**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 March 31, 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 AreaCode:  **(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 check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

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

 

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 May 9, 2008, the registrant had 14,637,046 shares of commonstock outstanding.

 

 

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**Cornell Companies, Inc.**

** **

**Table of Contents**

 

**Form 10-Q**

** **
| ** **       | ** **                                                                                  | **Page**   |
|------------------|---------------------------------------------------------------------------------------------|------------|
| **Part I**  | ** **                                                                                  | ** ** |
| Item 1.          | Financial Statements (unaudited)                                                            | 5          |
| Item 2.          | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 26         |
| Item 3.          | Quantitative and Qualitative Disclosures  About Market Risk                                 | 40         |
| Item 4.          | Controls and Procedures                                                                     | 41         |
|             |                                                                                        |       |
| **Part II** |                                                                                        |       |
| Item 1.          | Legal  Proceedings                                                                          | 42         |
| Item 1A.         | Risk  Factors                                                                               | 42         |
| Item 2.          | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 42         |
| Item 3.          | Defaults  Upon Senior Securities                                                            | 42         |
| Item 4.          | Submission  of Matters to a Vote of Security Holders                                        | 42         |
| Item 5.          | Other  Information                                                                          | 42         |
| Item 6.          | Exhibits                                                                                    | 42         |

 

2

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**Forward-Looking Information**

 

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 annual report include, but are notlimited to, statements about the following subjects:

 

·                  revenues,

·                  revenue mix,

·                  expenses, including personnel and medicalcosts

·                  results of operations,

·                  operating margins

·                  supply and demand,

·                  market outlook in our various markets

·                  our other expectations with regard tomarket outlook,

·                  utilization,

·                  parolee, detainee, inmate and youthoffender trends

·                  pricing and per diem rates,

·                  contract commencements,

·                  new contract opportunities,

·                  operations at, future contracts for, andresults from our Regional Correctional Center,

·                  the timing, cost of completion and otheraspects of planned expansions, including without limitation the D. Ray JamesPrison and Great Plains Correctional Facility expansions,

·                  adequacy of insurance,

·                  insurance proceeds,

·                  debt levels,

·                  debt reduction,

·                  the effect of FIN No. 48,

·                  our effective tax rate,

·                  tax assessments,

·                  results and effects of legal proceedingsand governmental audits and assessments,

·                  liquidity,

·                  cash flow from operations,

·                  adequacy of cash flow for ourobligations,

·                  capital requirements

·                  capital expenditures,

·                  effects of accounting changes andadoption 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”

·               “intends”

·               “may”

·               “might”

 

3

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·               “plans”

·               “predicts”

·               “projects”

·               “scheduled”

·               “should”

 

Such statements aresubject to numerous risks, uncertainties and assumptions, including, but notlimited to:

 

·                        those described in the Company’s 2007Annual Report on Form 10-K under “Item 1A. Risk Factors” as filed with theSEC,

·                        the adequacy of sources of liquidity,

·                        the effect and results of litigation,audits and contingencies, and

·                        other factors discussed in this annualreport and in the Company’s other filings with the SEC, which are availablefree of charge on the SEC’s website at *www.sec.gov*.

 

Should one or more ofthese risks or uncertainties materialize, or should underlying assumptionsprove incorrect, actual results may vary materially from those indicated.

 

All subsequent writtenand oral forward-looking statements attributable to the Company or to personsacting on our behalf are expressly qualified in their entirety by reference tothese risks and uncertainties. You should not place undue reliance onforward-looking statements. Each forward-looking statement speaks only as ofthe date of the particular statement, and we undertake no obligation topublicly update or revise any forward-looking statements.

 

4

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**PART I  FINANCIAL INFORMATION**

**ITEM 1.      Financial Statements.**

 

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

 
| ** **                                                                                                                                                            | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| **CURRENT ASSETS:**                                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                             |       | $                        | 2,829      |                        | $          | 3,028 |   |
| Investment securities available for sale                                                                                                                              |       | 250                      |       | 250                         |       |
| Accounts receivable – trade (net of allowance for doubtful accounts  of $4,989 and $4,372, respectively)                                                         |       | 66,439                   |       | 69,787                      |       |
| Other receivables (net of allowance for doubtful accounts of $5,126)                                                                                                  |       | 3,867                    |       | 3,201                       |       |
| Debt service fund and other restricted assets                                                                                                                         |       | 28,486                   |       | 27,523                      |       |
| Deferred tax assets                                                                                                                                                   |       | 7,138                    |       | 6,750                       |       |
| Prepaid expenses and other                                                                                                                                            |       | 6,465                    |       | 6,131                       |       |
| **Total current assets**                                                                                                                                              |       | 115,474                  |       | 116,670                     |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 400,223                  |       | 383,952                     |       |
| **OTHER ASSETS:**                                                                                                                                                     |       |                     |       |                        |       |
| Debt service reserve fund                                                                                                                                             |       | 23,492                   |       | 23,638                      |       |
| Goodwill, net                                                                                                                                                         |       | 13,355                   |       | 13,355                      |       |
| Intangible assets, net                                                                                                                                                |       | 4,031                    |       | 4,520                       |       |
| Deferred costs and other                                                                                                                                              |       | 21,955                   |       | 20,152                      |       |
| **Total assets**                                                                                                                                                      |       | $                        | 578,530    |                        | $          | 562,287 |   |
|                                                                                                                                                                  |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                        | ** ** | ** **               | ** ** | ** **                  | ** ** |
|                                                                                                                                                                  |       |                     |       |                        |       |
| **CURRENT LIABILITIES:**                                                                                                                                              | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Accounts payable and accrued liabilities                                                                                                                              |       | $                        | 62,366     |                        | $          | 57,502 |   |
| Current portion of long-term debt                                                                                                                                     |       | 11,411                   |       | 11,411                      |       |
| **Total current liabilities**                                                                                                                                         |       | 73,777                   |       | 68,913                      |       |
| **LONG-TERM DEBT, net of current portion**                                                                                                                            |       | 280,341                  |       | 275,298                     |       |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 14,407                   |       | 13,226                      |       |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 3,128                    |       | 4,401                       |       |
| **Total liabilities**                                                                                                                                                 |       | 371,653                  |       | 361,838                     |       |
|                                                                                                                                                                  |       |                     |       |                        |       |
| **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,  16,067,817 and 16,068,677 shares issued and 14,561,654 and 14,553,631 shares  outstanding, respectively |       | 16                       |       | 16                          |       |
| Additional paid-in capital                                                                                                                                            |       | 161,307                  |       | 160,319                     |       |
| Retained earnings                                                                                                                                                     |       | 55,761                   |       | 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                                                                                                                                |       | 1,827                    |       | 1,092                       |       |
| **Total stockholders’ equity**                                                                                                                                   |       | 206,877                  |       | 200,449                     |       |
| **Total liabilities and stockholders’ equity**                                                                                                                   |       | $                        | 578,530    |                        | $          | 562,287 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

5

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**CORNELL COMPANIES, INC.****CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVEINCOME****(Unaudited)(in thousands, except per share data)**

 
| ** **                                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                                                           |       |                                             |       |   |   |
| REVENUES                                                                                       |       | $                                                | 95,392     |   | $ | 89,644 |   |
| OPERATING EXPENSES, EXCLUDING DEPRECIATION                                                     |       | 70,209                                           |       | 69,610 |   |
| DEPRECIATION AND AMORTIZATION                                                                  |       | 4,157                                            |       | 3,841 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                            |       | 6,536                                            |       | 8,358 |   |
|                                                                                           |       |                                             |       |   |   |
| INCOME FROM OPERATIONS                                                                         |       | 14,490                                           |       | 7,835 |   |
|                                                                                           |       |                                             |       |   |   |
| INTEREST EXPENSE                                                                               |       | 6,605                                            |       | 6,781 |   |
| INTEREST INCOME                                                                                |       | (310                                             | )          | (146 | ) |
|                                                                                           |       |                                             |       |   |   |
| INCOME FROM OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                       |       | 8,195                                            |       | 1,200 |   |
|                                                                                           |       |                                             |       |   |   |
| PROVISION FOR INCOME TAXES                                                                     |       | 3,561                                            |       | 536 |   |
|                                                                                           |       |                                             |       |   |   |
| NET INCOME                                                                                     |       | $                                                | 4,634      |   | $ | 664 |   |
|                                                                                           |       |                                             |       |   |   |
| EARNINGS PER SHARE:                                                                            |       |                                             |       |   |   |
| BASIC                                                                                          |       | $                                                | .32        |   | $ | .05 |   |
| DILUTED                                                                                        |       | $                                                | .32        |   | $ | .05 |   |
|                                                                                           |       |                                             |       |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                |       |                                             |       |   |   |
| BASIC                                                                                          |       | 14,272                                           |       | 13,984 |   |
| DILUTED                                                                                        |       | 14,583                                           |       | 14,246 |   |
|                                                                                           |       |                                             |       |   |   |
| COMPREHENSIVE INCOME:                                                                          |       |                                             |       |   |   |
| Net income                                                                                     |       | $                                                | 4,634      |   | $ | 664 |   |
| Unrealized gain on derivative instruments, net of tax provision of  $511 and $57, respectively |       | 735                                              |       | 81 |   |
| Comprehensive income                                                                           |       | $                                                | 5,369      |   | $ | 745 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

6

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

 
| ** **                                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Net income                                                                                              |       | $                                                | 4,634      |   | $ | 664 |   |
| Adjustments to reconcile net income to net cash provided by (used) in  operating activities —      |       |                                             |       |   |   |
| Depreciation                                                                                            |       | 3,669                                            |       | 3,280 |   |
| Amortization of intangibles and other assets                                                            |       | 488                                              |       | 561 |   |
| Amortization of deferred financing costs                                                                |       | 407                                              |       | 394 |   |
| Amortization of Senior Notes Discount                                                                   |       | 46                                               |       | 46 |   |
| Stock-based compensation                                                                                |       | 999                                              |       | 448 |   |
| Provision for bad debts                                                                                 |       | 1,248                                            |       | 510 |   |
| (Gains) losses on sale of property and equipment, net                                                   |       | (3                                               | )          | 28 |   |
| Deferred income taxes                                                                                   |       | 283                                              |       | — |   |
| Change in assets and liabilities:                                                                       |       |                                             |       |   |   |
| Accounts receivable                                                                                     |       | (1,500                                           | )          | 3,191 |   |
| Other restricted assets                                                                                 |       | (167                                             | )          | (776 | ) |
| Other assets                                                                                            |       | (259                                             | )          | (46 | ) |
| Accounts payable and accrued liabilities                                                                |       | (1,350                                           | )          | (12,212 | ) |
| Other liabilities                                                                                       |       | (1,273                                           | )          | (55 | ) |
| Net cash provided by (used in) operating activities                                                     |       | 7,222                                            |       | (3,967 | ) |
|                                                                                                    |       |                                             |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Capital expenditures                                                                                    |       | (11,924                                          | )          | (3,218 | ) |
| Purchases of investment securities                                                                      |       | —                                           |       | (117,325 | ) |
| Sales of investment securities                                                                          |       | —                                           |       | 118,800 |   |
| Withdrawals (payments) from (to) restricted debt payment account, net                                   |       | (650                                             | )          | 1,258 |   |
| Net cash used in investing activities                                                                   |       | (12,574                                          | )          | (485 | ) |
|                                                                                                    |       |                                             |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                   |       |                                             |       |   |   |
| Proceeds from line of credit                                                                            |       | 5,000                                            |       | — |   |
| Payments of capital lease obligations                                                                   |       | (3                                               | )          | (2 | ) |
| Tax benefit of stock option exercises                                                                   |       | —                                           |       | 214 |   |
| Proceeds from exercise of stock options                                                                 |       | 156                                              |       | 692 |   |
| Net cash provided by financing activities                                                               |       | 5,153                                            |       | 904 |   |
|                                                                                                    |       |                                             |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                               |       | (199                                             | )          | (3,548 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                        |       | 3,028                                            |       | 18,529 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                              |       | $                                                | 2,829      |   | $ | 14,981 |   |
|                                                                                                    |       |                                             |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                      |       |                                             |       |   |   |
| Other comprehensive income                                                                              |       | $                                                | 735        |   | $ | 81 |   |
| Common stock issued for board of directors fees                                                         |       | 148                                              |       | — |   |
| Increase in fair value of interest rate swap                                                            |       | —                                           |       | 577 |   |
| Effect of change in accounting for uncertain tax positions                                              |       | —                                           |       | 262 |   |
| Purchases and additions to property and equipment included in  accounts payable and accrued liabilities |       | 8,012                                            |       | 2,791 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

7

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

** **

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

 

Theaccompanying unaudited consolidated financial statements have been prepared byCornell Companies, Inc. (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 audited financialstatements but does not include all disclosures required by GAAP. In theopinion of management, adjustments and disclosures necessary for a fairpresentation of these financial statements have been included.  Estimates were used in the preparation of thesefinancial statements.  Actual resultscould differ from those estimates.  Thesefinancial statements should be read in conjunction with the financialstatements and notes thereto included in the Company’s 2007 Annual Report on Form 10-Kas filed with the Securities and Exchange Commission.

