. We recorded acontract-based revenue adjustment (in March 2008) of approximately $1.5 millionfor the contract year ended March 2008, for which the related receivable iscarried in accounts receivable — trade at September 30, 2008.

 

***Walnut GroveYouth Correctional Facility***

 

In August 2007, we were notified by the Stateof Mississippi that funding had been approved for a 500 bed expansion of the941 bed Walnut Grove Youth Correctional Facility that we have been managingsince 2004. Expansion of the facility, which is being entirely funded by theState of Mississippi, began in the third quarter 2007 and was completed andbecame operational in the third quarter 2008.

 

**NewAccounting Pronouncements**

 

***Statementof Financial Accounting Standards No. 141 (Revised)***

 

In December 2007,the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFASNo. 141R”).  SFAS No. 141Rsignificantly changes the accounting for business combinations.  Under SFAS No. 141R, an acquiring entitywill be required to recognize all the assets acquired and liabilities assumedin a transaction at the acquisition-date fair value with limitedexceptions.  SFAS No. 141R changesthe accounting treatment for certain specific items, including acquisitioncosts, noncontrolling interests, acquired contingent liabilities, in-processresearch and development costs, restructuring costs and changes in deferred taxasset valuation allowances and income tax uncertainties subsequent to theacquisition date.  SFAS No. 141Rapplies prospectively to business combinations for which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after December 15, 2008.  Earlieradoption is not permitted.

 

***FASB Staff Position No. FAS 142-3***

** **

This FASB Staff Position (“FSP”) amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset under SFAS No. 142,“Goodwill and Other Intangible Assets”. The intent of this FSP is to improve the consistency between the usefullife of a recognized intangible asset under SFAS No. 142 and the period ofexpected cash flows used to measure the fair value of the asset under SFAS No. 141(Revised 2007), “Business Combinations” and other U.S. generally acceptedaccounting principles.  This FSP iseffective for financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those fiscal years.  Early adoption is not permitted.  We do not expect this FSP to have asignificant impact on our consolidated financial position, results ofoperations or cash flows.

 

***Statementof Financial Accounting Standards No. 157***

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”).  SFAS No. 157 defines fair value,establishes a framework for measuring fair value within generally acceptedaccounting principles and expands disclosures about fair value measurements forfinancial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in thefinancial statements. SFAS No. 157 became effective for 

 

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financial statementsissued for fiscal years beginning after November 15, 2007, and interimperiods within those fiscal years.  Thisstatement applies prospectively to financial assets and liabilities.   In February 2008, theFASB issued FSP 157-2, which delayed the effective date of SFAS No. 157 byone year for nonfinancial assets and liabilities.  Our adoption of SFAS No. 157 on January 1,2008 with respect to financial assets and liabilities did not have any financialimpact on our consolidated results of operations or financial condition.  We are currently evaluating the impact ofimplementation with respect to nonfinancial assets and liabilities on ourconsolidated financial statements.

 

Weadopted SFAS No. 157 on January 1, 2008 for our financial assets andliabilities measured on a recurring basis. As defined in SFAS No. 157, fair value is the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date (“exit price”).  SFAS No. 157 requires disclosure thatestablishes a framework for measuring fair value and expands disclosures aboutfair value measurements.  SFAS No. 157requires that fair value measurements be classified and disclosed in one of thefollowing categories:

 
| Level  1 |   | Unadjusted  quoted prices in active markets that are accessible at the measurement date  for identical, unrestricted assets or liabilities;                                       |
|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                              |
| Level  2 |   | Quoted  prices in markets that are not active, or inputs that are observable, either  directly or indirectly, for substantially the full term of the asset or  liability; and     |
|     |   |                                                                                                                                                                              |
| Level  3 |   | Prices  or valuation techniques that require inputs that are both significant to the  fair value measurement and unobservable (i.e., supported by little or no  market activity). |

 

Asrequired by SFAS No. 157, financial assets and liabilities are classifiedbased on the lowest level of input that is significant for the fair valuemeasurement.  The following table summarizesthe valuation of our financial assets and liabilities by pricing levels, asdefined by the provisions of SFAS No. 157, as of September 30, 2008:

 
| ** **                                  | ** ** | **Fair Value as of September 30, 2008 (in thousands)** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Level 1**                                                                               | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Assets:                                     |       |                                                                                           |       |   |   |   |   |   |   |
| Cash and Cash Equivalents                   |       | $                                                                                              | 1,784      |   | $ | — |   | $ | — |   | $ | 1,784 |   |
| Corporate Bonds                             |       | —                                                                                         |       | 4,337 |   | — |   | 4,337 |   |
| Money Market Funds                          |       | —                                                                                         |       | 40,773 |   | — |   | 40,773 |   |
| Liabilities:                                |       |                                                                                           |       |   |   |   |   |   |   |
| Derivative Instruments (Debt Service Funds) |       | $                                                                                              | —     |   | $ | — |   | $ | 1,160 |   | $ | 1,160 |   |

 

Thecorporate bonds and money market funds are carried in debt service fund andother restricted assets and the debt service reserve fund in the accompanyingbalance sheet. The derivative instrument is carried in other long termliabilities in the accompany balance sheet.

 

SFAS No. 157 requires a reconciliation of thebeginning and ending balances for fair value measurements using Level 3inputs.  The table below sets forth areconciliation for assets and liabilities measured at fair value on a recurringbasis using significant unobservable inputs (Level 3) during the six monthsended September 30, 2008 (in thousands):

 
| Derivative instruments as of December 31, 2007  |   | $    | 2,151  |   |
|------------------------------------------------------|--------|------|--------|--------|
| Unrealized gain, net                                 |   | (735 | )      |
| Tax provision                                        |   | (511 | )      |
| Derivative instruments as of March 31, 2008     |   | 905  |   |
| Unrealized loss, net                                 |   | 618  |   |
| Tax benefit                                          |   | 428  |   |
| Derivative instruments as of June 30, 2008      |   | $    | 1,951  |   |
| Unrealized gain, net                                 |   | (467 | )      |
| Tax provision                                        |   | (324 | )      |
| Derivative instruments as of September 30, 2008 |   | $    | 1,160  |   |

 

***FASB Staff Position SFAS No. 157-3***

 

InOctober 2008, the FASB issued FSP SFAS No. 157-3, “Determining the Fair Valueof a Financial Asset When the Market for That Asset Is Not Active” (“FSP SFAS157-3”).  This FSP clarifies theapplication of SFAS No. 157 in a market that is not active and provides anexample to illustrate key considerations in determining the fair value of afinancial asset when the market for that financial asset is not active.  This FSP was effective upon issuance,including prior periods for which financial statements have not beenissued.   We applied this FSP tofinancial assets measured at fair value on a recurring basis at September 30,2008.  See Note 7 – New AccountingPronouncements – “Statement of Financial Accounting Standards No. 157”.  The adoption of FSP SFAS 157-3 did not have asignificant impact on our consolidated financial position, results ofoperations or cash flows.”

 

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***Statement of Financial Accounting Standards No. 159***

 

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities —Including an amendment of FASB Statement No. 115” (“SFAS No. 159”).SFAS No. 159 permits entities to choose to measure many financialinstruments and certain other items at fair value that are not currentlyrequired to be measured at fair value and establishes presentation anddisclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 became effective for financial statements issuedfor fiscal years beginning after November 15, 2007, provided the entityelects to apply the provisions of SFAS No. 157. Our adoption of SFAS No. 159on January 1, 2008 did not have any impact on our consolidated results ofoperations or financial condition as we have elected not to apply theprovisions of SFAS No. 159 to our financial instruments or other eligibleitems that are not required to be measured at fair value.

 

***Statement of Financial Accounting Standards No. 160***

 

In December 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements — An Amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 establishes new accountingand reporting standards for the noncontrolling interest in a subsidiary and forthe deconsolidation of a subsidiary. SFAS No. 160 requires the recognition of a noncontrolling interest(minority interest) as equity in the consolidated financial statements andseparate from the parent’s equity.  Theamount of net income attributable to the noncontrolling interest will beincluded in consolidated net income on the face of the income statement.  This statement clarifies that changes in aparent’s ownership interest in a subsidiary that do not result indeconsolidation are equity transactions if the parent retains its controllingfinancial interest.  In addition, thisstatement requires that a parent recognize a gain or loss in net income when asubsidiary is deconsolidated.  Such gainor loss will be measured using the fair value of the noncontrolling equityinvestment on the deconsolidation date.  SFASNo. 160 also includes expanded disclosure requirements regarding theinterests of the parent and its noncontrolling interest.  SFAS No. 160 is effective for fiscalyears, and interim periods within those fiscal years, beginning on or after December 15,2008.  Earlier adoption is prohibited.

 

***Statement of Financial Accounting Standards No. 161***

 

InMarch 2008, the FASB issued SFAS No. 161, “Disclosures aboutDerivative Instruments and Hedging Activities — an Amendment of FASB Statement133” (“SFAS No. 161”).  SFAS No. 161is intended to improve financial reporting about derivatives and hedgingactivities by requiring enhanced qualitative and quantitative disclosuresregarding derivative instruments, gains and losses on such instruments andtheir effects on an entity’s financial position, financial performance and cashflows.  SFAS No. 161 is effectivefor fiscal years and interim periods beginning after November 15,2008.   We are currently evaluating theimpact that this pronouncement may have on our consolidated financialstatements.

 

***Statement of Financial Accounting Standards No. 162***

 

InMay 2008, the FASB issued SFAS No. 162, “The Hierarchy of GenerallyAccepted Accounting Principles (“SFAS No. 162”).  SFAS No. 162 identifies the sources ofaccounting principles and the framework for selecting the principles to be usedin the preparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles in theUnited States of America.  SFAS No. 162is effective sixty days following the SEC’s approval of Public CompanyAccounting Oversight Board amendments to AU Section 411, “The Meaning of ‘PresentFairly’ in Conformity with Generally Accepted Accounting Principles.”  We do not expect this pronouncement to have asignificant impact on our consolidated financial position, results ofoperations or cash flows.

