**UNITED STATESSECURITIES 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 June 30, 2007**                                             |
|       |       |                                                                                          |
| ** ** | ** ** | **OR**                                                                                        |
|       |       |                                                                                          |
| **o**      |       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from               to               **

**CommissionFile Number 1-14472**

**CORNELLCOMPANIES, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

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

 

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

Yes  x  No o

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

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

 

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

Yes  x  No o

At July 31, 2007,the registrant had 14,304,793 shares of common stock outstanding.

 

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**Cornell Companies, Inc.**

**Table of Contents**

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

 

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**PART I      FINANCIALINFORMATION**

**ITEM 1.      Financial Statements.**

**CORNELLCOMPANIES, INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**
| ** **                                                                                                                                                            | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                            | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **CURRENT ASSETS:**                                                                                                                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                                                                            |       | $                       | 12,848     |                        | $          | 18,529 |   |
| Investment  securities available for sale                                                                                                                             |       | 8,450                   |       | 11,925                      |       |
| Accounts  receivable — trade (net of allowance for doubtful accounts of $3,698 and  $3,644, respectively)                                                        |       | 62,292                  |       | 72,723                      |       |
| Other  receivables (net of allowance for doubtful accounts of $5,297)                                                                                                 |       | 3,068                   |       | 3,751                       |       |
| Debt service  fund and other restricted assets                                                                                                                        |       | 30,652                  |       | 24,611                      |       |
| Deferred tax  assets                                                                                                                                                  |       | 6,672                   |       | 6,672                       |       |
| Prepaid expenses  and other                                                                                                                                           |       | 5,899                   |       | 7,540                       |       |
| **Total  current assets**                                                                                                                                             |       | 129,881                 |       | 145,751                     |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                       |       | 340,779                 |       | 319,064                     |       |
| **OTHER ASSETS:**                                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Debt service  reserve fund                                                                                                                                            |       | 24,228                  |       | 23,801                      |       |
| Goodwill                                                                                                                                                              |       | 13,355                  |       | 12,339                      |       |
| Intangible  assets, net                                                                                                                                               |       | 5,804                   |       | 6,926                       |       |
| Deferred costs  and other                                                                                                                                             |       | 20,992                  |       | 15,652                      |       |
| **Total  assets**                                                                                                                                                     |       | $                       | 535,039    |                        | $          | 523,533 |   |
|                                                                                                                                                                  |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                        | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                                  |       |                    |       |                        |       |
| **CURRENT LIABILITIES:**                                                                                                                                              | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts payable  and accrued liabilities                                                                                                                             |       | $                       | 60,291     |                        | $          | 60,163 |   |
| Current portion  of long-term debt                                                                                                                                    |       | 10,510                  |       | 10,510                      |       |
| **Total  current liabilities**                                                                                                                                        |       | 70,801                  |       | 70,673                      |       |
| **LONG-TERM DEBT, net of current  portion**                                                                                                                           |       | 254,463                 |       | 255,471                     |       |
| **DEFERRED TAX LIABILITIES**                                                                                                                                          |       | 11,708                  |       | 11,373                      |       |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                       |       | 8,945                   |       | 4,452                       |       |
| **Total  liabilities**                                                                                                                                                |       | 345,917                 |       | 341,969                     |       |
|                                                                                                                                                                  |       |                    |       |                        |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                                  |       |                    |       |                        |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                        | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Preferred stock,  $.001 par value, 10,000,000 shares authorized, none issued                                                                                          |       | —                  |       | —                      |       |
| Common stock,  $.001 par value, 30,000,000 shares authorized, 15,745,917 and 15,603,917  shares issued and 14,230,871 and 14,063,523 shares outstanding, respectively |       | 16                      |       | 16                          |       |
| Additional  paid-in capital                                                                                                                                           |       | 157,948                 |       | 154,411                     |       |
| Retained  earnings                                                                                                                                                    |       | 43,324                  |       | 38,964                      |       |
| Treasury stock  (1,515,046 and 1,540,394 shares of common stock, at cost, respectively)                                                                               |       | (12,105                 | )          | (12,308                     | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                        |       | (61                     | )          | 481                         |       |
| **Total  stockholders’ equity**                                                                                                                                  |       | 189,122                 |       | 181,564                     |       |
| **Total liabilities and  stockholders’ equity**                                                                                                                  |       | $                       | 535,039    |                        | $          | 523,533 |   |

 

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

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**CORNELL COMPANIES,INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME**

**(Unaudited)**

**(in thousands,except per share data)**
| ** **                                                                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                         | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| REVENUES                                                                                                           |       | $                                | 91,494     |                           | $          | 90,497 |   | $ | 181,138 |   | $ | 174,345 |   |
| OPERATING EXPENSES                                                                                                 |       | 68,360                           |       | 67,135                         |       | 137,973 |   | 132,278 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                  |       | —                           |       | 3⁄4                         |       | — |   | 2,657 |   |
| DEPRECIATION AND AMORTIZATION                                                                                      |       | 3,912                            |       | 4,213                          |       | 7,753 |   | 7,939 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                |       | 7,175                            |       | 5,438                          |       | 15,532 |   | 10,550 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                             |       | 12,047                           |       | 13,711                         |       | 19,880 |   | 20,921 |   |
| INTEREST EXPENSE                                                                                                   |       | 6,687                            |       | 7,220                          |       | 13,467 |   | 12,785 |   |
| INTEREST INCOME                                                                                                    |       | (769                             | )          | (625                           | )          | (915 | ) | (1,148 | ) |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME  TAXES                                               |       | 6,129                            |       | 7,116                          |       | 7,328 |   | 9,284 |   |
| PROVISION FOR INCOME TAXES                                                                                         |       | 2,683                            |       | 3,053                          |       | 3,219 |   | 4,009 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS                                                                                  |       | 3,446                            |       | 4,063                          |       | 4,109 |   | 5,275 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT OF $98 AND $381 IN  2006                                               |       | —                           |       | (182                           | )          | — |   | (707 | ) |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| NET INCOME                                                                                                         |       | $                                | 3,446      |                           | $          | 3,881 |   | $ | 4,109 |   | $ | 4,568 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                         |       |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                              |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                                                                 |       | $                                | .24        |                           | $          | .29 |   | $ | .29 |   | $ | .38 |   |
| Loss from  discontinued operations, net of tax                                                                     |       | —                           |       | (.01                           | )          | — |   | (.05 | ) |
| Net income                                                                                                         |       | $                                | .24        |                           | $          | .28 |   | $ | .29 |   | $ | .33 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| DILUTED                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                                                                 |       | $                                | .24        |                           | $          | .29 |   | $ | .29 |   | $ | .38 |   |
| Loss from  discontinued operations, net of tax                                                                     |       | —                           |       | (.01                           | )          | — |   | (.05 | ) |
| Net income                                                                                                         |       | $                                | .24        |                           | $          | .28 |   | $ | .29 |   | $ | .33 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                    |       |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                              |       | 14,124                           |       | 13,906                         |       | 14,067 |   | 13,865 |   |
| DILUTED                                                                                                            |       | 14,465                           |       | 14,034                         |       | 14,382 |   | 14,000 |   |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| COMPREHENSIVE INCOME:                                                                                              |       |                             |       |                           |       |   |   |   |   |
| Net income                                                                                                         |       | $                                | 3,446      |                           | $          | 3,881 |   | $ | 4,109 |   | $ | 4,568 |   |
| Unrealized loss  on derivative instruments, net of tax benefit of $433 and $376 in 2007 and  $327 and $536 in 2006 |       | (623                             | )          | (470                           | )          | (541 | ) | (771 | ) |
| Comprehensive income                                                                                               |       | $                                | 2,823      |                           | $          | 3,411 |   | $ | 3,568 |   | $ | 3,797 |   |

 

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

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**CORNELL COMPANIES, INC.**

# **CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**
| ** **                                                                                              | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                              | ** ** | **June 30,**              | ** ** |
| ** **                                                                                              | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                   |       |                           |       |   |   |
| Net income                                                                                              |       | $                              | 4,109      |   | $ | 4,568 |   |
| Adjustments to  reconcile net to net cash provided by operating activities -                            |       |                           |       |   |   |
| Depreciation                                                                                            |       | 6,631                          |       | 6,818 |   |
| Amortization of  intangibles and other assets                                                           |       | 1,208                          |       | 1,208 |   |
| Amortization of  deferred compensation                                                                  |       | —                         |       | (21 | ) |
| Amortization of  deferred financing costs                                                               |       | 701                            |       | 799 |   |
| Amortization of  Senior Notes discount                                                                  |       | 92                             |       | 92 |   |
| Stock-based  compensation                                                                               |       | 1,270                          |       | 1,156 |   |
| Provision for  bad debts                                                                                |       | 1,030                          |       | 1,005 |   |
| (Gain)/loss on  sale of property and equipment                                                          |       | (282                           | )          | 2 |   |
| Deferred income  taxes                                                                                  |       | 711                            |       | 2,877 |   |
| Change in  assets and liabilities, net of effects of acquisitions:                                      |       |                           |       |   |   |
| Accounts  receivable                                                                                    |       | 4,765                          |       | (8,360 | ) |
| Other restricted  assets                                                                                |       | (985                           | )          | 609 |   |
| Other assets                                                                                            |       | 502                            |       | 1,932 |   |
| Accounts  payable and accrued liabilities                                                               |       | (1,825                         | )          | (1,857 | ) |
| Other long-term  liabilities                                                                            |       | (115                           | )          | 16 |   |
| Net cash  provided by operating activities                                                              |       | 17,812                         |       | 10,844 |   |
|                                                                                                    |       |                           |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                   |       |                           |       |   |   |
| Capital  expenditures                                                                                   |       | (15,003                        | )          | (9,073 | ) |
| Purchases of  investment securities                                                                     |       | (241,425                       | )          | (185,050 | ) |
| Sales of  investment securities                                                                         |       | 244,900                        |       | 183,325 |   |
| Acquisition of  a facility                                                                              |       | (8,948                         | )          | — |   |
| Payments to restricted  debt payment account, net                                                       |       | (5,483                         | )          | (6,294 | ) |
| Net cash used  in investing activities                                                                  |       | (25,959                        | )          | (17,092 | ) |
|                                                                                                    |       |                           |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                   |       |                           |       |   |   |
| Tax benefit of  stock option exercises                                                                  |       | 455                            |       | 198 |   |
| Payments of  capital lease obligations                                                                  |       | (5                             | )          | (5 | ) |
| Proceeds from  exercise of stock options                                                                |       | 2,016                          |       | 1,554 |   |
| Net cash  provided by financing activities                                                              |       | 2,466                          |       | 1,747 |   |
|                                                                                                    |       |                           |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                               |       | (5,681                         | )          | (4,501 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                                        |       | 18,529                         |       | 13,723 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                              |       | $                              | 12,848     |   | $ | 9,222 |   |
|                                                                                                    |       |                           |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                      |       |                           |       |   |   |
| Decrease in  fair value of interest rate swap                                                           |       | $                              | 1,095      |   | $ | 2,941 |   |
| Other  comprehensive loss, net of tax                                                                   |       | (541                           | )          | (771 | ) |
| Common stock  issued for board of directors fees                                                        |       | —                         |       | 266 |   |
| Borrowings  under capital leases                                                                        |       | —                         |       | 56 |   |
| Purchases and additions to property and equipment included in  accounts payable and accrued liabilities |       | 4,113                          |       | — |   |

 

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

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**CORNELLCOMPANIES, INC.****NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

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

The accompanying unaudited consolidated financialstatements have been prepared by Cornell Companies, Inc. (collectively with itssubsidiaries and consolidated special purpose entities, the “Company,” “we,” “us”or “our”) pursuant to the rules and regulations of the Securities and ExchangeCommission.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles in the United States (“GAAP”)have been condensed or omitted pursuant to such rules and regulations. Theyear-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 ofthese financial statements.  Actualresults could differ from those estimates. These financial statements should be read in conjunction with thefinancial statements and notes thereto included in the Company’s 2006 AnnualReport on Form 10-K as filed with the Securities and Exchange Commission.

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

See a description of our accounting policies in our2006 Annual Report on Form 10-K.

***Adoption ofFinancial Accounting Standards Board Interpretation No. 48***

InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASB InterpretationNo. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASBStatement No. 109” (“FIN No. 48”).  FINNo. 48 establishes a single model to address the accounting for uncertain taxpositions.  FIN No. 48 clarifies theaccounting for income taxes by prescribing a minimum recognition threshold atax position is required to meet before being recognized in the financialstatements.  FIN No. 48 also providesguidance on the measurement, derecognition, classification and disclosure of taxpositions, as well as the accounting for the related interest and penalties,transition and accounting in interim periods. FIN No. 48 is effective for fiscal years beginning after December 15,2006 and requires that the impact of the adoption of FIN No. 48 be recorded asan adjustment to beginning retained earnings at January 1, 2007.

Weadopted the provisions of FIN No. 48 on January 1, 2007.  Our total amount of unrecognized tax benefitsas of the adoption date was approximately $3.0 million.  As a result of the adoption of FIN No. 48, werecorded a cumulative effect adjustment of approximately $0.3 million whichincreased retained earnings at January 1, 2007. The amount of unrecognized tax benefits did not materially change in thesix months ended June 30, 2007.

Includedin the unrecognized tax benefits balance as of January 1, 2007, areapproximately $0.8 million of tax benefits that, if recognized in futureperiods, would impact our effective tax rate. The difference of approximately $2.2 million between the total amount ofunrecognized tax benefits of $3.0 million and the amount that would impact oureffective tax rate was offset by an increase in deferred tax assets, primarilyrelated to net operating loss carry forwards, as of January 1, 2007.

Estimatedinterest and penalties related to the underpayment of income taxes areclassified as a component of income tax expense in the Consolidated Statementsof Operations and Comprehensive Income (loss) and totaled approximately $0.02million and $0.04 million in the three and six months ended June 30, 2007.Accrued interest and penalties were approximately $0.3 million at June 30, 2007and January 1, 2007.

Weare subject to income tax in the United States and many of the individualstates we operate in.  We currently havesignificant operations in Texas, California 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 ended December 31, 2003 through December 31,2006.

Wedo not anticipate a significant change in the balance of our unrecognized taxbenefits within the next 12 months.

**AccountingFor Stock-Based Compensation**

Our stock incentiveplans provide for the granting of stock options (both incentive stock optionsand nonqualified stock 

6

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options), stockappreciation rights, restricted stock units and other stock-based awards toofficers, directors and employees of the Company. Grants of stock options madeto date under these plans vest over periods up to seven years after the date ofgrant and expire no more than 10 years after grant.

EffectiveJanuary 1, 2006, we adopted the provisions of the FASB Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. Under this method,compensation cost recognized for the quarter, includes the applicable amountsof: (a) compensation cost of all stock-based awards granted prior to, but notyet vested, as of January 1, 2006 (based on the grant-date fair value estimatedin accordance with the original provisions of SFAS No. 123), and (b)compensation cost for all stock-based awards granted subsequent to January 1,2006 (based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123R).

Additionally, we have an employeestock purchase plan (“ESPP”)under whichemployees can make contributions to purchase our common stock. Participation inthe plan is elected annually by employees. The plan year typically begins eachJanuary 1st (the “Grant Date”) and ends on December 31st (the “Exercise Date”).For 2007, however, the plan year began April 1, 2007.  Purchases of common stock are made at the endof the year using the lower of the fair market value on either the Grant Dateor Exercise Date, less a 15% discount. Under SFAS No. 123R ouremployee-stock purchase plan is considered to be a compensatory ESPP, andtherefore, we are required to recognize compensation cost over the requisiteservice period for grants made under the ESPP.

SFAS No. 123R amends SFAS No. 95, “Statementof Cash Flows,” to require reporting of excess tax benefits as a financing cashflow, rather than as a reduction of taxes paid. These excess tax benefitsresult from tax deductions in excess of the cumulative compensation expenserecognized for options exercised. Prior to the adoption of SFAS No. 123R, wepresented all tax benefits resulting from the exercise of stock options asoperating cash flows in our Consolidated Statements of Cash Flows.