 

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

 

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 yeartypically begins each January 1st (the “Beginning Date”), as was the casein 2008, and ends on December 31st (the “Ending Date”). For 2007, however,the plan year began April 1, 2007. Purchases of common stock are made atthe end of the year using the lower of the fair market value on either theBeginning Date or Ending Date, less a 15% discount. Under SFAS No. 123R our employee-stockpurchase plan is considered to be a compensatory ESPP, and therefore, werecognize compensation expense over the requisite service period for grantsmade 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.

 

AtMarch 31, 2007, 107,500 shares of restricted stock were outstandingsubject to performance-based vesting criteria (30,000 of these restricted shareswere considered market-based restricted stock under SFAS No. 123R). Therewere also 100,100 stock options outstanding subject to performance-basedvesting criteria. We recognized $0.13 million of expense associated with theseshares of restricted stock and stock options during the three months ended March 31,2007.

 

AtMarch 31, 2008, 127,500 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 $0.5 million of expense associated with theseshares of restricted stock and stock options during the three months ended March 31,2008.

 

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 (95,000 shares) that vest based upon performance conditionsis not recorded for such performance-based awards until it has been deemedprobable that the related performance targets allowing the vesting of theseoptions and restricted stock will be met. We are required to periodicallyre-assess the probability that these options will vest and record expense atthat point in time. During the three months ended March 31, 2008 it wasdeemed probable that certain performance targets pertaining to certainrestricted stock and stock options would be achieved by their vesting date.Accordingly, compensation expense of approximately $0.4 million was recognizedin the three months ended March 31, 2008 related to these stock-basedawards.

 

We recognize expense for our stock-based compensationover the vesting period, which represents the period in which an employee isrequired to provide service in exchange for the award. We recognizecompensation expense for stock-based awards immediately if the award hasimmediate vesting.

 

8

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***Assumptions***

 

The fair values for the significant stock-based awards granted duringthe three months ended March 31, 2008 and 2007 were estimated at the dateof grant using a Black-Scholes option pricing model with the followingweighted-average assumptions:

 
| ** **                       | ** ** | **Three Months Ended   March 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|
| ** **                       | ** ** | **2008**                                               | ** ** | **2007** | ** ** |
|                             |       |                                                   |       |   |   |
| Risk-free rate of return         |       | 3.35                                                   | %          | 4.51 | % |
| Expected life of award           |       | 5.67 years                                             |       | 6.25 years |   |
| Expected dividend yield of stock |       | 0                                                      | %          | 0 | % |
| Expected volatility of stock     |       | 38.74                                                  | %          | 42.00 | % |
| Weighted-average fair value      |       | $                                                      | 9.46       |   | $ | 9.77 |   |
|                                  |            |                                                        |            |  |  |  |  |

 

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 three months ended March 31,2008 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                                           |       | (300                   | )          | 11.55                                  |       |                                                |       |                            |       |
| Canceled                                            |       | —                 |       | —                                 |       |                                                |       |                            |       |
|                                                |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at March 31, 2008                  |       | 535,542                |       | $                                      | 14.91      |                                                | 7.3        |                            | $          | 8.0 |   |
|                                                |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and expected to vest at  March 31, 2008 |       | 464,120                |       | $                                      | 14.74      |                                                | 7.1        |                            | $          | 6.8 |   |
|                                                |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at March 31, 2008                  |       | 358,031                |       | $                                      | 13.77      |                                                | 6.8        |                            | $          | 4.9 |   |

 

The total intrinsic value of stock options exercised during the threemonths ended March 31, 2008 and 2007 was $0.01 million and $0.6 million,respectively. Net cash proceeds from the exercise of stock options wereapproximately $0.01 million and $0.7 million for the three months ended March 31,2008 and 2007, respectively.

 

As of March 31, 2008, approximately $0.5 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 9.1 months.

 

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The following table summarizes information with respect to stockoptions outstanding and exercisable at March 31, 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       |       | 25,510                  |       | 3.5                                                 |       | $                                      | 5.75       |                    | 25,510     |                                   | $          | 5.75 |   |
| $10.01  to  $13.50      |       | 176,032                 |       | 6.3                                                 |       | 12.78                                  |       | 152,296                 |       | 12.79                                  |       |
| $13.51  to $14.50            |       | 209,800                 |       | 7.4                                                 |       | 13.96                                  |       | 127,100                 |       | 13.90                                  |       |
| $14.51  to $25.00            |       | 124,200                 |       | 9.1                                                 |       | 21.42                                  |       | 53,125                  |       | 20.16                                  |       |
|                                        |       | 535,542                 |       | 7.3                                                 |       | $                                      | 14.91      |                    | 358,031    |                                   | $          | 13.77 |   |

 

Stock-based award activity for nonvested awards during the three monthsended March 31, 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                              |       | (85,148                | )          | 14.45                                                       |       |
| Canceled                            |       | —                 |       | —                                                      |       |
|                                |       |                   |       |                                                        |       |
| Nonvested at March 31, 2008    |       | 177,511                |       | $                                                           | 17.20      |   |

 

***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 threemonths ended March 31, 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 three months ended March 31, 2008 was as follows:

 
| ** **                          | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|-------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at December 31, 2007 |       | 303,000                |       | $                                                           | 21.75      |   |
| Granted                             |       | 7,500                  |       | 22.68                                                       |       |
| Vested                              |       | (33,876                | )          | 16.77                                                       |       |
| Canceled                            |       | —                 |       | —                                                      |       |
|                                |       |                   |       |                                                        |       |
| Nonvested at March 31, 2008    |       | 276,624                |       | $                                                           | 22.38      |   |

 

Werecognized $0.3 million of expense associated with nonvested time-basedrestricted stock awards during the three months ended March 31, 2008.  As of March 31, 2008, approximately $2.6million of estimated expense with respect to nonvested time-based restrictedstock awards had yet to be recognized and will be amortized over a weightedaverage period of 2.2 years. Approximately $2.3 million ofestimated expense with respect to nonvested performance-based restricted stockoption awards had yet to be recognized as of March 31, 2008.

 

**4.****     Terminated Merger Agreement**

 

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

 

OurBoard of Directors unanimously approved the Merger Agreement. In connectionwith the Merger, the Parent and certain of 

 

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ourstockholders entered into a Voting Agreement dated on or about October 6,2006, whereby such stockholders agreed, among other things, to vote theirrespective shares of our stock in favor of the Merger Agreement, the Merger andthe transactions contemplated thereby. At a special meeting of our stockholdersheld on January 23, 2007, the proposed Merger Agreement was rejected.

 

Underthe terms of the Merger Agreement, because the Merger was terminated, wereimbursed $2.5 million of costs incurred by Veritas, Parent and Merger Sub inconnection with the proposed merger in February 2007. Such costs for legaland external professional and consulting fees are reflected in general andadministrative expenses for the three months ended March 31, 2007.

 

**5.****    ****Intangible Assets**

 

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

 
| ** **                                               | ** ** | **March 31,****2008** | ** ** | **December 31,****2007** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
|                                                     |       |                       |       |                          |       |
| Non-compete agreements                                   |       | $                          | 9,040      |                          | $          | 9,040 |   |
| Accumulated amortization – non-compete  agreements  |       | (7,753                     | )          | (7,541                        | )          |
| Acquired contract value                                  |       | 6,442                      |       | 6,442                         |       |
| Accumulated amortization – acquired contract  value |       | (3,698                     | )          | (3,421                        | )          |
| Identified intangibles, net                              |       | 4,031                      |       | 4,520                         |       |
| Goodwill, net                                            |       | 13,355                     |       | 13,355                        |       |
| Total intangibles, net                                   |       | $                          | 17,386     |                          | $          | 17,875 |   |

 

There were no changes inthe carrying amount of our goodwill in the three months ended March 31,2008.

 

Amortizationexpense for our non-compete agreements was approximately $0.2 million and $0.3million for the three months ended March 31, 2008 and 2007, respectively.Amortization expense for our non-compete agreements is expected to beapproximately $0.8 million for the year ending December 31, 2008 andapproximately $0.6 million for the year ending December 31, 2009.

 

Amortizationexpense for our acquired contract value was approximately $0.3 million for eachof the three months ended March 31, 2008 and 2007.  Amortization expense for our acquiredcontract value is expected to be approximately $1.1 million for each of thenext two years ending December 31, and approximately $0.7 million for thefinal year.

 

**6.****    ****New Accounting Pronouncements**

 

**New Accounting Pronouncements**

 

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

 

InSeptember 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. 157is effective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years.  This statement applies prospectively to financialassets and liabilities. In February 2008, the FASB issued FSP157-2, which delayed the effective date of SFAS No. 157 by one year fornonfinancial assets and liabilities.  Ouradoption of SFAS No. 157 on January 1, 2008 with respect to financialassets and liabilities did not have a material financial impact on ourconsolidated results of operations or financial condition.  We are currently evaluating the impact ofimplementation with respect to nonfinancial assets and liabilities on ourconsolidated financial statements.

 

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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 tablesummarizes the valuation of our financial assets and liabilities by pricinglevels, as defined by the provisions of SFAS No. 157, as of March 31,2008:

 
| ** **                                  | ** ** | **Fair Value as of March 31, 2008 (in thousands)** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Level 1**                                                                           | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Assets:                                     |       |                                                                                       |       |   |   |   |   |   |   |
| Certificates of Deposits                    |       | $                                                                                          | —     |   | $ | 250 |   | $ | — |   | $ | 250 |   |
| Corporate Bonds                             |       | —                                                                                     |       | 9,996 |   | — |   | 9,996 |   |
| Money Market Funds                          |       | —                                                                                     |       | 39,182 |   | — |   | 39,182 |   |
| Liabilities:                                |       |                                                                                       |       |   |   |   |   |   |   |
| Derivative Instruments (Debt Service Funds) |       | $                                                                                          | —     |   | $ | — |   | $ | 905 |   | $ | 905 |   |

 

SFAS No. 157requires a reconciliation of the beginning and ending balances for fair valuemeasurements using Level 3 inputs.  Thetable below sets forth a reconciliation for assets and liabilities measured atfair value on a recurring basis using significant unobservable inputs (Level 3)during the three months ended March 31, 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   |   |

 

 

***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. 159 iseffective for financial statements issued for fiscal years beginning after November 15,2007, provided the entity elects to apply the provisions of SFAS No. 157.Our adoption of SFAS No. 159 on January 1, 2008 did not have amaterial impact on our consolidated results of operations or financialcondition 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***

 

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.

 

***Statement of Financial AccountingStandards 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 

 

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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 itnoncontrolling 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.

 

**7.****    ****Credit Facilities**

 

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

 
| ** **                                                                                                                                                                  | ** ** | **March 31,** | ** ** | **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                                                                               |       | $                  | 111,217    |                  | $          | 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”) |       | 35,000             |       | 30,000                |       |
| Capital lease obligations                                                                                                                                                   |       | 35                 |       | 37                    |       |
| Subtotal                                                                                                                                                                    |       | 146,252            |       | 141,209               |       |
|                                                                                                                                                                        |       |               |       |                  |       |
| **Debt of  Special Purpose Entity (MCF):**                                                                                                                                  |       |               |       |                  |       |
| 8.47% Bonds due 2016                                                                                                                                                        |       | 145,500            |       | 145,500               |       |
|                                                                                                                                                                        |       |               |       |                  |       |
| Total consolidated debt                                                                                                                                                     |       | 291,752            |       | 286,709               |       |
|                                                                                                                                                                        |       |               |       |                  |       |
| Less: current maturities                                                                                                                                                    |       | (11,411            | )          | (11,411               | )          |
|                                                                                                                                                                        |       |               |       |                  |       |
| Consolidated long-term debt                                                                                                                                                 |       | $                  | 280,341    |                  | $          | 275,298 |   |

 

***Long-Term Credit Facilities.***  OurAmended 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. Theavailable commitment under our Amended Credit Facility was approximately $55.3million at March 31, 2008.  We hadoutstanding borrowings under our Amended Credit Facility of $35.0 million andwe had outstanding letters of credit of approximately $9.7 million at March 31,2008.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million.  The Amended CreditFacility 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 March 31, 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% perannum 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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Thebonds are limited, nonrecourse obligations of MCF and secured by the propertyand equipment, bond reserves, assignment of subleases and substantially allassets related to the facilities included in the 2001 Sale and LeasebackTransaction (in which we sold eleven facilities to MCF).  The bonds are notguaranteed by Cornell.