 

***FASB Staff Position No. EITF 03-6-1***

 

ThisFASB Staff Position (“FSP”) addresses whether instruments granted inshare-based payment transactions are participating securities prior to vestingand, therefore, need to be included in the earnings allocation in computingearnings per share (“EPS”) under the two-class method described in FASBStatement No. 128, “Earnings Per Share”. This FSP is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008, and the interim periods within thoseyears.  All prior-period EPS data willhave to be adjusted retrospectively (including interim financial statements,summaries of earnings, and selected financial data) to conform to theprovisions of this FSP.  Earlyapplication is not permitted.  We do notexpect this FSP to have a significant impact on our consolidated financialposition, results of operations or cash flows.

 

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**Liquidity and CapitalResources**

 

***General*****.**Ourprimary capital requirements are for (1) purchases, construction orrenovation of new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operatingcontracts, (5) acquisitions of businesses or facilities, (6) informationsystems hardware and software and (7) furniture, fixtures andequipment.  Working capital requirementsgenerally increase immediately prior to commencing management of a new facility(or activation of a facility expansion) as we incur start-up costs and purchasenecessary equipment and supplies before facility management revenue isrealized.

 

***CashFlows From Operating Activities.***  Cash provided by operations wasapproximately $21.0 million for the nine months ended September 30, 2008compared to $17.6 million for the nine months ended September 30, 2007.  The increase from the prior period wasprincipally due to higher net income as well as changes in certain workingcapital accounts (including principally accounts receivable and accountspayable) due to timing of  paymentsreceived and made.

 

***CashFlows From Investing Activities*****. **Cash used ininvesting activities was approximately $54.5 million for the nine months ended September 30,2008 due to capital expenditures of $59.3 million related primarily to theexpansion projects at the D. Ray James Prison and the Great Plains CorrectionalFacility. These payments were partially offset by net withdrawals from therestricted debt payment account of $3.7 million and proceeds of $0.8 millionfrom the sale of certain property.  Additionally, we had sales ofinvestment securities of $0.3 million.****Cash used in investing activities was approximately$38.0 million for the nine months ended September 30, 2007 due primarilyto the High Plains Correctional Facility and the formerly leased Washington, D.C.facility purchases for an aggregate cost of approximately $18.6 million, the$5.1 million purchase of the Hudson, Colorado site (to be utilized under ourcontract with the Colorado Department of Corrections) and capital expendituresof approximately $30.6 million related primarily to the expansion projects atthe Big Spring Correctional Center and the D. Ray James Prison. Additionally,we had net sales of investment securities of $11.2 million and withdrawals fromthe restricted debt payment account, net, of $4.6 million.

 

***CashFlows From Financing Activities*****. **Cash providedby financing activities was approximately $32.3 million for the nine monthsended September 30, 2008 due primarily to borrowings on our Amended CreditFacility of $43.0 million and proceeds from the exercise of stock options of$0.6 million. These were partially offset by MCF’S annual principal payment of$11.4 million in July 2008.****Cash flows provided by financing activities wasapproximately $2.8 million for the nine months ended September 30, 2007due primarily to proceeds from the exercise of stock options and warrants, andthe related tax benefit, of $3.3 million and proceeds from the borrowings underour Credit Facility of $10.0 million, offset by MCF’s annual principal paymentof $10.5 million in July 2007.

 

***TreasuryStock Repurchases.***  We did not purchase any of our common stockin the nine months ended September 30, 2008 and 2007.

 

***Long-Term Credit Facilities.***  Our Amended CreditFacility provides for borrowings up to $100.0 million (including letters ofcredit), matures in December 2011 and bears interest, at our electiondepending on our total leverage ratio, at either the LIBOR rate plus a marginranging from 1.50% to 2.25%, or a rate which ranges from 0.00% to 0.75% abovethe applicable prime rate. The available commitment under our AmendedCredit Facility was approximately $11.4 million at September 30,2008.  We had outstanding borrowingsunder our Amended Credit Facility of $73.0 million and we had outstandingletters of credit of approximately $15.6 million at September 30,2008.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million, although the indenture for our Senior Notes limits ourability, subject to certain conditions, to expand the Amended Credit Facilitybeyond $100.0 million.  The AmendedCredit Facility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries. The Amended Credit Facility is not secured bythe assets of MCF, a special purpose entity. Our Amended Credit Facilitycontains commonly used covenants including compliance with laws and limitationson certain financing transactions and mergers and also includes various financialcovenants.  We believe the mostrestrictive covenant under our Amended Credit Facility is the fixed chargecoverage ratio.  At September 30,2008, we were in compliance with all of our debt financial covenants.

 

MCF is obligated for the outstanding balanceof its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds is due on the earlier of August 1,2016 (maturity) or as noted under the bond documents.

 

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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 (in which we sold eleven facilities  to MCF). The bonds are not guaranteed by Cornell.

 

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 unsecuredsenior indebtedness and are guaranteed by all of our existing and futuresubsidiaries (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, wemay redeem all or a portion of the Senior Notes at the redemption prices(expressed as a percentage of the principal amount) listed below, plus accruedand unpaid interest, if any, on the Senior Notes redeemed, to the applicabledate of redemption, if redeemed during the 12-month period commencing on July 1of each of the years indicated below:

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

 

Asthe Senior Notes are now redeemable at our option (subject to the requirementsnoted) we anticipate we will monitor the capital markets and continue to assessour capital needs and our capital structure, including a potential redemptionof the Senior Notes.

 

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.  The Senior Notes were issued under an indenturewhich limits our ability and the ability of our Guarantors to, among otherthings, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

In conjunction with theissuance of the Senior Notes, we entered into an interest rate swap transactionwith a financial institution to hedge our exposure to changes in the fair valueon $84.0 million of our Senior Notes. The purpose of this transaction was to convert future interest due on$84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contractand the underlying debt instrument were identical.  The swap agreement was designated as a fairvalue hedge.  The swap had a notionalamount of $84.0 million and matured in July 2012 to mirror the maturity ofthe Senior Notes.  Under the agreement,we paid, on a semi-annual basis (each January 1 and July 1), afloating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceived a fixed-rate interest of 10.75%. For the three and nine months ended September 30,2007, we recorded interest expense related to this interest rate swap ofapproximately $0.07 million and $0.2 million, respectively. The swapagreement was marked to market each quarter with a corresponding mark-to-marketadjustment reflected as either a discount or premium on the Senior Notes. Thecarrying value of the Senior notes as of this date was adjusted accordingly bythe same amount. Because the swap agreement was an effective fair-value hedge,there was no effect on our results of operations from the mark-to-marketadjustment as long as the swap was in effect. In October 2007, weterminated the swap agreement. We received approximately $0.2 million inconjunction with the termination, which is being amortized over the remainingterm of the Senior Notes.

 

***Future Liquidity***

 

Ourshelf registration statement on Form S-3 for potential for offerings fromtime to time of up to $75.0 million in gross proceeds of debt securities,common stock, preferred stock, warrants or certain other securities wasdeclared effective by the Securities and Exchange Commission in September 2008.

 

Weexpect to use existing cash balances, internally generated cash flows andborrowings from our Amended Credit Facility to fulfill anticipated obligationssuch as capital expenditures, working-capital needs and scheduled debtmaturities over at least the next twelve months. We expect to be fully drawn onour Amended Credit Facility by December 31, 2008. We also will continue toanalyze our capital structure, including a potential refinancing of our SeniorNotes and financing for our expected future capital expenditures, including anypotential acquisitions. We will consider potential acquisitions from time totime. Our principal focus for acquisitions is anticipated to be in our AdultSecure and Adult Community-Based divisions, although we would 

 

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alsopursue attractively priced acquisitions in our Abraxas division. We may decideto use internally generated funds, bank financing, equity issuances,  debt issuances or a combination of any of theforegoing to finance our future capital needs.

 

Our internally generated cash flow is directlyrelated to our business. Should the private corrections and juvenile businessesdeteriorate, or should we experience poor results in our operations, cash flowfrom operations may be reduced. We have, however, continued to generatepositive cash flow from operating activities over recent years and expect thatcash flow will continue to be positive over the next year. Our access to debtand equity markets may be reduced or closed to us due to a variety of events,including, among others, restrictions under our Senior Notes indenture or ourAmended Credit Facility, industry conditions, general economic conditions,market conditions, credit rating agency downgrades of our debt and/or marketperceptions of us and our industry. The extreme volatility seen in thefinancial markets beginning in the third quarter of 2008 has continued into thefourth quarter of 2008 and is expected to be present for the near term. Suchvolatility could result in decreased availability of capital at economicalterms and could also put additional financial and budgetary pressure on ourcustomers. Such conditions could potentially result in our inability to pursueadditional growth opportunities (such as facility expansions or new facilityconstruction) and, if coupled with unexpected client, operational or otherissues affecting our cash flow, in a need to seek additional financing at termswe would otherwise not accept.

 

Inaddition, our accounts receivable are with federal, state, county and localgovernment agencies, which we generally believe reduces our credit risk.However, it is possible that situations such as continuing budget resolutions,delayed passage of budgets or budget pressures, may increase the length ofrepayment of certain of these receivables.

 

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**Results ofOperations**

 

The followingtable sets forth for the periods indicated the percentages of revenuerepresented by certain items in our historical consolidated statements ofoperations.

 
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                      | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                            |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                        |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                              |       | 74.9                             |       | 78.4                            |       | 73.5 |   | 76.9 |   |
| Depreciation and amortization                                   |       | 4.7                              |       | 4.6                             |       | 4.5 |   | 4.4 |   |
| General and administrative  expenses                            |       | 5.7                              |       | 4.9                             |       | 6.7 |   | 7.4 |   |
| Income from operations                                          |       | 14.7                             |       | 12.1                            |       | 15.3 |   | 11.3 |   |
| Interest expense, net                                           |       | 6.0                              |       | 6.9                             |       | 6.2 |   | 6.9 |   |
| Income before provision for  income taxes and minority interest |       | 8.7                              |       | 5.2                             |       | 9.1 |   | 4.4 |   |
| Provision for income taxes                                      |       | 3.5                              |       | 2.4                             |       | 3.9 |   | 2.0 |   |
| Minority interest in  consolidated special purpose entity       |       | 0.1                              |       | —                          |       | — |   | — |   |
| Net income                                                      |       | 5.1                              | %          | 2.8                             | %          | 5.2 | % | 2.4 | % |

 

***ThreeMonths Ended September 30, 2008 Compared to Three Months Ended September 30,2007***

 

***Revenues*****.**Revenues increasedapproximately $7.9 million, or 9.0%, to $95.2 million for the three monthsended September 30, 2008 from $87.3 million for the three months ended September 30,2007.