On March 29, 2005, the SEC issuedStaff Accounting Bulletin (“SAB”) 107 to address certain issues related to SFASNo. 123R. SAB 107 provides guidance on transition methods, valuation methods,income tax effects and other share-based payment topics, and we had alsoapplied this guidance in our adoption of SFAS No. 123R.

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

At June 30, 2006,60,000 shares of restricted stock were outstanding subject to performance-basedvesting criteria (30,000 of these are considered market-based restricted stockunder SFAS No. 123R). Additionally, 152,200 stock options were outstandingsubject to performance-based vesting criteria (19,600 of these were consideredmarket-based options under SFAS No. 123R). The 30,000 shares of restricted stock and the 19,600 stock options whichwere considered market-based restricted stock were valued using a Monte Carlosimulation probability model to estimate future stock returns. The grant datefair value of these shares was $9.05 per share for a total value of $0.5million. We recognized $0.04 million and $0.08 million of expense associatedwith these shares of restricted stock and options during the three and six monthsended June 30, 2006, respectively.

AtJune 30, 2007, 137,500 shares of restricted stock were outstanding subject toperformance-based vesting criteria (45,000 of these restricted shares wereconsidered market-based restricted stock under SFAS No. 123R).  There were also 100,100 stock optionsoutstanding subject to performance-based vesting criteria.  We recognized $0.13 million and $0.26 millionof expense associated with these shares of restricted stock and stock optionsduring the three and six months ended June 30, 2007.

The amounts above relate to theimpact of recognizing compensation expense related to stock options andrestricted stock. Compensation expense related to stock options (100,100shares) and restricted stock (92,500 shares) that vest based upon performanceconditions is not recorded for such performance-based awards until it has beendeemed probable that the related performance targets allowing the vesting ofthese options and restricted stock  willbe met. We are required to periodically re-assess the probability and recordexpense at the point in time, if ever, it becomes probable these options will 

7

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vest. During the fourth quarter of 2006 it was deemedprobable that the performance targets pertaining to certain restricted stockand stock options would be achieved by their vesting date. Accordingly,compensation expense of approximately $0.1 million and $0.2 million has beenrecognized for the three and six months ended June 30, 2007, respectively,related to these stock-based awards.

Werecognize expense for our stock-based compensation over the vesting period,which represents the period in which an employee is required to provide servicein exchange for the award. We recognize compensation expense for stock-basedawards immediately if the award has immediate vesting.

**Assumptions**

Thefair values for the significant stock-based awards granted during the sixmonths ended June 30, 2007 and 2006 were estimated at the date of grantusing a Black-Scholes option pricing model with the following weighted-averageassumptions:
|                                   | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **June 30,**              | ** ** |
| ** **                        | ** ** | **2007**                       | ** ** | **2006** | ** ** |
|                              |       |                           |       |   |   |
| Risk-free rate  of return         |       | 4.55                           | %          | 4.31 | % |
| Expected life of  award           |       | 5.55 years                     |       | 5 years |   |
| Expected  dividend yield of stock |       | 0                              | %          | 0 | % |
| Expected volatility  of stock     |       | 41.95                          | %          | 45.48 | % |
| Weighted-average fair  value      |       | $                              | 9.74       |   | 6.24 |   |
|                                   |            |                                |            |  |  |  |

 

Theexpected volatility of stock assumption was derived by referring to changes inthe Company’s historical common stock prices over a timeframe similar to thatof the expected life of the award. We currently have no reason to believe thatfuture stock volatility will differ significantly from historical stockvolatility. Estimated forfeiture rates are derived from historical forfeiturepatterns. We believe the historical experience method is the best estimate offorfeitures currently available.

Inaccordance with SAB 107, we used the “simplified” method for “plain vanilla”options to estimate the expected term of options granted during the six monthsended June 30, 2007 and 2006.

Stock-basedaward activity during the six months ended June 30, 2007 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, 2006             |       | 655,260                |       | $                                      | 12.87      |                                                | 7.6        |                            | $          | 8.4 |   |
| Granted                                       |       | 68,750                 |       | 21.30                                  |       |                                                |       |                            |       |
| Exercised                                     |       | (142,000               | )          | 12.11                                  |       |                                                |       |                            |       |
| Canceled                                      |       | (44,988                | )          | 13.15                                  |       |                                                |       |                            |       |
|                                          |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  June 30, 2007                 |       | 537,022                |       | $                                      | 14.12      |                                                | 7.2        |                            | $          | 7.6 |   |
|                                          |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and  expected to vest at June 30, 2007 |       | 411,988                |       | $                                      | 14.12      |                                                | 7.1        |                            | $          | 5.8 |   |
|                                          |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at June 30,  2007                 |       | 270,693                |       | $                                      | 13.63      |                                                | 6.8        |                            | $          | 3.7 |   |

 

8

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Thetotal intrinsic value of stock options exercised during the six months endedJune 30, 2007 and 2006 was $1.3 million and $0.6 million, respectively.Net cash proceeds from the exercise of stock options were approximately $2.0million and $1.6 million for the six months ended June 30, 2007 and 2006,respectively.

Asof June 30, 2007, approximately $0.8 million of estimated expense with respectto time-based nonvested stock option awards has yet to be recognized and willbe amortized into expense over the employee’s remaining requisite serviceperiod of approximately 2.75 years. As of June 30, 2007, approximately$0.6 million of estimated expense with respect to performance basednonvested stock option awards has yet to be recognized and will be recorded ifit becomes probable that these options will vest.

Thefollowing table summarizes information with respect to stock optionsoutstanding and exercisable at June 30, 2007.
| 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   |       | 27,370                  |       | 4.3                                                 |       | $                                      | 5.83       |                    | 26,557     |                                   | $          | 5.76 |   |
| $10.01  to  $13.50  |       | 180,302                 |       | 7.0                                                 |       | 12.78                                  |       | 93,086                  |       | 12.79                                  |       |
| $13.51  to $14.50        |       | 247,000                 |       | 7.0                                                 |       | 13.96                                  |       | 105,700                 |       | 13.85                                  |       |
| $14.51  to $22.00        |       | 82,350                  |       | 8.8                                                 |       | 20.31                                  |       | 45,350                  |       | 19.44                                  |       |
|                                    |       | 537,022                 |       | 7.2                                                 |       | $                                      | 14.12      |                    | 270,693    |                                   | $          | 13.63 |   |

 

Stock-based awardactivity for nonvested awards during the six months ended June 30, 2007 was asfollows:
|                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|
| Nonvested at  December 31, 2006 |       | 322,170                |       | $                                                       | 13.40      |   |
| Granted                         |       | 68,750                 |       | 21.30                                                   |       |
| Vested                          |       | (79,603                | )          | 16.27                                                   |       |
| Canceled                        |       | (44,988                | )          | 13.15                                                   |       |
|                            |       |                   |       |                                                    |       |
| Nonvested at June 30,  2007     |       | 266,329                |       | $                                                       | 14.63      |   |

 

***RestrictedStock***

We have previously issuedrestricted stock under certain employment agreements which vests over aspecific period of time, generally three to five years.  During the six months ended June 30, 2007, wealso issued restricted stock under both certain employment agreements and our2006 Equity Incentive plan.  These sharesof restricted common stock are subject to restrictions on transfer and certainconditions to vesting.

Restricted stock activityfor the six months ended June 30, 2007 was as follows:
|                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|
| Nonvested at  December 31, 2006 |       | 85,000                 |       | $                                                       | 10.87      |   |
| Granted                         |       | 185,000                |       | 22.67                                                   |       |
| Vested                          |       | —                 |       |                                                    |       |
| Canceled                        |       | —                 |       |                                                    |       |
|                            |       |                   |       |                                                    |       |
| Nonvested at June 30,  2007     |       | 270,000                |       | $                                                       | 18.95      |   |

 

9

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We recognized $0.18million and $0.23 million of expense associated with nonvested time-basedrestricted stock awards during the three and six months ended June, 30, 2007.As of June 30, 2007, approximately $2.4 million of estimated expense withrespect to nonvested time-based restricted stock awards had yet to berecognized and will be amortized over a weighted average period of 3.01 years.Approximately $1.8 million of estimated expense with respect to nonvestedperformance-based restricted stock option awards had yet to be recognized as ofJune 30, 2007.

***Reclassifications***

Certain reclassifications have been made to theprior year financial statements contained herein to conform to current yearpresentation.

**3.****                 MergerAgreement**

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 our stockholders entered into aVoting Agreement dated on or about October 6, 2006, whereby such stockholdersagreed, among other things, to vote their respective shares of our stock infavor of the Merger Agreement, the Merger and the transactions contemplatedthereby.  At a special meeting of ourstockholders held on January 23, 2007, the proposed Merger Agreement wasrejected.

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 legal andexternal professional and consulting fees are reflected in general andadministrative expenses for the six months ended June 30, 2007.

**4.****                ****Discontinued Operations andManagement Restructuring**

Weclassify as discontinued operations those components of our business that wehold for sale or that have been disposed and have cash flows that are clearlydistinguishable operationally and for financial reporting purposes from therest of our operations. For those components, we have no significant continuinginvolvement after completion of disposal and their operations are eliminatedfrom our ongoing operations. During 2005, we closed certain facilities thatqualified for discontinued operations and notifications were made to therequired contracting entities regarding the termination of the relatedprograms. At June 30, 2007, we did not have any significant net propertyand equipment balances pertaining to these operations.  There were no revenues generated by thesediscontinued operations in the three and six months ended June 30, 2007 and2006.

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

Intangible assets at June 30, 2007 and December 31,2006 consisted of the following (in thousands):
|                                                         | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                    |       |                    |       |                        |       |
| Non-compete  agreements                                 |       | $                       | 10,040     |                        | $          | 10,040 |   |
| Accumulated  amortization – non-compete agreements |       | (7,809                  | )          | (7,240                      | )          |
| Acquired  contract value                                |       | 6,442                   |       | 6,442                       |       |
| Accumulated  amortization – contract value         |       | (2,869                  | )          | (2,316                      | )          |
| Identified intangibles, net                             |       | 5,804                   |       | 6,926                       |       |
| Goodwill, net                                           |       | 13,355                  |       | 12,339                      |       |
| Total  intangibles, net                                 |       | $                       | 19,159     |                        | $          | 19,265 |   |

 

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The changes in the carrying amount ofgoodwill for the six months ended June 30, 2007 are as follows: (in thousands):
|                                  | ** ** | **Adult  Secure** | ** ** | **Juvenile** | ** ** | **Adult  Community-  Based** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------------|------------|--------------|------------|------------------------------|------------|-----------|------------|
|                             |       |              |       |         |       |                         |       |      |       |
| Balance as of  December 31, 2006 |       | $                 | 1,509      |         | $          | 1,060                        |       | $         | 9,770      |   | $ | 12,339 |   |
| Addition to  goodwill            |       | —            |       | —       |       | 1,016                        |       | 1,016     |       |
| Balance as of June 30, 2007      |       | $                 | 1,509      |         | $          | 1,060                        |       | $         | 10,786     |   | $ | 13,355 |   |

 

During the six months ended June 30,2007, an addition was recorded to goodwill to reflect the final release ofamounts previously placed in escrow related to the acquisition of CorrectionalSystems, Inc. in April 2005.

Amortizationexpense for our non-compete agreements was approximately $0.3 million for thethree months ended June 30, 2007 and 2006 and approximately $0.6 million forthe six months ended June 30, 2007 and 2006. Amortization expense for our non-compete agreements is expected to beapproximately $1.1 million for each of the next two years ended December 31 andapproximately $0.7 million for the third year.

Amortizationexpense for our acquired contract value was approximately $0.3 million for thethree months ended June 30, 2007 and 2006 and approximately $0.6 million forthe six months ended June 30, 2007 and 2006. Amortization expense for our acquired contract value is expected to beapproximately $1.1 million for each of the next three years ended December 31and approximately $0.6 million for the fourth year.

**6.****                ****Credit Facilities**

AtJune 30, 2007 and December 31, 2006, our long-term debt consisted of thefollowing (in thousands):

|                                                                                                                                                           | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                      |       |                    |       |                        |       |
| **Debt of  Cornell Companies, Inc.:**                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Senior Notes, unsecured, due July 2012 with an  interest rate of 10.75%, net of discount of $921 and $1,013, respectively                                 |       | $                       | 111,079    |                        | $          | 110,987 |   |
| Fair-value adjustment of Senior Notes as a result of  interest rate swap                                                                                  |       | (2,148                  | )          | (1,053                      | )          |
| Revolving Line of Credit due June 2008 with an  interest rate of LIBOR plus 2.25% to 3.5% or prime plus 0.75% to 2.00% (the  “Credit Facility”) |       | —                  |       | —                      |       |
| Capital lease obligations                                                                                                                                 |       | 42                      |       | 47                          |       |
| Subtotal                                                                                                                                                  |       | 108,973                 |       | 109,981                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| **Debt of  Special Purpose Entity:**                                                                                                                      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| 8.47% Bonds due 2016                                                                                                                                      |       | 156,000                 |       | 156,000                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Total  consolidated debt                                                                                                                                  |       | 264,973                 |       | 265,981                     |       |
|                                                                                                                                                      |       |                    |       |                        |       |
| Less: current  maturities                                                                                                                                 |       | (10,510                 | )          | (10,510                     | )          |
|                                                                                                                                                      |       |                    |       |                        |       |
| Consolidated long-term  debt                                                                                                                              |       | $                       | 254,463    |                        | $          | 255,471 |   |

 

***Long-Term CreditFacilities.***  Our Credit Facility provides for borrowingsof up to $60.0 million under a revolving line of credit, and is reduced byoutstanding letters of credit.  Theavailable commitment under our Credit Facility was approximately $49.7 millionat June 30, 2007.  We had no outstandingborrowings on our Credit Facility at June 30, 2007, but we had outstandingletters of credit of approximately $10.3 million.  Subject to certain requirements, we have theright to increase the commitments under our Credit Facility up to an aggregateamount of $100.0 million.  Our CreditFacility matures in June 2008 and bears interest, at our election, depending onour total leverage ratio, at either the prime rate plus a 

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margin ranging from 0.75% to 2.00%, or a rate which ranges from 2.25%to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

MCF is obligatedfor the outstanding balance of its 8.47% Taxable Revenue Bonds, Series2001.  The bonds bear interest at a rateof 8.47% per annum and are payable in semi-annual installments of interest andannual installments of principal.  Allunpaid principal and accrued interest on the bonds is due on the earlier ofAugust 1, 2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by the Company.

In June 2004,we issued $112.0 million in principal of 10.75% Senior Notes (the “Senior Notes”)due July 1, 2012.  The Senior Notes areunsecured senior indebtedness and are guaranteed by all of our existing andfuture subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of each year,commencing January 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:
| Year                | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Uponthe occurrence of specified change of control events, unless we have exercisedour option to redeem all the Senior Notes as described above, each holder willhave the right to require us to repurchase all or a portion of such holder’sSenior Notes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to paydividends or other payments to us, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

Inconjunction with the issuance of the Senior Notes, we entered into an interestrate swap transaction with a financial institution to hedge our exposure tochanges in the fair value on $84.0 million of our Senior Notes.  The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a variablerate.  The terms of the interest rateswap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and six months ended June 30, 2007, we recorded interest expense relatedto this interest rate swap of approximately $0.09 million and $0.1 million,respectively, which is reflected as interest expense in the accompanyingfinancial statements. For the three and six months ended June 30, 2006, werecorded interest expense related to this interest rate swap of approximately$0.1 million and $0.04 million, respectively, which is reflected as interestexpense in the accompanying financial statements.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either adiscount or premium on the Senior Notes. At June 30, 2007 and December 31, 2006, the fair value of thisderivative instrument was approximately ($2.1) million and ($1.1) million,respectively, and is included in other long-term liabilities in theaccompanying financial statements.  Thecarrying value of the Senior Notes as of these dates was adjusted accordinglyby the same amount. Because the swap agreement is an effective fair-valuehedge, there will be no effect on our results of operations from themark-to-market adjustment as long as the swap is in effect.