 

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

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

 

Upon theoccurrence of specified change of control events, unless we have exercised ouroption to redeem all the Senior Notes as described above, each holder will havethe right to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture 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 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 months ended March 31,2007, we recorded interest expense related to this interest rate swap ofapproximately $0.01 million.  Theswap agreement was marked to market each quarter with a correspondingmark-to-market adjustment reflected as either a discount or premium on theSenior Notes.  At March 31, 2007,the fair value of this derivative instrument was approximately ($0.5) millionand was included in other long-term liabilities in the accompanying financialstatements.  The carrying value of theSenior Notes as of this date was adjusted accordingly by the same amount.Because the swap agreement was an effective fair-value hedge, there was noeffect on our results of operations from the mark-to-market adjustment as longas the swap was in effect. In October 2007, we terminated the swapagreement. We received approximately $0.2 million in conjunction with thetermination, which is being amortized over the remaining term of the SeniorNotes.

 

**8.****             ****Income Taxes**

 

In July 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109”(“FIN 48”).  FIN 48 established a singlemodel to address the accounting for uncertain tax positions.  FIN 48 clarifies the accounting for incometaxes by prescribing a minimum recognition threshold a tax position is requiredto meet before being recognized in the financial statements.  FIN 48 also provides guidance on themeasurement, recognition, classification and disclosure of tax positions, aswell as the accounting for the related interest and penalties, transition andaccounting in interim periods.

 

We adopted the provisions of FIN 48 effective January 1,2007.  As a result of our adoption of FIN48, we recorded an adjustment of approximately $0.3 million which increasedretained earnings at January 1, 2007. There were no changes to the total amount of our unrecognized taxbenefits in the three months ended March 31, 2008.

 

Estimated interest and penalties related to theunderpayment of income taxes are classified as a component of income taxexpense in the accompanying Consolidated Statements of Income and ComprehensiveIncome.  There were no material changesto our accrued interest and penalties in the three months end March 31, 2008.

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We are subject to income tax in the United Statesand many of the individual states we operate in.  We currently have significant operations inTexas, California, Oklahoma, Georgia, Illinois and Pennsylvania.  State income tax returns are generallysubject to examination for a period of three to five years after filing.  The state impact of any changes made to thefederal return remains subject to examination by various states for a period upto 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.

 

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

 

**9.****             ****Earnings Per Share**

 

Basic earningsper share (“EPS”) are computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended March 31,2008 and 2007, there were 64,200 shares ($23.24 average price) and 12,500shares ($20.12 average price), respectively, of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.

 

The followingtable summarizes the calculation of net earnings and weighted average commonshares and common equivalent shares outstanding for purposes of the computationof earnings per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                                     |       |                                             |       |   |   |
| Net income                                                               |       | $                                                | 4,634      |   | $ | 664 |   |
|                                                                     |       |                                             |       |   |   |
| Weighted average common  share outstanding                               |       | 14,272                                           |       | 13,984 |   |
| Weighted average common  share equivalents outstanding                   |       | 311                                              |       | 262 |   |
| Weighted average common  shares and common share equivalents outstanding |       | 14,583                                           |       | 14,246 |   |
|                                                                     |       |                                             |       |   |   |
| Basic income per share                                                   |       | $                                                | .32        |   | $ | .05 |   |
|                                                                     |       |                                             |       |   |   |
| Diluted income per  share                                                |       | $                                                | .32        |   | $ | .05 |   |

 

**10.****      ****Commitments andContingencies**

 

***FinancialGuarantees***

 

During the normal course of business, we enter intocontracts that contain a variety of representations and warranties and providegeneral indemnifications. Our maximum exposure under these arrangements isunknown as this would involve future claims that may be made against us thathave not yet occurred. However, based on experience, we believe the risk ofloss to be remote.

 

***Legal Proceedings***

 

We are party to various legal proceedings,including those noted below. While management presently believes that theultimate outcome of these proceedings will not have a material adverse effecton our financial position, overall trends in results of operations or cashflows, litigation is subject to inherent uncertainties, and unfavorable rulingscould occur. An unfavorable ruling could include monetary damages or equitablerelief, and could have a material adverse impact on the net income of theperiod in which the ruling occurs or in future periods.

 

***ValenciaCounty Detention Center***

 

In April 2007, a lawsuit was filedagainst the Company in the Federal District court in Albuquerque, New Mexico,by Joe Torres and Eufrasio Armijo, who each alleged that he was strip searchedat the Valencia County Detention Center (“VCDC”) in New Mexico in violation ofhis federal rights under the Fourth, Fourteenth and Eighth amendments to theU.S. Constitution.  The 

 

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claimants also allege violation of their rights under state law andseek to bring the case as a class action on behalf of themselves and alldetainees at VCDC during the applicable statues of limitation.  Theplaintiffs seek damages and declaratory and injunctive relief.  ValenciaCounty is also a named defendant in the case and operated the VCDC for a significantlygreater portion of the period covered by the lawsuit.  Discovery has commenced in the case but theultimate outcome of the lawsuit cannot be determined at this time. We intend tovigorously defend this lawsuit.

 

***LincolnCounty Detention Center***

 

In August 2005, a lawsuit was filed by adetainee at the Lincoln County Detention Center (“LCDC”) in the U.S. DistrictCourt of New Mexico (Santa Fe) seeking unspecified damages. The lawsuit relatesto the former LCDC policy that required strip and visual body cavity searchesfor all detainees and inmates and alleges that such policy violates a detainee’sFourth and Fourteenth Amendment rights under the U.S. Constitution. The lawsuitwas filed as a putative class action lawsuit brought on behalf of all inmateswho were searched 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, werecorded a charge of $0.2 million related to this lawsuit. In addition, wepreviously have provided insurance reserves for this matter (as part of ourregular review of reported and unreported claims) totaling approximately $0.5million. During the third quarter of 2006, we recorded an additional settlementcharge of approximately $0.9 million and the related reimbursement from ourgeneral liability and professional liability insurance. The charge andreimbursement were recognized in general and administrative expenses for theyear ended December 31, 2006. The reimbursement was funded by theinsurance carrier in the first quarter of 2007 into a settlement account. Thecourt granted preliminary approval of the settlement in the second quarter of2007 and the claims administration process is now underway. We expect theclaims administration process to be completed and the final court approval ofthe settlement in 2008.

 

***Alexander Youth Services Center***

 

In April 2006, we were sued in an actionstyled as *Juana Michelle Brown, Administratrix of the Estateof Lakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. etal.,* No. 4-06 CV00000434, in the United States District Courtfor the Eastern District of Arkansas. The lawsuit alleges that we violated therights of Lakeisha Shantrail Brown, the deceased daughter of Juana MichelleBrown, under the U.S. Constitution and the laws of the State of Arkansas bydenying Ms. Brown medical treatment that caused her death and soughtunspecified actual and punitive damages. In September 2006, the plaintifffiled, and the court granted, an order for voluntary dismissal without prejudice.The lawsuit was refiled in December 2006 as *JuanaMichelle Brown, Administratrix of the Estate of Lakeisha Shantrail Brown,Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06CV17808*,*in the United States District Courtfor the Eastern District of Arkansas. We have reached an agreement with theplaintiff to settle the matter, and the settlement has now been approved by aprobate court and the case has been resolved. Our insurance funded thesettlement subject to our normal deductible.

 

***Shareholder Lawsuits***

 

On October 19, 2006, a purported class actioncomplaint was filed in the District Court of Harris County, Texas, 269thJudicial District (No. 2006-67413) by Ted Kinbergy, an alleged stockholderof Cornell. The complaint names as defendants Cornell and each member of ourboard of directors as well as Veritas Capital Fund III, L.P. (“Veritas”). Thecomplaint alleges, among other things, that (i) the defendants havebreached fiduciary duties they assertedly owed to our stockholders inconnection with our entering into the Agreement and Plan of Merger, dated as ofOctober 6, 2006, with Veritas, Cornell Holding Corp., and CCI AcquisitionCorp., and (ii) the merger consideration is unfair and inadequate. Theplaintiffs sought, among other things, an injunction against the consummationof the merger. The proposed merger was rejected at a special meeting of ourstockholders held on January 23, 2007. We believe that the lawsuit iswithout merit and intend to defend ourselves vigorously.

 

We hold insurance policies to cover potentialdirector and officer liability, some of which may limit our cash outflows inthe event of a decision adverse to us in the matters discussed above. However,if an adverse decision in these matters exceeds the insurance coverage or ifthe insurance coverage is deemed not to apply to these matters, it could have amaterial adverse effect on us, our financial condition, results of operationsand future cash flows.

 

***Other***

 

Additionally, we currently and from time totime are subject to claims and suits arising in the ordinary course ofbusiness, including claims for damages for personal injuries or for wrongfulrestriction of or interference with offender privileges and employment matters.If an adverse decision in these matters exceeds our insurance coverage, or ifour coverage is deemed not to 

 

16

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apply to these matters, or if the underlying insurance carrier wasunable to fulfill its obligation under the insurance coverage provided, itcould have a material adverse effect on our financial condition, results ofoperations or cash flows.

 

While the outcome of such other matterscannot be predicated with certainty, based on the information known to date, webelieve that the ultimate resolution of these matters will not have a materialadverse effect on our financial condition, but could be material to operatingresults or cash flows for a particular reporting period.

 

**11.***      ***Derivative FinancialInstruments And Guarantees**

 

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

 

In August 2001, MCF, a special purpose entity,completed a bond offering to finance the 2001 Sale and Leaseback Transaction(in which we sold eleven facilities (as identified in Item 1 of this report) toMCF. In connection with this bond offering, two reserve fund accounts wereestablished by MCF pursuant to the terms of the indenture: (1) MCF’s DebtService Reserve Fund, aggregating $23.5 million at March 31, 2008, wasestablished to make payments on MCF’s outstanding bonds in the event we (aslessee) should fail to make the scheduled rental payments to MCF and (2) MCF’sDebt Service Fund, aggregating $25.7 million at March 31, 2008, wasestablished to accumulate the monthly lease payments that MCF receives from usuntil such funds are used to pay MCF’s semi-annual bond interest and annualbond principal payments. These reserve funds are invested in short-term moneymarkets and commercial paper. Both reserve fund accounts are subject to theagreements with the MCF Equity Investors whereby guaranteed rates of return of3.0% and 5.08%, respectively, are provided for in the balance of the DebtService Reserve Fund and the Debt Service Fund. The guaranteed rates of returnare characterized as cash flow hedge derivative instruments. At inception, thederivative instruments had an aggregate fair value of $4.0 million, which hasbeen recorded as a decrease to the equity investment in MCF made by the MCFEquity Investors (MCF minority interest) and as a liability in our ConsolidatedBalance Sheets. Changes in the fair value of the derivative instruments arerecorded as an adjustment to other long-term liabilities and reported as othercomprehensive income (loss) in our Consolidated Statements of Income andComprehensive Income. At March 31, 2008 and December 31, 2007, thefair value of these derivative instruments was a liability of approximately$0.9 million and $2.2 million, respectively. As a result, our Consolidated Statements of Income and ComprehensiveIncome include other comprehensive income, net of taxes, of approximately $0.7million and $0.1 million for the three months ended March 31, 2008 and2007, respectively.