 

*AdultSecure Services.*****Adult SecureServices revenues increased $8.4 million, or 19.5%, to $51.5 million for thethree months ended September 30, 2008 from $43.1 million for the threemonths ended September 30, 2007 due primarily to 1) an increase inrevenues of $4.9 million at the Great Plains Correctional Facility which beganoperating under a contract with the Arizona Department of Corrections in September 2007(this facility was vacant in July - August 2007) as well as increasedoccupancy as a result of a facility expansion completed in September 2008,2) an increase in revenues of $2.4 million at the Big Spring CorrectionalCenter due to increased occupancy as a result of the facility expansioncompleted in November 2007 related to the take-or-pay contract awarded tous by the BOP in 2007, 3) an increase in revenues of $1.2 million at the D. RayJames Prison due to increased occupancy as a result of a facility expansioncompleted in the first quarter of 2008 and 4) an increase in revenues of $0.6million at the Regional Correctional Center due to increased occupancy (aspreviously discussed, ICE had removed all of its inmates as of August 2007).  The increase in revenues due to the aboveitems was offset, in part, by a decrease in revenues of $1.1 million due to thetransition of our management contract at the Donald W. Wyatt Detention Centerto the facility owner in July 2007. The remaining net increase in revenues of $0.4 million was due tovarious insignificant fluctuations in revenues at our other Adult Secure Servicesfacilities.

 

At September 30, 2008,we operated 10 Adult Secure Services facilities with an aggregate servicecapacity of 12,841. Average contract occupancy was 89.9% for the three monthsended September 30, 2008 compared to 99.6% for the three months ended September 30,2007. The decrease in the average contract occupancy is primarily due to theadditional capacity of approximately 1,600 beds brought into operation in September 2008at the Great Plains Correctional Facility and the Walnut Grove Youth CorrectionalFacility. The average per diem rate for our Adult Secure Services facilitieswas approximately $53.12 and $53.54 for the three months ended September 30,2008 and 2007, respectively.

 

*AbraxasYouth and Family Services.*Abraxas Youth and Family Servicesrevenues decreased $0.9 million, or 3.3%, to $26.2 million for the three monthsended September 30, 2008 from $27.1 million for the three months ended September 30,2007 due primarily to 1) a decrease in revenues of $1.7 million at the CornellAbraxas I (“A-1”) facility due to reduced occupancy, 2) a decrease in revenuesof $0.6 million due to the termination of our management contract for theReading Alternative Education School Program in June 2008 and 3) adecrease in revenues of $0.5 million at the Texas Adolescent Center (“TATC”)due to reduced occupancy.  The decreasein revenues due to the above items was offset, in part, by 1) an increase inrevenues of $1.1 million at the Cornell Abraxas Academy due to increasedoccupancy and 2) an increase in revenues of $0.5 million at the Cornell Abraxasof Ohio facility principally due to improved occupancy.  The remaining net increase in revenues of$0.3 million was due to various insignificant fluctuations in revenues at ourother Abraxas Youth and Family Services facilities and programs.

 

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At September 30,2008, we operated 18 residential Abraxas Youth and Family Services facilitiesand 11 non-residential community-based programs with an aggregate servicecapacity of 3,488. Additionally, we had one residential facility with a servicecapacity of 70 that was vacant at September 30, 2008. Average contractoccupancy for the three months ended September 30, 2008 was 74.6% comparedto 91.8% for the three months ended September 30, 2007. The reduction inaverage contract occupancy reflects the under-utilization at certainfacilities, including A-1, the Cornell Abraxas Academy and the Hector GarzaResidential Treatment Center, among others.

 

The average per diem rate for our residentialfacilities was approximately $193.89 for the three months ended September 30,2008 compared to $176.26 for the three months ended September 30, 2007.The increase in average per diem rates is due to the increased occupancy at theCornell Abraxas Academy as well as change in the mix of services provided atother facilities. Our average fee-for-service rate for our non-residentialcommunity-based facilities and programs was approximately $45.32 for the threemonths ended September 30, 2008 compared to $44.81 for the three monthsended September 30, 2007.

 

*AdultCommunity-Based.*AdultCommunity-Based Services revenues increased approximately $0.3 million, or1.7%, to $17.5 million for the three months ended September 30, 2008 from $17.2million for the three months ended September 30, 2007 due to variousinsignificant fluctuations in revenues at our various Adult Community-BasedServices facilities and programs.

 

At September 30,2008, we operated 28 residential Adult Community-Based Services facilities andthree non-residential Adult Community-Based programs with an aggregate servicecapacity of 3,792. Average contract occupancy was 99.6% for the three monthsended September 30, 2008 compared to 102.3% for the three months ended September 30,2007. The average per diem rate for our residential Adult Community-BasedServices facilities was approximately $68.46 for the three months ended September 30,2008 compared to $62.61 for the three months ended September 30, 2007. Theaverage fee-for-service rate for our non-residential Adult Community-BasedServices programs was approximately $11.90 for the three months ended September 30,2008 compared to $11.34 for the three months ended September 30, 2007.

 

We gave notice of early termination of ourmanagement contract for the Lincoln County Detention Center in Lincoln County,New Mexico in February 2008 and transitioned operation of the facility toa new operator in May 2008.  Wefaced continual staffing and other issues in the rural area and decided thatour continued operation of that facility was not in the best interest of ourshareholders.  The contract for thisfacility generated revenues of approximately $0.5 million in the three monthsended September 30, 2007.

 

***Operating Expenses****.*Operatingexpenses increased approximately $2.7 million, or 3.9%, to $71.2 million forthe three months ended September 30, 2008 from $68.5 million for the threemonths ended September 30, 2007.

 

*AdultSecure Services.*****Adult SecureServices operating expenses increased approximately $2.6 million, or 8.0%, to$34.9 million for the three months ended September 30, 2008 from $32.3million for the three months ended September 30, 2007 due primarily to 1)an increase in operating expenses of $2.5 million at the Great PlainsCorrectional Facility due to increased occupancy resulting from our contractwith the Arizona Department of Corrections which commenced in September 2007as well as the completion of a facility expansion in September 2008, 2) anincrease in operating expenses of $1.0 million at the D. Ray James Prison dueto increased occupancy resulting from the completion of a facility expansion inthe first quarter of 2008, 3) an increase in operating expenses of $0.7 millionat the Big Spring Correctional Center due to increased occupancy and 4) anincrease in operating expenses of $0.6 million at the Walnut Grove YouthCorrectional Facility due to increased occupancy resulting from a facilityexpansion completed in September 2008. The increase in operating expensesdue to the above items was offset, in part, by a decrease in operating expensesof $1.2 million due to the transition of our management contract for the DonaldW. Wyatt Detention Center to the facility owner in July 2007. Theremaining net decrease in operating expenses of $1.0 million was due to variousinsignificant fluctuations in operating expenses at our other Adult SecureServices facilities.

 

As a percentageof segment revenues, Adult Secure Services operating expenses were 67.8% forthe three months ended September 30, 2008 compared to 74.9% for the threemonths ended September 30, 2007. The 2008 operating margin was favorably impacted primarily by the 2007contract awards at the Big Spring Correctional Center and the Great PlainsCorrectional Facility (which began in November 2007 and September 2007,respectively), and the related expansions at these facilities.

 

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*AbraxasYouth and Family Services.*****Abraxas Youth******and Family Services operatingexpenses increased approximately $0.1 million, or 0.4%, to $23.8 million forthe three months ended September 30, 2008 from $23.7 million for the threemonths ended September 30, 2007 due to various insignificant fluctuationsin operating expenses at our various Abraxas Youth and Family Servicesfacilities and programs.******As a percentage of segment revenues, Abraxas Youth and FamilyServices operating expenses were 90.8% for the three months ended September 30,2008 compared to 87.6% for the three months ended September 30, 2007. The2008 operating margin was negatively impacted by the lower utilization at thosefacilities previously noted.

 

*AdultCommunity-Based Services.* Adult Community-Based Services operatingexpenses were approximately $12.5 million for the three months ended September 30,2008 and 2007. As a percentage of segment revenues, Adult Community-BasedServices operating expenses were 71.5% for the three months ended September 30,2008 compared to 72.9% for the three months ended September 30, 2007.

 

***Depreciation and Amortization*****.**Depreciation and amortization increasedapproximately $0.5 million, or 12.5%, to $4.5 million for the three monthsended September 30, 2008 from $4.0 million for the three months ended September 30,2007. The increase was due primarily to the depreciation expense related to thefacility expansions at the Great Plains Correctional Facility, the BigSpring Correctional Center and the D. Ray James Prison. Amortization of intangibles wasapproximately $0.5 million and $0.6 million for the three months ended September 30,2008 and 2007.

 

***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $1.2 million, or 27.9%, to$5.5 million for the three months ended September 30, 2008 from $4.3million for the three months ended September 30, 2007 due primarilyto a net $1.5 million legal claims settlement received in August 2007.

 

***Interest.*** Interest expense, net of interestincome, decreased to approximately $5.8 million for the three months ended September 30,2008 from $6.0 million for the three months ended September 30, 2007. Forthe three months ended September 30, 2008, we capitalized interest ofapproximately $1.0 million related to the expansion projects at the D. RayJames Prison and the Great Plains Correctional Facility. We capitalizedinterest of $0.4 million in three months ended September 2007 related tothe expansion projects at the Big Spring Correctional Center and the D. RayJames Prison. Additionally, MCF made an annual bond principal payment of $11.4million on July 31, 2008 which reduced bond interest expense for the threemonths ended September 30, 2008 by approximately $0.2 million as comparedto the same period of 2007.