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

During2006, the Federal Bureau of Prisons (“BOP”) solicited a Request for Proposals (“RFP”)for services to house approximately 7,000 low security, non-United Statescitizens, sentenced males in an existing secure correctional institutionprocured from private sources or state and local governments, with excesscapacity, located in Arizona, California, Louisiana, New Mexico, Oklahoma orTexas to replace several existing intergovernmental agreements (“IGA”) for suchservices, including the IGA relating to our Big Spring Correctional Center inTexas. In January 2007, we were awarded a contract from the BOP for our BigSpring Correctional Center. In conjunction with this contract, we areperforming certain facility expansion projects during the year ending December31, 2007. As of June 30, 2007, we had incurred and capitalized costs of approximately$7.8 million related to these expansion projects.

InMay 2007, we were awarded a contract by the Arizona Department of Correctionsfor our Great Plains Correctional Facility in Hinton, Oklahoma. The contractcalls for a total of 2,000 medium-security inmates to be housed at thefacility. We expect to house approximately 916 inmates at the existing facilityand the remainder would be housed through an expansion of the existingfacility. We are finalizing the scheduling with the customer; and we currentlyexpect to begin receiving inmates late in the third quarter of 2007 and tocomplete expansion of the facility in the fourth quarter of 2008. Total capitalexpenditures associated with the expansion are estimated at approximately $55.0million, subject to finalization of design and construction agreements.

Weare also expanding the D. Ray James Prison in Georgia during the year endingDecember 31, 2007 to increase its service capacity by 300 beds. As of June 30,2007, we had incurred and capitalized costs of approximately $7.6 millionrelated to this expansion. In August 2007, we announced that we intend toinitiate a second expansion at the D. Ray James Prison. This expansion isexpected to increase service capacity by 700 beds and construction, which weanticipate will begin in 2008, should be complete by the beginning of 2009. Weexpect the related capital expenditures for this expansion to range from $28.0million to $33.0 million, depending on the finalization of design andconstruction agreements.

**8.****                ****Earnings Per Share**

Basic earningsper share (“EPS”) is computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended June 30, 2007 and2006, there were 15,000 shares ($25.00 average price) and 69,100 shares ($15.58average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive. Forthe six months ended June 30, 2007 and 2006, there were 15,000 shares ($25.00average price) and 71,600 shares ($15.55 average price), respectively, of stockoptions that were not included in the computation of diluted EPS because to doso would have been anti-dilutive.

The following table summarizes thecalculation of net earnings and weighted average common shares and commonequivalent shares outstanding for purposes of the computation of earnings pershare (in thousands, except per share data):
| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                               | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Income from continuing operations                                        |       | $                                | 3,446      |                           | $          | 4,063 |   | $ | 4,109 |   | $ | 5,275 |   |
| Loss from discontinued operations, net of taxes                          |       | —                           |       | (182                           | )          | — |   | (707 | ) |
| Net income                                                               |       | $                                | 3,446      |                           | $          | 3,881 |   | $ | 4,109 |   | $ | 4,568 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding                               |       | 14,124                           |       | 13,906                         |       | 14,067 |   | 13,865 |   |
| Weighted average common share equivalents outstanding                    |       | 341                              |       | 128                            |       | 315 |   | 135 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares and common share equivalents  outstanding |       | 14,465                           |       | 14,034                         |       | 14,382 |   | 14,000 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Basic earnings (loss) per share:                                         |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                       |       | $                                | .24        |                           | $          | .29 |   | $ | .29 |   | $ | .38 |   |
| Loss from  discontinued operations, net of tax                           |       | —                           |       | (.01                           | )          | — |   | (.05 | ) |
| Net income                                                               |       | $                                | .24        |                           | $          | .28 |   | $ | .29 |   | $ | .33 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Diluted earnings (loss) per share:                                       |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                       |       | $                                | .24        |                           | $          | .29 |   | $ | .29 |   | $ | .38 |   |
| Loss from  discontinued operations, net of tax                           |       | —                           |       | (.01                           | )          | — |   | (.05 | ) |
| Net income                                                               |       | $                                | .24        |                           | $          | .28 |   | $ | .29 |   | $ | .33 |   |

 

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**9.      Commitmentsand Contingencies**

**LegalProceedings**

***Valencia County DetentionCenter***

In April 2007, a lawsuit was filed against the Companyin Federal District court in Albuquerque, New Mexico, by Joe Torres andEufrasio Armijo, who each alleged that he was stripped searched at the ValenciaCounty Detention Center (“VCDC”) in New Mexico in violation of his federalrights under the Fourth, Fourteenth and Eighth amendments to the U.S.constitution.  The claimants also allege violation of their rights understate law and seek to bring the case as a class action on behalf of themselvesand all detainees at VCDC during the applicable statues of limitation. The plaintiffs seek damages and declaratory and injunctive relief.  Thelawsuit is in its early stages and no discovery has been conducted. Theultimate outcome of the lawsuit cannot be determined at this time. However, weintend to vigorously defend this lawsuit.  We have not recorded any lossaccruals related to this lawsuit.

***LincolnCounty Detention Center***

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

In the year ended December 31, 2005, we recorded acharge of $0.2 million related to this lawsuit. In addition, we previously haveprovided insurance reserves for this matter (as part of our regular review ofreported and unreported claims) totaling approximately $0.5 million.  During the third quarter of 2006, we recordedan additional settlement charge of approximately $0.9 million and the relatedreimbursement from our general liability and professional liabilityinsurance.  The charge and reimbursementwas recognized in general and administrative expenses for the year endedDecember 31, 2006. The reimbursement was funded by the insurance carrier in thefirst quarter of 2007 into a settlement account.  The court granted preliminary approval of thesettlement in the second quarter of 2007, and the claims administration processis now underway. We expect the claims administration process to be completed bythe end of 2007 and the final court approval of the settlement in the firsthalf of 2008.

***Alexander Youth Services Center***

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas.  The lawsuitalleges that we violated the rights of Lakeisha Shantrail Brown, the deceaseddaughter of Juana Michelle Brown, under the U.S. Constitution and the laws ofthe State of Arkansas by denying Ms. Brown medical treatment that caused herdeath and sought unspecified actual and punitive damages.  In September 2006, the plaintiff filed, andthe court granted, an order for voluntary dismissal without prejudice.  The lawsuit was refiled in December 2006 as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV17808*,*in the United States District Court for the EasternDistrict of Arkansas.   We are unable atthis time to estimate our financial exposure relating to this lawsuit.  We believe our insurance coverage is adequateto cover any potential damages relating to this action.  We intend to vigorously defend thismatter; however, the ultimate outcome of this lawsuit cannot be determined atthis time.

***Southern Peaks Regional TreatmentCenter***

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atJune

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30,2007. In December 2004, the jury awarded us approximately $6.5 million incompensatory damages and approximately $1.4 million in punitive damages, plusattorneys’ fees. The actual damages portion of the award under the finalJudgment and Decree (“Judgment”) entered on December 20, 2006 was adjusteddownward to the $5.4 million actually lost by us.  The award for compensatory damages accruespre-judgment interest at a rate of 7 percent from the date of loss through thedate of judgment. Following the jury verdicts, we collected approximately $0.4million in January 2005 in funds that had been previously frozen under atemporary restraining order issued at the time that we commenced thislitigation. Currently, one of the defendants has filed an appeal of theJudgment.  Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we recorded an additional reserve in the amount of approximately$0.3 million in the quarter ended December 31, 2006.  We will continue to maintain our existingreserve of approximately $5.3 million in an allowance for doubtful accountsagainst the corresponding balance as carried in other receivables at June 30,2007 and December 31, 2006.

***ShareholderLawsuits***

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 stockholder ofCornell. The complaint names as defendants Cornell and each member of our boardof directors as well as Veritas Capital Fund III, L.P. (“Veritas”). Thecomplaint alleges, among other things, that (i) the defendants have breachedfiduciary duties they assertedly owed to our stockholders in connection withour entering into the Agreement and Plan of Merger, dated as of October 6,2006, with Veritas, Cornell Holding Corp., and CCI Acquisition Corp., and (ii)the merger consideration is unfair and inadequate. The plaintiffs sought, amongother things, an injunction against the consummation of the merger. Theproposed merger was rejected at a special meeting of our stockholders held onJanuary 23, 2007. We believe that the lawsuit is without merit and intend todefend ourselves vigorously.

We hold insurance policies to cover potential directorand officer liability, some of which may limit our cash outflows in the eventof a decision adverse to us in the matters discussed above. However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance 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.

***Settlement of Claim***

In August 2007, we settled a lawsuit we had filed inthe 333rd State District Court in Houston, Texas, CauseNo. 2005-55083 against Locke Liddell & Sapp PLLC and an individual partnerof Locke Liddell & Sapp PLLC, (the “Defendants”) relating to the Defendant’srepresentation of the Company in a transaction involving our Southern PeaksRegional Treatment Center in Canon City, Colorado. Under the terms of thesettlement, we are to receive approximately $1.9 million in August 2007. Weexpect to incur approximately $0.3 million in expense related to this matter inthe third quarter of 2007.

***Other***

Additionally, we currently and from time to time aresubject to claims and suits arising in the ordinary course of business,including claims for damages for personal injuries or for wrongful restrictionof or interference with offender privileges and employment matters. If anadverse decision in these matters exceeds our insurance coverage, or if ourcoverage is deemed not to apply to these matters, or if the underlyinginsurance carrier was unable to fulfill its obligation under the insurance coverageprovided, it could have a material adverse effect on our financial condition,results of operations or cash flows.

During the period from August 2000 throughMay 2003, our general liability and professional liability coverage wasprovided by Specialty Surplus Insurance Company, a Kemper Insurance Company(Kemper) group member. In June 2004, the Illinois Department of Insurancegave Kemper permission to proceed with a run-off plan it had previouslysubmitted. The three-year plan is designed to help Kemper meet its goal ofresolving, to the maximum extent possible, all valid policyholder claims. Inview of the risks and uncertainties involved in implementing the plan,including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulators, the plan maynot be successfully implemented by Kemper. In the year ended December 31,2004, we accrued a provision of $0.6 million, and estimated our range ofadditional exposure to be approximately $0.5 million with respect tooutstanding claims incurred during this policy period with Kemper which wouldbecome our obligation to resolve if not settled through Kemper. During the yearended December 31, 2005, Kemper continued to implement its run-off plan.As a result, several of our significant claims were settled by Kemper during2005. In conjunction with these settlements, we recorded a charge against ourexisting

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accrualin the amount of $0.3 million. Based on our analysis of the claims activityduring the third quarter of 2005, we felt it necessary to accrue an additionalprovision in the amount of approximately $0.2 million during the third quarterof 2005. Additional significant claims continued to be settled by Kemper duringthe second half of 2006. As a result, we released reserves of approximately$0.4 million during the quarter ended December 31, 2006. At June 30, 2007, wedo not believe there is significant exposure above our existing $0.1 millionaccrual for those outstanding claims which could become our obligation toresolve if not settled through Kemper.

While the outcome of such matters cannot be predicatedwith certainty, based on the information known to date, we believe that theultimate resolution of these matters will not have a material adverse effect onour financial condition, operating results or cash flows.

**10.   FacilityAcquisition**

***High PlainsCorrectional Facility***

In May 2007, we acquired from GRW Corporation the HighPlains Correctional Facility in Brush, Colorado. The facility currently has thecapacity to house approximately 270 medium-security female inmates under anIntergovernmental Agreement with the City of Brush and the Colorado Departmentof Corrections.  The purchase price was$8.9 million and was allocated entirely to the property and equipment acquired.

**11.   Derivative Financial Instruments andGuarantees**

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

In August 2001, MCFcompleted a bond offering to finance the 2001 Sale and LeasebackTransaction.  In connection with thisbond offering, two reserve fund accounts were established by MCF pursuant tothe terms of the indenture: (1) MCF’s Debt Service Reserve Fund, aggregatingapproximately $24.2 million at June 30, 2007, was established to make paymentson MCF’s outstanding bonds in the event we (as lessee) should fail to make thescheduled rental payments to MCF and (2) MCF’s Debt Service Fund, aggregatingapproximately $28.4 million at June 30, 2007, used to accumulate the monthlylease payments that MCF receives from us until such funds are used to pay MCF’ssemi-annual bond interest and annual bond principal payments.  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 return are characterized as cash flow hedgederivative instruments.  At inception,the derivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income.  AtJune 30, 2007 and December 31, 2006, the fair value of these derivative instrumentswas approximately $4.1 million and $3.2 million, respectively.  Our Consolidated Statements of Operations andComprehensive Income include a comprehensive loss of approximately $0.6 millionand $0.5 million in the three and six months ended June 30, 2007 related tothese derivative instruments. For the three and six months ended June 30, 2006,we reported unrealized losses in other comprehensive income of approximately$0.5 million and $0.8 million, respectively.

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

**12.   Segment Disclosure**

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of 10 and 17 who haveeither been adjudicated or suffer from behavioral problems.  The adult community-based corrections andtreatment services segment consists of providing pre-release and halfway houseprograms for adult offenders who are either on probation or serving the lastthree to six-months of their sentences on parole and preparing for re-entryinto society at large as well as community-based treatment and educationprograms as an alternative to incarceration. All of our customers and long-lived

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assets are located in the United States ofAmerica.  The accounting policies of ourreportable segments are the same as those described in the summary ofsignificant accounting policies in our 2006 Annual Report on Form 10-K.  Intangible assets are not included in eachsegment’s reportable assets, and the related amortization of intangible assetsis not included in the determination of a segment’s income fromoperations.  We evaluate performancebased on income or loss from operations before general and administrativeexpenses, incentive bonuses, amortization of intangibles, interest and incometaxes.  Corporate and other assets arecomprised primarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferred taxes,deferred costs and other assets. Corporate and other expense from operations primarily consists ofdepreciation on the corporate office facilities and equipment and specificgeneral and administrative charges pertaining to corporate personnel, and ispresented separately as such charges cannot be readily identified forallocation to a particular segment.