 

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

 

17

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**12.****      ****Segment Disclosure**

 

Our three operating divisions are our reportablesegments. The Adult Secure Services segment consists of the operations of secureadult incarceration facilities. The Abraxas Youth and Family Services segmentconsists of providing residential treatment and educational programs andnon-residential community-based programs to juveniles between the ages of tenand seventeen who have either been adjudicated or suffer from behavioralproblems. The Adult Community-Based Services segment consists of providingpre-release and halfway house programs for adult offenders who are either onprobation or serving the last three to six-months of their sentences on paroleand preparing for re-entry into society as well as community-based treatmentand education programs as an alternative to incarceration. All of our customersand long-lived assets are located in the United States of America. The accountingpolicies of our reportable segments are the same as those described in thesummary of significant accounting policies in Note 2 in our 2007 Annual Reporton Form 10-K.  Intangible assets arenot included in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a reportable segment’soperating income. We evaluate performance based on income or loss fromoperations before general and administrative expenses, amortization ofintangibles, interest and income taxes. Corporate and other assets arecomprised primarily of cash, investment securities available for sale, accountsreceivable, debt service and debt service reserve funds, deposits, property andequipment, deferred taxes, deferred costs and other assets. Corporate and otherexpenses from operations consists of depreciation and amortization on thecorporate office facility and equipment and specific general and administrativecharges pertaining to corporate personnel. Such expenses are presentedseparately, as they cannot be readily identified for allocation to a particularsegment.

 

The only significant non-cash items reportedin the respective segments’ income from operations is depreciation andamortization excluding intangibles (in thousands).

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------------|------------|
| ** **                          | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                |       |                                             |       |   |   |
| Revenues:                           |       |                                             |       |   |   |
| Adult Secure Services               |       | $                                                | 49,899     |   | $ | 46,509 |   |
| Abraxas Youth and Family Services   |       | 27,773                                           |       | 26,798 |   |
| Adult Community-Based Services      |       | 17,720                                           |       | 16,337 |   |
| Total revenues                      |       | $                                                | 95,392     |   | $ | 89,644 |   |
|                                |       |                                             |       |   |   |
| Income from operations:             |       |                                             |       |   |   |
| Adult Secure Services               |       | $                                                | 15,113     |   | $ | 11,871 |   |
| Abraxas Youth and Family Services   |       | 1,768                                            |       | 2,410 |   |
| Adult Community-Based Services      |       | 4,809                                            |       | 2,652 |   |
| Sub-total                           |       | 21,690                                           |       | 16,933 |   |
| General and administrative expenses |       | (6,536                                           | )          | (8,358 | ) |
| Amortization of intangibles         |       | (488                                             | )          | (561 | ) |
| Corporate and other expenses        |       | (176                                             | )          | (179 | ) |
| Total income from operations        |       | $                                                | 14,490     |   | $ | 7,835 |   |

 
| ** **                        | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Assets:                           |       |                     |       |                        |       |
| Adult Secure Services             |       | $                        | 309,026    |                        | $          | 290,930 |   |
| Abraxas Youth and Family Services |       | 109,258                  |       | 108,978                     |       |
| Adult Community-Based Services    |       | 61,941                   |       | 63,008                      |       |
| Intangible assets, net            |       | 17,386                   |       | 17,875                      |       |
| Corporate and other               |       | 80,919                   |       | 81,496                      |       |
| Total assets                      |       | $                        | 578,530    |                        | $          | 562,287 |   |

 

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**13.****      ****Guarantor Disclosures**

 

Wecompleted an offering of $112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofour subsidiaries (Guarantor Subsidiaries). MCF does not guarantee the Senior Notes (“Non-Guarantor Subsidiary”).These guarantees are joint and several obligations of the GuarantorSubsidiaries.  The following condensedconsolidating financial information presents the financial condition, resultsof operations and cash flows for the Parent, the Guarantor Subsidiaries and theNon-Guarantor Subsidiary, together with the consolidating adjustments necessaryto present our results on a consolidated basis.

 

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# **Condensed Consolidating Balance Sheet as of March 31, 2008 (inthousands) (unaudited)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                  |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash equivalents                        |       | $          | 2,585      |                        | $          | 217                               |       | $                | 27         |             | $          | — |   | $ | 2,829 |   |
| Investment securities                            |       | 250        |       | 3⁄4                      |       | 3⁄4                            |       | 3⁄4           |       | 250              |       |
| Accounts receivable                              |       | 1,165      |       | 68,840                      |       | 301                               |       | 3⁄4           |       | 70,306           |       |
| Restricted assets                                |       | 3⁄4     |       | 2,799                       |       | 25,687                            |       | 3⁄4           |       | 28,486           |       |
| Prepaids and other                               |       | 11,991     |       | 1,612                       |       | 3⁄4                            |       | 3⁄4           |       | 13,603           |       |
| Total current assets                             |       | 15,991     |       | 73,468                      |       | 26,015                            |       | 3⁄4           |       | 115,474          |       |
| Property and equipment,  net                     |       | 304        |       | 259,431                     |       | 145,141                           |       | (4,653           | )          | 400,223          |       |
| Other assets:                                    |       |       |       |                        |       |                              |       |             |       |             |       |
| Debt service reserve  fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,492                            |       | 3⁄4           |       | 23,492           |       |
| Deferred costs and other                         |       | 57,682     |       | 26,268                      |       | 5,868                             |       | (50,477          | )          | 39,341           |       |
| Investment in  subsidiaries                      |       | 43,917     |       | 1,856                       |       | 3⁄4                            |       | (45,773          | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 117,894    |                        | $          | 361,023                           |       | $                | 200,516    |             | $          | (100,903 | ) | $ | 578,530 |   |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 41,356     |                        | $          | 19,598                            |       | $                | 2,090      |             | $          | (678 | ) | $ | 62,366 |   |
| Current portion of  long-term debt               |       | 3⁄4     |       | 11                          |       | 11,400                            |       | 3⁄4           |       | 11,411           |       |
| Total current  liabilities                       |       | 41,356     |       | 19,609                      |       | 13,490                            |       | (678             | )          | 73,777           |       |
| Long-term debt, net of  current portion          |       | 146,217    |       | 24                          |       | 134,100                           |       | 3⁄4           |       | 280,341          |       |
| Deferred tax  liabilities                        |       | 13,057     |       | 94                          |       | 3⁄4                            |       | 1,256            |       | 14,407           |       |
| Other long-term  liabilities                     |       | 6,621      |       | 134                         |       | 51,273                            |       | (54,900          | )          | 3,128            |       |
| Intercompany                                     |       | (296,234   | )          | 296,239                     |       | 3⁄4                            |       | (5               | )          | 3⁄4           |       |
| Total liabilities                                |       | (88,983    | )          | 316,100                     |       | 198,863                           |       | (54,327          | )          | 371,653          |       |
| Stockholders’ equity                        |       | 206,877    |       | 44,923                      |       | 1,653                             |       | (46,576          | )          | 206,877          |       |
| Total liabilities and  stockholders’ equity |       | $          | 117,894    |                        | $          | 361,023                           |       | $                | 200,516    |             | $          | (100,903 | ) | $ | 578,530 |   |

 

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

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                  |       |       |       |                        |       |                              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 2,565      |                        | $          | 408                               |       | $                | 55         |             | $          | — |   | $ | 3,028 |   |
| Investment securities                            |       | 250        |       | 3⁄4                      |       | 3⁄4                            |       | 3⁄4           |       | 250              |       |
| Accounts receivable                              |       | 1,814      |       | 70,495                      |       | 679                               |       | 3⁄4           |       | 72,988           |       |
| Restricted assets                                |       | 3⁄4     |       | 2,486                       |       | 25,629                            |       | (592             | )          | 27,523           |       |
| Prepaids and other                               |       | 11,362     |       | 1,519                       |       | 3⁄4                            |       | 3⁄4           |       | 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                       |       | 3⁄4     |       | 3⁄4                      |       | 23,638                            |       | 3⁄4           |       | 23,638           |       |
| Deferred costs and  other                        |       | 56,500     |       | 24,460                      |       | 6,035                             |       | (48,968          | )          | 38,027           |       |
| Investment in  subsidiaries                      |       | 41,445     |       | 1,856                       |       | 3⁄4                            |       | (43,301          | )          | 3⁄4           |       |
| 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               |       | 3⁄4     |       | 11                          |       | 11,400                            |       | 3⁄4           |       | 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                           |       | 3⁄4           |       | 275,298          |       |
| Deferred tax  liabilities                        |       | 12,387     |       | 94                          |       | 3⁄4                            |       | 745              |       | 13,226           |       |
| Other long-term  liabilities                     |       | 6,705      |       | 162                         |       | 49,702                            |       | (52,168          | )          | 4,401            |       |
| Intercompany                                     |       | (284,258   | )          | 284,263                     |       | 3⁄4                            |       | (5               | )          | 3⁄4           |       |
| 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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# **Condensed Consolidating Statement of Income for the three months ended March 31,2008**(in thousands) (unaudited)

 
| ** **                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                        |       |       |       |                        |       |                              |       |             |       |             |       |
| Revenues                                    |       | $          | 4,502      |                        | $          | 108,496                           |       | $                | 4,502      |             | $          | (22,108 | ) | $ | 95,392 |   |
| Operating expenses,  excluding depreciation |       | 3,086      |       | 89,135                      |       | 12                                |       | (22,024          | )          | 70,209           |       |
| Depreciation and  amortization              |       | 3⁄4     |       | 3,260                       |       | 1,056                             |       | (159             | )          | 4,157            |       |
| General and  administrative expenses        |       | 6,517      |       | 3⁄4                      |       | 19                                |       | 3⁄4           |       | 6,536            |       |
| Income (loss) from  operations              |       | (5,101     | )          | 16,101                      |       | 3,415                             |       | 75               |       | 14,490           |       |
| Overhead allocations                        |       | (13,342    | )          | 13,342                      |       | 3⁄4                            |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                               |       | 2,068      |       | 1,273                       |       | 3,016                             |       | (62              | )          | 6,295            |       |
| Equity earnings in  subsidiaries            |       | 1,802      |       | 3⁄4                      |       | 3⁄4                            |       | (1,802           | )          | 3⁄4           |       |
| Income before provision  for income taxes   |       | 7,975      |       | 1,486                       |       | 399                               |       | (1,665           | )          | 8,195            |       |
| Provision for income  taxes                 |       | 3,341      |       | 3⁄4                      |       | 3⁄4                            |       | 220              |       | 3,561            |       |
| Net income                                  |       | $          | 4,634      |                        | $          | 1,486                             |       | $                | 399        |             | $          | (1,885 | ) | $ | 4,634 |   |

 

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# **Condensed Consolidating Statement of Income for the three months ended March 31,2007**(in thousands) (unaudited)

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                              |       |             |       |             |       |
| Revenues                                         |       | $          | 4,502      |                        | $          | 101,422                           |       | $                | 4,502      |             | $          | (20,782 | ) | $ | 89,644 |   |
| Operating expenses,  excluding depreciation      |       | 3,314      |       | 86,981                      |       | 13                                |       | (20,698          | )          | 69,610           |       |
| Depreciation and  amortization                   |       | —     |       | 2,942                       |       | 1,056                             |       | (157             | )          | 3,841            |       |
| General and  administrative expenses             |       | 8,339      |       | —                      |       | 19                                |       | —           |       | 8,358            |       |
| Income (loss) from  operations                   |       | (7,151     | )          | 11,499                      |       | 3,414                             |       | 73               |       | 7,835            |       |
| Overhead allocations                             |       | (10,987    | )          | 10,987                      |       | —                            |       | —           |       | —           |       |
| Interest, net                                    |       | 1,793      |       | 1,274                       |       | 3,047                             |       | 521              |       | 6,635            |       |
| Equity loss in  subsidiaries                     |       | (810       | )          | —                      |       | —                            |       | 810              |       | —           |       |
| Income (loss) before  provision for income taxes |       | 1,233      |       | (762                        | )          | 367                               |       | 362              |       | 1,200            |       |
| Provision for income  taxes                      |       | 569        |       | —                      |       | —                            |       | (33              | )          | 536              |       |
| Net income (loss)                                |       | $          | 664        |                        | $          | (762                              | )          | $                | 367        |             | $          | 395 |   | $ | 664 |   |

 

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# **Condensed Consolidating Statement of Cash Flows for the three monthsended March 31, 2008 (in thousands) (unaudited)**