 

***Income Taxes.*** For thethree months ended September 30, 2008, we recognized a provision forincome taxes at an estimated effective rate of 40.7%. For the three monthsended September 30, 2007, we recognized a provision for income taxes at anestimated effective rate of 46.4%. The change in our estimated effective taxrate in 2008 was related to an increase in operating income across certain ofour business segments, changes in our FIN 48 liabilities, the decreased impactof certain nondeductible expenses and the utilization of certain tax credits.

 

***NineMonths Ended September 30, 2008 Compared to Nine Months Ended September 30,2007***

 

***Revenues*****.** Revenues increased approximately $16.7million, or 6.2%, to $285.2 million for the nine months ended September 30,2008 from $268.5 million for the nine months ended September 30, 2007.

 

*AdultSecure Services.*****Adult SecureServices revenues increased approximately $14.3 million, or 10.4%, to $151.7million for the nine months ended September 30, 2008 from $137.4 millionfor the nine months ended September 30, 2007 due primarily to 1) anincrease in revenues of $12.5 million at the Great Plains Correctional Facilitydue to increased occupancy resulting from our contract with the ArizonaDepartment of Corrections which began in September 2007 as well as afacility expansion completed in September 2008, 2) an increase in revenuesof $8.3 million at the Big Spring Correctional Center due to increasedoccupancy as a result of the facility expansion completed in November 2007related to the take-or-pay contract awarded to us by the BOP in 2007, 3) anincrease in revenues of $3.7 million at the D. Ray James Prison due toincreased occupancy resulting from the facility expansion completed in thefirst quarter of 2008, 4) an increase in revenues of $1.8 million at the HighPlains Correctional Facility acquired in May 2007 and 5) an increase inrevenues of $0.8 million at the Leo Chesney Community Correctional Facility dueto increased occupancy.  The increase inrevenues due to the above items was offset, in part, by 1) a decrease inrevenues of $8.0 million due to the transition of our management contract atthe Donald W. Wyatt Detention Center to the facility owner in July 2007and 2) a decrease in revenues of $5.2 million at the Regional CorrectionalCenter due to the removal of all ICE inmates as of August 2007 (includingthe $1.5 million contract-based revenue adjustment recorded in March 2008).  The remaining net increase in revenues of$0.4 million was due to various insignificant fluctuations in revenues at ourother Adult Secure facilities.

 

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Average contract occupancy for the nine months endedSeptember 30, 2008 was 92.5% compared to 103.8% for the nine months ended September 30,2007. The decrease in average contract occupancy was primarily due tothe additional capacity of approximately 1,600 beds brought into operation in September 2008at the Great Plains Correctional Facility and the Walnut Grove YouthCorrectional Facility, as well as the removal by ICE of all of its inmates fromthe Regional Correctional Center as of August 2007. The average per diem rate for our AdultSecure Services facilities was approximately $54.00 and $54.65 for the ninemonths ended September 30, 2008 and 2007, respectively.

 

*AbraxasYouth and Family Services.*****AbraxasYouth and Family Services revenues increased approximately $0.3 million, or0.4%, to $80.9 million for the nine months ended September 30, 2008 from $80.6million for the nine months ended September 30, 2007 due primarily to 1)an increase in revenues of $3.8 million at the Cornell Abraxas Academy due toincreased occupancy, 2) an increase in revenues of $1.8 million at the SouthernPeaks Regional Treatment Center due to both improved occupancy and a change incustomer mix, 3) an increase in revenues of $1.0 million at the Hector GarzaResidential Treatment Center which we reactivated in August 2007 and 4) anincrease in revenues of $1.2 million at the Cornell Abraxas of Ohio facilitydue to improved occupancy. The increase in revenues due to the above items wasoffset by 1) a decrease in revenues of $3.4 million at A-1 due to reducedoccupancy, 2) a decrease in revenues of $1.8 million due to the termination ofour management contract for the Harrisburg Alternative Education School Programfor the 2007-2008 school year (due to lack of funding by the contractingagency), 3) a decrease in revenues of $1.3 million at the Texas AdolescentCenter due to reduced occupancy and 4) a decrease in revenues of $0.9 millionat the Alexander Youth Services Center which closed in January 2007.  The remaining net decrease in revenues of$0.1 million was due to various insignificant fluctuations in revenues at ourother Abraxas Youth and Family Services facilities and programs.

 

Average contract occupancy was 80.5% for the ninemonths ended September 30, 2008 compared to 92.7% for the nine monthsended September 30, 2007. The reduction in average contract occupancyreflects the under-utilization at certain facilities including A-1, the CornellAbraxas Academy and the Hector Garza Residential Treatment Center, amongothers. The average per diem rate for our residential Abraxas Youth and FamilyServices facilities was approximately $191.03 and $171.11 for the nine monthsended September 30, 2008 and 2007, respectively. The increase inthe average per diem rate was due to the increased occupancy at the CornellAbraxas Academy as well as change in the mix of services provided at otherfacilities. Our averagefee-for-service rate for our non-residential Abraxas Youth and Family Servicescommunity-based facilities and programs was approximately $47.85 and $44.81 forthe nine months ended September 30, 2008 and 2007, respectively.

 

*AdultCommunity-Based Services.* Adult Community-Based Servicesrevenues increased approximately $2.3 million, or 4.6%, to $52.7 million forthe nine months ended September 30, 2008 from $50.4 million for the ninemonths ended September 30, 2007 due to 1) an increase in revenuesof $1.0 million at the Cordova Center principally due to improved occupancy and2) an increase in revenues of $0.5 million at the Midtown Center which wasreactivated in late September 2007. The remaining net increase in revenues of $0.8 million was due tovarious insignificant fluctuations in revenues at our other AdultCommunity-Based Services facilities and programs.

 

Average contract occupancy for the nine months endedSeptember 30, 2008 was 100.4% compared to 101.3% for the nine months endedSeptember 30, 2007. The average per diem rate for our residential AdultCommunity-Based Services facilities was $66.44 and $62.47 for the nine monthsended September 30, 2008 and 2007, respectively. The averagefee-for-service rate for our non-residential Adult Community-Based Servicesprograms was $13.71 and $12.71 for the nine months ended September 30,2008 and 2007, respectively.

 

We gave notice of early termination of ourmanagement contract for the Lincoln County Detention Center in Lincoln County,New Mexico in February 2008 and transitioned operation of the facility toa new operator in May 2008.  Wefaced continual staffing and other issues in the rural area and decided thatour continued operation of that facility was not in the best interest of ourshareholders.  The contract for thisfacility generated revenues of approximately $0.6 million in the nine monthsended September 30, 2008 and approximately $1.5 million in the nine monthsended September 30, 2007.

 

***Operating Expenses.***Operating expenses increased approximately $3.2 million, or 1.5%, to $209.7 millionfor the nine months ended September 30, 2008 from $206.5 million for thenine months ended September 30, 2007.

 

*AdultSecure Services.*****Adult SecureServices operating expenses increased approximately $0.6 million, or 0.6%, to $99.4million for the nine months ended September 30, 2008 from $98.8 millionfor the nine months ended September 30, 2007 due primarily to 1) anincrease in operating expenses of $6.1 million at the Great Plains CorrectionalFacility due to increased occupancy resulting from the commencement of ouroperating contract with Arizona Department of Corrections in September 2007as well as a facility expansion that was completed in September 2008, 2)an increase in operating expenses of $2.4 million at the D. Ray James Prisondue to increased occupancy resulting from the facility expansion completed inthe 

 

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first quarter of 2008, 3) an increase in operating expenses of $1.5million at the High Plains Correctional Facility acquired in May 2007, 4)an increase in operating expenses of $1.4 million at the Big SpringCorrectional Center due to increased occupancy following the facility expansioncompleted in November 2007 and 5) an increase in operating expenses of$0.9 million at the Walnut Grove Youth Correctional Facility due to a facilityexpansion completed in September 2008. The increase in operating expenses due to the above items was offset, inpart, by 1) a decrease in operating expenses of $7.5 million due to thetransition of our management contract for the Donald W. Wyatt Detention Centerto the facility owner in July 2007 and 2) a decrease in operating expensesof $2.6 million at the Regional Correctional Center due to the removal of allICE inmates as of August 2007.  Theremaining net decrease in operating expenses of $1.6 million was due to variousinsignificant fluctuations in operating expenses at our other Adult SecureServices facilities as well as a reduction in divisional operating expenses.

 

As a percentageof segment revenues, Adult Secure Services operating expenses were 65.5% forthe nine months ended September 30, 2008 compared to 71.9% for the ninemonths ended September 30, 2007. The 2008 operating margin wasfavorably impacted by the $1.5 million contract-based revenue adjustment at theRegional Correctional Center for the contract year ended March 2008 (werecognized this revenue in March 2008), by the reactivation of the GreatPlains Correctional Facility in September 2007 and subsequent facilityexpansion completed in first quarter of 2008, and by the expansioncompletion/activations at the Big Spring Correctional Center (November 2007)and D. Ray James Prison (first quarter of 2008).

 

*AbraxasYouth and Family Services.*****AbraxasYouth and Family Services operating expenses increased approximately $3.1million, or 4.4%, to $72.9 million for the nine months ended September 30,2008 from $69.8 million for the nine months ended September 30, 2007 dueprimarily to 1) an increase in operating expenses of $2.5 million at theCornell Abraxas Academy due to increased occupancy, 2) an increase in operatingexpenses of $1.0 million at the Hector Garza Residential Treatment Center whichwe reactivated in August 2007, 3) an increase in operating expenses of$0.6 million at the Southern Peaks Regional Treatment Center due to increasedoccupancy, 4) an increase in operating expenses of $0.5 million at the CornellAbraxas of Ohio facility due to increased occupancy and 5) an increase inoperating expenses of $0.4 million due to the addition of several newalternative education programs in 2008. The increase in operating expenses due to the above items was offset, inpart, by 1) a decrease in operating expenses of $1.8 million due to thetermination of our management contract for the Harrisburg Alternative EducationSchool Program for the 2007-2008 school year (due to lack of funding by thecontracting agency) and 2) a decrease in operating expenses of $0.5 million atTATC due to reduced occupancy.  Theremaining net increase in operating expenses of $0.4 million was due to variousinsignificant fluctuations in operating expenses at our other Abraxas Youth andFamily Services facilities and programs.