Thefollowing table excludes the results of discontinued operations for therevenue, pre-opening and start-up expenses and income from operations categoriesfor all periods presented.  The onlysignificant non-cash item reported in the respective segment’s income fromoperations is depreciation and amortization (excluding intangibles) (inthousands).
|                                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                               |       |                                            |       |                                          |       |   |   |   |   |
| Revenues                                           |       |                                            |       |                                          |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                               | 47,775     |                                          | $          | 45,827 |   | $ | 94,284 |   | $ | 83,711 |   |
| Juvenile                                           |       | 26,767                                          |       | 28,699                                        |       | 53,565 |   | 57,992 |   |
| Adult  community-based                             |       | 16,952                                          |       | 15,971                                        |       | 33,289 |   | 32,642 |   |
| Total revenues                                     |       | $                                               | 91,494     |                                          | $          | 90,497 |   | $ | 181,138 |   | $ | 174,345 |   |
|                                               |       |                                            |       |                                          |       |   |   |   |   |
| Pre-opening and  start-up expenses                 |       |                                            |       |                                          |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | 2,657 |   |
| Juvenile                                           |       | —                                          |       | —                                        |       | — |   | — |   |
| Adult  community-based                             |       | —                                          |       | —                                        |       | — |   | — |   |
| Total pre-opening  and start-up expenses           |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | 2,657 |   |
|                                               |       |                                            |       |                                          |       |   |   |   |   |
| Income from  operations                            |       |                                            |       |                                          |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                               | 11,756     |                                          | $          | 13,110 |   | $ | 23,627 |   | $ | 20,674 |   |
| Juvenile                                           |       | 3,721                                           |       | 4,098                                         |       | 6,121 |   | 6,611 |   |
| Adult  community-based                             |       | 4,495                                           |       | 2,762                                         |       | 7,152 |   | 5,881 |   |
| Subtotal                                           |       | 19,972                                          |       | 19,970                                        |       | 36,900 |   | 33,166 |   |
| General and  administrative expense                |       | (7,175                                          | )          | (5,438                                        | )          | (15,532 | ) | (10,550 | ) |
| Amortization of  intangibles                       |       | (561                                            | )          | (561                                          | )          | (1,121 | ) | (1,121 | ) |
| Corporate and  other                               |       | (189                                            | )          | (260                                          | )          | (367 | ) | (574 | ) |
| Total income  from operations                      |       | $                                               | 12,047     |                                          | $          | 13,711 |   | $ | 19,880 |   | $ | 20,921 |   |
|                                               |       |                                            |       |                                          |       |   |   |   |   |
| Loss on  discontinued operations, net of tax       |       |                                            |       |                                          |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                               | —     |                                          | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | —                                          |       | (183                                          | )          | — |   | (707 | ) |
| Adult  community-based                             |       | —                                          |       | 1                                             |       | — |   | — |   |
| Total loss on  discontinued operations, net of tax |       | $                                               | —     |                                          | $          | (182 | ) | $ | — |   | $ | (707 | ) |

 
|                             | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Assets                      |       |                    |       |                        |       |
| Adult secure  institutional |       | $                       | 252,104    |                        | $          | 233,670 |   |
| Juvenile                    |       | 98,831                  |       | 100,366                     |       |
| Adult  community-based      |       | 61,267                  |       | 63,105                      |       |
| Intangible  assets, net     |       | 19,159                  |       | 19,265                      |       |
| Corporate and  other        |       | 103,678                 |       | 107,127                     |       |
| Total assets                |       | $                       | 535,039    |                        | $          | 523,533 |   |

 

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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 (the Guarantor Subsidiaries). These guarantees are joint and several obligations of the GuarantorSubsidiaries. MCF does not guarantee the Senior Notes (Non-GuarantorSubsidiary). The following condensed consolidating financial informationpresents the financial condition, results of operations and cash flows of theGuarantor Subsidiaries and the Non-Guarantor Subsidiary, together with theconsolidating adjustments necessary to present our results on a consolidatedbasis.

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**CondensedConsolidating Balance Sheet as of June 30, 2007 (in thousands) (unaudited)**
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                  |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 12,252     |                        | $          | 555                             |       | $                | 41         |             | $          | — |   | $ | 12,848 |   |
| Investment  securities available for sale        |       | 8,450      |       | —                      |       | —                          |       | —           |       | 8,450            |       |
| Accounts  receivable                             |       | 1,629      |       | 63,021                      |       | 710                             |       | —           |       | 65,360           |       |
| Debt service  fund and other restricted assets   |       | —     |       | 2,216                       |       | 28,436                          |       | —           |       | 30,652           |       |
| Prepaid  expenses and other                      |       | 11,554     |       | 1,017                       |       | —                          |       | —           |       | 12,571           |       |
| Total current  assets                            |       | 33,885     |       | 66,809                      |       | 29,187                          |       | —           |       | 129,881          |       |
| Property and  equipment, net                     |       | 234        |       | 197,302                     |       | 148,308                         |       | (5,065           | )          | 340,779          |       |
| Other assets:                                    |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service  reserve fund                       |       | —     |       | —                      |       | 24,228                          |       | —           |       | 24,228           |       |
| Deferred costs  and other                        |       | 53,086     |       | 26,336                      |       | 6,394                           |       | (45,665          | )          | 40,151           |       |
| Investment in  subsidiaries                      |       | 29,347     |       | 1,856                       |       | —                          |       | (31,203          | )          | —           |       |
| Total assets                                     |       | $          | 116,552    |                        | $          | 292,303                         |       | $                | 208,117    |             | $          | (81,933 | ) | $ | 535,039 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and stockholders’ equity**    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Current  liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $          | 41,437     |                        | $          | 14,698                          |       | $                | 4,156      |             | $          | — |   | $ | 60,291 |   |
| Current portion  of long-term debt               |       | —     |       | 10                          |       | 10,500                          |       | —           |       | 10,510           |       |
| Total current  liabilities                       |       | 41,437     |       | 14,708                      |       | 14,656                          |       | —           |       | 70,801           |       |
| Long-term debt,  net of current portion          |       | 108,931    |       | 32                          |       | 145,500                         |       | —           |       | 254,463          |       |
| Deferred tax  liabilities                        |       | 11,670     |       | 94                          |       | (56                             | )          | —           |       | 11,708           |       |
| Other long-term  liabilities                     |       | 9,532      |       | 95                          |       | 46,257                          |       | (46,939          | )          | 8,945            |       |
| Intercompany                                     |       | (244,140   | )          | 244,140                     |       | —                          |       | —           |       | —           |       |
| Total  liabilities                               |       | (72,570    | )          | 259,069                     |       | 206,357                         |       | (46,939          | )          | 345,917          |       |
| Stockholders’  equity                       |       | 189,122    |       | 33,234                      |       | 1,760                           |       | (34,994          | )          | 189,122          |       |
| Total  liabilities and stockholders’ equity |       | $          | 116,552    |                        | $          | 292,303                         |       | $                | 208,117    |             | $          | (81,933 | ) | $ | 535,039 |   |

 

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**CondensedConsolidating Balance Sheet as of December 31, 2006 (in thousands)**
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| **Assets**                                       | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                  |       |       |       |                        |       |                            |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 18,083     |                        | $          | 371                             |       | $                | 75         |             | $          | — |   | $ | 18,529 |   |
| Investment  securities available for sale        |       | 11,925     |       | 3⁄4                      |       | 3⁄4                          |       | 3⁄4           |       | 11,925           |       |
| Accounts  receivable                             |       | 2,661      |       | 73,448                      |       | 365                             |       | 3⁄4           |       | 76,474           |       |
| Debt services  and other restricted assets       |       | 3⁄4     |       | 1,658                       |       | 22,953                          |       | 3⁄4           |       | 24,611           |       |
| Prepaid  expenses and other                      |       | 11,909     |       | 2,303                       |       | 3⁄4                          |       | 3⁄4           |       | 14,212           |       |
| Total current  assets                            |       | 44,578     |       | 77,780                      |       | 23,393                          |       | 3⁄4           |       | 145,751          |       |
| Property and  equipment, net                     |       | 108        |       | 173,916                     |       | 150,419                         |       | (5,379           | )          | 319,064          |       |
| Other assets:                                    |       |       |       |                        |       |                            |       |             |       |             |       |
| Debt service  reserve fund                       |       | 3⁄4     |       | 3⁄4                      |       | 23,801                          |       | 3⁄4           |       | 23,801           |       |
| Deferred costs  and other                        |       | 48,448     |       | 21,943                      |       | 6,754                           |       | (42,228          | )          | 34,917           |       |
| Investment in  subsidiaries                      |       | 27,427     |       | 2,237                       |       | 3⁄4                          |       | (29,664          | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 120,561    |                        | $          | 275,876                         |       | $                | 204,367    |             | $          | (77,271 | ) | $ | 523,533 |   |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| **Liabilities and Stockholders’ Equity**    | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                             |       |       |       |                        |       |                            |       |             |       |             |       |
| Current  liabilities:                            |       |       |       |                        |       |                            |       |             |       |             |       |
| Accounts  payable and accrued liabilities        |       | $          | 46,791     |                        | $          | 9,371                           |       | $                | 5,577      |             | $          | (1,576 | ) | $ | 60,163 |   |
| Current portion  of long-term debt               |       | 3⁄4     |       | 10                          |       | 10,500                          |       | 3⁄4           |       | 10,510           |       |
| Total current  liabilities                       |       | 46,791     |       | 9,381                       |       | 16,077                          |       | (1,576           | )          | 70,673           |       |
| Long-term debt,  net of current portion          |       | 109,934    |       | 37                          |       | 145,500                         |       | 3⁄4           |       | 255,471          |       |
| Deferred tax  liabilities                        |       | 10,959     |       | 94                          |       | 3⁄4                          |       | 320              |       | 11,373           |       |
| Other long-term  liabilities                     |       | 6,011      |       | 211                         |       | 42,680                          |       | (44,450          | )          | 4,452            |       |
| Intercompany                                     |       | (234,698   | )          | 234,698                     |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Total  liabilities                               |       | (61,003    | )          | 244,421                     |       | 204,257                         |       | (45,706          | )          | 341,969          |       |
| Stockholders’  equity                       |       | 181,564    |       | 31,455                      |       | 110                             |       | (31,565          | )          | 181,564          |       |
| Total  liabilities and stockholders’ equity |       | $          | 120,561    |                        | $          | 275,876                         |       | $                | 204,367    |             | $          | (77,271 | ) | $ | 523,533 |   |

 

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**CondensedConsolidating Statement of Operations for the three months ended June 30,2007****(in thousands) (unaudited)**
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                        |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                    |       | $          | 4,502      |                        | $          | 103,180                         |       | $                | 4,502      |             | $          | (20,690 | ) | $ | 91,494 |   |
| Operating expenses                                                          |       | 5,858      |       | 83,077                      |       | 29                              |       | (20,604          | )          | 68,360           |       |
| Pre-opening and start-up expenses                                           |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Depreciation and amortization                                               |       | —     |       | 3,012                       |       | 1,055                           |       | (155             | )          | 3,912            |       |
| General and administrative expenses                                         |       | 7,157      |       | —                      |       | 18                              |       | —           |       | 7,175            |       |
| Income (loss) from operations                                               |       | (8,513     | )          | 17,091                      |       | 3,400                           |       | 69               |       | 12,047           |       |
| Overhead allocations                                                        |       | (12,950    | )          | 12,950                      |       | —                          |       | —           |       | —           |       |
| Interest, net                                                               |       | 1,770      |       | 1,272                       |       | 2,876                           |       | —           |       | 5,918            |       |
| Equity earnings in subsidiaries                                             |       | 3,219      |       | —                      |       | —                          |       | (3,219           | )          | —           |       |
| Income (loss) from continuing operations before provision for  income taxes |       | 5,886      |       | 2,869                       |       | 524                             |       | (3,150           | )          | 6,129            |       |
| Provision for income taxes                                                  |       | 2,440      |       | —                      |       | 243                             |       | —           |       | 2,683            |       |
| Income (loss) from continuing operations                                    |       | 3,446      |       | 2,869                       |       | 281                             |       | (3,150           | )          | 3,446            |       |
| Discontinued operations                                                     |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Net income (loss)                                                           |       | $          | 3,446      |                        | $          | 2,869                           |       | $                | 281        |             | $          | (3,150 | ) | $ | 3,446 |   |

 

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**CondensedConsolidating Statement of Operations for the three months ended June 30,2006****(in thousands) (unaudited)**
| ** **                                                                  | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                        |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                    |       | $          | 4,502      |                        | $          | 103,501                         |       | $                | 4,502      |             | $          | (22,008 | ) | $ | 90,497 |   |
| Operating  expenses                                                         |       | 4,893      |       | 84,157                      |       | 7                               |       | (21,922          | )          | 67,135           |       |
| Pre-opening and  start-up expenses                                          |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Depreciation and  amortization                                              |       | —     |       | 3,291                       |       | 1,055                           |       | (133             | )          | 4,213            |       |
| General and  administrative expenses                                        |       | 5,419      |       | —                      |       | 19                              |       | —           |       | 5,438            |       |
| Income (loss)  from operations                                              |       | (5,810     | )          | 16,053                      |       | 3,421                           |       | 47               |       | 13,711           |       |
| Overhead  allocations                                                       |       | (9,017     | )          | 9,017                       |       | —                          |       | —           |       | —           |       |
| Interest, net                                                               |       | 2,119      |       | 1,271                       |       | 3,195                           |       | 10               |       | 6,595            |       |
| Equity earnings  in subsidiaries                                            |       | 5,738      |       | —                      |       | —                          |       | (5,738           | )          | —           |       |
| Income (loss)  from continuing operations before provision for income taxes |       | 6,826      |       | 5,765                       |       | 226                             |       | (5,701           | )          | 7,116            |       |
| Provision for  income taxes                                                 |       | 2,945      |       | —                      |       | —                          |       | 108              |       | 3,053            |       |
| Income (loss)  from continuing operations                                   |       | 3,881      |       | 5,765                       |       | 226                             |       | (5,809           | )          | 4,063            |       |
| Discontinued  operations, net of tax benefit of $98                         |       | —     |       | (182                        | )          | —                          |       | —           |       | (182             | )          |
| Net income  (loss)                                                          |       | $          | 3,881      |                        | $          | 5,583                           |       | $                | 226        |             | $          | (5,809 | ) | $ | 3,881 |   |

 

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**CondensedConsolidating Statement of Operations for the six months ended June 30,2007****(in thousands) (unaudited)**
|                                                                             | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                        |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                    |       | $          | 9,004      |                        | $          | 204,602                         |       | $                | 9,004      |             | $          | (41,472 | ) | $ | 181,138 |   |
| Operating  expenses                                                         |       | 9,175      |       | 170,058                     |       | 42                              |       | (41,302          | )          | 137,973          |       |
| Pre-opening and  start-up expenses                                          |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Depreciation  and amortization                                              |       | —     |       | 5,954                       |       | 2,111                           |       | (312             | )          | 7,753            |       |
| General and  administrative expenses                                        |       | 15,495     |       | —                      |       | 37                              |       | —           |       | 15,532           |       |
| Income (loss)  from operations                                              |       | (15,666    | )          | 28,590                      |       | 6,814                           |       | 142              |       | 19,880           |       |
| Overhead  allocations                                                       |       | (23,937    | )          | 23,937                      |       | —                          |       | —           |       | —           |       |
| Interest, net                                                               |       | 3,562      |       | 2,546                       |       | 6,444                           |       | —           |       | 12,552           |       |
| Equity earnings  in subsidiaries                                            |       | 2,409      |       | —                      |       | —                          |       | (2,409           | )          | —           |       |
| Income (loss)  from continuing operations before provision for income taxes |       | 7,118      |       | 2,107                       |       | 370                             |       | (2,267           | )          | 7,328            |       |
| Provision for  income taxes                                                 |       | 3,009      |       | —                      |       | 210                             |       | —           |       | 3,219            |       |
| Income (loss)  from continuing operations                                   |       | 4,109      |       | 2,107                       |       | 160                             |       | (2,267           | )          | 4,109            |       |
| Discontinued  operations                                                    |       | —     |       | —                      |       | —                          |       | —           |       | —           |       |
| Net income  (loss)                                                          |       | $          | 4,109      |                        | $          | 2,107                           |       | $                | 160        |             | $          | (2,267 | ) | $ | 4,109 |   |

 