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|
| **Cash  flows from operating activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Net cash (used in)  provided by operating activities |       | $          | (5,136     | )                           | $          | 11,736                            |       | $                | 622        |   | $ | 7,222 |   |
| ** **                                           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Capital expenditures                                 |       | 3⁄4     |       | (11,924                     | )          | 3⁄4                            |       | (11,924          | )          |
| Payments to restricted  debt payment account, net    |       | 3⁄4     |       | 3⁄4                      |       | (650                              | )          | (650             | )          |
| Net cash used in  investing activities               |       | 3⁄4     |       | (11,924                     | )          | (650                              | )          | (12,574          | )          |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| **Cash  flows from financing activities:**           | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Proceeds from line of  credit                        |       | 5,000      |       | 3⁄4                      |       | 3⁄4                            |       | 5,000            |       |
| Payments on capital  lease obligations               |       | 3⁄4     |       | (3                          | )          | 3⁄4                            |       | (3               | )          |
| Proceeds from exercise  of stock options             |       | 156        |       | 3⁄4                      |       | 3⁄4                            |       | 156              |       |
| Net cash provided by  (used in) financing activities |       | 5,156      |       | (3                          | )          | 3⁄4                            |       | 5,153            |       |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| Net increase (decrease) in cash and cash equivalents |       | 20         |       | (191                        | )          | (28                               | )          | (199             | )          |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| Cash and cash equivalents at beginning of  period    |       | 2,565      |       | 408                         |       | 55                                |       | 3,028            |       |
|                                                 |       |       |       |                        |       |                              |       |             |       |
| Cash and cash equivalents at end of period           |       | $          | 2,585      |                        | $          | 217                               |       | $                | 27         |   | $ | 2,829 |   |

 

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**Condensed Consolidating Statement of CashFlows for the three months ended March 31, 2007 (in thousands) (unaudited)**

 
| ** **                                             | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor****Subsidiary** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------|------------|
| **Cash  flows from operating activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Net cash (used in)  provided by operating activities   |       | $          | (5,969     | )                           | $          | 3,268                             |       | $                | (1,266     | ) | $ | (3,967 | ) |
| ** **                                             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Capital expenditures                                   |       | —     |       | (3,218                      | )          | —                            |       | (3,218           | )          |
| Purchase of investment securities                      |       | (117,325   | )          | —                      |       | —                            |       | (117,325         | )          |
| Sales of investment  securities                        |       | 118,800    |       | —                      |       | —                            |       | 118,800          |       |
| Withdrawals from  restricted debt payment account, net |       | —     |       | —                      |       | 1,258                             |       | 1,258            |       |
| Net cash (used in)  provided by investing activities   |       | 1,475      |       | (3,218                      | )          | 1,258                             |       | (485             | )          |
|                                                   |       |       |       |                        |       |                              |       |             |       |
| **Cash  flows from financing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                        | ** ** | ** **       | ** ** |
| Payments on capital  lease obligations                 |       | —     |       | (2                          | )          | —                            |       | (2               | )          |
| Tax benefit of stock  option exercises                 |       | 214        |       | —                      |       | —                            |       | 214              |       |
| Proceeds from exercise  of stock options               |       | 692        |       | —                      |       | —                            |       | 692              |       |
| Net cash (used in)  provided by financing activities   |       | 906        |       | (2                          | )          | —                            |       | 904              |       |
|                                                   |       |       |       |                        |       |                              |       |             |       |
| Net (decrease) increase in cash and cash equivalents   |       | (3,588     | )          | 48                          |       | (8                                | )          | (3,548           | )          |
|                                                   |       |       |       |                        |       |                              |       |             |       |
| Cash and cash equivalents at beginning of  period      |       | 18,083     |       | 371                         |       | 75                                |       | 18,529           |       |
|                                                   |       |       |       |                        |       |                              |       |             |       |
| Cash and cash equivalents at end of period             |       | $          | 14,495     |                        | $          | 419                               |       | $                | 67         |   | $ | 14,981 |   |

 

25

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**ITEM 2.****         ****Management’sDiscussion and Analysis of Financial 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 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 March 31, 2008,we operated 74 facilities with a total service capacity of 18,939 and had onefacility with a service capacity of 70 beds that was vacant. Our facilitiesare located in 15 states and the District of Columbia.

 

The following table sets forth for the periods indicated totalresidential service capacity and contracted beds in operation at the end of theperiods shown, average contract occupancy percentages and total non-residentialservice capacity.

 
| ** **                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                                           |       |                                             |       |   |   |
| **Residential**                                                                |       |                                             |       |   |   |
| Service capacity (1)                                                           |       | 16,056                                           |       | 14,556 |   |
| Contracted beds in operation  (end of period) (2)                              |       | 14,618                                           |       | 13,352 |   |
| Average contract occupancy based  on contracted beds in operation (3) (4) |       | 95.5                                             | %          | 100.3 | % |
| Average contract occupancy  excluding start-up operations (3) (4)         |       | 95.5                                             | %          | 100.3 | % |
| **Non-Residential**                                                            |       |                                             |       |   |   |
| Service capacity (5)                                                           |       | 2,953                                            |       | 3,921 |   |

 

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(1)          Residential service capacity is comprisedof the number of beds currently available for service in our residentialfacilities.

 

(2)          At certain residentialfacilities, the contracted capacity is lower than the facility’s servicecapacity. We could increase a facility’s contracted capacity by obtainingadditional contracts or by renegotiating existing contracts to increase thenumber of beds covered. However, we may not be able to obtain contracts thatprovide occupancy levels at a facility’s service capacity or be able tomaintain current contracted capacities in future periods.

 

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

 

(4)          Average contract occupancypercentages are calculated based on actual occupancy for the period as apercentage of the contracted capacity for residential facilities in operation.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)          Service capacity fornon-residential programs is based on either contractual terms or an estimate ofthe number of clients to be served. We update these estimates at least annuallybased on the program’s budget and other factors.

 

Our operating results forthe three months ended March 31, 2008 were impacted by a few significantevents.  We completed a 300 bed expansionat the D. Ray James Prison and activated these beds in February 2008. Wealso continued the 1,100 bed expansion at the Great Plains CorrectionalFacility and began the 700 bed expansion at the D. Ray James Prison. Inaddition, we recorded a contract-based revenue adjustment of approximately $1.5million at the Regional Correctional Center for the contract year ended March 2008.

 

We derive substantially allof our revenues from providing adult corrections and treatment and juvenilejustice, educational and treatment services outsourced by federal, state andlocal government agencies in the United States. Revenues for our services aregenerally recognized on a per diem rate based upon the number of occupant daysor hours served for the period, on a guaranteed take-or-pay basis or on acost-plus reimbursement basis. For the three months ended March 31, 2008,our revenue base consisted of 51.9% for services provided under per diemcontracts, 41.7% for services provided under take-or-pay and managementcontracts, 4.1% for services provided under cost-plus reimbursement contracts,2.0% for services provided under fee-for-service contracts and 0.3% from othermiscellaneous sources.  For the threemonths ended March 31, 2007, our revenue base consisted of 67.2% forservices provided under per diem contracts, 25.1% for services provided undertake-or-pay and management contracts, 4.7% for services provided undercost-plus reimbursement contracts, 2.3% for services provided underfee-for-service contracts and 0.7% from other miscellaneous sources. Theincrease in the percentage of revenues provided under take-or-pay andmanagement contracts in the three months ended March 31, 2008 was dueprimarily to the take-or-pay contract awarded by the BOP to our Big SpringCorrectional Center in 2007 and the 916 inmate take-or-pay contract awarded bythe Arizona Department of Corrections at our Great Plains 

 

26

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Correctional Facility underwhich we began operations in September 2007. The increase in thepercentage of revenues provided under take-or-pay contracts was partiallyoffset by (1) the transition of our management contract for the Donald W.Wyatt Detention Center to the facility owner in July 2007 and (2) thetermination of our management contract for the Harrisburg Alternative EducationSchool program for the 2007-2008 school year. The decrease in the percentage of revenues provided under per diemcontracts in the three months ended March 31, 2008 as compared to the sameperiod of the prior year was due primarily to the transition of the contractsat the Great Plains Correctional Facility and Big Spring Correctional Center aspreviously noted. This was partially offset by the addition of the High PlainsCorrectional Center, which we acquired in May 2007.

 

Revenues can fluctuate from period to period due tochanges in government funding policies, changes in the number or types ofclients referred to our facilities by various governmental agencies who wecontract with, the opening of new facilities or the expansion of existingfacilities and the termination of a contract for a facility or the closure of afacility.

 

Factors considered in determining billing rates to charge include: (1) theprograms specified by the contract and the related staffing levels; (2) wagelevels customary in the respective geographic areas; (3) whether theproposed facility is to be leased or purchased and (4) the anticipatedaverage occupancy levels that could reasonably be expected to be maintained.

 

Revenues for our AdultSecure Services division are primarily generated from per diem and take-or-paycontracts. For the three months ended March 31, 2008 and 2007, we realizedaverage per diem rates on our adult secure facilities of approximately $55.56and $54.99, respectively. The increase in the 2008 average per diem rate wasdue primarily to a higher per diem rate at the Great Plains CorrectionalFacility under contract with the Arizona Department of Corrections which beganin September 2007 and also reflects the $1.5 million contract-basedrevenue adjustment at the Regional Correctional Center for thecontract year ended March 2008.

 

Revenues for our Abraxas Youth and Family Servicesdivision are primarily generated from per diem, fee-for-service and cost-plusreimbursement contracts.  For the threemonths ended March 31, 2008 and 2007, we realized average per diem rateson our residential Abraxas Youth and Family Services facilities ofapproximately $186.94 and $171.50, respectively. The increase in the 2008 averageper diem rate was due primarily to the continued ramp up in population at theCornell Abraxas Academy and the reactivation of the Hector Garza ResidentialTreatment Center in August 2007. For the three months ended March 31, 2008 and 2007, we realizedaverage fee-for-service rates for our non-residential community-based AbraxasYouth and Family Services facilities and programs, including rates that arelimited by Medicaid and other private insurance providers, of approximately$50.24 and $44.11, respectively.  Theincrease in the 2008 average fee-for-service rate was due to an increase inrates at certain facilities and programs as well as changes in the mix ofservices provided by our various Abraxas Youth and Family Services programs andfacilities.   The majority of our AbraxasYouth and Family Services contracts renew annually.

 

Revenues for our Adult Community-Based Servicesdivision are primarily generated from per diem contracts and fee-for-servicecontracts.  For the three months ended March 31,2008 and 2007, we realized average per diem rates on our residential AdultCommunity-Based Services facilities of approximately $65.96 and $62.11,respectively.  The increase in the 2008 averageper diem rate was due primarily to rate increases at certain facilities.  For the three months ended March 31,2008 and 2007, we realized average fee-for-service rates on our non-residentialAdult Community-Based Services facilities and programs of approximately $13.11and $15.94, respectively.  The 2008 averagefee-for-service rate decreased as a result of changes in the mix of servicesprovided by our various Adult Community-Based Services programs and facilities.

 

We have historically experienced higher operatingmargins in our Adult Secure Services and our Adult Community-Based Servicesdivisions as compared to our Abraxas Youth and Family Services division.  Our operating margin in a given period willbe impacted by those facilities which may either be dormant or have beenreactivated during the period. We have reactivated several facilities in recentperiods including the Hector Garza Residential Treatment Center and GreatPlains Correctional Facility in 2007. Additionally, changes in contract terms based resulting from contractrenewals, revisions, or new contract awards can impact our operatingmargin.  Our operating margins within adivision can vary from facility to facility based on various factors such aswhether a facility is owned or leased, the level of competition for thecontract award, the proposed length of the contract, the mix of servicesprovided, the occupancy levels for a facility, the level of capital commitmentrequired with respect to a facility, the anticipated changes in operating costsover the term of the contract and our ability to increase a facility’s contractrevenue.  Under take-or-pay contracts fornew or vacant facilities, such as the contract at the Moshannon ValleyCorrectional Center, operating margins are typically higher during the earlystages of the contract as the facility’s population increases (as revenues arereceived at contract percentages regardless of occupancy level).  As variable costs (primarily resident relatedand certain facility costs) increase with the increase in population, operatingmargins will generally decline to a stabilized level.  A decline in occupancy at certain of ourAbraxas Youth and Family Services facilities can have a significant impact onour operating margins due to the higher average per diem rates at thesefacilities.

 

27

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We have experienced and expect to continue toexperience interim period operating margin fluctuations due to various factorssuch as the number of calendar days in the period, higher payroll taxes(generally in the first half of the year) and salary and wage increases andinsurance cost increases that are incurred prior to certain contract rateincreases. Periodically, many of the governmental agencies with whom wecontract may experience budgetary pressures and may approach us to limitor reduce per diem rates. Decreases in, or the lack of anticipated increasesin, per diem rates could adversely impact our operating margin. Additionally, adecrease in per diem rates without a corresponding decrease in operating expensescould also adversely affect our operating margin.