 

 As a percentage of segment revenues, AbraxasYouth and Family Services operating expenses were 90.1% for the nine monthsended September 30, 2008 compared to 86.6% for the nine months ended September 30,2007. The 2008 operating margin was negatively impacted by under-utilization atcertain facilities, including the occupancy declines at A-1 and TATC.

 

*AdultCommunity-Based Services.* Adult Community-Based Servicescorrections and treatment services division operating expenses decreasedapproximately $0.5 million, or 1.3%, to $37.4 million for the nine months endedSeptember 30, 2008 from $37.9 million for the nine months ended September 30,2007 due primarily to a decrease in operating expenses of $0.8 milliondue to the closure of the Lincoln County Detention Center in May 2008offset, in part, by an increase in operating expenses of $0.4 million at theMidtown Center which we reactivated in late September 2007.

 

As a percentage of segment revenues, AdultCommunity-Based Services operating expenses were 71.0% for the nine monthsended September 30, 2008 compared to 75.1% for the nine months ended September 30,2007. The 2008 operating margin was favorably impacted by increasedoperations and a change in the mix of services provided during the period.

 

***Impairment of Long-Lived Assets.***  Weevaluate the realization of our long-lived assets at least annually or whenchanges in circumstances or a specific triggering event indicates that thecarrying value of the asset may not be recoverable.  As a part of our evaluation, we makejudgments regarding such factors as estimated market values and the potentialfuture operating results and undiscounted cash flows associated with individualfacilities or assets.  Additionally,should we decide to sell a facility or other such asset, realization isevaluated based on the estimated sales price based on the best marketinformation available.  In conjunctionwith our review of certain of our long-lived assets based on estimated marketvalues associated with these assets, we determined that our carrying value fora currently vacant site of land was not fully recoverable and exceeded its fairvalue and, as a result, we recorded an impairment charge of $0.3 million in thenine months ended September 30, 2008. This charge isreflected in general and administrative expenses in the accompanying financialstatements for the applicable period.

 

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***Depreciation and Amortization*****.**Depreciation and amortization expense increasedapproximately $1.1 million, or 9.4%, to $12.8 million for the nine months endedSeptember 30, 2008 from $11.7 million for the nine months ended September 30,2007. Depreciation and amortization of property and equipment wasapproximately $11.4 million and $10.1 million for the nine months ended September 30,2008 and 2007, respectively. The increase is due primarily to an increase indepreciation expense related to the building expansions at the Great PlainsCorrectional Facility, the Big Spring Correctional Center and the D. Ray JamesPrison. Amortizationof intangibles was approximately $1.5 million and $1.7 million for the ninemonths ended September 30, 2008 and 2007, respectively.

 

***General and Administrative Expenses.*** Generaland administrative expenses decreased approximately $0.6 million, or 3.2%, to $19.2million for the nine months ended September 30, 2008 from $19.8 millionfor the nine months ended September 30, 2007. General andAdministrative expenses for the nine months ended September 30, 2007include the reimbursement of approximately $2.5 million of costs to Veritasrelated to the terminated merger agreement. These expenses were partially offset by a net $1.5 million legal claimsettlement received in August 2007.

 

***Interest.*** Interest expense, net of interestincome, decreased to $17.6 million for the nine months ended September 30,2008 from $18.6 million for the nine months ended September 30, 2007. MCFmade an annual principal payment of $11.4 million on their outstanding bondswhich reduced interest expense for the nine months ended September 30,2008 by approximately $0.7 million from the 2007 period. For the nine monthsended September 30, 2008, we capitalized interest of approximately $2.3million related to the facility expansion projects at the Great PlainsCorrectional Facility and the D. Ray James Prison. For the nine months ended September 30,2007, we capitalized interest of approximately $0.6 million related to thefacility expansion projects at the Big Spring Correctional Center and the D.Ray James Prison. Additionally, interest expense related to our AmendedCredit Facility increased approximately $1.9 million in the nine months ended September 30,2008 as compared to the same period of 2007 due to higher outstanding balancein the 2008 period.

 

***Income Taxes.*** For thenine months ended September 30, 2008, we recognized a provision for incometaxes at an estimated effective rate of 42.3%. For the nine months ended September 30,2007, we recognized a provision for income taxes at an estimated effective rateof 44.9%. The change in our estimated effective rate in 2008 was related to anincrease in operating income across certain of our business segments, thedecreased impact of certain nondeductible expenses and the utilization ofcertain tax credits.

 

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

 

***RegionalCorrectional Center.***InJuly 2007, we were notified by ICE that it was removing all ICE detaineesfrom the Regional Correctional Center. The withdrawal of all ICE detainees wascompleted in early August 2007.  In February 2008,ICE informed us that it would not resume use of the facility. The facility isstill being utilized by the United States Marshall Service (“USMS”), and since May 2008by the BOP, but not at its full capacity. OFDT holds the contract on behalf of ICE, USMS and the BOP withBernalillo County (the “County”) through an intergovernmental servicesagreement, and we have an agreement with the County.  In February 2008, OFDT attempted tounilaterally amend its agreement with the County to reduce the number ofminimum annual guaranteed mandays under the agreement from 182,500 to66,300.  Neither we nor the Countybelieve OFDT has the right to unilaterally amend the contract in this manner,and OFDT has been informed of our position. Either party to theintergovernmental services agreement has the right to terminate upon 180 daysnotice.

 

Also,there is a motion pending in a lawsuit against the County concerning the Countyjail system that could involve the Regional Correctional Center in such case. Jimmy McClendon and other plaintiffs sued the County in federal districtcourt in the District of New Mexico in 1994 over conditions at the county jail,which was then located at what is now the Regional Correctional Center and runby the County.  The County subsequently built their new MetropolitanDetention Center to house the County inmates and also negotiated two stipulatedagreements in 2004 designed to end the McClendon lawsuit.  The court inthat case is considering the application of the lawsuit to the RegionalCorrectional Center as a result of the County’s ownership of thefacility.  The County has informed us that, should the court rule thatthe case applies to the facility, it plans to appeal the decision since theCounty does not believe McClendon should apply to the Regional CorrectionalCenter.  We do not believe we are contractually obligated to bear anyincremental costs of complying with McClendon although the County hasexpressed its desire for us to absorb a portion of any costs that would beincurred. Should the court rule that the lawsuit applies to the facility,we would further discuss the matter with the County. We plan to continue tooperate the facility and also continue with our marketing plans for theRegional Correctional Center.

 

Revenues for this facility were approximately $6.6 million (including a$1.5 million contract-based revenue adjustment for the contract year ended March 2008)and $11.8 million for the nine months ended September 30, 2008 and 2007,respectively. The net carrying value of the leasehold improvements for thisfacility was approximately $1.6 million and $3.0 million at September 30,2008 and December 31, 2007, respectively. Our lease for this facilityrequires monthly rent 

 

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payments of approximately $0.13 million for the remaining term of thelease (through June 2009). To date, we have brought in the BOP as anadditional  customer for this facility,however the facility still has substantial available capacity. Our inability toexpand the existing population with current or new customers could have anadverse effect on our financial condition, results of operations and cashflows.  We believe that pursuant to theprovisions of SFAS No. 144, no impairment to the carrying value of theleasehold improvements for this facility has occurred.

 

***Hector GarzaResidential Treatment Center.***In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas. We reactivated thefacility during the third quarter of 2007. The net carrying value for thisfacility was approximately $4.1 million and $4.2 million at September 30,2008 and December 31, 2007, respectively. We believe that, pursuant to the provisions of SFAS No. 144, noimpairment to the carrying value of this facility has occurred.

 

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

 

We maintain operating leases in theordinary course of our business activities. These leases include those for operating facilities, office space andoffice and operating equipment, and the terms of these agreements range from2008 until 2075.  As of September 30,2008, our total commitment under these operating leases was approximately $121.0million.

 

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The followingtable details our known future cash payments (on an undiscounted basis) relatedto various contractual obligations as of September 30, 2008 (inthousands):

 
| ** **                                  | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                | ** ** | ** ** | ** ** | **2009 -** | ** ** | **2011 -** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Total**                                 | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** | **Thereafter** | ** ** |
|                                        |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                  |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.        |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | 112,000 |   | $ | — |   |
| · Special Purpose  Entities            |       | 134,100                                   |       | — |   | 25,800 |   | 30,400 |   | 77,900 |   |
| Long-term debt - interest                   |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.        |       | 45,150                                    |       | 3,010 |   | 24,080 |   | 18,060 |   | — |   |
| · Special Purpose  Entities            |       | 55,009                                    |       | — |   | 21,666 |   | 17,110 |   | 16,233 |   |
| Revolving line of credit-principal          |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.        |       | 73,000                                    |       | — |   | — |   | 73,000 |   | — |   |
| Revolving line of credit-interest           |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.        |       | 1,246                                     |       | 486 |   | 522 |   | 238 |   | — |   |
| Capital lease obligations                   |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.        |       | 29                                        |       | 5 |   | 24 |   | — |   | — |   |
| Construction commitments                    |       | 15,954                                    |       | 9,454 |   | 6,500 |   |   |   |   |   |
| Operating leases                            |       | 121,006                                   |       | 1,888 |   | 21,652 |   | 22,050 |   | 75,416 |   |
| Consultative and non-competition agreements |       | 10                                        |       | 10 |   | — |   | — |   | — |   |
| Total contractual cash obligations          |       | $                                         | 557,504    |   | $ | 14,853 |   | $ | 100,244 |   | $ | 272,858 |   | $ | 169,549 |   |

 

Approximately $2.9 million of unrecognized taxbenefits have been recorded as liabilities in accordance with FIN 48 as of September 30,2008 but are not included in the contractual obligations table above because weare uncertain as to if or when such amounts may be settled.  Related to the unrecognized tax benefits notincluded in the table above, we have also recorded a liability for potentialpenalties of approximately $0.1 million and for interest of approximately $0.2million as of September 30, 2008.