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**CondensedConsolidating Statement of Operations for the six months ended June 30,2006****(in thousands) (unaudited)**
|                                                                             | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                        |       |       |       |                        |       |                            |       |             |       |             |       |
| Revenues                                                                    |       | $          | 9,004      |                        | $          | 197,691                         |       | $                | 9,004      |             | $          | (41,354 | ) | $ | 174,345 |   |
| Operating  expenses                                                         |       | 10,072     |       | 163,356                     |       | 33                              |       | (41,183          | )          | 132,278          |       |
| Pre-opening and  start-up expenses                                          |       | —     |       | 2,657                       |       | —                          |       | —           |       | 2,657            |       |
| Depreciation  and amortization                                              |       | —     |       | 6,090                       |       | 2,111                           |       | (262             | )          | 7,939            |       |
| General and  administrative expenses                                        |       | 10,512     |       | —                      |       | 38                              |       | —           |       | 10,550           |       |
| Income (loss)  from operations                                              |       | (11,580    | )          | 25,588                      |       | 6,822                           |       | 91               |       | 20,921           |       |
| Overhead  allocations                                                       |       | (17,403    | )          | 17,403                      |       | —                          |       | —           |       | —           |       |
| Interest, net                                                               |       | 2,597      |       | 2,540                       |       | 6,479                           |       | 21               |       | 11,637           |       |
| Equity earnings  in subsidiaries                                            |       | 5,181      |       | —                      |       | —                          |       | (5,181           | )          | —           |       |
| Income (loss)  from continuing operations before provision for income taxes |       | 8,407      |       | 5,645                       |       | 343                             |       | (5,111           | )          | 9,284            |       |
| Provision for  income taxes                                                 |       | 3,839      |       | —                      |       | —                          |       | 170              |       | 4,009            |       |
| Income (loss)  from continuing operations                                   |       | 4,568      |       | 5,645                       |       | 343                             |       | (5,281           | )          | 5,275            |       |
| Discontinued  operations, net of tax benefit of $381                        |       | —     |       | (707                        | )          | —                          |       | —           |       | (707             | )          |
| Net income  (loss)                                                          |       | $          | 4,568      |                        | $          | 4,938                           |       | $                | 343        |             | $          | (5,281 | ) | $ | 4,568 |   |

 

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2007 (in thousands) (unaudited)**
| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Cash flows from  operating activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net cash provided  by (used in) operating activities      |       | $          | (11,777    | )                           | $          | 24,140                          |       | $                | 5,449      |             | $          | — |   | $ | 17,812 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from  investing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Capital  expenditures                                     |       | —     |       | (15,003                     | )          | —                          |       | —           |       | (15,003          | )          |
| Acquisition of  a facility                                |       | —     |       | (8,948                      | )          | —                          |       | —           |       | (8,948           | )          |
| Purchases of  investment securities                       |       | (241,425   | )          | —                      |       | —                          |       | —           |       | (241,425         | )          |
| Sales of  investment securities                           |       | 244,900    |       | —                      |       | —                          |       | —           |       | 244,900          |       |
| Payments to  restricted debt payment account, net         |       | —     |       | —                      |       | (5,483                          | )          | —           |       | (5,483           | )          |
| Net cash  provided by (used in) investing activities      |       | $          | 3,475      |                        | $          | (23,951                         | )          | $                | (5,483     | )                | $          | — |   | $ | (25,959 | ) |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from  financing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Tax benefit of  stock option exercises                    |       | 455        |       | —                      |       | —                          |       | —           |       | 455              |       |
| Payments on  capital lease obligations                    |       | —     |       | (5                          | )          | —                          |       | —           |       | (5               | )          |
| Proceeds from exercise  of stock options                  |       | 2,016      |       | —                      |       | —                          |       | —           |       | 2,016            |       |
| Net cash  provided by (used in) financing activities      |       | 2,471      |       | (5                          | )          | —                          |       | —           |       | 2,466            |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Net increase  (decrease) in cash and cash equivalents** |       | (5,831     | )          | 184                         |       | (34                             | )          | —           |       | (5,681           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at beginning of period**     |       | 18,083     |       | 371                         |       | 75                              |       | —           |       | 18,529           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at end of period**           |       | $          | 12,252     |                        | $          | 555                             |       | $                | 41         |             | $          | — |   | $ | 12,848 |   |

 

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2006 (in thousands) (unaudited)**
| ** **                                                | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Cash flows from  operating activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net cash  provided by (used in) operating activities      |       | $          | (4,090     | )                           | $          | 8,615                           |       | $                | 6,319      |             | $          | — |   | $ | 10,844 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from  investing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Capital  expenditures                                     |       | —     |       | (9,073                      | )          | —                          |       | —           |       | (9,073           | )          |
| Purchase of  investment securities                        |       | (185,050   | )          | —                      |       | —                          |       | —           |       | (185,050         | )          |
| Sales of  investment securities                           |       | 183,325    |       | —                      |       | —                          |       | —           |       | 183,325          |       |
| Payments to  restricted debt payment account, net         |       | —     |       | —                      |       | (6,294                          | )          | —           |       | (6,294           | )          |
| Net cash used  in investing activities                    |       | $          | (1,725     | )                           | $          | (9,073                          | )          | $                | (6,294     | )                | $          | — |   | $ | (17,092 | ) |
|                                                      |       |       |       |                        |       |                            |       |             |       |             |       |
| **Cash flows from  financing activities:**                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Tax benefit of  stock option exercises                    |       | 198        |       | —                      |       | —                          |       | —           |       | 198              |       |
| Payments on  capital lease obligations                    |       | —     |       | (5                          | )          | —                          |       | —           |       | (5               | )          |
| Proceeds from  exercise of stock options                  |       | 1,554      |       | —                      |       | —                          |       | —           |       | 1,554            |       |
| Net cash  provided by (used in) financing activities      |       | 1,752      |       | (5                          | )          | —                          |       | —           |       | 1,747            |       |
|                                                      |       |       |       |                        |       |                            |       |             |       |             |       |
| **Net (decrease)  increase in cash and cash equivalents** |       | (4,063     | )          | (463                        | )          | 25                              |       | —           |       | (4,501           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at beginning of period**     |       | 12,579     |       | 1,114                       |       | 30                              |       | —           |       | 13,723           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash  equivalents at end of period**           |       | $          | 8,516      |                        | $          | 651                             |       | $                | 55         |             | $          | — |   | $ | 9,222 |   |

 

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

**General**

We are a leading provider ofcorrectional, detention, educational, rehabilitation and treatment servicesoutsourced by federal, state and local government agencies. We provide adiversified portfolio of services for adults and juveniles through our threeoperating divisions: (1) adult secure institution and detention services;(2) juvenile justice, educational and treatment services and (3) adultcommunity-based corrections and treatment services. At June 30,2007, we operated 74 facilities with a total service capacity of 17,257. Wealso had four facilities that were vacant with an aggregate service capacity of990. Our facilities are located in 16 states and the District of Columbia.

The following table(which excludes data related to discontinued operating facilities) sets forthfor the periods indicated total residential service capacity and contractedbeds in operation at the end of the periods shown, average contract occupancypercentages and total non-residential service capacity.
|                                                                                    | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **2007**          | ** ** | **2006**          | ** ** |
| **Residential**                                                                    |       |              |       |              |       |
| Service  capacity (1) (2)                                                          |       | 14,826            |       | 14,348            |       |
| Contracted beds  in operation (end of period) (1) (3)                              |       | 12,856            |       | 13,624            |       |
| Average  contract occupancy based on contracted beds in operation (1) (4) (5) |       | 103.6             | %          | 95.7              | %          |
| Average  contract occupancy excluding start-up operations (1) (4) (5)         |       | 103.6             | %          | 95.7              | %          |
| **Non-Residential**                                                                |       |              |       |              |       |
| Service capacity (1) (6)                                                           |       | 3,421             |       | 4,792             |       |

 

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(1)          Data presented excludes discontinued operating facilities.

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

(3)          At certain residentialfacilities, the contracted capacity is lower than the facility’s servicecapacity.  We could increase a facility’scontracted capacity by obtaining additional contracts or by renegotiatingexisting contracts to increase the number of beds covered.  However, there is no guarantee that we willbe able to obtain contracts that provide occupancy levels at a facility’sservice capacity or that current contracted capacities can be maintained infuture periods.

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

(5)          Average contractoccupancy percentages are calculated based on actual occupancy for the periodas a percentage of the contracted capacity for residential facilities inoperation.  These percentages do notreflect the operations of non-residential community-based programs.  At certain residential facilities, ourcontracted capacity is lower than the facility’s service capacity.  Additionally, certain facilities have and arecurrently operating above the contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

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

We derive substantially all of our revenues fromproviding adult corrections and treatment and juvenile justice, educational andtreatment services outsourced by federal, state and local government agenciesin the United States.  Revenues for ourservices are generally recognized on a per diem rate based upon the number ofoccupant days or hours served for the period, on a guaranteed take-or-pay basisor on a cost-plus reimbursement basis. For the three months endedJune 30, 2007, our revenue base consisted of 73.3% for services providedunder per diem contracts, 20.1% for services provided under take-or-pay andmanagement contracts, 4.0% for services provided under cost-plus reimbursementcontracts, 2.0% for services provided under fee-for-service contracts and 0.6%from other miscellaneous sources. For the six months ended June 30, 2007,our revenue base consisted of 72.9% for services provided under per diemcontracts, 20.0% for services provided under take-or-pay and managementcontracts, 4.4% for services provided under cost-plus reimbursement contracts,2.2% for services provided under fee-for-service contracts and 0.5% from othermiscellaneous sources.  While thesepercentages are generally consistent with comparable statistics for the threeand six months ended June 30, 2006, there has been a decrease in the percentageof revenues for services provided under per diem contracts and in thepercentage of revenues for services

27

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provided undercost-plus reimbursement contracts, and an increase in the percentage ofrevenues for services provided under take-or-pay contracts between thecomparable periods.  The decrease in thepercentage of revenues for services provided under per diem contracts and the increasein the percentage of revenues for services provided under take-or-pay contractsis primarily due to the operations of the Moshannon Valley Correctional Center whichopened in April 2006.  The decrease inthe percentage of revenues for services provided under cost-plus reimbursementcontracts is due primarily to the termination of our management contracts atthe Alexander Youth Services Center in January 2007 and at the South MountainSecure Treatment Unit (“SMSTU”) in June 2006. Revenues can fluctuate from period to perioddue to changes in government funding policies, changes in the number of peoplereferred to our facilities by governmental agencies, the opening of newfacilities or the expansion of existing facilities and the termination of contractsfor a facility or the closure of a facility.

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

Revenues for our adultsecure institutional services division are primarily generated from per diem,take-or-pay and management contracts.  Webelieve that these types of contracts will continue to be offered to theprivate sector as federal, state and local government agencies face challengesposed by increasing inmate populations. In addition, heightened focus on borderpatrol and immigration enforcement is expected to generate increased need fordetention services from the federal sector. We intend to work with existing andpotential customers to service these needs as such opportunities arise.

For the three months endedJune 30, 2007 and 2006, we realized average per diem rates on our adultsecure institutional facilities of $55.35 and $58.63, respectively.   For the six months ended June 30, 2007and 2006, we realized average per diem rates of $55.18 and $56.34,respectively. The decrease in the average per diem rate in 2007 is a result ofthe increased population (as the facility ramped-up) at the Moshannon ValleyCorrectional Center which opened in April 2006 and operates under a take-or-paycontract.

Revenues for our juvenile justice, educational andtreatment services division are primarily generated from per diem,fee-for-service and cost-plus reimbursement contracts.  We believe that our ability to work with highly-troubledyouth offers our customers a solution to addressing the unique needs ofspecialized juvenile populations. Through our Abraxas Youth and Family Servicesoperations, we expect to look for opportunities where our expertise atservicing these populations are of value to counties, school districts andother contracting agencies. In addition, we intend to leverage our nationalfootprint and scale to compete in an increasingly regulated market place.

For the three months ended June 30, 2007 and2006, we realized average per diem rates on our residential juvenile facilitiesof $167.00 and $164.28, respectively. For the six months ended June 30, 2007 and 2006, we realizedaverage per diem rates of $169.23 and $168.89, respectively.  For the three months ended June 30, 2007and 2006, we realized average fee-for-service rates for our non-residentialcommunity-based juvenile facilities and programs, including rates that arelimited by Medicaid and other private insurance providers, of $44.48 and$36.33, respectively.  For the six monthsended June 30, 2007 and 2006, we realized average fee-for-service rates of$44.30 and $35.63, respectively. The increase in the average fee-for-servicerates in the three and six months ended June 30, 2007 is due to changes in themix of services provided by our various juvenile justice, educational andtreatment programs and facilities. This includes the reactivation of theCornell Abraxas Academy (formerly the New Morgan Academy) in October 2006. Themajority of our juvenile services contracts renew annually.

Revenues for our adult community-based corrections andtreatment services division are primarily generated from per diem andfee-for-service contracts. We believe that these contracts, when coupled withour adult secure institutional offerings, position us to service the fullspectrum of adult corrections needs. Increasing numbers of probationers andparolees, along with an emphasis on providing re-entry services for thesepopulations, suggest that market conditions will continue to favor programslike those operated by us. We expect that our national presence anddemonstrated experience in this sector will allow us to effectively compete fornew contracts.

For the three months ended June 30, 2007 and2006, we realized average per diem rates on our residential adultcommunity-based facilities and programs of $62.04 and $59.66,respectively.  For the six months endedJune 30, 2007 and 2006, we realized average per diem rates of $62.08 and$61.87, respectively.  For the threemonths ended June 30, 2007 and 2006, we realized average fee-for-servicerates on our non-residential adult community-based programs of $13.59 and$10.16, respectively.  For the six monthsended June 30, 2007 and 2006, we realized average fee-for-service rates of$14.69 and $8.75, respectively.  Ouraverage fee-for-service rates can fluctuate from year-to-year due to changes inthe mix of services provided by our various adult community-based correctionsand treatment facilities and programs.

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We have historicallyexperienced higher operating margins in our adult secure institution anddetention services decision and our adult community-based corrections and treatmentservices division as compared to our juvenile justice, educational andtreatment services division. Additionally, our operating margins within adivision can vary from facility to facility based on a number of factors,including whether a facility is owned or leased, the level of competition forthe contract award, the proposed length of the contract, the occupancy levelsfor a facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract and our ability to increase a facility’s contract revenue. Undertake-or-pay contracts, such as the Moshannon Valley Correctional Center,operating margins are typically higher during the early stages of the contractas the facility’s population ramps up (as revenues are received at contractpercentages regardless of actual occupancy). As the variable costs (primarily resident related and certain facilitycosts) increase with population growth, operating margins will generallydecline to a stabilized level. Following its activation in April 2006, weexperienced such an operating margin impact pertaining to the Moshannon ValleyCorrectional Center in the three and six months ended June 30, 2007. A declinein occupancy at certain juvenile facilities and programs can have a moresignificant impact on operating margins than the adult secure institutionalservices division due to higher per diem rates at certain juvenile facilities.

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

We are responsible for allfacility operating costs, except for certain debt service and interest or leasepayments for facilities where we have a management contract only. At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all otheroperating expenses at these facilities. We operated 18 and 21 facilities undermanagement contracts at June 30, 2007 and 2006, respectively.

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

We incur pre-opening andstart-up expenses, including payroll and related taxes, benefits, training andother operating costs, prior to opening a new or expanded facility and duringthe period of operation that occupancy is ramping up. These costs vary bycontract. Since pre-opening and start-up expenses are generally factored intothe per diem rate that is charged to the contracting agency, we typicallyexpect to recover these upfront costs over the life of the contract. Becauseoccupancy rates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs. We do not anticipate incurring significant post-openingstart-up costs at any adult secure facilities operated under any futurecontracts with the Federal Bureau of Prisons (“BOP”) because these contractsare currently expected to be operated under guaranteed take-or-pay contracts,meaning that the BOP will pay at least 80.0% of the contractual monthly revenuewhen the facility opens, regardless of actual occupancy.

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

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Workingcapital requirements generally increase immediately prior to commencing operationof a new or expanded facility as we incur start-up costs and purchase necessaryequipment and supplies before facility management revenue is realized.

General and administrativeexpenses consist primarily of costs for corporate and administrative personnelwho provide senior management, legal, finance, accounting, human resources,payroll and information systems, costs of business development and outsideprofessional and consulting fees. As discussed in Note 3 to the accompanyingconsolidated financial statements, we incurred additional outside legal andprofessional and consulting fees related to the Merger Agreement.