 

We are responsible for all facility operating costs,except for certain debt service and interest or lease payments for facilitieswhere we have a management contract only. At these facilities, the facilityowner is responsible for all debt service and interest or lease paymentsrelated to the facility. We are responsible for all other operating expenses atthese facilities. We operated 16 and 18 facilities under management contractsat March 31, 2008 and 2007, respectively.

 

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

 

We incur pre-opening andstart-up expenses including payroll, benefits, training and other operatingcosts prior to opening a new or expanded facility and during the period ofoperation while occupancy is ramping up. These costs vary by contract. Sincepre-opening and start-up costs are generally factored into the revenue per diemrate that is charged to the contracting agency, we typically expect to recoverthese upfront costs over the life of the contract. Because occupancy ratesduring an adult secure facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days (and typically longer for a youthfacility), we may incur additional post-opening start-up costs. We do notanticipate post-opening start-up costs at any adult secure facilities operatedunder any future contracts with the BOP because these contracts are currentlyexpected to continue to be take-or-pay contracts, meaning that the BOP will payat least 80.0% of the contractual monthly revenue once the facility opens,regardless of actual occupancy.

 

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

 

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

 

General and administrative expenses consistprimarily of costs for corporate and administrative personnel who providemanagement, legal, finance, accounting, human resources, investor relations,payroll and information systems, costs of business development and outsideprofessional and consulting fees.

 

#### **Recent Developments**

#### ** **

***GreatPlains Correctional Facility***

 

In May 2007, we wereawarded a contract by the Arizona Department of Corrections for our Great PlainsCorrectional Facility in Hinton, Oklahoma. The contract calls for a total of2,000 medium-security inmates to be housed at the facility. We currently houseapproximately 916 inmates and the remainder will be housed through an expansionof the existing facility. We began receiving inmates in September 2007 andsubstantially completed the initial ramp-up in December 2007. Theexpansion of the facility to accommodate all 2,000 inmates commenced in thefourth quarter of 2007 and is expected to be completed by the fourth quarter of2008. We currently estimate that the expansion cost will be approximately $45.0million.  As of March 31, 2008, wehad incurred and capitalized costs of approximately $20.0 million related tothis expansion.  We believe that our existingcash and available balance under our Amended Credit Facility will provideadequate funding to complete this facility expansion.

 

28

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***D. Ray James Prison***

 

We recently completed (inFebruary 2008) the initial expansion of the D. Ray James Prison in Georgiato increase its service capacity by 300 beds to a total service capacity of2,132 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 2,800 beds.This expansion project began in the first quarter of 2008 and is expected to becompleted in the first quarter of 2009. We currently estimate that the capitalexpenditures related to this expansion project will be approximately $34.0million.  As of March 31, 2008, wehad incurred and capitalized costs of approximately $2.4 million related tothis expansion. We believe that our existing cash and available balance underour Amended Credit Facility will provide adequate funding to complete thisfacility expansion.

 

***Regional Correctional Center***

 

In July 2007, wewere notified by ICE that they were removing all ICE detainees from theRegional Correctional Center in Albuquerque, New Mexico. The withdrawal wascompleted in early August 2007 and ICE informed us in February 2008that it would not resume use of the facility. Also, in February 2008, the client, the Office of Federal DetentionTrustee (“OFDT”), attempted to unilaterally amend its agreement to reduce thenumber of minimum annual guaranteed mandays under the agreement. We do notbelieve OFDT has the right to make such a change.  Refer to “-Results of Operations — Liquidityand Capital Resources - ContractualUncertainties Related to Certain Facilities - Regional Correctional Center” formore information concerning this and other developments concerning the RegionalCorrectional Center.

 

#### **New Accounting Pronouncements**

#### ** **

***Statement of Financial Accounting Standards No. 141***

 

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 the acquisitiondate.  SFAS No. 141R appliesprospectively to business combinations for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008.  Earlier adoption is not permitted.

 

***Statement of 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 is effective for 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 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.

 

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). |

 

29

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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 tablesummarizes the valuation of our financial assets and liabilities by pricinglevels, as defined by the provisions of SFAS No. 157, as of March 31,2008:

 
| ** **               | ** ** | **Fair Value as of March 31, 2008 (in thousands)** | ** ** |
|--------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **               | ** ** | **Level 1**                                                                           | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
| Assets:                  |       |                                                                                       |       |   |   |   |   |   |   |
| Certificates of Deposits |       | $                                                                                          | —     |   | $ | 250 |   | $ | — |   | $ | 250 |   |
| Corporate Bonds          |       | —                                                                                     |       | 9,996 |   | — |   | 9,996 |   |
| Money Market Funds       |       | —                                                                                     |       | 39,182 |   | — |   | 39,182 |   |
| Liabilities:             |       |                                                                                       |       |   |   |   |   |   |   |
| Derivative Instruments   |       |                                                                                       |       |   |   |   |   |   |   |
| (Debt Service Funds)     |       | $                                                                                          | —     |   | $ | — |   | $ | 905 |   | $ | 905 |   |

 

SFAS No. 157requires a reconciliation of the beginning and ending balances for fair valuemeasurements using Level 3 inputs.  Thetable below sets forth a reconciliation for assets and liabilities measured atfair value on a recurring basis using significant unobservable inputs (Level 3)during the three months ended March 31, 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   |   |

 

 

***Statement of Financial Accounting StandardsNo. 159***

 

In February 2007,the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities – Including an amendment of FASB Statement No. 115”(“SFAS No. 159”). SFAS No. 159 permits entities to choose to measuremany financial instruments and certain other items at fair value that are notcurrently required to be measured at fair value and establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 is effective for financial statements issued forfiscal years beginning after November 15, 2007, provided the entity electsto apply the provisions of SFAS No. 157. Our adoption of SFAS No. 159on January 1, 2008 did not have a material impact on our consolidatedresults of operations or financial condition as we have elected not to applythe provisions of SFAS No. 159 to our financial instruments or othereligible items that are not required to be measured at fair value.

 

***Statement of Financial Accounting StandardsNo. 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. SFAS No. 160 also includes expanded disclosure requirementsregarding the interests 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.

 

30

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

 

In March 2008, the FASB issued SFAS No. 161,“Disclosures about Derivative Instruments and Hedging Activities – an Amendmentof FASB Statement 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 theimpact that this pronouncement may have on our consolidated financialstatements.

 

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**Results of Operations**

 

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

 
| ** **                                               | ** ** | **Three Months  Ended March 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                               | ** ** | **2008**                                         | ** ** | **2007** | ** ** |
|                                                     |       |                                             |       |   |   |
| Revenues                                                 |       | 100.0                                            | %          | 100.0 | % |
| Operating expenses, excluding depreciation               |       | 73.5                                             |       | 77.7 |   |
| Depreciation and amortization                            |       | 4.4                                              |       | 4.3 |   |
| General and administrative expenses                      |       | 6.9                                              |       | 9.3 |   |
| Income from operations                                   |       | 15.2                                             |       | 8.7 |   |
| Interest expense, net                                    |       | 6.6                                              |       | 7.4 |   |
| Income from operations before provision for income taxes |       | 8.6                                              |       | 1.3 |   |
| Provision for income taxes                               |       | 3.7                                              |       | 0.6 |   |
| Net income                                               |       | 4.9                                              | %          | 0.7 | % |

 

##### ***Three Months Ended March 31,2008 Compared to Three Months Ended March 31, 2007***

##### *** ***

***Revenues***.  Revenues increased approximately $5.8million, or 6.5%, to $95.4 million for the three months ended March 31,2008 from approximately $89.6 million for the three months ended March 31,2007.

 

*AdultSecure Services*. Adult Secure Services revenues increasedapproximately $3.4 million, or 7.3%, to $49.9 million for the three monthsended March 31, 2008 from approximately $46.5 million for the three monthsended March 31, 2007 due primarily to (1) an increase in revenues of$3.1 million at the Big Spring Correctional Center due to increased occupancyresulting from the facility expansion completed in November 2007 under itstake-or-pay contract (awarded in 2007) with the BOP, (2) an increase inrevenues of $2.9 million at the Great Plains Correctional Facility as a resultof a higher per diem rate under our new operating contract with the ArizonaDepartment of Corrections which began in September 2007, (3) an increasein revenues of $1.1 million at the D. Ray James Prison due to improvedoccupancy and (4) revenues of $1.2 million from the High PlainsCorrectional Center acquired in May 2007. The increase in revenues due to the above was offset, in part, by a decreasein revenues of $3.3 million due to the transfer of our management contract forthe Donald W. Wyatt Detention Center to the facility’s owner in July 2007and a net decrease in revenues of $2.1 million at the Regional CorrectionalCenter due to decreased occupancy resulting from the removal of all ICE inmatesin August 2007 (the decrease is net of a $1.5 million contract-basedrevenue adjustment for the contract year ended March 2008). The remainingnet increase in revenues of $0.5 million was due to various fluctuations inrevenues at our other adult secure facilities.

 

At March 31, 2008, weoperated ten adult secure facilities with an aggregate service capacity of10,965.  Average contract occupancy was95.5% for the three months ended March 31, 2008 compared to 102.0% for thethree months ended March 31, 2007. The decline in the 2008 average contract occupancy percentage was dueprimarily to the reduced occupancy at the Regional Correctional Center in thethree months ended March 31, 2008 due to the removal of all ICE inmates inAugust 2007. The average per diem rate was $55.56 and $54.99 for the threemonths ended March 31, 2008 and 2007, respectively. The increase in the 2008average per diem rate was due primarily to a higher per diem rate at the GreatPlains Correctional Facility under the contract with the Arizona Department ofCorrections as of September 2007 and also reflects the $1.5 millioncontract-based revenue adjustment at the Regional Correctional Center for thecontract year ended March 2008.  Therewere no revenues attributable to start-up operations for the three months endedMarch 31, 2008 and 2007.

 

*AbraxasYouth and Family Services*. Abraxas Youth and Family Services revenuesincreased approximately $1.0 million, or 3.7%, to $27.8 million for the threemonths ended March 31, 2008 from $26.8 million for the three months ended March 31,2007 due primarily to (1) an increase in revenues of $1.4 million at theCornell Abraxas Academy due to increased occupancy resulting from thereactivation of the facility in October 2006, (2) revenues of $0.5million from the Hector Garza Residential Treatment Center which we reactivatedin August 2007 and (3) an increase in revenues of $0.4 million at theSouthern Peaks Regional Treatment Center due to a rate increase for certainprograms operated at this facility.  Theincrease in revenues due to the above was offset, in part, by (1) adecrease in revenues of $0.9 million due to the termination of our managementcontract for the Harrisburg Alternative Education School Program for the2007-2008 school year (due to lack of funding) and (2) a decrease inrevenues of $0.9 million due to the termination of our management contract atthe Alexander Youth Services Center in January 2007.  The remaining net increase in revenues of$0.5 million was due to various insignificant fluctuations in revenues at ourother Abraxas Youth and Family Services facilities and programs.

 

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*** ***

***At March 31, 2008, we operated 18 residential AbraxasYouth and Family Services facilities and 11 non-residential community-basedprograms and facilities with an aggregate service capacity of 3,638.Additionally, we had one vacant facility with a service capacity of 70 beds.Average contract occupancy for the three months ended March 31, 2008 was85.5% compared to 91.8% for the three months ended March 31, 2007.  The decrease in the 2008 average contract occupancypercentage was due primarily to population fluctuations at certain facilities.  Additionally, the 2008 average contractoccupancy percentage reflects the impact of the termination of our managementcontract at the Alexander Youth Services Center in January 2007.***

*** ***

***The average per diem rate for our residential Abraxas Youthand Family Services facilities was $186.94 for the three months ended March 31,2008 compared to $171.50 for the three months ended March 31, 2007. ***The increase in the 2008 averageper diem rate was due primarily to the continued ramp up in population at theCornell Abraxas Academy, the reactivation of the Hector Garza ResidentialTreatment Center in August 2007 and rate increases received at certainprograms.  Our average fee-for-service rate for ournon-residential Abraxas Youth and Family Services community-based facilitiesand programs was $50.24 for the three months ended March 31, 2008 comparedto $44.11 for the three months ended March 31, 2007. The increase in the 2008 averagefee-for-service rate was due to an increase in rates for certain of ourfacilities and programs as well as changes in the mix of services provided byour various Abraxas Youth and Family Services non-residential community-basedprograms and facilities. There were norevenues attributable to start-up operations for the three months ended March 31,2008 and 2007.