 

We enter intoletters of credit in the ordinary course of our operating and financingactivities. As of September 30, 2008, we had outstanding letters of creditof approximately $15.6 million related to insurance and other operatingactivities. The following table details our letter of credit commitments as of September 30,2008 (in thousands):

 
| ** **                 | ** ** | **Total**     | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|----------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Over** | ** ** |
| ** **                 | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
|                       |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Commercial Commitments:    |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of  credit |       | $             | 15,605     |                                                                    | $          | 14,355 |   | $ | 1,250 |   | $ | — |   | $ | — |   |
|                            |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

Inthe normal course of business, we are exposed to market risk, primarily fromchanges in interest rates.  Wecontinually monitor exposure to market risk and develop appropriate strategiesto manage this risk.  We are not exposedto any other significant market risks, including commodity price risk, foreigncurrency exchange risk or interest rate risk from the use of derivativefinancial instruments.  In conjunctionwith the issuance of the Senior Notes, we entered into an interest rate swap of$84.0 million related to the interest obligations under the Senior Notes ineffect converting them to a floating rate based on six-month LIBOR. Weterminated the interest rate swap in October 2007.

 

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**Credit Risk**

 

Due to the short duration of our investments, changes in marketinterest rates would not have a significant impact on their fair value.  In addition, our accounts receivables arewith federal, state, county and local government agencies, which we generallybelieve reduces our credit risk. However, it is possible that such situationsas continuing budget resolutions, delayed passage of budgets or budget pressures may increase the lengthof repayment of certain receivables.

 

**Interest Rate Exposure**

 

Our exposure to changesin interest rates primarily results from our Amended Credit Facility, as theseborrowings have floating interest rates. The debt on our consolidated financial statements at September 30,2008 with fixed interest rates consist of the 8.47% Bonds issued by MCF, aspecial purpose entity, in August 2001 in connection with the 2001 Sale andLeaseback Transaction and $112.0 million of Senior Notes.  The detrimental effect of a hypothetical 100basis point increase in interest rates on our current borrowings under ourAmended Credit Facility would be to reduce income before provision for incometaxes by approximately $0.5 million for the nine months ended September 30,2008.  At September 30, 2008, thefair value of our consolidated fixed rate debt approximated carrying valuebased upon discounted future cash flows using current market prices.

 

**Inflation**

 

Other than personnel, resident/inmate medical costsat certain facilities, and employee medical and worker’s compensation insurancecosts, we believe that inflation has not had a material effect on our resultsof operations during the past two years. We have experienced significant increases in resident/inmate medicalcosts and employee medical and worker’s compensation insurance costs, and wehave also experienced higher personnel costs during the past two years. Most ofour facility management contracts provide for payments of either fixed per diemfees or per diem fees that increase by only small amounts during the term ofthe contracts. Inflation could substantially increase our personnel costs (thelargest component of our operating expenses), medical and insurance costs orother operating expenses at rates faster than any increases in contractrevenues. Foodcosts (part of our resident/inmate care costs) have also been subject to risingprices in 2008. We believe we have limited our exposure through long-termcontracts with fixed term pricing.

 

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

 

**Evaluation of Disclosure Controls and Procedures**

 

We maintain disclosure controls and proceduresdesigned to provide reasonable assurance that information disclosed in ourannual and periodic reports is recorded, processed, summarized and reportedwithin the time periods 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 ofour disclosure controls and procedures.

 

We do not expect that our disclosure controls andprocedures will prevent all errors or fraud. A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met. In addition, thedesign of disclosure controls and procedures must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitation in a cost-effectivecontrol system, misstatements due to error or fraud could occur and not bedetected.

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, and as required by paragraph (b) ofRules 13a-15 and 15d-15 of the Exchange Act, we have evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of theExchange Act) as of the end of the period required by this report. Based onthat evaluation, our principal executive officer and principal financialofficer have concluded that these controls and procedures are effective as ofthat date.

 

**Changes in Internal Control overFinancial Reporting**

 

In connection with the evaluation as requiredby paragraph (d) of Rules 13a-15 and 15d-15 of the Exchange Act, wehave not identified any change in our internal control over financial reporting(as such term is defined in Rules 13a-15(f) and 15d-15(f) underExchange Act) during our fiscal quarter ended September 30, 2008 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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

 
| **ITEM 1.**  |   | **Legal Proceedings.**                                                                                          |
|--------------|--------|-----------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                            |
|         |   | See Part I, Item 1. Note 11 to the Consolidated Financial  Statements, which is incorporated by reference. |
|         |   |                                                                                                            |
| **ITEM 1A.** |   | **Risk Factors.**                                                                                               |

 

***Resistance to privatization of correctionaland detention facilities could result in our inability to obtain new contractsor the loss of existing contracts.***

 

Managementof correctional and detention facilities, particularly of adult securefacilities, by private entities has not achieved complete acceptance by eitherthe government or the public. The movement toward privatization of correctionaland detention facilities has also encountered resistance from certain groups,such as labor unions, local sheriff’s departments, religious organizations andgroups believing that correctional and detention facility operations shouldonly be conducted by government agencies. Changes in the dominant politicalparty in any market in which correctional facilities are located could have anadverse impact on privatization. Furthermore, some government agencies are notlegally permitted to delegate their traditional management responsibilities forcorrectional and detention facilities to private companies.

 

Inaddition, as a private prison manager, we are subject to government legislationand regulation restricting the ability of private prison managers to housecertain types of inmates, such as inmates from other jurisdictions or inmatesat medium or higher security levels. Legislation has been enacted in severalstates, and has previously been proposed in the United States House ofRepresentatives, containing such restrictions. Any such legislation may have amaterial adverse affect on us.

 

Anyof these resistances may make it more difficult for us to renew or maintainexisting contracts, to obtain new contracts or sites on which to operate newfacilities or to develop or purchase facilities and lease them to government orprivate entities, any or all of which could have a material adverse effect onour business.

 

***We are subject to the short-term nature ofgovernment contracts.***

 

Manygovernmental agencies are legally limited in their ability to enter into fixedlong-term contracts that would bind elected officials responsible for futurebudgets. Therefore, many contracts with government agencies, including the BOP,typically either have a very short term or, even when for a longer term, aresubject to termination on short notice without cause. The majority of ourcontracts have primary terms of one to three years. Our contracts withgovernmental agencies may contain one or more renewal options that may beexercised only by the contracting governmental agency. Some of these contractsmay not be renewed by the governmental agency and no assurance can be giventhat the governmental agency will exercise a renewal option in the future. Inaddition, the governmental agency may elect to solicit bids pursuant to a RFPor request for qualifications (“RFQ”) rather than exercise a renewal option. Wemay not be successful in responding to a RFP or RFQ.

 

Thenon-renewal or termination of any of our significant contracts withgovernmental agencies, our inability to secure new facility managementcontracts from others or our failure to successfully respond to a RFP or RFQcould materially adversely affect our financial condition, results of operationand liquidity. To the extent we have made significant capital expenditures andhave short-term contracts with our customers that are not renewed or extended,we may not recover our entire capital investment.

 

***Budgetary pressure on federal,state, county and local governments may result in contract cancellation or a reductionin per diem rates, which would reduce our profitability.***

 

Ourcash flow is subject to the receipt of sufficient funding of and timely paymentby contracting governmental entities. If the appropriate governmental agencydoes not receive sufficient appropriations to cover its contractualobligations, a contract may be terminated or the amounts payable to us may bedeferred or reduced.  Also, we aredependent upon funding for anticipated future contracts, including those forcertain facility expansions and new construction projects that we haveundertaken, such as those at D. Ray James and Hudson, Colorado.

 

Federal,state, county and local governments have encountered, and are expected tocontinue to encounter, significant budgetary constraints that may result in areduction of spending on the outsourced services that we provide. Suchbudgetary limitations may cause the contractual commitments to be reduced oreven eliminated, which would make it unprofitable to continue operating a certainfacility and require us to find alternate customers or close such facility.

 

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Manystates as well as the federal government are facing significant budget deficitsand are under pressure to reduce current levels of spending or controladditional spending. As a result of this increased budgetary pressure, incertain cases we have granted a few of our customers relief from formulaicincrease provisions in their agreements and some of our customers have notincluded in their appropriation legislation amounts that would increase the perdiem rates payable to us or have otherwise attempted to reduce the contractvalue. Contractual rate increases are generally intended to offset increases inexpenses and inflation. To the extent rates are not increased or are reduced,our profitability will be adversely affected. Examples of this budget pressure include the need of the federalgovernment to operate under a continuing resolution as a result of its failureto pass a new 2008/2009 year budget and reported budget pressures in variousstates including Georgia and California.

 

***Our ability to win new contracts to developand manage correctional, detention and treatment facilities depends on manyfactors outside our control.***

 

Ourgrowth is generally dependent upon our ability to win new contracts to developand manage new correctional, detention and treatment facilities. This dependson a number of factors we cannot control, including crime rates and sentencingpatterns in various jurisdictions. Accordingly, the demand for our facilitiescould be adversely affected by the relaxation of enforcement efforts, leniencyin conviction and sentencing practices or through the legal decriminalizationof certain activities that are currently proscribed by criminal laws. Forinstance, changes in laws relating to drugs and controlled substances orillegal immigration could reduce the number of persons arrested, convicted andsentenced, thereby potentially reducing demand for correctional facilities tohouse them and community-based services to transition offenders back into thecommunity. Similarly, reductions in crime rates could lead to reductions inarrests, convictions and sentences requiring correctional facilities.