#### **Recent Developments**

***Big Spring Correctional Center***

During2006, the BOP solicited a RFP for services to house approximately 7,000 lowsecurity, non-United States citizen, sentenced males in an existing securecorrectional institution procured from private sources or state and localgovernments with excess capacity located in Arizona, California, Louisiana, NewMexico, Oklahoma or Texas to replace several existing intergovernmentalagreements (“IGA”) for such services, including the IGA relating to our BigSpring Correctional Center.  In January2007, we were awarded a contract from the BOP to operate the Big SpringCorrectional Center. This guaranteed take-or-pay contract, which is effectiveApril 1, 2007, provides for an initial contract term of four years with threetwo-year renewal option periods. In conjunction with this contract, we areundertaking certain facility expansion activities in 2007. As of June 30, 2007,we had incurred and capitalized costs of approximately $7.8 million related tothese expansion activities.

***Facility Acquisition***

InMay 2007, we acquired from GRW Corporation the High Plains CorrectionalFacility located in Brush, Colorado. The facility currently has the capacity tohouse approximately 270 medium-security female inmates under an IntergovernmentalAgreement with the City of Brush and the Colorado Department ofCorrections.  The purchase price wasapproximately $8.9 million and was allocated entirely to the property andequipment acquired.

***Great Plains Correctional Facility***

InMay 2007, we were awarded a contract by the Arizona Department of Correctionsfor our Great Plains Correctional Facility in Hinton, Oklahoma.  The contract calls for a total of 2,000medium-security inmates to be housed at the facility.  We expect to house approximately 916 inmatesat the existing facility and the remainder would be housed through an expansionof the existing facility.  We currentlyestimate that the expansion cost will be approximately $55.0 million, pending thefinalization of design and construction agreements.  We are finalizing the scheduling with thecustomer; and we currently expect to begin receiving inmates late in the thirdquarter of 2007 and to complete expansion of the facility in the fourth quarterof 2008.

***D. Ray James Prison***

Weare expanding the D. Ray James Prison in Georgia during the year endingDecember 31, 2007 to increase its current service capacity of 1,640 by 300beds.  As of June 30, 2007, we hadincurred and capitalized costs of approximately $7.6 million related to thisexpansion.  We believe that our existingcash and available balance under our Credit Facility will provide adequatefunding to complete this facility expansion.

InAugust 2007, we announced that we intend to initiate a second expansion at D.Ray James Prison. This expansion is expected to increase service capacity by700 beds, and construction, which we anticipate will begin in 2008, should becomplete by the beginning of 2009. We expect the related capital expendituresfor this expansion to range from $28.0 million to $33.0 million, depending onfinalization of design and construction agreements.

***Regional Correctional Center***

 

InJuly 2007, we were notified by Immigration and Customs Enforcement (“ICE”) thatit was removing all ICE detainees from our 970 bed Regional Correctional Centerin Albuquerque, New Mexico.  See “*ContractualUncertainties Related to Certain Facilities, Regional Correctional Center.*” 

***Settlement of Claim***

InAugust 2007, we settled a lawsuit we had filed in the 333rd State District Court in Houston, Texas, CauseNo. 2005-55083 against Locke Liddell & Sapp PLLC and an individual partnerof Locke Liddell & Sapp PLLC, (the “Defendants”) relating to the Defendant’srepresentation of the Company in a transaction involving our Southern PeaksRegional Treatment Center in Canon City, Colorado. Under the terms of thesettlement, we are to receive approximately $1.85 million in August 2007. Weexpect to incur approximately $0.3 million in expense related to this matter inthe third quarter of 2007.

***Walnut Grove Youth Correctional Facility***

InAugust 2007, we announced that we have been notified by the State ofMississippi that funding has been approved for a 500-bed expansion at the941-bed Walnut Grove Youth Correctional Facility which Cornell has managedsince 2004.  Expansion construction,which will be entirely funded by the State of Mississippi, is expected to beginin the third quarter of this year, and the company anticipates that the newcapacity will come online during the fourth quarter of 2008.  Assuming Cornell’s contract is extended toinclude the additional 500 beds at its current terms, the expansion is expectedto generate over $5.0 million in annualized revenues.

***Contracts***

 

Wetransitioned our management contract for the Donald W. Wyatt Detention centerto another operator at the end of July 2007.  See “*Results of Operations, Three Months EndedJune 30, 2007 Compared to Three Months Ended June 30, 2006, AdultSecure.*”  Also, in July 2007, we were notified that the fundingfor our Harrisburg Alternative Education School program had been eliminated forthe 2007-2008 school year.  See “*Resultsof Operations, Three Months Ended June 30, 2007 Compared to Three MonthsEnded June 30, 2006, Juvenile*.”

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**New Accounting Pronouncements**

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

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standard (“SFAS”) No. 157, “Fair Value Measurements.” This statementestablishes a framework for measuring fair value within generally acceptedaccounting principles and expands the required disclosures concerning fairvalue measurements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. The provisions of SFAS No. 157 must be appliedprospectively as of the beginning of the fiscal year in which it is adopted,except in limited circumstances. We plan to adopt the provisions of SFAS No.157 effective January 1, 2008. We are currently evaluating the impact that theadoption of this standard may have on our consolidated financial statements.

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

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115.” This statement, for which adoption is optional, 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 as of the beginning of an entity’s first fiscal year that beginsafter November 15, 2007. Early adoption is permitted as of the beginning of afiscal year that begins on or before November 15, 2007, provided the entityalso elects to apply the provisions of SFAS No. 157, “Fair Value Measurements.”  We are currently evaluating the impact theadoption of this standard may have on our consolidated financial statements.

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**Results of Operations**

The followingtable sets forth for the periods indicated the percentages of revenue representedby certain items in our historical consolidated statements of operations.

|                                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                          | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                            |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                  |       | 74.7                             |       | 74.2                           |       | 76.1 |   | 75.8 |   |
| Pre-opening and start-up expenses                                   |       | —                           |       | —                         |       | — |   | 1.5 |   |
| Depreciation and amortization                                       |       | 4.3                              |       | 4.7                            |       | 4.3 |   | 4.6 |   |
| General and administrative expenses                                 |       | 7.8                              |       | 6.0                            |       | 8.6 |   | 6.1 |   |
| Income from operations                                              |       | 13.2                             |       | 15.1                           |       | 11.0 |   | 12.0 |   |
| Interest expense, net                                               |       | 6.5                              |       | 7.3                            |       | 6.9 |   | 6.7 |   |
| Income from continuing operations before provision for income taxes |       | 6.7                              |       | 7.8                            |       | 4.1 |   | 5.3 |   |
| Provision for income taxes                                          |       | 2.9                              |       | 3.4                            |       | 1.8 |   | 2.3 |   |
| Income from continuing operations                                   |       | 3.8                              |       | 4.4                            |       | 2.3 |   | 3.0 |   |
| Discontinued operations, net of tax                                 |       | —                           |       | (0.2                           | )          | — |   | (0.4 | ) |
| Net income                                                          |       | 3.8                              | %          | 4.2                            | %          | 2.3 | % | 2.6 | % |

 

***ThreeMonths Ended June 30, 2007 Compared to Three Months Ended June 30,2006***

Certain comparisons of revenue, expense and averagecontract occupancy contained in this report have been made excluding the effectof pre-opening and start-up expenses and revenues, and related occupancy andcontract capacity. Pre-opening and start-up expenses are charged to operationsas incurred. They include payroll, benefits, training and other operating costsduring periods prior to opening a new or expanded facility and during theperiod of operation while occupancy is ramping up.  We believe supplemental disclosuresconcerning pre-opening and start-up expenses and revenues increase the reader’sunderstanding of our operating trends.

***Revenues*****.** Revenues increased approximately $1.0 million, or 1.1%, to $91.5 millionfor the three months ended June 30, 2007 from $90.5 million for the threemonths ended June 30, 2006.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $2.0million, or 4.4%, to $47.8 million for the three months ended June 30, 2007from $45.8 million for the three months ended June 30, 2006 due primarilyto (1) an increase in revenues of approximately $1.7 million at theRegional Correctional Center due to increased occupancy, (2) an increase inrevenues of approximately $1.1 million at the Donald W. Wyatt Detention Centerdue to increased occupancy, (3) revenues of approximately $0.6 million at the HighPlains Correctional Facility acquired in May 2007, (4) an increase in revenuesof approximately $0.5 million at the Big Spring Correctional Center due toincreased occupancy and (5) an increase in revenues of approximately $0.5million at the D. Ray James Prison due to increased occupancy.  The increase in revenues due to the above wasoffset, in part, by a decrease in revenues of approximately $3.2 million at theGreat Plains Correctional Facility due to the termination of our managementcontract with the Oklahoma Department of Corrections (“OKDOC”) in April 2007.The remaining net increase in revenues of approximately $0.8 million was due tovarious insignificant fluctuations in revenues at our other adult securefacilities.

Ouradult secure institutional services division revenues are primarily generatedfrom contracts with federal and state government agencies.  At June 30, 2007, we operated 10 adultsecure institutional facilities with an aggregate service capacity of 8,946.The Great Plains Correctional Facility, which has a service capacity of 766 beds,was vacant at June 30, 2007.

InJuly 2007, we completed the transition of our management contract at the DonaldW. Wyatt Detention Center to another operator. This contract generated revenuesof approximately $3.5 million and $2.4 million in the three months ended June30, 2007 and 2006, respectively.

Averagecontract occupancy was 109.9% for the three months ended June 30, 2007compared to 93.2% for the three months ended June 30, 2006. The increase inthe average contract occupancy percentage for the three months ended June 30,2007 was 

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due to theincreased occupancy at the Regional Correctional Center, the D. Ray JamesPrison, the Big Spring Correctional Center and the Moshannon Valley CorrectionalCenter in the 2007 period. The average per diem rate for our adult securefacilities was $55.35 and $58.63 for the three months ended June 30, 2007and 2006, respectively.  The decrease inthe average per diem rate for the three months ended June 30, 2007 is a resultof the increased population at the Moshannon Valley Correctional Center (as thefacility ramped up occupancy subsequent to its April 2006 activation) whichoperates under a take-or-pay contract. There were no revenues attributable tostart-up operations in the three months ended June 30, 2007 and 2006.

***Juvenile.***Juvenile justice, educational andtreatment services division revenues decreased approximately $1.9 million, or6.6%, to $26.8 million for the three months ended June 30, 2007 from $28.7million for the three months ended June 30, 2006 due primarily to (1) adecrease in revenues of approximately $2.3 million due to the termination ofour management contract at the Alexander Youth Services Center in January 2007and (2) a decrease in revenues of approximately $0.9 million at the SouthMountain Secure Treatment Unit (“SMSTU”) due to the expiration of ourmanagement contract in June 2006.   Thedecrease in revenues due to the above was offset, in part, by (1) an increasein revenues of approximately $0.6 million at the Leadership Development Programdue to improved occupancy and (2) an increase in revenues of approximately $0.6million at the Cornell Abraxas Academy (formerly the New Morgan Academy) whichwe reactivated in October 2006. The remaining net increase in revenues ofapproximately $0.1 million was due to various insignificant fluctuations inrevenues at our other juvenile facilities and programs.

InJuly 2007, we were notified that the funding for our Harrisburg AlternativeEducation Program was discontinued for the 2007-2008 school year. This programgenerated revenues of approximately $0.9 million and $0.6 million in the threemonths ended June 30, 2007 and 2006, respectively.

AtJune 30, 2007, we operated 16 residential juvenile facilities and 14non-residential juvenile community-based programs with an aggregate servicecapacity of 3,916. Additionally, we had two facilities that were vacant at June30, 2007 with an aggregate service capacity of 192.  Our contracts for these facilities andprograms are generally with state and local government agencies and generallyrenew annually.

Average contractoccupancy for the three months ended June 30, 2007 was 95.2% compared to92.1% for the three months ended June 30, 2006.

Theaverage per diem rate for our residential juvenile facilities was $167.00 forthe three months ended June 30, 2007 compared to $164.28 for the threemonths ended June 30, 2006.  Ouraverage fee-for-service rate for our non-residential juvenile community-basedfacilities and programs was $44.48 for the three months ended June 30,2007 compared to $36.33 for the three months ended June 30, 2006. Theincrease in our average fee-for-service rate in 2007 was due to changes in themix of services provided at our various juvenile facilities and programs. Therewere no revenues attributable to start-up operations in the three months endedJune 30, 2007 and 2006.

***Adult Community-Based.*****Adult community-based corrections andtreatment services division revenues increased approximately $1.0 million, or6.3%, to $17.0 million for the three months ended June 30, 2007 from $16.0million for the three months ended June 30, 2006 due to variousinsignificant fluctuations in revenues at our adult community-based facilitiesand programs.

AtJune 30, 2007, we operated 28 residential adult community-based facilitiesand seven non-residential adult community-based programs with an aggregateservice capacity of 4,395. Additionally, we had one facility that was vacant atJune 30, 2007 with a service capacity of 32. Average contract occupancy was 102.6% for the three months ended June 30,2007 compared to 96.0% for the three months ended June 30, 2006.

Theaverage per diem rate for our residential adult community-based facilities was $62.04for the three months ended June 30, 2007 compared to $59.66 for the threemonths ended June 30, 2006.  Theaverage fee-for-service rate for our non-residential adult community-basedprograms was $13.59 for the three months ended June 30, 2007 compared to$10.16 for the three months ended June 30, 2006. The increase in ouraverage fee-for-service rate in 2007 was due to changes in the mix of servicesprovided at our various adult community-based facilities and programs. Therewere no revenues attributable to start-up operations in the three months endedJune 30, 2007 and 2006.

***Operating Expenses****.*Operating expenses increasedapproximately $1.3 million, or 1.9%, to $68.4 million for the three monthsended June 30, 2007 from $67.1 million for the three months ended June 30,2006.

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***Adult Secure.***Adultsecure institutional services division operating expenses increased approximately$3.3 million, or 10.8%, to $33.9 million for the three months ended June 30,2007 from $30.6 million for the three months ended June 30, 2006 due primarilyto (1) an increase in operating expenses of approximately $1.2 millionat the Moshannon Valley Correctional Center which opened in April 2006, (2) anincrease in operating expenses of approximately $1.1 million at the Donald W.Wyatt Detention Center due to increased occupancy, (3) an increase in operatingexpenses of approximately $0.8 million at the Regional Correctional Center dueto increased occupancy, (4) operating expenses of approximately $0.7 million atthe High Plains Correctional Facility acquired in May 2007 and (5) an increasein operating expenses of approximately $0.3 million at the Big SpringCorrectional Center due to increased occupancy. The increase in operating expenses due to the above was offset, in part,by a decrease in operating expenses of approximately $1.6 million at the GreatPlains Correctional Facility due to the termination of our management contractwith the OKDOC in April 2007. The remaining net increase in operating expensesof $0.8 million was due to various insignificant fluctuations in operatingexpenses at our other adult secure facilities.

As a percentage of segment revenues, adult secureinstitutional services division operating expenses were 71.0% for the threemonths ended June 30, 2007 compared to 66.7% for the three months endedJune 30, 2006. The increase in the 2007 percentage reflects thestabilization of the operating margin at the Moshannon Valley CorrectionalCenter (which operates under a take-or-pay contract) subsequent to itsactivation in April 2006, as well as the temporary closure of the Great PlainsCorrectional Facility in April 2007.

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses decreased approximately $1.4million, or 5.9%, to $22.4 million for the three months ended June 30, 2007from $23.8 million for the three months ended June 30, 2006 due primarilyto (1) a decrease in operating expenses of approximately $2.3 million atthe Alexander Youth Services Center due to the termination of our managementcontract in January 2007 and (2) a decrease in operating expenses ofapproximately $0.8 million due to the expiration of our management contract atthe SMSTU in June 2006.  The decrease inoperating expenses due to the above was offset, in part, by an increase inoperating expenses of approximately $0.6 million at the Cornell Abraxas Academy(formerly the New Morgan Academy) which we reactivated in October 2006. Theremaining net increase in operating expenses of $1.1 million was due to variousinsignificant fluctuations in operating expenses at our other juvenilefacilities and programs.