*** ***

*AdultCommunity-Based*. Adult Community-Based Services revenues increasedapproximately $1.4 million, or 8.6%, to $17.7 million for the three monthsended March 31, 2008 from $16.3 million for the three months ended March 31,2007 primarily due to (1) an increase in revenues of approximately $0.3million at the Cordova Center due to both improved occupancy and a per diemrate increase, (2) an increase in revenues of $0.2 million at the OaklandCenter due to increased occupancy, (3) an increase in revenues of $0.1million at the Parkview Center due to increased occupancy coupled with a perdiem rate increase and (4) revenues of $0.2 million at the Midtown Centerwhich was vacant in the three months ended March 31, 2007 (the facilitywas reactivated in September 2007). The remaining net increase in revenues of $0.6 million was due tovarious insignificant fluctuations in revenues at our other AdultCommunity-Based Services facilities and programs.

 

At March 31, 2008, we operated 29 residentialAdult Community-Based Services facilities and 6 non-residential community-basedprograms with an aggregate service capacity of 4,336. Averagecontract occupancy for the three months ended March 31, 2008 was 100.6%compared to 99.0% compared for the three months ended March 31, 2007. The average perdiem rate for our residential Adult Community-Based Services facilities was$65.96 for the three months ended March 31, 2008 compared to $62.11 forthe three months ended March 31, 2007. The increase in the 2008 averageper diem rate was due primarily to rate increases at certain facilities. Theaverage fee-for-service rate for our non-residential Adult Community-BasedServices programs was $13.11 for the three months ended March 31, 2008compared to $15.94 for the three months ended March 31, 2007.  The 2008 average fee-for-service ratedecreased as a result of changes in the mix of services provided by our variousAdult Community-Based Services programs and facilities. There were no revenuesattributable to start-up operations for the three months ended March 31,2008 and 2007.

 

We gave notice of early termination of ourmanagement contract for the Lincoln County Detention Center in Lincoln County,New Mexico in February 2008.  Wefaced continual staffing and other issues in the rural area and decided thatcontinued operation of that facility was not in the best interest of ourshareholders.  The contract for thisfacility generated revenues of approximately $0.5 million in each of the threemonths ended March 31, 2008 and 2007.

 

***OperatingExpenses****.*Operating expenses increasedapproximately $0.6 million, or 0.9%, to $70.2 million for the three monthsended March 31, 2008 from $69.6 million for the three months ended March 31,2007.

 

*AdultSecure Services*. Adult Secure Services operating expenses decreasedapproximately $0.2 million, or 0.6%, to $32.4 million for the three monthsended March 31, 2008 from $32.6 million for the three months ended March 31,2007. The decrease was primarily due to (1) a decrease in operatingexpenses of $3.1 million due to the transition of our management contract atthe Donald W. Wyatt Detention Center to the facility’s owner in July 2007and (2) a decrease in operating expenses of $0.6 million at the RegionalCorrectional Center due to reduced occupancy resulting from the withdrawal ofall ICE inmates in August 2007.  Thedecrease in operating expenses due to the above was offset, in part, by (1) anincrease in operating expenses of $1.1 million at the Great Plains CorrectionalFacility due to increased occupancy resulting from our contract with theArizona Department of Corrections as of September 2007, (2) operatingexpenses of $1.0 million at the High Plains Correctional Facility acquired in May 2007,(3) an increase in operating expenses of $0.7 million at the D. Ray JamesPrison due to increased occupancy and (4) an increase in operatingexpenses of $0.4 million at the Big Spring Correctional Center due to increasedoccupancy.  The remaining net increase inoperating expenses of $0.3 million was due to various insignificantfluctuations in operating expenses at our other Adult Secure Servicesfacilities.

 

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As a percentage of segment revenues, Adult SecureServices operating expenses were 64.9% for the three months ended March 31,2008 compared to 70.1% for the three months ended March 31, 2007.  The 2008 operating margin was favorablyimpacted by the $1.5 million contract-based revenue adjustment at the RegionalCorrectional Center for the contract year ended March 2008 (which werecognized in the three months ended March 31, 2008), as well as the 2007contract awards at both the Big Spring Correctional Center and the Great PlainsCorrectional Facility (which began in November 2007 and September 2007,respectively).

 

*AbraxasYouth and Family Services*.** **Abraxas Youth and Family Services operating expenses increasedapproximately $1.6 million, or 6.8%, to $25.3 million for the three monthsended March 31, 2008 from $23.7 million for the three months ended March 31,2007 due primarily to (1) an increase in operating expenses of $0.8million at the Cornell Abraxas Academy due to increased occupancy resultingfrom the reactivation of the facility in October 2006, (2) an increase inoperating expenses of $0.3 million at the Hector Garza Residential TreatmentCenter which we reactivated in August 2007 and (3) an increase inoperating expenses of $0.3 million at the Southern Peaks Regional TreatmentCenter due to increased occupancy. The increase in operating expenses due tothe above was offset, in part, by a decrease in operating expenses of $0.7million due to the termination of our management contract for the HarrisburgAlternative Education School Program for the 2007-2008 school year (due to alack of funding) and a decrease in operating expenses of $0.3 million at the WashingtonDC Facility due primarily to a reduction in rent expense as a result of ourpurchase of this previously leased facility in September 2007.  The remaining net increase in operatingexpenses of $1.2 million was due to various fluctuations in operating expenses atour various Abraxas Youth and Family Services facilities and programs as wellas an increase in divisional administrative expenses.  As a percentage of segmentrevenues, Abraxas Youth and Family Services division operating expenses were91.1% for the three months ended March 31, 2008 compared to 88.5% for thethree months ended March 31, 2007.

 

*AdultCommunity-Based Services*. Adult Community-Based Services operatingexpenses decreased approximately $0.8 million, or 6.0%, to $12.5 million forthe three months ended March 31, 2008 from $13.3 million for the three months ended March 31,2007 due primarily to a decrease in operating expenses of $0.4 million at the TundraCenter due to a decrease in occupancy. The remaining net decrease in operating expenses of $0.4 million was dueto various insignificant fluctuations in operating expenses at our variousAdult Community-Based Services facilities and programs. As a percentage ofsegment revenues, Adult Community-Based Services operating expenses were 70.7%for the three months ended March 31, 2008 compared to 81.4% for the threemonths ended March 31, 2007.  Theimprovement in the 2008 operating margin was due primarily to the rateincreases previously discussed and improved occupancy at certain facilities.

 

***Pre-opening andstart-up expenses.***** **There were no pre-openingand start-up expenses for the three months ended March 31, 2008 and 2007.

 

***Depreciation andAmortization*****. **Depreciation and amortization was approximately $4.2 million and $3.8million for the three months ended March 31, 2008 and 2007,respectively.  The increase indepreciation expense in the three months ended March 31, 2008 was dueprimarily to depreciation expense related to the High Plains CorrectionalFacility acquired in May 2007, the Washington DC Facility purchased in September 2007and additional depreciation expense resulting from the facility expansions atthe Big Spring Correctional Center and the D. Ray James Prison.  Amortization of intangibles was approximately$0.5 million and $0.6 million for the three months ended March 31, 2008and 2007, respectively.

 

***General andAdministrative Expenses. ***General andadministrative expenses decreased approximately $1.9 million, or 22.6%, toapproximately $6.5 million for the three months ended March 31, 2008 from $8.4million for the three months ended March 31, 2007 due primarily to thereimbursement to Veritas of $2.5 million of costs related to the MergerAgreement in the three months ended March 31, 2007.  Additionally, stock-based compensationexpense increased approximately $0.5 million in the three months ended March 31,2008 as compared to the same period of the prior year.

 

***Interest. ***Interest expense, net ofinterest income, decreased to approximately $0.3 million, or 4.5%, to $6.3million for the three months ended March 31, 2008 from $6.6 million forthe three months ended March 31, 2007 due primarily to an increase incapitalized interest in the 2008 period. For the three months ended March 31, 2008, we capitalized interestof approximately $0.5 million related to the facility expansion projects at theGreat Plains Correctional Facility and the D. Ray James Prison.  Capitalized interest was approximately $0.02million for the three months ended March 31, 2007 and related primarily tothe expansion projects at the Big Spring Correctional Center and the D. RayJames Prison.

 

***Income Taxes.***For the threemonths ended March 31, 2008, we recognized a provision for income taxes atan estimated effective rate of 43.5%. For the three months ended March 31, 2007, we recognized aprovision for income taxes at an estimated effective rate of 44.7%.

 

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## ** **

## **Liquidity and Capital Resources**

## ** **

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

 

***Cash Flows FromOperating Activities.*** Cash flows provided by operating activities wereapproximately $7.2 million for the three months ended March 31, 2008compared to cash used in operating activities of approximately $4.0 million forthe three months ended March 31, 2007. The increase from the prior periodwas principally due to higher net income as well as changes in certain workingcapital accounts (including accounts payable and accrued liabilities) due totiming of payments.

 

***Cash Flows From Investing Activities*****.** Cash used ininvesting activities was approximately $12.6 million for the three months endedMarch 31, 2008 due primarily to capital expenditures of approximately$11.9 million, primarily related to the facility expansion projects at the D.Ray James Prison and the Great Plains Correctional Facility. There were alsonet payments to the restricted debt payment account of approximately $0.7million. Cash used in investing activities was approximately $0.5 million forthe three months ended March 31, 2007 due primarily to capitalexpenditures of approximately $3.2 million primarily related to the facility expansionprojects at the Big Spring Correctional Center and the D. Ray James Prison.  Additionally, we had net sales of investmentsecurities of approximately $1.5 million and withdrawals from the restricteddebt payment account, net, of approximately $1.3 million.

 

***Cash Flows FromFinancing Activities*****. **Cash provided by financingactivities was approximately $5.2 million for the three months ended March 31,2008 due primarily to borrowings on our Amended Credit Facility of $5.0million.****Cash providedby financing activities was approximately $0.9 million for the threemonths ended March 31, 2007 due primarily to proceeds from the exercise ofstock options and the tax benefit of these stock option exercises.

 

***Treasury StockRepurchases.*** We did notpurchase any of our common stock in the three months ended March 31, 2008and 2007.  Under the terms of our SeniorNotes and our Amended Credit Facility, we can purchase shares of our stocksubject to certain cumulative restrictions.

 

***Long-Term Credit Facilities.***  OurAmended 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. Theavailable commitment under our Amended Credit Facility was approximately $55.3million at March 31, 2008.  We hadoutstanding borrowings under our Amended Credit Facility of $35.0 million andwe had outstanding letters of credit of approximately $9.7 million at March 31,2008.  Subject to certain requirements,we have the right to increase the commitments under our Amended Credit Facilityup to $150.0 million.  The Amended CreditFacility 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 March 31, 2008, we were in compliance with all of our debtfinancial covenants.

 

MCFis obligated for the outstanding balance of its 8.47% Taxable Revenue Bonds, Series 2001.  The bonds bear interest at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds are 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 notguaranteed by Cornell.

 

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

 

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

 

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Upon theoccurrence of specified change of control events, unless we have exercised ouroption to redeem all the Senior Notes as described above, each holder will havethe right to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under 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 months ended March 31,2007, we recorded interest expense related to this interest rate swap ofapproximately $0.01 million.  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.  At March 31, 2007, the fair value ofthis derivative instrument was approximately ($0.5) million, and was includedin other long-term liabilities in the accompanying financial statements.  The carrying value of the Senior Notes as ofthis date was adjusted accordingly by the same amount. Because the swapagreement was an effective fair-value hedge, there was no effect on our resultsof operations from the mark-to-market adjustment as long as the swap was ineffect. In October 2007,we terminated 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***

*** ***

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. We also continue to analyze our capital structure, including apotential refinancing of our Senior Notes, as well as financing for ourexpected future capital expenditures. We may decide to use internally generatedfunds, bank financing, equity issuances, public debt or a combination of any ofthe foregoing to finance our future capital needs.

 

Ourinternally generated cash flow is directly related to our business. Should theprivate corrections and juvenile businesses deteriorate, or should weexperience poor results in our operations, cash flow from operations may bereduced. We have, however, continued to generate positive cash flow fromoperating activities over recent years and expect that cash flow will continueto be positive over the next year. Our access to debt and equity markets may bereduced or closed to us due to a variety of events, including, among others,industry conditions, general economic conditions, market conditions, creditrating agency downgrades of our debt and market perceptions of us and ourindustry.