 

Whenseeking bids, most governmental entities evaluate the financial strength of thebidders. To the extent they believe we do not have sufficient financialresources, we will be unable to effectively compete for bids. Additionally, oursuccess in obtaining new awards and contracts may depend, in part, upon ourability to locate land that can be leased or acquired on favorable terms.Furthermore, desirable locations may be in or near populated areas and,therefore, may generate legal action or other forms of opposition fromresidents in areas surrounding a proposed site.

 

***Our profitability may suffer if the numberof offenders occupying our correctional, detention and treatment facilitiesdecreases or there is a shift in occupancy among our divisions.***

 

Ourcorrectional, detention and treatment facilities are dependent upongovernmental agencies supplying offenders and we do not control occupancylevels at our facilities. We believe the rate of growth experienced in theadult secure sector during the late 1980s and early 1990s is stabilizing.

 

Historically,a substantial portion of our revenues has been generated under contracts thatspecify a net rate per day per resident, or a per diem rate, sometimes with nominimum guaranteed occupancy levels, even though most correctional facilitycost structures are relatively fixed. Under such a per diem rate structure, adecrease in occupancy levels at a particular facility could have a materialadverse effect on the financial condition and results of operations at suchfacility. A decrease in the occupancy of certain juvenile justice, educationand treatment facilities would have a more significant impact on our operatingresults than a decrease in occupancy in the Adult Secure division due to higherper diem revenue at certain juvenile facilities.

 

Certainsocial commentators and various political or governmental representativessuggest that community-based corrections of adults may be emphasized in thefuture as alternatives to traditional incarceration. We have historicallyexperienced higher operating margins in the Adult Secure and the AdultCommunity-Based sectors than in the juvenile services sector. A shift inoccupancy among our segments of business operations could result in a decreasein our profitability.

 

***A failure to comply with existingregulations could result in material penalties or non-renewal or termination ofour contracts.***

 

Ourindustry is subject to a variety of federal, state, county and localregulations, including education, environmental, health care and safetyregulations, which are administered by various regulatory authorities. We maynot always successfully comply with these regulations, and failure to complycould result in material penalties or non-renewal or termination of facilitymanagement contracts. The contracts typically include extensive reportingrequirements and supervision and on-site monitoring by representatives ofcontracting governmental agencies. Corrections officers are customarilyrequired to meet certain training standards, and in some instances facilitypersonnel are required to be licensed 

 

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andsubject to background investigation. Certain jurisdictions also require thatsubcontracts be awarded on a competitive basis or that we subcontract withbusinesses owned by members of minority groups. The failure to comply with anyapplicable laws, rules or regulations and the loss of any required licensecould adversely affect the financial condition and results of operations at ouraffected facilities.

 

***Governmental agencies may investigate andaudit our contracts and, if any improprieties are found, we may be required torefund revenues we have received, and/or to forego anticipated revenues and maybe subject to penalties and sanctions, including prohibitions on our bidding inresponse to RFPs.***

 

Governmentalagencies we contract with have the authority to audit and investigate ourcontracts with them. As part of that process, some governmental agencies reviewour performance on the contract, our pricing practices, our cost structure andour compliance with applicable laws, regulations and standards. If the agencydetermines that we have improperly allocated costs to a specific contract, wemay not be reimbursed for those costs and we could be required to refund theamount of any such costs that have been reimbursed. If a government audituncovers improper or illegal activities by us or we otherwise determine thatthese activities have occurred, we may be subject to civil and criminalpenalties and administrative sanctions, including termination of contracts,forfeitures of profits, suspension of payments, fines and suspension ordisqualification from doing business with the government. Any adversedetermination could adversely impact our ability to bid in response to RFPs inone or more jurisdictions and significantly reduce the probability of oursuccess in the bid process for future contracts.

 

***If we fail to satisfy our contractualobligations, our ability to compete for future contracts and our financial conditionmay be adversely affected.***

 

Ourfailure to comply with contract requirements or to meet our client’sperformance expectations when performing a contract could materially andadversely affect our financial performance and our reputation, which, in turn,would impact our ability to compete for new contracts. Our failure to meetcontractual obligations could also result in substantial actual andconsequential damages. In addition, our contracts often require us to indemnifyclients for our failure to meet performance standards. Some of our contractscontain liquidated damages provisions and financial penalties related toperformance failures. Although we have liability insurance, the policy limitsmay not be adequate to provide protection against all potential liabilities.

 

***Competitors in our industry may adverselyaffect the profitability of our business.***

 

Wemust compete with government entities and other private operators on the basisof cost, quality and range of services offered, experience in managingfacilities, reputation of personnel and ability to design, finance and constructnew facilities on a cost effective competitive basis. While there are somebarriers for companies seeking to enter into the management and operation ofcorrectional, detention and treatment facilities, these barriers have not beensufficient to materially limit additional competition. Certain areas of ouroperation may not pose a significant barrier to entry into the market byprivate operators. For example, private operators may not find it as difficultto bid for juvenile treatment, educational and detention services andpre-release correctional and treatment services as they do adult correctionaland detention services.

 

Further,our government customers may assume the management of a facility currentlymanaged by us upon the termination of the corresponding management contract or,if such customers have capacity at their facilities, may take inmates currentlyhoused in our facilities and transfer them to government run facilities. Theresulting decrease in occupancy levels would reduce our revenue due to the perdiem rate structure and could result in a significant decrease in theprofitability of our business.

 

***A disturbance or violent occurrence in oneof our facilities could result in closure of a facility or harm to our business.***

 

Anescape, riot, disturbance or violent occurrence at one of our facilities couldadversely affect the financial condition, results of operations and liquidityof our operations. Among other things, the negative publicity generated as aresult of an event could adversely affect our ability to retain an existingcontract or obtain future ones. In addition, if such an event were to occur,there is a possibility that the facility where the event occurred may be shutdown by the relevant governmental agency. A closure of certain of ourfacilities could adversely affect the financial condition, results ofoperations and liquidity of our operations. Such negative events may alsoresult in a significant increase in our liability insurance costs.

 

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***Negative media coverage, includinginaccurate or misleading information, could adversely affect our reputation andour ability to bid for government contracts.***

 

Themedia frequently focuses its attention on private operators’ contracts withgovernmental agencies. If the media coverage of private operators is negative,it could influence government officials to slow the pace of outsourcinggovernment services, which could reduce the number of RFPs. The media may alsofocus its attention on the activities of political consultants engaged by us,even when their activities are unrelated to our business, and we may be taintedby adverse media coverage about their activities. Moreover, inaccurate,misleading or negative media coverage about us could harm our reputation and,accordingly, our ability to bid for and win government contracts.

 

***We often incur significant costs beforereceiving related revenues, which could result in cash shortfalls and a risk ofnot recovering our investment.***

 

Whenwe are awarded a contract to manage a new facility, we may incur significantexpenses before we receive contract payments. These expenses include purchasingreal estate, constructing new facilities, leasing office space, purchasingoffice equipment and hiring and training personnel. As a result, when thegovernment does not fund a facility’s pre-opening and start-up costs, we may berequired to invest significant sums of money before receiving related contractpayments. In addition, payments due to us from governmental agencies may bedelayed due to billing cycles or as a result of failures by our governmentalcustomers to attain necessary budget approvals and finalize contracts in a timelymanner. Several juvenile services contracts related to educational servicesprovide for annual collection several months after a school year is completed.In addition, a contract may be terminated prior to its scheduled expiration andas a result we may not recover these expenses or realize any return on ourinvestment.

 

Wemay choose to undertake development projects without written commitments tomake use of such facilities. We may not be able to obtain contracts for thesefacilities in a timely fashion, if at all. To the extent we do not obtaincontracts, we could be unable to recover our investment and our financialcondition and results of operations would be adversely affected.

 

***The volatility and disruption ofthe capital and credit markets and adverse changes in the economy maynegatively impact our ability to access financing, revenues and earnings.***

 

The capital and creditmarkets have been experiencing extreme volatility and disruption for more thantwelve months.  In the third and fourthquarters of 2008, the volatility and disruption have reached unprecedentedlevels.  The markets have exerteddownward pressure on availability of liquidity and credit capacity for manyissuers, including us.

 

Whilewe intend to finance our operations with existing cash, cash flow fromoperations and borrowing under our existing credit facility, we may requireadditional financing to support our continued growth.  However, due to the existing uncertainty inthe capital and credit markets, access to capital may be limited on termsacceptable to us or unavailable.  Ourcustomers may also come under greater budgetary pressure as a result ofeconomic and financial market conditions, which could negatively impact ourrevenues and earnings.

 

***Our significantlevel of indebtedness could adversely affect our financial condition.***

 

Wehave a significant amount of indebtedness. Our total consolidated indebtedness as of September 30, 2008 wasapproximately $318 million.  Our abilityto make scheduled payments or to refinance our debt obligations depends on ourfinancial and operating performance, which is subject to prevailing economicand competitive conditions and to certain other financial, business and otherfactors beyond our control. We cannot assure you that we will maintain a levelof cash flows from operating activities sufficient to permit us to pay theprincipal, premium, if any, and interest and additional interest, if any, onour indebtedness.  We may need to reduceor delay capital expenditures, sell assets, seek additional capital orrestructure or refinance all or a portion of our indebtedness on or beforematurity.  However, we may not be able tocomplete these alternative measures on commercially reasonable terms or at all.  Additionally, a significant portion of ourassets is owned, and a significant percentage of our revenue is generated, byour subsidiaries. Our cash flows and our ability to repay our indebtednessdepends upon the performance of these subsidiaries and their ability to makedistributions.  See ‘‘Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Liquidity and Capital Resources.’’

 

Certainof our borrowings, including any borrowings under our Amended Credit Facility,will be at variable rates of interest and expose us to interest rate risk. Ifinterest rates increase, our debt service obligations on the variable rateindebtedness would increase even though the amount borrowed remained the same,and our net income would decrease.

 

***Therestrictive covenants in our Senior Notes and Amended Credit Facility mayaffect our ability to operate our business successfully.***

 

Theindenture governing our Senior Notes and our Amended Credit Facility containvarious covenants that limit our ability to engage in specified types oftransactions. These covenants limit our ability to, among other things: incuradditional debt; pay dividends or other distributions; make certain types ofinvestments; incur liens; restrict distributions from our subsidiaries; enterinto transactions with affiliates; and consolidate or merge with or into, orsell substantially all of our assets to, another.