 As apercentage of segment revenues, juvenile services division operating expenseswere 83.6% for the three months ended June 30, 2007 compared to 83.0% forthe three months ended June 30, 2006.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses decreasedapproximately $0.6 million, or 4.7%, to $12.1 million for the three monthsended June 30, 2007 from $12.7 million for the three months ended June 30,2006 due to various insignificant fluctuations in operating expenses at ouradult community-based facilities and programs.

As a percentageof segment revenues, adult community-based division operating expenses were71.2% for the three months ended June 30, 2007 compared to 79.8% for the threemonths ended June 30, 2006.

***Pre-Opening and Start-up Expenses.*** Therewere no pre-opening and start-up expenses for the three months ended June 30,2007 and 2006.

***Depreciation and Amortization*****. **Depreciationand amortization expense was approximately $3.9 million and $4.2 million forthe three months ended June 30, 2007 and 2006, respectively. Amortizationof intangibles was approximately $0.6 million for the three months endedJune 30, 2007 and 2006.

***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $1.8 million, or 33.3%, to$7.2 million for the three months ended June 30, 2007 from $5.4 millionfor the three months ended June 30, 2006 due to an increase inlegal and professional expenses and development costs of approximately $1.1million, including approximately $0.5 million of costs related to the MergerAgreement and an increase in stock-based compensation expense of approximately$0.3 million.

***Interest.*** Interest expense, net of interestincome, decreased to approximately $5.9 million for the three months ended June 30,2007 from $6.6 million for the three months ended June 30, 2006.  In the three months ended June 30,2007 and 2006, we recognized interest expense related to the interest rate swapof approximately $0.09 million and $0.1 million, respectively.  At current interest rate levels, we expect toincur additional interest expense under our interest rate swap in futureperiods.  Any additional rise in interestrates would increase our reported interest expense.  In addition, interest expense for thethree months ended June 30, 2007 pertaining to the MCF bonds was approximately$0.2 million lower in the three months ended June 30, 2007 due to a lower 

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outstanding principal balanceduring the 2007 period. Capitalized interest for the three months endedJune 30, 2007 was approximately $0.2 million and related to the facilityexpansion projects at the Big Spring Correctional Center and the D. Ray JamesPrison. We did not capitalize any interest in the three months endedJune 30, 2006.

***Income Taxes.*** For thethree months ended June 30, 2007, we recognized a provision for incometaxes at an estimated effective rate of 43.8%. For the three months ended June 30, 2006, we recognized a provisionfor income taxes on income from continuing operations at an estimated effectiverate of 42.9%.  The change in ourestimated effective tax rate in 2007 was related to an increase in operatingincome across certain of our business segments and apportionment to higher taxrate jurisdictions, as well as an increase in nondeductible equity compensationexpense attributable to certain share based awards.

***SixMonths Ended June 30, 2007 Compared to Six Months Ended June 30, 2006***

***Revenues*****.** Revenues increased approximately $6.8million, or 3.9%, to $181.1 million for the six months ended June 30, 2007from $174.3 million for the six months ended June 30, 2006.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $10.6million, or 12.7%, to $94.3 million for the six months ended June 30, 2007from $83.7 million for the six months ended June 30, 2006 due primarily to(1) an increase in revenues of approximately $9.1 million at theMoshannon Valley Correctional Center which opened in April 2006, (2) anincrease in revenues of approximately $2.1 million at the Donald W. WyattDetention Center due to increased occupancy, (3) an increase in revenues ofapproximately $0.9 million at the Regional Correctional Center due to increasedoccupancy, (4) an increase in revenues of approximately $0.7 million at the D.Ray James Prison due to increased occupancy, (5) revenues of approximately $0.6million at the High Plains Correctional Facility acquired in May 2007, (6) anincrease in revenues of approximately $0.7 million at the Leo Chesney CommunityCorrectional Facility due to increased occupancy and (7) an increase inrevenues of approximately $0.5 million at the Big Spring Correctional Centerdue to increased occupancy. The increase in revenues due to the above wasoffset, in part, by a decrease in revenues of approximately $4.5 million at theGreat Plains Correctional Facility due to the termination of our managementcontract with the OKDOC in April 2007. The remaining net increase in revenuesof $0.5 million was due to various insignificant fluctuations in revenues atour other adult secure facilities.

InJuly 2007, we completed the transition of our management contract at the DonaldW. Wyatt Detention Center to another operator. This contract generated revenuesof approximately $6.8 million and $4.7 million in the six months ended June 30,2007 and 2006, respectively.

Average contract occupancy for the six months endedJune 30, 2007 was 106.0% compared to 95.9% for the six months endedJune 30, 2006.  The increasein average contract occupancy in the six months ended June 30, 2007 was due tothe increased occupancy at the Regional Correctional Center, the D. Ray JamesPrison, the Big Spring Correctional Center and the Moshannon ValleyCorrectional Center.

 The averageper diem rate for our adult secure institutional facilities was $55.18 and$56.34 for the six months ended June 30, 2007 and 2006, respectively.  The decrease in the 2007 average per diemrate was a result of the increased population at the Moshannon ValleyCorrectional Center (as the facility ramped up occupancy subsequent to itsApril 2006 activation) which operates under a take-or-pay contract. There wereno revenues attributable to start-up operations for the six months ended June30, 2007 and 2006.

***Juvenile.***Juvenile justice, educational andtreatment services division revenues decreased approximately $4.4 million, or7.6%, to $53.6 million for the six months ended June 30, 2007 from $58.0million for the six months ended June 30, 2006 due primarily to (1)a decrease in revenues of approximately $4.0 million due to the termination ofour management contract at the Alexander Youth Services Center in January 2007,(2) a decrease in revenues of approximately $1.8 million due the  termination of our management contract forthe SMSTU in June 2006 and (3) a decrease in revenues of approximately $0.9million at the Danville Center for Adolescent Females due to the expiration ofour management contract in March 2006. The decrease in revenues due to the above was offset, in part, by (1) anincrease in revenues of approximately $1.2 million at the LeadershipDevelopment Program due to increased occupancy and (2) revenues ofapproximately $0.9 million at the Cornell Abraxas Academy (formerly the NewMorgan Academy) which we reactivated in October 2006. The remaining netincrease in revenues of $0.2 million was due to various insignificantfluctuations in revenues at our other juvenile facilities and programs.

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InJuly 2007, we were notified that the funding for our Harrisburg AlternativeEducation Program was discontinued for the 2007-2008 school year. This programgenerated revenues of approximately $1.8 million and $1.2 million in the sixmonths ended June 30, 2007 and 2006, respectively.

Average contract occupancy was 93.6% and 91.8% forthe six months ended June 30, 2007 and 2006, respectively. The average perdiem rate for our residential juvenile facilities was $169.23 and $168.89 forthe six months ended June 30, 2007 and 2006, respectively.  The average fee-for-service rate for ournon-residential juvenile community-based facilities and programs was $44.30 and$35.63 for the six months ended June 30, 2007 and 2006, respectively. Theincrease in the average fee-for-service rate for 2007 was due to changes in themix of services provided by our various non-residential juvenile facilities andprograms. There were no revenues attributable to start-up operations forthe six months ended June 30, 2007 and 2006.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division revenues increased approximately$0.7 million, or 2.1%, to $33.3 million for the six months ended June 30,2007 from $32.6 million for the six months ended June 30, 2006 due tovarious insignificant fluctuations in revenues at our adult community-based correctionsand treatment facilities and programs.

Average contract occupancy for the six months endedJune 30, 2007 was 100.9% compared to 97.3% for the six months endedJune 30, 2006.  The average per diemrate for our residential adult community-based facilities was $62.08 and $61.87for the six months ended June 30, 2007 and 2006, respectively.   The average fee-for-service rate for ournon-residential adult community-based programs was $14.69 and $8.75 for the sixmonths ended June 30, 2007 and 2006, respectively. The increase in theaverage fee-for-service rate for 2007 was due to changes in the mix of servicesprovided by our various non-residential adult community-based facilities andprograms. There were no revenues attributable to start-up operations for thesix months ended June 30, 2007 and 2006.

***Operating Expenses.***Operating expenses increased approximately $5.7 million, or 4.3%, to $138.0 millionfor the six months ended June 30, 2007 from $132.3 million for the sixmonths ended June 30, 2006.

***Adult Secure.***Adultsecure institutional services division operating expenses increased approximately$9.8 million, or 17.3%, to $66.5 million for the six months ended June 30,2007 from $56.7 million for the six months ended June 30, 2006 due to(1) an increase in operating expenses of approximately $6.7 millionat the Moshannon Valley Correctional Center which opened in April 2006, (2) anincrease in operating expenses of approximately $2.1 million at the Donald W.Wyatt Detention Center due to increased occupancy, (3) an increase in operatingexpenses of approximately $1.6 million at the Regional Correctional Center dueto increased occupancy and (4) operating expenses of approximately $0.7 millionat the High Plains Correctional Facility acquired in May 2007.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of approximately$1.8 million at the Great Plains Correctional Facility due to the terminationof our management contract with the OKDOC in April 2007. The remaining netincrease in operating expenses of $0.5 million was due to various insignificantfluctuations in operating expenses at our other adult secure facilities.

As a percentageof segment revenues, adult secure institutional services division operatingexpenses were 70.5% for the six months ended June 30, 2007 compared to 67.7%for the six months ended June 30, 2006. The decrease in the 2007 operatingmargin reflects the stabilization of the operating margin at the MoshannonValley Correctional Center (which operates under a take-or-pay contract)subsequent to its activation in April 2006, as well as the temporary closure ofthe Great Plains Correctional Facility in April 2007.

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses decreased approximately $3.7million, or 7.4%, to $46.1 million for the six months ended June 30, 2007from $49.8 million for the six months ended June 30, 2006 due primarily to(1) a decrease in operating expenses of approximately $3.7 milliondue to the termination of our management contract at the Alexander YouthServices Center in January 2007, (2) a decrease in operating expenses ofapproximately $1.6 million at the SMSTU due to the expiration of our managementcontract in June 2006 and (3) a decrease in operating expenses of approximately$0.8 million at the Danville Center for Adolescent Females due to theexpiration of our management contract in March 2006.  The decrease in operating expenses due to theabove was offset, in part, by an increase in operating expenses of approximately$1.1 million at the Cornell Abraxas Academy (formerly the New Morgan Academy)which we reactivated in October 2006. The remaining net increase in operatingexpenses of $1.3 million was due to various insignificant fluctuations inoperating expenses at our other juvenile facilities and programs.

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As a percentageof segment revenues, juvenile services division operating expenses were 86.0%and 85.9% for the six months ended June 30, 2007 and 2006, respectively.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses decreasedapproximately $0.4 million, or 1.6%, to $25.4 million for the six months endedJune 30, 2007 from $25.8 million for the six months ended June 30,2006 due to various insignificant fluctuations in operating expense atour adult community-based facilities and programs. As a percentage of segment revenues, adult community-based correctionsand treatment services division operating expenses were 76.2% for the sixmonths ended June 30, 2007 compared to 79.1% for the six months endedJune 30, 2006.

***Pre-Opening and Start-up Expenses.*** Therewere no pre-opening and start-up expenses in the six months ended June 30,2007. Pre-opening and start-up expenses for the six months ended June 30,2006 were approximately $2.7 million and were attributable to the pre-openingactivities of the Moshannon Valley Correctional Center.

***Depreciation and Amortization*****.** Depreciation and amortization expense wasapproximately $7.8 million and $7.9 million for the six months ended June 30,2007 and 2006, respectively. Amortization of intangibles was approximately $1.1 million for the sixmonths ended June 30, 2007 and 2006.

***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $4.9 million, or 46.2%, to $15.5million for the six months ended June 30, 2007 from $10.6 million for thesix months ended June 30, 2006 due primarily to (1) thereimbursement of approximately $2.5 million of costs to Veritas related to theMerger Agreement, (2) an increase in legal and professional fees anddevelopment costs including approximately $1.2 million of costs related to theMerger Agreement and (3) an increase in stock-based compensation expense ofapproximately $0.1 million.

***Interest.*** Interest expense, net of interestincome, increased to approximately $12.6 million for the six months ended June 30,2007 from $11.6 million for the six months ended June 30, 2006.  For the six months ended June 30, 2007 and2006, we recognized interest expense related to the interest rate swap ofapproximately $0.1 million and $0.04 million, respectively.  At current interest rate levels, we expect toincur additional interest expense under our interest rate swap in futureperiods.  Any additional rise in interestrates would increase our reported interest expense. For the six months endedJune 30, 2007, we capitalized interest of approximately $0.2 million related tothe facility expansion projects at the Big Spring Correctional Center and theD. Ray James Prison. For the six months ended June 30, 2006, we capitalizedinterest of approximately $1.5 million related to  construction of the MoshannonValley Correctional Center.

***Income Taxes.*** For thesix months ended June 30, 2007, we recognized a provision for income taxesat an estimated effective rate of 43.9%. For the six months ended June 30, 2006, we recognized a provisionfor income taxes on our income from continuing operations at an estimatedeffective rate of 43.2%.

**Liquidity andCapital Resources**

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

***Cash Flows From Operating Activities.***  Cash provided by operations was approximately$17.8 million for the six months ended June 30, 2007 compared to $10.8million for the six months ended June 30, 2006.  The increase is principally due to areduction in accounts receivable due to timing of collections.

***Cash Flows From Investing Activities*****. **Cash usedin investing activities was approximately $26.0 million for the six monthsended June 30, 2007 due to the purchase of the High Plains Correctional Centerin May 2007 for approximately $8.9 million, capital expenditures ofapproximately $15.0 million related primarily to the expansion projects at theBig Spring Correctional Center and the D. Ray James Prison and net payments tothe restricted debt payment account of approximately $5.5 million.  Additionally, we had net sales of investmentsecurities of approximately $3.5 million. Cash used in investing activities wasapproximately $17.1 million for the six months ended June 30, 2006 due to netpurchases of investment securities of approximately $1.7 million, capitalexpenditures of approximately $9.1 million and net payments to the restricteddebt payment account of approximately $6.3 million.

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***Cash Flows From Financing Activities*****. **Cashprovided by financing activities was approximately $2.5 million for the sixmonths ended June 30, 2007 due primarily to the proceeds from stock optionexercises and the related tax benefit. For the six months ended June 30, 2006,cash provided by financing activities was approximately $1.7 million dueprimarily to proceeds from the exercise of stock options and the related tax benefit.

***Treasury Stock Repurchases.***  We did not purchase any of our common stockin the six months ended June 30, 2007 and 2006.

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $49.7 million at June 30, 2007.  We had no outstanding borrowings on ourCredit Facility at June 30, 2007, but we had outstanding letters of credit ofapproximately $10.3 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder our Credit Facility up to an aggregate amount of $100.0 million.  Our Credit Facility matures in June 2008 andbears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants. We believe that we will be able to maintain a revolvingline of credit (either through extension or replacement) at the maturity of ourexisting Credit Facility.