 

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

 

*Regional CorrectionalCenter.*****In July 2007, we were notified byICE that they were removing all ICE detainees from the Regional CorrectionalCenter. The withdrawal of all ICE detainees was completed in early August 2007and ICE has recently indicated to us that it will not resume use of thefacility. The facility is still being utilized by the United States MarshallService (‘USMS”) but not at its full capacity. OFDT holds the contract on behalf of ICE, USMS and the BOP with theBernalillo County through an intergovernmental services agreement, and we havean agreement with the County.  OFDTrecently attempted to unilaterally amend its agreement with the County toreduce the number of minimum annual guaranteed mandays under the agreement from182,500 to 66,300.  Neither we nor theCounty believe OFDT has the right to unilaterally amend the contract in thismanner, 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 of Bernalilloconcerning the County jail system that could involve the Regional CorrectionalFacility in such case.  Jimmy McClendon and other plaintiffs sued theCounty of Bernalillo in federal district court in the District of New Mexico in1994 over conditions at the county jail, which was then located at what is nowthe Regional Correctional Facility and run by the County.  The Countysubsequently built their new Metropolitan Detention Center to house the Countyinmates and also negotiated two stipulated agreements in 2004 designed to endthe McClendon lawsuit.  The court in that case is considering theapplication of the lawsuit to the Regional Correctional Facility as a result ofthe County’s ownership of the facility.  The County has informed us that,should the court rule that the case applies to the facility, it plans to appealthe decision since the County does not believe McClendon should apply toRCC.  We do not believe we are contractually obligated to bear anyincremental costs of complying with McClendon.  The County has expressedits desire for us to absorb a portion of any costs that would be incurred. Shouldthe court rule that the lawsuit applies to the facility, we would furtherdiscuss the matter with the County. We plan to continue to operate the facilityand also continue with our marketing plans for the Regional CorrectionalFacility.

 

Revenuesfor this facility were approximately $2.6 million (including a $1.5 million contract-basedrevenue adjustment for the contract year ended March 2008) and $4.6million for the three months ended March 31, 2008 and 2007, respectively.The net carrying value of the leasehold improvements for this facility wasapproximately $2.5 million and $3.0 million at March 31, 2008 and December 31,2007, respectively. Our lease for this facility requires monthly rent paymentsof approximately $0.13 million for the remaining term of the lease (through June 2009).To date, we do not have an alternative customer for this facility. Ourinability to obtain a new customer for this facility could have an adverseeffect on our financial condition, results of operations and cash flows.  We believe that pursuant to the provisions ofSFAS No. 144, no impairment to the carrying value of the leaseholdimprovements for this facility has occurred in the three months ended March 31,2008.

 

*Hector Garza ResidentialTreatment Center.*****In October 2005, we initiated thetemporary closure of this leased facility in San Antonio, Texas. We reactivatedthe facility during the third quarter of 2007. The net carrying value for this 

 

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facility wasapproximately $4.1 million and $4.2 million at March 31, 2008 and December 31,2007, respectively.  We believe that,pursuant to the provisions of SFAS No. 144, no impairment to the carryingvalue of this facility has occurred in the three months ended March 31, 2008.

 

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

###### ***ContractualObligations and Commercial Commitments***

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

We have assumed variousfinancial obligations and commitments in the ordinary course of conducting ourbusiness.  We have contractualobligations requiring future cash payments, such as management, consulting andnon-competition agreements.

 

We maintain operating leasesin the ordinary course of our business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the agreementsexpire between 2008 and 2075. As of March 31, 2008, our total commitmentunder these operating leases was approximately $23.6 million.

 

The following table detailsthe known future cash payments (on an undiscounted basis) related to our variouscontractual obligations as of March 31, 2008 (in thousands):

 
| ** **                              | ** ** | **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 Entity           |       | 145,500                                   |       | 11,400 |   | 25,800 |   | 30,400 |   | 77,900 |   |
| Long-term debt – interest          |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.    |       | 51,170                                    |       | 9,030 |   | 24,080 |   | 18,060 |   | — |   |
| · Special Purpose Entity           |       | 62,098                                    |       | 6,162 |   | 21,666 |   | 17,110 |   | 17,160 |   |
| Revolving line of credit-principal      |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.    |       | 35,000                                    |       | — |   | — |   | 35,000 |   | — |   |
| Revolving line of credit-interest       |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.    |       | 334                                       |       | 334 |   | — |   | — |   | — |   |
| Capital lease obligations               |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell  Companies, Inc.    |       | 35                                        |       | 11 |   | 24 |   | — |   | — |   |
| Construction commitments                |       | 57,106                                    |       | 51,106 |   | 6,000 |   | — |   | — |   |
| Operating leases                        |       | 23,552                                    |       | 5,592 |   | 9,292 |   | 1,573 |   | 7,095 |   |
| Consultative and non-compete agreements |       | 250                                       |       | 250 |   | — |   | — |   | — |   |
| Total contractual cash obligations      |       | $                                         | 487,045    |   | $ | 83,885 |   | $ | 86,862 |   | $ | 214,143 |   | $ | 102,155 |   |

 

Approximately$3.2 million of unrecognized tax benefits have been recorded as liabilities inaccordance with FIN 48 as of March 31, 2008 but are not included in thecontractual obligations table above because we are uncertain as to if or whensuch amounts may be settled.  Related tothe unrecognized tax benefits not included in the table above, we have alsorecorded a liability for potential penalties of approximately $0.1 million andfor interest of approximately $0.3 million as of March 31, 2008.

 

Weenter into letters of credit in the ordinary course of operating and financingactivities.  As of March 31, 2008, wehad outstanding letters of credit of approximately $9.7 million primarily forcertain workers’ compensation insurance and other operating obligations.  The following table details our letters ofcredit commitments as of March 31, 2008 (in thousands):

 
| ** **                | ** ** | **Total**     | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **More Than** | ** ** |
| ** **                | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **5 Years** | ** ** |
| Commercial Commitments:   |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of credit |       | $             | 9,716      |                                                                    | $          | 8,966 |   | $ | 750 |   | $ | — |   | $ | — |   |
|                           |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

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** **

**ITEM 3.      QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

** **

Inthe normal course of business, we are exposed to market risk, primarily fromchanges in interest rates. We continually monitor exposure to market risk anddevelop appropriate strategies to manage this risk. We are not exposed to anyother significant market risks, including commodity price risk or, foreigncurrency exchange risk or interest rate risks from the use of derivativefinancial instruments. In conjunction with the issuance of the Senior Notes, wehad previously entered into an interest rate swap of $84.0 million related tothe interest obligations under the Senior Notes, in effect converting suchnotes to a floating rate based on six-month LIBOR.  We terminated the interest rate swap in October 2007.

 

**Credit Risk**

 

Dueto the short duration of our investments, changes in market interest rateswould not have a significant impact on their fair value.  In addition, our accounts receivables arewith federal, state, county and local government agencies, which we believereduces our credit risk. We regularly review our accounts receivable andmonitor our collection experience to manage the risk as described in ouraccounting policies in our 2007 Annual Report on Form 10-K.

 

**InterestRate Exposure**

 

Ourexposure to changes in interest rates primarily results from our Amended CreditFacility, as these borrowings have floating interest rates.  The debt on our consolidated financialstatements at March 31, 2008 with fixed interest rates consist of the8.47% Bonds issued by MCF, a special purpose entity, in August 2001 inconnection with the 2001 Sale and Leaseback Transaction and $112.0 million ofSenior Notes.  The detrimental effect ofa hypothetical 100 basis point increase in interest rates on our currentborrowings under our Amended Credit Facility would be to reduce income beforeprovision for income taxes by approximately $0.1 million for the three months endedMarch 31, 2008.  At March 31,2008, the fair value of our consolidated fixed rate debt approximated carryingvalue based upon discounted future cash flows using current market prices.

 

**Inflation**

 

Other than personnel, offender 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 offender medical costs andemployee medical and worker’s compensation insurance costs, and we have alsoexperienced higher personnel costs during the past two years. Most of ourfacility 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 contract revenues.

 

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** **

**ITEM4.**        Controlsand Procedures.

** **

**Evaluationof Disclosure Controls and Procedures**

 

Wemaintain disclosure controls and procedures designed to provide reasonableassurance that information disclosed in our annual and periodic reports isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. In addition,we designed these disclosure controls and procedures to ensure that thisinformation is accumulated and communicated to management, including the chiefexecutive officer (“CEO”) and chief financial officer (“CFO”), to allow timelydecisions regarding required disclosures. SEC rules require that wedisclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

 

We do not expect that our disclosure controls and procedures willprevent all errors or fraud. A control system, no matter how well conceived andoperated, can provide only reasonable, not absolute, assurance that theobjectives of the control system are met. In addition, the design of disclosure controls and procedures mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitation in a cost-effective control system, misstatements due to error orfraud could occur and not be detected.

 

Underthe supervision and with the participation of our management, including our principalexecutive officer and principal financial officer, and as required by paragraph(b) of Rules 13a-15 and 15d-15 of the Securities Exchange Act of1934, as amended (the “Exchange Act”), we have evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as of theend of the period required by this report. Based on that evaluation, ourprincipal executive officer and principal financial officer have concluded thatthese controls and procedures are effective as of that date.

 

**Changesin Internal Control over Financial 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) that occurred during our fiscal quarter ended March 31, 2008that has materially affected, or is reasonably likely to materially affect, ourinternal control 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 herein by reference.                                                                                            |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
| **ITEM 1A.** | ** ** | **Risk Factors.**                                                                                                                                                                                                  |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
|         |       | The  risk factors as previously discussed in our Form 10-K for the fiscal  year ended December 31, 2007 are incorporated herein by this reference.  There were no material changes to such risk factors. |
|         |       |                                                                                                                                                                                                               |
| **ITEM 2.**  | ** ** | **Unregistered Sales of Equity Securities and Use of  Proceeds.**                                                                                                                                                  |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 3.**  | ** ** | **Defaults Upon Senior Securities.**                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                               |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM 4.**  | ** ** | **Submission of Matters to a Vote of Security Holders.**                                                                                                                                                           |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
|         |       | There  have been no matters submitted to a vote of the security holders in the three  months ended March 31, 2008.                                                                                            |
|         |       |                                                                                                                                                                                                               |
| **ITEM 5.**  | ** ** | **Other Information.**                                                                                                                                                                                             |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
|         |       | None.                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                               |
| **ITEM  6.** | ** ** | **Exhibits.**                                                                                                                                                                                                      |
| ** **   | ** ** | ** **                                                                                                                                                                                                         |
| ** **   | ** ** | **3.1**                                                                                                                                                                                                            | ** ** | **Restated  Certificate of Incorporation of Cornell Companies, Inc.**(incorporated by reference to  Exhibit 3.1 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 1996). |
| ** **   | ** ** | **3.2**                                                                                                                                                                                                            | ** ** | **Amended  and Restated Bylaws of Cornell Companies, Inc.**(incorporated by reference to  Exhibit 3.1 to the Company’s Current Report on Form 8-K dated December 13, 2007). |
| ** **   | ** ** | **3.3**                                                                                                                                                                                                            | ** ** | **Certificate  of Amendment of Restated Certificate of Incorporation of Cornell  Companies, Inc.**(incorporated by reference to Exhibit 4.2 to the Company’s Registration Statement on Form S-8  (Reg. No. 333-42444) filed on July 28, 2000. |
|         |       | 31.1                                                                                                                                                                                                               |   | Section 302  Certification of Chief Executive Officer |
|         |       | 31.2                                                                                                                                                                                                               |   | Section 302  Certification of Chief Financial Officer |
|         |       | 32.1                                                                                                                                                                                                               |   | Section 906  Certification of Chief Executive Officer |
|         |       | 32.2                                                                                                                                                                                                               |   | Section 906  Certification of Chief Financial Officer |

 

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**SIGNATURES**

 

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

 
|                                |   | **CORNELL COMPANIES, INC.**                                                                                                 |
|-------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|
|                                |   |                                                                                                                             |
|                                |   |                                                                                                                             |
| Date:  May 12,  2008 | By:    | /s/  James E. Hyman                                                                                                              |
|                                |   | JAMES  E. HYMAN                                                                                                                  |
|                                |   | Chief  Executive Officer, President and Chairman   of the Board (Principal Executive Officer)                                    |
|                                |   |                                                                                                                             |
|                                |   |                                                                                                                             |
| Date:  May 12,  2008 | By:    | /s/  John R. Nieser                                                                                                              |
|                                |   | JOHN  R. NIESER                                                                                                                  |
|                                |   | Senior  Vice President, Chief Financial Officer   and Treasurer (Principal Financial Officer and   Principal Accounting Officer) |

 

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