 

Inaddition, our Amended Credit Facility requires us to maintain specifiedfinancial ratios. Any failure to comply with the restrictions of our AmendedCredit Facility and the indenture governing our Senior Notes or any othersubsequent financing agreements may result in an event of default.  An event of default may allow the creditorsto accelerate the related 

 

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debtas well as any other debt to which a cross-acceleration or cross-defaultprovision applies and terminate all commitments to extend further credit.   Furthermore, we have pledged a significantportion of our assets as collateral under our Amended Credit Facility.  If we default on the financial covenants inour Amended Credit Facility, our lenders could proceed against the collateralgranted to them to secure that indebtedness, which would have a materialadverse effect on our business, results of operation and financial condition.

 

***Despite currentindebtedness levels, we may still be able to incur substantially more debt.This could further exacerbate the risks described above.***

 

Theterms of the indenture governing our Senior Notes and our Amended CreditFacility restrict our ability to incur but do not prohibit us from incurringsignificant additional indebtedness in the future.  We have several ongoing expansion projectsunderway and anticipate commencing other projects, and we will likely need tofinance these future outlays of capital since our cash on hand and cash flowsfrom operations will not be sufficient to fully fund all of these potentialexpenditures.  Depending on market conditions and other factors, we willconsider additional debt financing to fund these outlays of capital as well asto refinance a portion of our existing indebtedness.   If new indebtedness is added to our and oursubsidiaries’ current debt levels, the related risks that we and they now facecould intensify.

 

***We may be unable to attract and retainsufficient qualified personnel necessary to sustain our business.***

 

Ourdelivery of services is labor-intensive. When we are awarded a contract, wemust hire operating management, security, case management and other personnel.The success of our business requires that we attract, develop, motivate andretain these personnel. Our ability to recruit and retain qualified individualsvaries by facility and is related to the socio-economic factors in theparticular community in which the facility operates. The Department of Laborwages we offer our employees are often higher than wages they could obtainelsewhere in the community. However, if the local economy where a facility islocated is robust and unemployment is low, we may have difficulty hiring and retainingqualified personnel. In addition, there are inherent risks associated with thenature of the services we provide, which could cause certain qualifiedindividuals to seek other employment opportunities. We have experienced highturnover of personnel in our juvenile and adult secure facilities within thefirst year of their employment. Our inability to hire sufficient personnel on atimely basis or the loss of significant numbers of personnel could adverselyaffect our business.

 

***If we do not successfully integrate thebusinesses that we acquire, our results of operations could be adverselyaffected.***

 

Wemay be unable to manage businesses that we may acquire profitably or integratethem successfully without incurring substantial expenses, delays or otherproblems that could negatively impact our results of operations. Acquisitionsgenerally require the integration of facilities, some of which may be locatedin states in which we do not currently have operations.

 

Moreover,business combinations involve additional risks, including:

 

·      diversionof management’s attention;

·      loss ofkey personnel;

·      assumptionof unanticipated legal or financial liabilities;

·      ourbecoming significantly leveraged as a result of the incurrence of debt tofinance an acquisition;

·      unanticipatedoperating, accounting or management difficulties in connection with the acquiredentities;

·      amortizationor possible impairment charges of acquired intangible assets, including goodwill;and

·      dilutionto our earnings per share.

 

Also,client dissatisfaction or performance problems with an acquired business couldmaterially and adversely affect our reputation as a whole. Further, theacquired businesses may not achieve the revenues and earnings we anticipated.

 

***Because environmental laws impose strict,as well as joint and several, liability for clean up costs, unforeseen environmentalrisks could prove to be costly.***

 

Ourfacilities, and any facilities that we may acquire in the future, may besubject to unforeseen environmental risks. The federal ComprehensiveEnvironmental Response, Compensation, and Liability Act (CERCLA) imposesstrict, as well as joint and several, liability for certain environmentalcleanup costs on several classes of potentially responsible parties, includingcurrent owners and operators of the property. Other federal and state laws incertain circumstances may impose liability for environmental remediation, whichcosts may be substantial. Further, the operation of our facilities, and thedevelopment of new facilities, requires that we obtain, and comply with,permits and other authorizations under 

 

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environmentallaws. Obtaining such permits and authorizations may affect our existingfacilities or could delay the opening of new facilities, which could have amaterial adverse effect on our business and results of operations.

 

***We have in the past incurred, and maycontinue to incur, significant expenses for facilities that we no longer operate.***

 

Ifwe close a facility, we may remain committed to perform our obligations underthe applicable lease, which would include, among other things, payment of thebase rent for the balance of the lease term. We may also be required to incurother expenses with respect to such facilities. The potential losses associatedwith our inability to cancel leases may result in our keeping openunderperforming facilities. As a result, ongoing lease operations at closed orunder-performing facilities could impair our results of operations.

 

***We may continue to operate under unprofitablecontracts at facilities that we own to offset expenses associated withownership of the facility.***

 

Ifour operations are unprofitable at a leased facility or if the leased facilityis performing significantly below targeted levels, we would typically terminatethe contract and the lease. However, we may continue to operate our contract atan owned facility to offset the expenses associated with ownership. Continuedperformance of such a contract could have a material adverse effect on ourbusiness and results of operations.

 

***We depend on a limited number ofgovernmental customers for significant portion of our revenues.***

 

Wecurrently derive, and expect to continue to derive, a significant portion ofour revenues from the BOP and various state agencies. The loss of, or asignificant decrease in, business from the BOP or those state agencies couldseriously harm our financial condition and results of operations. Our BOPcontracts accounted for approximately 32.1% of our total revenues for the yearended December 31, 2007 ($115.7 million), 28.2 % of our total revenues forthe year ended December 31, 2006 ($101.9 million) and 23.0% of our totalrevenues for the year ended December 31, 2005 ($71.6 million). We expectto continue to depend upon the BOP and a relatively small group of othergovernmental customers for a significant percentage of our revenues.

 

***Because our revenues can fluctuate fromperiod to period, we may face short-term funding shortfalls from time to time.***

 

Revenuescan fluctuate from year to year due to changes in government funding policies,changes in the number of clients referred to our facilities by governmentalagencies, the opening of new facilities or the expansion of existing facilitiesand the termination of contracts for a facility or the closure of a facility.Our revenues fluctuate from quarter to quarter, based on the number ofcontracted days in each quarter. Because our revenues can vary, we may faceshort-term funding shortfalls from time to time. In addition, full-year resultsare not likely to be a direct multiple of any particular quarter or combinationof quarters.

 

***We are subject to significant insurancecosts.***

 

Worker’scompensation, employee health and general liability insurance representsignificant costs to us. We may continue to incur increasing insurance costs,typically due to adverse claims experience or rising healthcare costs ingeneral. Due to concerns over corporate governance and recent corporateaccounting scandals, liability and other types of insurance have become moredifficult and costly to obtain. In addition, stockholder lawsuits willgenerally serve to increase our directors’ and officers’ liability insurance.Unanticipated additional insurance costs could adversely impact our results ofoperations and cash flows, and the failure to obtain or maintain any necessaryinsurance coverage or the inability of an insurance carrier to perform underits obligations through issued coverage could have a material adverse effect onus.

 

***We may be adversely affected by inflation.***

 

Manyof our facility management contracts provide for fixed management fees or feesthat increase by only small amounts during their term. If, due to inflation orother causes, our operating expenses, such as wages and salaries of our employees,and insurance, medical and food costs, increase at rates faster than increases,if any, in our management fees, then our profitability would be adverselyaffected.

 

***We are subject to risks associated withownership of real estate and related operation of our facilities.***

 

Ourownership of correctional and detention facilities subjects us to riskstypically associated with investments in real estate. Moreover, correctionaland detention facilities are relatively illiquid and therefore, our ability todivest ourselves 

 

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ofone or more of our facilities promptly in response to changed conditions islimited. Investments in correctional and detention facilities subject us torisks involving potential exposure to uninsured loss. Our operating costs maybe affected by the obligation to pay for the cost of complying with existinglaws, ordinances and regulations, as well as the cost of complying with futurelegislation.  Our facilities are alsosubject to hazards such as fire, hurricanes, earthquakes and other naturaldisasters.  For example, Hurricane Ikethat recently came ashore in Texas damaged our Beaumont Transitional TreatmentCenter, Leidel Comprehensive Sanction Center and Reid Community ResidentialFacility.  See ‘‘Management’s Discussionand Analysis of Financial Condition and Results of Operations—Recent Events.’’  In addition, although we maintain insurance formany types of losses, there are certain types of losses, such as losses fromearthquakes, riots and acts of terrorism, which may be either uninsurable orfor which it may not be economically feasible to obtain insurance coverage. Asa result, we could lose both our capital invested in, and anticipated profitsfrom, one or more of the facilities we own. Further, we could experience lossesthat may exceed the limits of our insurance coverage.

 
| **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.**                                                     |
|         |       |                                                              |   |
|         |       | 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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|   |   | *  | Filed herewith.     |
|--------|--------|----|---------------------|
|   |   | ** | Furnished herewith. |

 

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**SIGNATURES**

 

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

 

 
| ** **                                          |   | **CORNELL  COMPANIES, INC.**          |
|-----------------------------------------------------|--------|---------------------------------------|
|                                                |   |                                  |
|                                                |   |                                  |
| Date:    November 7,  2008 | By:    | /s/ James E. Hyman                    |
|                                                |   | JAMES E. HYMAN                        |
|                                                |   | Chief Executive Officer,              |
|                                                |   | President and Chairman of the Board   |
|                                                |   | (Principal Executive Officer)         |
|                                                |   |                                  |
|                                                |   |                                  |
| Date:    November 7, 2008  | By:    | /s/ John R. Nieser                    |
|                                                |   | JOHN R. NIESER                        |
|                                                |   | Chief Financial Officer, Senior  Vice |
|                                                |   | President and Treasurer               |
|                                                |   | (Principal Financial Officer)         |

 

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