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

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes (the “SeniorNotes”) due July 1, 2012.  The SeniorNotes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of each year,commencing January 1, 2005.  On or afterJuly 1, 2008, we may redeem all or a portion of the Senior Notes at theredemption prices (expressed as a percentage of the principal amount) listedbelow, plus accrued and unpaid interest, if any, on the Senior Notes redeemed,to the applicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:
| Year                | ** ** | **Percentages** | ** ** |
|---------------------|------------|-----------------|------------|
| 2008                |       | 105.375         | %          |
| 2009                |       | 102.688         | %          |
| 2010 and thereafter |       | 100.000         | %          |

 

Uponthe occurrence of specified change of control events, unless we have exercisedour option to redeem all the Senior Notes as described above, each holder willhave the right to require us to repurchase all or a portion of such holder’sSenior Notes at a purchase price in cash equal to 101% of the aggregateprincipal amount of the notes repurchased plus accrued and unpaid interest, ifany, on the Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to paydividends or other payments to us, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

Inconjunction with the issuance of the Senior Notes, we entered into an interestrate swap transaction with a financial institution to hedge our exposure tochanges in the fair value on $84.0 million of our Senior Notes.  The purpose of this transaction was toconvert future interest due on $84.0 million of the Senior Notes to a variablerate.  The terms of the interest rateswap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  

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Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and six months ended June 30, 2007, we recorded interest expense relatedto this interest rate swap of approximately $0.09 million and $0.1 million,respectively, which is reflected as interest expense in the accompanyingfinancial statements.  For the three andsix months ended June 30, 2006, we recorded interest expense related to thisinterest rate swap of approximately $0.1 million and $0.4 million,respectively, which is reflected as interest expense in the accompanyingfinancial statements.  The swap agreementsare marked to market each quarter with a corresponding mark-to-marketadjustment reflected as either a discount or premium on the Senior Notes. AtJune 30, 2007 and December 31, 2006, the fair value of this derivativeinstrument was approximately ($2.1) million and ($1.1) million, respectively,and is included in other long-term liabilities in the accompanying financialstatements. The carrying value of the Senior Notes as of these dates wasreduced by the same amount. Because the swap agreement is an effectivefair-value hedge, there is no effect on our results of operations from themark-to-market adjustment as long as the swap is in effect.

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

***Regional Correctional Center. ***In January 2003, we executeda five-year lease for the 970 bed Regional Correctional Center in Albuquerque,New Mexico. In July 2007, we were notified by Immigration and CustomsEnforcement (“ICE”) that it was removing all ICE detainees at the facility. Revenuesfor this facility were approximately $9.7 million and $8.8 million in the sixmonths ended June 30, 2007 and 2006, respectively. The net carrying value ofthis facility was approximately $4.4 million and $5.3 million at June 30, 2007and December 31, 2006, respectively. At June 30, 2007, the facility held 873detainees and had operated at its service capacity during the six months endedJune 30, 2007. Our lease for this facility requires monthly rent payments ofapproximately $0.13 million for the remaining three year term of the lease. Todate we do not have an alternative customer for this facility. Our inability toobtain a new customer for this facility could have an adverse effect on ourfinancial condition, results of operations and liquidity.

***Cornell Abraxas Academy (formerly the NewMorgan Academy).*** We closed the Cornell Abraxas Academy (formerly the New Morgan Academy)in the fourth quarter of 2002. The facility, which we reactivated in October 2006,operates as a residential treatment facility for youth sex offenders. The net carrying value of the property andequipment for this facility was approximately $19.3 million and $19.5 millionat June 30, 2007 and December 31, 2006, respectively. We believe that,pursuant to the provisions of SFAS No. 144, no impairment to the carrying valueof this facility has occurred.

***Great Plains Correctional Facility.*** We believe that our existing contract with theOklahoma Department of Corrections (“OKDOC”) with respect to our leased GreatPlains Correctional Facility expired in July 2006. Despite negotiations withOKDOC since early 2006, we were unable to agree on terms for a newcontract.  As a result, to preserve ourrights relative to other business opportunities, in October 2006 the HintonEconomic Development Authority notified OKDOC of our intent to terminate thecontract.  Effective April 1, 2007, thefacility was vacant. At our Great Plains Correctional Facility, as with all ourfacilities, we seek to maximize the operating potential based on an assessmentof which potential customer(s) would enable us to realize the highest economicvalue. This facility generated revenues of approximately $3.2 million in thethree months ended June 30, 2006 (none in the three months ended June 30,2007), and approximately $1.9 million and $6.4 million in the six months endedJune 30, 2007 and 2006, respectively. The net carrying value of this facility was approximately $35.6 millionand $36.1 million at June 30, 2007 and December 31, 2006, respectively. As itis our intent to reactivate this facility, the operations of this facility hasnot been reported as discontinued operations. In May 2007, we were awarded acontract by the Arizona Department of Corrections to house 2,000medium-security inmates at this facility. The anticipated start date of thecontract is expected to occur in the third quarter of 2007. We believe that noimpairment to the carrying value of this facility has occurred.

***Hector Garza Residential Treatment Center(formerly the Campbell Griffin Treatment Center).***  In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas.  It is our intent to reactivate this facilityduring the second half of the year ending December 31, 2007. Accordingly, ithas not been reported as discontinued operations.  Our net carrying value for this facility atJune 30, 2007 and December 31, 2006 was approximately $4.2 million. We believethat no impairment has occurred. Our inability to obtain a new customer forthis facility could have an adverse effect on our financial condition, resultsof operations and liquidity.

***Future Liquidity*****.**Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts. To the extent our cash and current financing arrangements do notprovide sufficient financing to fund construction costs related to future adultsecure 

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institutional contract awards or significantfacility expansions, we anticipate obtaining additional sources of financing tofund such activities. However, there can be no assurance that such financingwill be available or will be available on terms favorable to us.

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

We maintain operating leases in theordinary course of our business activities. These leases include those for operating facilities, office space andoffice and operating equipment, and the terms of these agreements range from2006 until 2075.  As of June 30,2007, our total commitment under these operating leases was approximately $26.9million.

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The followingtable details our known future cash payments (on an undiscounted basis) relatedto various contractual obligations as of June 30, 2007 (in thousands):
|                                                       | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008 -   2009** | ** ** | **2010 -   2011** | ** ** | **Thereafter** | ** ** |
|                                                  |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                             |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                            |       |                                      |       |   |   |   |   |   |   |   |   |
| ·   Cornell  Companies, Inc. |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| ·   Special  Purpose Entities     |       | 156,000                                   |       | 10,500 |   | 23,800 |   | 28,000 |   | 93,700 |   |
| Long-term debt - interest (1)                         |       |                                      |       |   |   |   |   |   |   |   |   |
| ·   Cornell  Companies, Inc. |       | 61,794                                    |       | 6,213 |   | 24,723 |   | 24,697 |   | 6,161 |   |
| ·   Special  Purpose Entities     |       |                                      |       |   |   |   |   |   |   |   |   |
| Construction  commitments                             |       | 16,408                                    |       | 16,408 |   | — |   | — |   | — |   |
| Capital lease  obligations                            |       |                                      |       |   |   |   |   |   |   |   |   |
| ·   Cornell  Companies, Inc. |       | 42                                        |       | 10 |   | 32 |   | — |   | — |   |
| Operating leases                                      |       | 26,899                                    |       | 2,988 |   | 10,093 |   | 4,864 |   | 8,954 |   |
| Consultative and  non-competition agreements          |       | 534                                       |       | 534 |   | — |   | — |   | — |   |
| Total contractual cash  obligations                   |       | $                                         | 373,677    |   | $ | 36,653 |   | $ | 58,648 |   | $ | 57,561 |   | $ | 220,815 |   |

 

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(1)          We have an interest rateswap agreement under which we receive a fixed interest rate and pay a floatinginterest rate. The future cash payments on the Cornell Companies, Inc.long-term debt — interest assume an effective rate of 10.96% on the relatedinterest rate swap contract. An increase in the six-month U.S. dollar LIBORrate would increase future interest payments as required under thisarrangement.

We enter intoletters of credit in the ordinary course of our operating and financingactivities.  As of June 30, 2007, wehad outstanding letters of credit of approximately $10.3 million related toinsurance and other operating activities. The following table details our letter of credit commitments as of June 30,2007 (in thousands):
|                           | ** ** | **Total**              | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                | ** ** | **Amounts  Committed** | ** ** | **Less than  1 Year**                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **Over  5 Years** | ** ** |
|                      |       |                   |       |                                                                    |       |   |   |   |   |   |   |
| Commercial Commitments:   |       |                   |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of credit |       | $                      | 10,251     |                                                                    | $          | 9,501 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                           |            |                        |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Forward-Looking Statements**

The statements includedin this quarterly report regarding future financial performance, expectedfuture actions and activities, results of operations and other statements thatare not historical facts are forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of the SecuritiesExchange Act of 1934 as amended (the “Exchange Act”).  Statements to the effect that we or management“anticipates,” “believes,” “budgets,” “estimates,” “expects,” “forecasts,” “intends,”“plans,” “predicts,” or “projects” a particular result or course of events, orthat such result or course of events “could,” “might,” “may,” “scheduled” or “should”occur, and similar expressions, are also intended to identify forward-lookingstatements. Forward-looking statements in this quarterly report include, butare not limited to, revenues, revenue mix, expenses, personnel costs, operatingmargins, financial results, liquidity, working capital requirements, pricing,per diem rates, utilization, increasing number of parolees and inmates,effectiveness of our strategy, capital requirements, capital expenditures, ourcontract from the Arizona Department of Corrections for our Great PlainsCorrectional Facility, operations at and results from our Regional CorrectionalCenter, planned projects, expansions, the timing and cost of completion ofcapital projects, including without limitation the D. Ray James Prison and BigSpring Correctional Center expansions, performance of acquired facilities andbusinesses, demand, supply, customer programs, contract commencements, futureactivity and market outlook in our various market sectors, debt levels andother uses of excess cash, our effective tax rate, changes in laws and 

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regulations, the effect of FIN No. 48, results andeffects of legal proceedings and governmental audits and assessments, adequacyof insurance, adequacy of cash flow for our obligations, effects of accountingchanges and adoption of accounting policies. Such statements are subject tonumerous risks, uncertainties and assumptions, including, but not limited to,those described in “Item 1A. Risk Factors” included in our Annual Report onForm 10-K for the year ended December 31, 2006 and other factors discussed inthis quarterly report and in our other filings with the SEC, which areavailable free of charge on the SEC’s website at www.sec.gov. Should one ormore of these risks or uncertainties materialize, or should underlyingassumptions prove incorrect, actual results may vary materially from thoseindicated. All subsequent written and oral forward-looking statementsattributable to us or to persons acting on our behalf are expressly qualifiedin their entirety by reference to these risks and uncertainties. You should notplace undue reliance on forward-looking statements. Each forward-lookingstatement speaks only as of the date of the particular statement, and weundertake no obligation to publicly update or revise any forward-lookingstatements.

**ITEM 3.          Quantitativeand Qualitative Disclosures about Market Risk**

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

**Interest Rate Exposure**

Our exposure tochanges in interest rates primarily results from our long-term debt with bothfixed and floating interest rates.  Thedebt on our consolidated financial statements with fixed interest ratesconsists of the 8.47% Bonds issued by MCF in August 2001 in connectionwith the 2001 Sale and Leaseback Transaction and approximately $28.0 million ofthe Senior Notes (not hedged by the interest rate swap entered into by theCompany).  At June 30, 2007, 31.7%($84.0 million of debt outstanding on the Senior Notes issued in June 2004)of our consolidated long-term debt was subject to variable interest rates.  The detrimental effect of a hypothetical 100basis point increase in interest rates would be to reduce income beforeprovision for income taxes by approximately $0.2 million and $0.4 million forthe three and six months ended June 30, 2007.  At June 30, 2007, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

**ITEM 4.          Controlsand Procedures**

**Evaluation of Disclosure Controls and Procedures**

We maintain disclosure controls and proceduresdesigned to provide reasonable assurance that information disclosed in ourannual and periodic reports is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’srules and forms. In addition, we designed these disclosure controls andprocedures to ensure that this information is accumulated and communicated tomanagement, including the chief executive officer (CEO) and chief financialofficer (CFO), to allow timely decisions regarding required disclosures. SECrules require that we disclose the conclusions of our CEO and CFO aboutthe effectiveness of our disclosure 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 disclosurecontrols and procedures must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitation in a cost-effective control system,misstatements due to error or fraud could occur and not be detected.

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

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**Changes in Internal Control over Financial Reporting**

In connection withthe evaluation as required by paragraph (d) of Rules 13a-15 and 15d-15 of theExchange Act, we have not identified any change in our internal control overfinancial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under Exchange Act) during our fiscal quarter endedJune 30, 2007 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

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**PART II****                          ****OTHER INFORMATION**
| **ITEM 1.**  | ** ** | **Legal Proceedings.**                                                                                                                                                                                            |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                                                                                                                                        |
|         |       | See Part I, Item 1. Note 9 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, 2006 are  incorporated herein by this reference. There are no material changes to such  risk factors. |
|         |       |                                                                                                                                                                                                              |
| **ITEM 2.**  | ** ** | **Unregistered Sales of Equity Securities and Use  of Proceeds.**                                                                                                                                                 |
|         |       |                                                                                                                                                                                                              |
|         |       | None.                                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                              |
| **ITEM 3.**  | ** ** | **Defaults Upon Senior Securities.**                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                              |
|         |       | None.                                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                              |
| **ITEM 4.**  | ** ** | **Submission of Matters to a Vote of Security  Holders.**                                                                                                                                                         |
|         |       |                                                                                                                                                                                                              |
|         |       | On June 14, 2007, the Company held its 2007 Annual Meeting  of Stockholders.  The matters voted on  at the meeting and the results thereof were as follows:                                             |
|         |       |                                                                                                                                                                                                              |
|         |       | 1. Stockholders elected the persons listed below as directors  whose terms expire at the 2008 Annual      Meeting of Stockholders.   Results by nominee were:                            |

 
|                            | ** ** | **Voted For** | ** ** | **Authority  Withheld** | ** ** |
|----------------------------|------------|--------------------|------------|-------------------------|------------|
|                       |       |               |       |                    |       |
| Max Batzer                 |       | 13,207,162         |       | 177,829                 |       |
| Anthony R. Chase           |       | 12,975,533         |       | 409,458                 |       |
| Richard Crane              |       | 12,870,351         |       | 514,640                 |       |
| Zachary R. George          |       | 12,872,996         |       | 511,995                 |       |
| Todd Goodwin               |       | 12,869,940         |       | 515,051                 |       |
| James E. Hyman.            |       | 12,952,882         |       | 432,109                 |       |
| Andrew R. Jones.           |       | 13,208,120         |       | 176,871                 |       |
| Alfred Jay Moran, Jr. |       | 12,872,220         |       | 512,771                 |       |
| D. Stephen Slack           |       | 12,977,807         |       | 407,184                 |       |

 
|        |       | 2. Stockholders ratified the appointment of  PricewaterhouseCoopers LLP as the Company’s independent registered public  accounting firm for the fiscal year ending December 31, 2007 with  13,381,329 shares voted for,  2,719  shares voted against and 943 shares abstained. |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                          |
| **ITEM 5.** | ** ** | **Other Information.**                                                                                                                                                                                                                                                                        |
|        |       |                                                                                                                                                                                                                                                                                          |
|        |       | None.                                                                                                                                                                                                                                                                                         |
|        | ** ** | ** **                                                                                                                                                                                                                                                                                    |

 
| ** ITEM 6.** | ** ** | **Exhibits.** |   |                                                       |
|-------------------|------------|---------------|--------|------------------------------------------------------------|
| ** **        |       |          |   |                                                       |
| ** **        |       | 31.1*         |   | Section 302 Certification of Chief Executive  Officer |
| ** **        |       | 31.2*         |   | Section 302 Certification of Chief Financial  Officer |
| ** **        |       | 32.1*         |   | Section 906 Certification of Chief Executive  Officer |
| ** **        |       | 32.2*         |   | Section 906 Certification of Chief Financial  Officer |

 

----

*              Filed herewith.

 

44

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**SIGNATURES**

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|                                                  | ** ** | **CORNELL COMPANIES,  INC.**           |
|--------------------------------------------------|------------|----------------------------------------|
|                                             |       |                                   |
|                                             |       |                                   |
| Date:    August 9, 2007 | By:        | /s/ James E. Hyman                     |
|                                             |       | JAMES E. HYMAN                         |
|                                             |       | Chief Executive Officer,               |
|                                             |       | President and Chairman of the Board    |
|                                             |       | (Principal Executive Officer)          |
|                                             |       |                                   |
|                                             |       |                                   |
| Date:    August 9, 2007      | By:        | /s/ John R.  Nieser                    |
|                                             |       | JOHN R. NIESER                         |
|                                             |       | Chief Financial  Officer and Treasurer |
|                                             |       | (Principal  Financial Officer)         |

 

45

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